- Equity-Like Features
- Debt-Like Characteristics
- Taxation Complexities Under IT Act
Introduction
A debenture is a form of raising debt capital instrument to run the business. Compulsory Converted Debentures (CCDs) are hybrid instruments that are both debt during issuance and equity after the conversion.[1] This dual nature of CCDs creates muddiness while deciding whether it is debt or equity. Under regulation 2(v) of Foreign Exchange Management (Transfer or Issue of a Security by a Person Resident outside India) Regulations, 2017 (‘FEMA Regulations’) debentures that are mandatorily, compulsorily, and fully convertible from the date of issuance are regarded as capital instruments that are par to equity shares.[2]
Section 36(1)(iii) of the Income-tax Act, 1961,[3] allows businesses to deduct the interest paid on capital borrowed. Whether Compulsorily Convertible Debentures (CCDs) are considered as capital ‘borrowed’ or ‘equity’ is crucial. If CCDs are seen as borrowed capital, the interest on them is tax-deductible. However, if they are categorized as equity, no deduction is permitted for returns on equity investments. The reclassification of CCDs as equity and the resulting disallowance of claimed interest expenditure have been a subject of discussion in several instances.
For this it is critical for us to know the true nature of CCDs for taxation purposes and whether it is debt or equity.
Convertible Debentures: An Overview
Convertible debentures represent hybrid financial products that incorporate elements of both debt and equity investments. Investors receive fixed interest payments during the bond’s active period and possess the option to convert it into equity if the stock price experiences growth. The conversion ratio, determining the number of shares allocated per debenture, is established at the time of issuance.
Companies utilize convertible debentures as fixed-rate loans, granting bondholders regular fixed interest payments. Bondholders have the choice of retaining the bond until maturity, entitling them to the return of their principal. Alternatively, they can opt to convert the debentures into stock, albeit typically after a predetermined time frame specified in the bond’s offering.
Advantages of Convertible Debentures Convertible debentures deliver numerous advantages to both the issuing company and investors. From the issuer’s perspective, they can yield cost savings on interest payments and taxes while postponing share dilution. These instruments enable businesses to raise capital without the immediate issuance of new shares, mitigating the risk of diluting the value of existing shares.
For investors, convertible debentures provide an avenue to earn regular interest income while also participating in the potential appreciation of the company’s equity. Should the company’s stock price exhibit an upward trajectory, investors can choose to convert their debentures into stock, potentially realizing significant gains.
Convertible debentures emerge as a versatile financial tool offering benefits to both corporate entities and investors. They amalgamate the stable income associated with bonds with the potential for equity-related gains, rendering them an appealing choice for a broad spectrum of investors. Nevertheless, akin to any investment, they entail inherent risks, necessitating careful consideration by potential investors before venturing into convertible debentures.
The Dual Nature of Convertible Debentures
Equity-Like Features
A CCD, or Compulsorily Convertible Debenture, is a financial instrument that must convert into equity either at a predetermined time or when specific events occur.[4] Because of this mandatory conversion aspect, it is challenging to classify it as “debt” since debt typically involves an obligation to repay. Given its obligatory conversion feature, a CCD can be better described as a postponed equity instrument.
Further in Narendra Kumar Maheshwari v. Union of India[5] the Supreme Court stated that Compulsorily Convertible Debenture (CCDs) does not provide repayment of the principal amount on maturation. Therefore, it is hard to say that they are debt instrument.
Debt-Like Characteristics
The Full Bench of the MRTPC in the case of DGIR vs. Deepak Fertilisers[6] made the following ruling: “The key question is whether convertible debentures should be immediately regarded as equity, that is, automatically upon the issuance of debentures, even before any allotment. Our opinion on this matter is negative. It is clear that if the company is liquidated before any allotment, the debenture holder has the right to receive the principal amount along with the accrued interest.”
The case of CWT vs. Spencer and Co[7] ruled that the manner in which a liability is discharged, such as through the transfer of shares as outlined in the resolution, does not alter the nature of the liability itself. The mode of settling a liability does not change its inherent character.
The Supreme Court ruling in Eastern Investments vs. CIT[8], which concerned the deduction of interest payment on debentures. In principle, there is no distinction if the payment is made in shares of the company instead of cash, provided the transaction is not tainted by fraud and has court approval.
