By Neo Penn, Director & Jess Fung, Associate from Webber Wentzel

Convertible preference shares (convertible prefs) are gaining traction as a flexible financing tool for companies looking to raise capital while offering investors a hybrid position—part protection, part upside. With preferential dividends and the option to convert into ordinary shares, they appeal to a wide range of investors, including private equity firms, venture capitalists and strategic stakeholders.

However, beyond their commercial appeal lies a complex layer of tax treatment. One key area that investors often overlook is the potential consequences of capital gains tax (CGT) tied to the conversion of these instruments.

What are convertible prefs?

Convertible prefs are generally preference shares that grant holders the right to convert into ordinary shares of the issuing company. This conversion can shift the investor's interest from a fixed-income-like position to a fully participatory equity interest, often with voting rights and exposure to company growth.

They are designed to offer downside protection with the upside potential of equity, making them especially attractive in growth-oriented deals.

When is CGT triggered?

In terms of the Income Tax Act^[1], for CGT to apply, two conditions must be met:

• there must be a disposal of an asset;  and
• the proceeds from such a disposal must exceed the base cost of that asset.

The pivotal question is whether the act of converting convertible prefs into ordinary shares qualifies as a disposal event for CGT purposes. This often depends largely on the terms of conversion.

Fixed vs contingent conversion: Why the details matter?

Fixed conversion can be defined as when conversion occurs automatically at a predetermined time or follows a predefined schedule without any dependencies. In that case, the conversion is not regarded as triggering a CGT disposal event. Consequently, no CGT should be triggered for the investor.

Contingent conversion is when conversion depends on uncertain future events, such as a change in control, achieving performance targets or receiving regulatory approval. In this case, the conversion may be deemed as a disposal, which could trigger CGT for the investor.

NB: This distinction can make a significant difference to the effective yield on an investment, yet it is often one of the most easily overlooked factors in legal documentation.

Key takeaway for investors

Before committing to convertible prefs, it is essential to:

• review the conversion clauses carefully and pay particular attention to any contingencies;
• engage tax advisers early in the structuring process;
• model potential CGT outcomes to assess post-tax returns; and
• ensure that legal and tax interpretations are aligned.

Convertible prefs can be a valuable addition to an investment strategy, which offers a blend of security and growth potential. However, the tax implications, especially the CGT consequences linked to how and when conversion takes place, should not be underestimated. By paying close attention to the details in the conversion terms and seeking specialist advice upfront, investors can better manage risks, avoid unexpected tax costs and maximise the overall benefit of these hybrid instruments.