Introduction
A business entity requires sufficient capital, as much as a business plan, to successfully implement the plan and run the business. Accessibility to adequate capital at the right time is therefore the backbone of any business entity. The capital of a company primarily comprises of equity capital and debt capital. While the equity capital refers to the capital raised through issuance of shares, the debt capital refers to the capital raised through assumption of debt, repayable after agreed time. There are varied forms in which the said capital can be acquired by the company. One of the ways to raise capital is by issuing Compulsorily Convertible Debentures (‘CCDs’).
CCDs, as the name suggests, are debentures which are to be compulsorily converted into equity after a certain time period. That is, CCDs are hybrid instruments, being debt at the time of issue along with a certainty to get converted into equity. Being of such nature, the guidelines on Foreign Direct Investment (‘FDI’) treat CCDs as equity for the purposes of reporting to the Reserve Bank of India (‘RBI’). In this context, a question arises as to whether CCDs would be regarded as equity capital under all other laws as well. The question is more relevant from the perspective of income-tax law, as the return on debt and equity have distinct treatment, both in the hands of the lender/ investor and the borrower/ issuer. But, before looking into the income-tax implications, few points fundamental to CCDs have been discussed in the following paragraphs.
Corporate law framework governing issuance of CCDs
Section 2(30) of the Companies Act, 2013 (‘Comp. Act’) defines a ‘debenture’ to include debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not. That is, a debenture is a debt instrument for the company.
Section 71 of the Comp. Act lays down the conditions attached to debentures. The relevant part reads as under:
“(1) A company may issue debentures with an option to convert such debentures into shares, either wholly or partly at the time of redemption:
Provided that the issue of debentures with an option to convert such debentures into shares, wholly or partly, shall be approved by a special resolution passed at a general meeting.
(2) No company shall issue any debentures carrying any voting rights….”
While the Comp. Act specifically provides for the issuance of convertible debentures, it also mandates that such issue shall be required to be approved by a special resolution. The fact that the Comp. Act deals with convertible debentures in the provisions relating to debentures, indicates that the statute seeks to regulate CCDs as debentures. Furthermore, debentures shall not carry any voting rights in the company.
As per Section 129 (Financial Statement) read with Schedule III (General Instructions for Preparation of Balance Sheet and Statement of Profit and Loss of a Company) of the Comp. Act, a company is required to inter alia provide appropriate disclosures with respect to debentures and the rate of interest and particulars of conversion thereof.
CCDs and the regulatory framework
The investment by a non-resident in an Indian Company, in any form, is regulated by the Foreign Exchange Management Act, 1999 read with Foreign Exchange Management (Transfer or Issue of a Security by a Person Resident outside India) Regulations, 2017 (‘FEMA Regulations’)[1]. The regulations prescribe the manner, limit, period, etc. of such investments. In other words, investment by a non-resident in a manner not prescribed, or in excess of the limits, etc. cannot be made in an Indian Company.
Regulation 2(xviii) defines ‘Foreign Investment’ to mean any investment made by a person resident outside India on a repatriable basis in ‘capital instruments’ of an Indian company or to the capital of an LLP. ‘Capital instruments’ have been defined under Regulation 2(v) to mean equity shares, ‘debentures’, preference shares and share warrants issued by an Indian company. The Explanation further provides that the expression ‘Debentures’ means fully, compulsorily and mandatorily convertible debentures. Thus, the CCDs which are fully and mandatorily convertible into equity, are considered as ‘capital instruments’ being at par with equity shares. Accordingly, investment in the CCDs by a non-resident would be subject to sectoral caps or the investment limits for equity investments[2].
As fully, compulsorily and mandatorily convertible debentures alone are regarded as capital instruments, optionally convertible or partially convertible debentures are treated as debt instruments under the FEMA Regulations. These debentures which do not fall within the ambit of ‘capital instruments’ would have to conform to the guidelines on External Commercial Borrowings, i.e. Foreign Exchange Management (Borrowing and Lending in Foreign Exchange) Regulations, 2000.
Treatment of CCDs as equity under income-tax law: Whether permissible?
Having said that the CCDs (fully, compulsorily and mandatorily convertible debentures) are treated as equity rather than debt under FEMA regulations from the date on which the CCDs are issued, the article now seeks to examine as to whether the basic character of CCDs as being a debt instrument till the date of their conversion, can be recharacterised as equity under the income-tax laws, by drawing reference from the afore-mentioned treatment under FEMA Regulations.
Before probing into the said question, it is relevant to first understand as to why a company may prefer to raise capital through a debt instrument (debenture) over equity. Firstly, a debt instrument does not dilute the ownership proportion of existing shareholders, secondly, a debt instrument does not carry voting rights and therefore, there is no interference in the management of the company and lastly, interest, unlike dividends, is generally allowed as deduction from the taxable profits of the company.