These tax rulings may not serve as direct precedents for defining the general nature of CCDs, but it is evident that a CCD is considered a form of debt until it undergoes conversion. For instance, the case of Deepak Fertilisers raised the question of what happens if the issuing entity faces liquidation before the scheduled conversion date of CCDs. In such a scenario, CCDs are treated as debt, eligible for payment, rather than equity distribution. Therefore, from a legal perspective, CCDs are considered a type of debt that can be settled by issuing equity in the company. However, in situations where the substance of the instrument is relevant, CCDs are often treated as equivalent to equity.
Challenges in Classifying Convertible Debentures
Taxation Complexities Under IT Act
When considering CCDs for income tax purposes, several questions arise. One of the primary questions is whether CCDs should be classified as debt, and consequently, whether the interest paid on CCDs is eligible for deduction from taxable income. Additionally, the issue of deducting expenses related to the issuance of CCDs is raised. It is a well-established principle that expenses related to issuing capital are not considered revenue expenditures. However, expenses related to issuing debt instruments are typically eligible for deduction. The key question is whether CCDs should be categorized as capital instruments or debt instruments.
One of the early rulings on this matter is the Ashima Syntex vs. ACIT[9] case. After referring to various precedents emphasizing the importance of substance over form, the Tribunal ruled that because the debentures in question were fully convertible with no obligation to repay but retained as capital through conversion into equity shares, they were not considered a form of borrowing. Consequently, the expenses incurred in issuing these debentures were not allowed as deductions. In this case, CCDs were treated similarly to advances for share capital, essentially like share application money.
Subsequently, in the case of Ganesh Benzoplast vs. ACIT[10], the ITAT differentiated the facts of the case from those of Ashima Syntex.[11] While Ashima Syntex was concerned the deductibility of expenses related to the issuance of debentures, the Ganesh Benzoplast[12] case revolved around the deductibility of interest on the debentures.
The Rajasthan High Court, in the case of C.I.T. Udaipur vs. M/S Secure Meters Ltd.,[13] held that expenses incurred in the issuance of debentures were deductible, even if the debentures were convertible. It’s worth noting that the case did not specify whether the debentures were mandatorily or optionally convertible. The Supreme Court dismissed a Special Leave Petition (SLP) by the Department against this ruling on August 11, 2009. Consequently, it seems to be established law that expenses related to the issuance of CCDs are also deductible.
Furthermore, it’s important to note that when CCDs (and, in fact, any convertible bonds) are converted into equity shares, there is no capital gain tax liability, as the conversion of debentures into shares is treated as a transfer under section 47(x) of the Income-tax Act.
Thin Capitalization Rule: A company is considered thinly capitalized when it maintains a high debt-to-equity ratio, meaning it holds a greater amount of debt relative to its equity. Thin capitalization pertains to a corporate financial structure where a significant portion of the capital is raised through debt financing rather than equity financing. This leads to a situation where companies become heavily leveraged and depend on external sources of capital, rather than relying on internal funds. Consequently, some of these companies may have a debt-to-equity ratio as high as 3:1, indicating a high level of financial risk.
Given that interest on loans can be deducted from a company’s taxable income, whereas dividends do not enjoy the same tax benefits, multinational corporations (MNCs) frequently adopt an imbalanced capital structure as part of a strategy to minimize taxation. In this strategy, the parent company provides loans to its subsidiaries located in countries with higher tax rates, thereby shifting profits and reducing their overall tax liabilities.
Thin capitalization rules, in essence, aim to restrict the amount of interest expenses a company can claim as tax deductions. Typically, these rules are defined by a debt-to-equity ratio, which sets a maximum allowable limit for the level of debt financing in relation to equity. If a company surpasses this threshold, its interest expenses may either be disallowed as deductions or subject to specific limitations, leading to higher tax obligations.
Thin capitalization rules serve as a measure to counteract tax avoidance by preventing the excessive use of artificial loan financing in international transactions. In alignment with the Base Erosion and Profit Shifting (BEPS) initiative and the recommendations outlined in Action Plan 4,[14] the Indian tax regulations introduced a new Section 94B[15] through the Finance Act 2017 to formally establish Thin Capitalization Rules.
