Introduction: Convertible Loan Notes Seen From Both Sides of the Atlantic
Convertible loan notes are the most common way to back a British start-up before it agrees a valuation, and for an American investor they create two tax systems that disagree on almost every point. The UK legal guides explain discounts, valuation caps and maturity dates. The US guides explain original issue discount. However, not one of the leading pages explains what happens when an American in London, or an American lending from New York, holds a note issued by a UK company.
That gap matters for wealthy investors. A London-based investment banker or founder can easily hold six or seven notes across a portfolio. Each of those convertible loan notes can produce taxable income in America years before Britain taxes anything. Furthermore, each note can trigger a US information return that most UK start-ups have never heard of. As a result, many angel investors discover the problem only when an accountant asks for a Form 1099-OID that the company will never send.
At TaxYork, we prepare US and UK returns for investors who hold convertible loan notes in British companies. This guide sets out the US interest rules, the UK capital gains position, the timing mismatch between them, the reporting duties, and a worked case study with real numbers.
How Convertible Loan Notes Work for American Investors
What Convertible Loan Notes Are
Convertible loan notes are loans to a company that convert into shares at a later funding round instead of being repaid in cash. A typical British note carries simple interest of six to ten per cent a year, rolled up rather than paid. It usually converts at a discount of fifteen to twenty-five per cent to the next round's price, often subject to a valuation cap. If no round happens before the maturity date, the investor can normally demand repayment or convert at a fixed price.
The Investopedia guide to convertible notes describes the same commercial structure that US founders use. In Britain, however, the instrument sits inside a different legal and tax framework. Consequently, the same piece of paper can be debt in one country and something closer to equity in the other.
Why Founders Prefer Them Over a Priced Round
Founders like convertible loan notes because they postpone the valuation debate. They are quicker and cheaper to document than a full share subscription. Moreover, they let a company bridge to its Series A without resetting the cap table. Investors accept convertible loan notes because the discount and the cap reward early risk.
For an American, though, that convenience comes with a tax price. The US treats the note as debt until conversion, so interest accrues for US purposes every year. Meanwhile, the UK usually taxes nothing until cash or shares change hands. Therefore, the commercial delay that founders want becomes a tax timing gap for you.
Convertible Notes, ASAs and SAFEs Compared
British companies also raise money through advance subscription agreements. An ASA is a payment for shares to be issued later, with no interest and no right to repayment. HMRC's guidance on advance subscription agreements makes clear that a payment which is in effect a loan will not qualify for the venture capital reliefs. In contrast, a SAFE is a US invention with no settled UK treatment. Each of these instruments is taxed differently in America, so you should identify exactly what you signed before you prepare any return.
US Tax on Convertible Loan Notes Before Conversion
Original Issue Discount Accrues Every Year
The most expensive surprise for American holders of convertible loan notes is that rolled-up interest is taxed as it accrues. Interest that is not payable at least once a year is not "qualified stated interest" under the US rules. Instead, it becomes original issue discount, and you must include it in income each year on a constant yield basis. Your method of accounting does not matter, because a cash-basis individual still includes OID annually.
The IRS explains the mechanics in Publication 1212 on original issue discount instruments. A US company would send you a Form 1099-OID each January. A British start-up will not. Accordingly, you must calculate the accrual yourself, translate it into dollars and report it as interest income on your Form 1040. In our experience, this is the single most common source of missed income on the returns of London-based angel investors.
The Contingent Payment Rules Usually Do Not Apply
Many advisers assume that a note with a discount and a cap must be a contingent payment debt instrument. That would bring in far more complex projected-yield rules. Fortunately, the regulation answers the question directly. Treasury Regulation 1.1275-4(a)(4) states that a debt instrument does not provide for contingent payments merely because it can convert into stock of the issuer.
Therefore, a standard UK note that converts into the issuer's own shares stays outside the contingent payment regime. However, unusual features can change that answer. A note that pays a multiple of principal on a sale of the company, or that converts into shares of a parent company, deserves a closer look.