Section 36(1)(iii) of the Income-tax Act, 1961 (‘IT Act’) provides for deduction of interest paid in respect of capital borrowed by a tax payer for its business. That is, if CCDs are treated as capital ‘borrowed’ for the purposes of the IT Act, then the interest paid thereon shall be allowable as deduction, whereas if the same is treated as ‘equity’, no deduction would be permissible for return paid on equity investment. The re-characterisation of CCDs as equity and the disallowance of the interest expenditure claimed thereof, has been an issue for consideration on a few occasions.
In CAE Flight Training[3], the Revenue raised the following arguments to deny the deduction for interest expenditure:
- The debt investment was to be treated as equity investment, in line with thin capitalisation[4] rules in Belgium, being the country of residence of the lender.
- The RBI has treated the CCDs as equity under FDI policy.
Regarding the first argument, the Tribunal relied on Besix Kier Dabhol[5] to hold that the thin capitalisation principle cannot be invoked in India, in absence of specific provisions under the IT Act at the relevant time, even though the same is on the statute book in the lender’s country.
Regarding the second contention, the Tribunal noted that mere characterising of a debt as equity as the RBI’s Policy would not affect the treatment of interest paid, under the IT Act. RBI’s FDI policy is guided by the requirement to control future repatriation obligations of the country in convertible foreign currency. Since in the case of CCDs, there is no repatriation obligation in foreign currency, as the debentures would at a defined time be converted into equity, the same is being treated as equity by the RBI for the purposes of FDI policy.
Regarding the query if the treatment given by RBI for FDI policy can be applied in every aspect of CCDs, the Tribunal put forth two basic questions regarding the nature of CCDs prior to their conversion into equity - whether the holder has voting rights and whether dividend can be paid to the holder. Since the answer to these questions was in negative, the Tribunal concluded that the CCDs cannot be treated as equity under the income-tax law.
Accordingly, the Tribunal held that the interest paid thereon is an allowable deduction under Section 36(1)(iii) of the IT Act. The said view has also been adopted in Embassy One Developers[6].
Despite the fact that the debt equity ratio was far higher than the industry norms and the limits prescribed by RBI[7], the Tribunal in Kolte Patil Developers[8] held that debt cannot be treated as equity, in the absence of General Anti-Avoidance Rules (‘GAAR’)[9] and thin capitalisation rule. The Tribunal held so, despite the fact that huge interests were paid to associated enterprises, with the debt equity ratio as skewed as 1:23.
The above orders endorse the well-established principle that if a certain act is not prohibited under the relevant statute, it is impliedly permitted thereunder. Therefore, since the IT Act did not provide for re-characterizing of a transaction prior to 1 April 2018 despite huge debts being borrowed so as to claim higher interest expenditure, the deduction claimed by the borrower was held to be allowable so long as the borrowed sum was used in the business of the borrower.
Conclusion
While the aforementioned cases have decided against treatment of CCDs as equity relying on the RBI policy on FDI, it is to be noted that these pertain to a period during which the income-tax law had no provision to re-characterise the transaction. With effect from 1 April 2018, GAAR and thin capitalisation rules have been implemented in India vide Chapter X-A and Section 94B of the IT Act respectively, and accordingly, one has to be mindful of the implications that may arise thereunder.
[The author is a Senior Associate, Direct Tax practice team, Lakshmikumaran & Sridharan Attorneys, Mumbai]
[1] Notification No. FEMA 20(R)/2017-RB, dated 7 November 2017.
[2] Regulation 5 of FEMA Regulations.
[3] ACIT v. CAE Flight Training (India) Pvt. Ltd. - IT(TP)A No. 2060/Bang/2016, Order dated 25 July 2019.
[4] Thin capitalisation refers to the situation when a company has higher debt than the equity, i.e. when the debt to equity ratio is high.
[5] Besix Kier Dabhol, SA v. Dy. DIT - [2010] 8 taxmann.com 37 (Mum.).
[6] Embassy One Developers Pvt. Ltd. v. DCIT - ITA Nos. 2239 and 2240/Bang/2018, Order dated 26 November 2020.
[7] RBI Master Circular No.07/2009-10 dated 01-07-2009 stipulating Debt Equity ratio of 4:1 on ECB.
[8] DCIT v. Kolte Patil Developers Ltd. - ITA No.2111 and 1980/PUN/2017, Order dated 8 December 2020.
[9] GAAR is an anti-avoidance tool to deal with the transactions designed solely for the purpose of obtaining tax benefit(s), by re-characterising the transaction, amongst others.