In CIT v. Secure Meters Ltd.[16] It was held that expenses related to the issuance of debentures, regardless of their convertibility, could be considered deductible business expenditures under section 37(1) of the Income Tax Act (ITA). It also emphasized that when debentures are initially issued, they are regarded as debt instruments. Therefore, whether they are convertible into equity or not does not alter their fundamental nature as debentures. The Supreme Court (SC) dismissed the Special Leave Petition (SLP) filed by the Revenue against the Rajasthan High Court’s decision.
In a case involving A Cements Ltd. vs. CIT,[17] it was established that even if there are indications that the debentures are likely to be converted into equity shares in the near future, the incurred expenses should be recognized as revenue expenditure based on the factual circumstances existing at the time of the debenture issuance. This perspective is consistent with similar opinions expressed in various other rulings[18] where the deductibility of CCDs or optionally convertible debentures (OCDs) as revenue deductions was upheld.
Moreover, a previous decision by a co-ordinate Bench of the Income Tax Appellate Tribunal (ITAT) addressed the issue of whether interest payments on OCDs could be claimed as a deduction. The ruling established that CCDs represent borrowed funds and maintain their status as debt until conversion into shares. Consequently, interest on CCDs could be allowed as a revenue deduction under section 36(1)(iii) of the Income Tax Act (ITA).
Conclusion
Convertible debentures combine elements of debt and equity investments, offering investors fixed interest payments and the option to convert into equity based on a conversion ratio. Companies use them to raise capital while delaying share dilution and reducing interest payments. For tax purposes, the classification of Compulsorily Convertible Debentures (CCDs) as either borrowed capital or equity has significant implications, impacting interest deductions.
CCDs exhibit a dual nature, resembling equity with mandatory conversion, yet treated as debt until conversion, ensuring payment to debenture holders during liquidation. The tax deductibility of expenses related to CCD issuance is supported by legal interpretations.
Thin capitalization rules address high debt-to-equity ratios, often employed by multinational corporations to minimize taxes. These rules restrict interest expense deductions, leading to higher tax liabilities if breached.
In summary, convertible debentures offer a versatile financing option. The ongoing debate over CCD tax classification, coupled with thin capitalization rules, underscores the importance of careful consideration in financial and tax decision-making.
[1] Neha Sharma, Compulsorily Convertible Debentures: Debt or Equity?, Lakshmikumaran & Sridharan Attorneys (last visited Nov. 2, 2023), [https://www.lakshmisri.com/insights/articles/compulsorily-convertible-debentures-debt-or-equity/].
[2] Regulation 5 of FEMA Regulations.
[3] Income-tax Act, No. 43 of 1961, § 36(1)(iii) (India).
[4] “Compulsory Convertible Debentures or CCD,” LetsVenture, last modified July 5, 2020, accessed November 4, 2023, https://www.letsventure.com/blogs/what-are-compulsory-convertible-debentures-or-ccd/.
[5] Narendra Kumar Maheshwari v. Union of India 1989 AIR SC 2138.
[6] DGIR vs. Deepak Fertilisers 81 Comp Cas 341.
[7] CWT vs. Spencer and Co 88 ITR 429.
[8] Eastern Investments vs. CIT WB 20 ITR 1.
[9] Ashima Syntex vs. ACIT 100 ITD 247 (ITAT – SB).
[10] Ganesh Benzoplast vs. ACIT [2007] 111 TTJ 385 (Mumbai).
[12] Supra Note 10. d
[13] C.I.T. Udaipur vs M/S Secure Meters Ltd. D.B. Income Tax Appeal No. 81/2017.
[14] Duff, David G., Action 4 of the OECD Action Plan on Base Erosion and Profit Shifting Initiative: Interest and Base-Eroding Payments – Insights from the Canadian Experience (May 11, 2015)
[15] Income Tax Act, No. 43 of 1961, § 94B (India).
[16] CIT Vs. Secure Meters Ltd. 321 ITR 661 (Raj-HC).
[17] Cements Ltd. vs. CIT [1966] 60 ITR 52.
[18] DCIT v. ITC Hotels Ltd.: 334 ITR 109 (Kar.), CIT v. South India Corporation (Agencies) Limited: 290 ITR 217 (Mad.), CIT v. East India Hotels Limited: 252 ITR 860 (Cal.), Ganesh Benzoplast v. ACIT: 111 TTJ 385 (Mum.), Crane Software International Ltd: ITA Nos. 741&742 Bang/2010 (Bang), DCIT v. Modern Syntex (India) Ltd.: 95 TTJ 161/3 SOT 27 (Jaipur).