Currency Rules on a Sterling Note
Almost all British convertible loan notes are denominated in sterling. For a US taxpayer, holding a debt instrument in a foreign currency brings it within section 988. You accrue the OID in pounds and translate it at the average rate for each year. Subsequently, when the principal is repaid or the note is sold, any movement in the exchange rate on the principal produces an ordinary currency gain or loss.
That rule cuts both ways. A weaker pound between issue and repayment gives you an ordinary loss. A stronger pound gives you ordinary income that Britain does not tax at all. As a result, there may be no UK tax available to credit against it.
What Happens When Convertible Loan Notes Convert
Conversion Is Generally Tax-Free in America
The good news on the US side is that conversion itself is not normally a taxable event. When convertible loan notes convert into shares of the same company, you exchange debt for equity without recognising gain. That remains true even when the shares are worth far more than the principal, which is the whole point of the discount and the cap. The IRS has accepted this treatment for decades, starting with Revenue Ruling 72-265.
Your basis in the new shares equals your basis in the note, increased by all OID you have already included in income. Moreover, your holding period in the shares includes the time you held the note. That tacked holding period often turns a later sale into a long-term capital gain from day one.
Accrued Interest Paid in Shares
Shares issued in satisfaction of accrued interest are a different matter. If you have already included that interest as OID, there is no further charge, because your basis already reflects it. If you have not, the value of the shares attributable to the interest is taxable as interest income in the year of conversion. Consequently, an investor who missed the annual OID accruals often faces a single large interest charge on conversion, together with amended returns for the earlier years.
Cash paid for fractional shares is treated as a sale of that fraction. That usually produces a small capital gain or loss.
No QSBS and No Section 1244
American founders and angels often rely on section 1202, which can exclude gain on qualified small business stock. Section 1202 applies only to stock of a domestic C corporation. A UK private limited company can never qualify, whatever its size or trade. Similarly, section 1244 ordinary loss treatment requires a domestic corporation, a point we explain in our guide to section 1244 stock in a UK company. Therefore, the US planning tools that make start-up investing attractive at home simply disappear for a British investee.
UK Tax on Convertible Loan Notes
Why the Notes Are Not Qualifying Corporate Bonds
The UK starts from a different question: is the note a qualifying corporate bond? A QCB is exempt from capital gains tax, so neither gains nor losses count. However, a QCB must represent a "normal commercial loan" at all times. HMRC's Capital Gains Manual at CG53705 confirms that, for QCB purposes, a loan cannot carry a right to convert into shares.
Consequently, convertible loan notes issued by unquoted start-ups are almost always non-QCBs. That makes them chargeable assets. A sale of the note before conversion produces a chargeable gain or an allowable loss. Furthermore, if the company fails, the loss is a capital loss you can use, which a QCB holder would never receive.
Conversion as a Reorganisation
When a non-QCB note converts into shares, UK law treats the conversion as a reorganisation under section 132 of the Taxation of Chargeable Gains Act 1992. There is no disposal. Instead, the shares stand in the shoes of the note and inherit its base cost. That broadly matches the US answer for the principal, which is helpful.
The interest is where the two systems part company. Britain taxes interest when it is paid, and HMRC treats interest satisfied by issuing shares as paid. You therefore pay UK income tax on the whole rolled-up amount in the tax year of conversion. The savings rates are 20%, 40% and 45% for 2026/27, rising to 22%, 42% and 47% from April 2027.
Withholding on Interest Paid by a UK Company
A UK company that pays yearly interest to an individual must deduct income tax at source under section 874 of the Income Tax Act 2007. The rate is 20% today and rises to 22% from April 2027. For an American living in Britain, the deduction is simply a payment on account against the final liability. For an investor living in America, Article 11 of the US-UK tax treaty reduces UK tax on interest to zero.
That treaty relief is not automatic. The company needs an HMRC direction, which in turn requires a US residency certificate on Form 6166. Moreover, any UK tax withheld in error is not a creditable foreign tax for US purposes, because the treaty would have prevented it. You must reclaim it from HMRC instead.
