Navigating the tax implications of convertible loan notes in life sciences

In this guest blog, Catherine Hsu, Managing Director, and Steve Cardosi, Senior Director, both in FTI Consulting's corporation tax department, discuss Convertible Loan Notes (CLNs), a popular, flexible funding option for life sciences companies, but say their hybrid debt-equity nature can create complex accounting treatments (including fair value volatility) that directly drive challenging tax outcomes.

Convertible Loan Notes (CLNs) have become an increasingly popular financing tool for life science companies, offering a faster and more flexible alternative to traditional equity rounds. By allowing companies to secure funding without immediately diluting ownership or committing to rigid terms, CLNs provide a valuable bridge during critical growth phases. However, their hybrid nature, combining debt and equity characteristics, introduces significant accounting and tax complexities that require careful consideration.

Understanding the accounting challenge

The dual structure of CLNs creates unique accounting requirements. Because they contain both a loan element and an option to convert into shares, the conversion feature may be treated as an embedded derivative requiring fair value assessment at each reporting date. Under IFRS or FRS 102, companies may need to bifurcate the instrument, separating the loan from its derivative component. These fair value movements flow through the income statement, potentially creating volatility in reported results.

Tax treatment considerations

The tax implications of CLNs depend heavily on their accounting treatment. While loan elements typically fall under loan relationship rules – making profits and losses taxable or deductible – bifurcated instruments which have been separated into their loan and derivative component introduce additional complexity. The embedded derivative component may be taxed under derivative contract provisions, with fair value movements potentially treated as non-taxable depending on circumstances.

Interest deductibility and recharacterisation

A critical consideration involves interest payments. Unless CLNs are listed on a recognised stock exchange or have comparable terms, they may be classified as "special securities," causing interest to be recharacterised as distributions. This recharacterisation eliminates tax deductibility which could result in a significant cost that can catch companies off guard. Additionally, cross-border interest payments may trigger 20% withholding tax obligations, though double tax treaties may provide relief.

Impact on R&D tax credits

Perhaps most overlooked is how CLNs affect R&D tax credit claims. Under the Enhanced Research and Development Intensive Support scheme (ERIS), companies must maintain R&D expenditure at 30% of total group expenditure. Large fair value movements or foreign exchange adjustments from CLN revaluations can inadvertently push companies below this threshold, disqualifying them from enhanced rates. Furthermore, the broad definition of "control" in R&D legislation may inadvertently include convertible loan holders, further complicating eligibility calculations.

While CLNs offer valuable financing flexibility, life science companies must thoroughly understand their tax implications before proceeding. Engaging with advisors early ensures that companies can structure these instruments appropriately, avoiding unexpected tax liabilities and preserving valuable R&D incentives that are crucial to innovation-driven growth.

This is a guest blog. Its author is responsible for content within it, which does not necessarily reflect the opinions or positions of BIA.