No EIS or SEIS Relief on Converted Shares
Many British angels assume their conversion shares will attract Enterprise Investment Scheme relief. They will not. HMRC's purpose-of-issue guidance at VCM12050 states that shares issued to clear a loan or convert loan stock do not raise money for the company. Furthermore, HMRC's value-received guidance at VCM15060 records the Optos decision, which treated the issue of conversion shares to repay loan notes as a receipt of value. That can claw back relief on EIS shares you already hold in the same company. Our guide to SEIS shares for American angel investors covers the parallel US problems with the reliefs themselves.
The Timing Mismatch and the Foreign Tax Credit
America Taxes Early, Britain Taxes Late
The central problem for an American in London holding convertible loan notes is timing. The IRS taxes the interest year by year as OID. HMRC taxes the same interest once, in the year it is paid or converted. As a result, the US tax arrives in years with no matching UK tax, and the UK tax arrives in a year with little matching US income.
The foreign tax credit cannot bridge that gap easily. You claim credits on Form 1116, and interest falls in the passive category. Credits you cannot use in the year of payment can be carried back one year and forward ten. However, a two- or three-year note means the earliest US accruals often sit outside the one-year carryback window. Unless you have spare passive credits from other UK investments, part of the early US tax becomes a permanent cost.
Practical Fixes Before You Sign
The cleanest solution is to change the terms of your convertible loan notes rather than the tax return. If the company pays interest in cash each year, the UK taxes it each year, and the two systems line up. Alternatively, a zero-interest note removes the OID altogether, although a discount to issue price can still create it. An advance subscription agreement avoids interest completely, though it brings its own US questions about holding periods.
Each of these choices affects the founder too, so they need agreeing at term sheet stage. Our tax treaty optimisation service models the credit position before you commit capital, which is far cheaper than repairing it afterwards.
The 3.8% Charge No Credit Reaches
High earners holding convertible loan notes also pay the net investment income tax on OID and on later capital gains. That 3.8% charge sits outside the foreign tax credit system for most Americans in Britain. Consequently, even a perfectly timed UK credit leaves the NIIT as a real cost on every note.
Reporting Convertible Loan Notes to the IRS
Form 8938 Applies to Directly Held Notes
A note issued by a UK company and held in your own name is a specified foreign financial asset. That brings it within Form 8938 under FATCA. For an unmarried American living abroad, the thresholds are $200,000 at the year end or $300,000 at any time. For a married couple filing jointly abroad, they are $400,000 and $600,000. Investors living in the United States face much lower limits of $50,000 and $75,000 for a single filer.
The penalty for a missed Form 8938 is $10,000, rising by up to $50,000 for continued failure after an IRS notice. Furthermore, an unreported asset keeps the assessment period for the whole return open. Our FBAR and FATCA reporting service prepares these schedules alongside your return.
The FBAR Usually Does Not
A directly held loan note is not a financial account, so it does not normally appear on the FinCEN FBAR. However, notes held through a nominee platform or a custody account can change that answer. In those cases the account itself, not the note, may be reportable. Accordingly, you should check how each investment is held before deciding.
Form 5471, PFIC and Form 8621
Ownership tests for controlled foreign corporations count options, which matters for large holdings of convertible loan notes, and the IRS has long treated convertible debt as an option for this purpose. As a result, a large note can make you a ten per cent US shareholder before conversion, which brings in Form 5471. After conversion, the start-up may also be a passive foreign investment company if most of its assets are cash raised from investors. The start-up exception can protect the first year with gross income, but only if strict conditions are met. Otherwise, you report the shares on Form 8621 and consider an election in the first year.
When a Note Becomes Worthless
Start-ups fail, and many convertible loan notes are never repaid. In America, a note in registered form is a security, so a worthless note gives a capital loss under section 165(g). An informal loan gives a short-term capital loss as a nonbusiness bad debt, which we cover in our guide to a nonbusiness bad debt on a loan to a UK company. In Britain, the non-QCB status of convertible loan notes means the loss is an allowable capital loss. A negligible value claim can crystallise it before the company is dissolved, although the two countries will often recognise it in different years.
Case Study: An American Banker's Note in a London Fintech
The Investment
Daniel is a US citizen who has lived and worked in London since 2018. He is an investment banker with income well into the UK additional rate. On 1 May 2025, he lends £250,000 to a London fintech on convertible loan notes with 8% simple interest, rolled up, and a 20% discount to the next round. At the IRS average rate for 2025 of $1 to £0.759, the principal is worth about $329,000. That alone takes him over the $300,000 Form 8938 limit for a single filer abroad.
The US Accruals
The interest accrues at £13,333 for 2025, £20,000 for 2026 and £6,667 for 2027. Using the 2025 IRS rate and an assumed $1.33 to the pound for later years, his OID inclusions are roughly $17,570, $26,600 and $8,870. At 37% plus the 3.8% NIIT, the 2025 accrual alone costs him about $7,170 of US tax. The company sends no Form 1099-OID, so his previous accountant reported nothing.
Conversion and the UK Charge
The fintech closes its Series A on 1 May 2027 at £5.00 a share. Daniel's £290,000 of principal and interest converts at £4.00, giving him 72,500 shares worth £362,500. Neither country taxes that £72,500 uplift. However, HMRC taxes the £40,000 of interest in 2027/28 at the new 47% additional rate, which costs £18,800, and the company must account for 22% withholding on it.
That UK tax lands in the 2027 US year, when only $8,870 of the interest is US income. The excess credit can go back to 2026. The 2025 accrual, in contrast, has no UK tax to absorb it unless Daniel has spare passive credits. Therefore, roughly $6,500 of US income tax on the 2025 interest becomes a permanent cost, before the NIIT.
The Exit
In 2030 the company sells for £12 a share, so Daniel receives £870,000. His UK gain is £580,000, and after the £3,000 annual exempt amount he pays £138,480 at 24%. For the US, his share basis is the dollar cost of the note plus all OID included, about $382,000. At an assumed $1.30 to the pound, his proceeds are $1,131,000 and his long-term gain is about $749,000.
Because Britain taxes the gain at more than ten per cent, the gain is foreign source for a US citizen with a London tax home. The UK tax of about $180,000 therefore exceeds and cancels the 20% US capital gains tax. Nevertheless, the NIIT of about $28,500 remains payable. Had the note paid cash interest annually, Daniel would have saved most of the stranded 2025 tax. Furthermore, catching the missed OID early meant two amended returns instead of a much larger catch-up exercise.
How TaxYork Can Help
TaxYork prepares the full set of US and UK returns for investors who hold convertible loan notes in British companies. We calculate OID accruals that UK start-ups never report, translate them under the currency rules, and track your basis through conversion and exit. Additionally, we prepare Form 8938, Form 5471, Form 8621 and the Form 1116 credit computation, together with your UK Self Assessment return.
Where earlier years contain missed income or missed reporting, we correct them through amended returns or, where appropriate, the IRS Streamlined Filing Compliance Procedures. Our US tax return preparation for expats brings your angel portfolio into one consistent filing position on both sides of the Atlantic.
Conclusion
Convertible loan notes look simple on the term sheet and complicated on the tax return. America taxes the rolled-up interest every year, ignores the conversion and denies the start-up reliefs it gives to domestic companies. Britain treats the notes as chargeable assets, taxes the interest only when it is paid and refuses EIS relief on the conversion shares.
The gap between those two systems is where the money is lost. You can close much of it by negotiating the instrument before you invest, reporting OID every year and filing the right information forms from the start. Ultimately, the investors who plan their convertible loan notes in advance keep far more of their upside than those who reconstruct the position at exit.
Contact Us
If you hold convertible loan notes in a British start-up, or are about to sign one, speak to our US-UK tax team before your next return is due. You can book a consultation online, email hello@taxyork.com or call 020 3488 8606. We will review each note, quantify the timing mismatch and prepare every filing your portfolio needs.
Disclaimer
This article provides general information only and does not constitute tax, legal or investment guidance for your circumstances. Tax rules, thresholds and exchange rates change, and their application depends on your own facts and the precise terms of each instrument. The case study is illustrative and uses assumed exchange rates for future years. You should obtain professional help from a qualified US-UK tax specialist before acting. TaxYork accepts no liability for actions taken in reliance on this article.