Over the years and more recently (especially since the surge in the number of start-ups in India), hybrid instruments have gained recognition. Hybrid instruments such as compulsorily convertible debentures (CCDs), as the name suggests, are debentures which are to be compulsorily converted into equity shares after a certain period. For investors, CCDs provide an avenue to earn regular interest income while also participating in the potential appreciation of the company’s equity. Also, the CCD holder does not have voting rights and is not eligible for dividends.
Regulatory considerations – Investor perspective
Foreign investors are also permitted to invest in CCDs issued by Indian companies under the foreign direct investment (FDI) route in any sector except those sectors that are prohibited. The guidelines on FDI treat CCDs as equity for the purposes of Indian exchange control laws. CCD investments by foreign investors are subject to pricing guidelines. As per the FDI guidelines on pricing, the price/ conversion formula is to be determined upfront at the time of issuance of the CCDs, and the price at the time of conversion cannot be lower than the fair market value at the time of the issuance of the CCDs.
Tax considerations – Investor perspective
In case of unlisted CCDs, any purchase or subscription of these instruments is subject to certain valuation norms prescribed under the tax laws. Purchase or subscription of the CCDs at a value below the prescribed valuation norms are subject to tax as any other income in the hands of the investors.
Taxability of interest income on CCDs is also a key consideration for the investors. As per tax laws, typically, interest income on CCDs is taxed as other income as per applicable slab rates/ maximum marginal rates (in case of resident investors) or as per relevant tax treaty rates (in case of non-resident investors).
In case of non-resident investors, an important aspect for availing beneficial tax rates under the tax treaties is whether the investor is a ‘beneficial owner’ of interest income. ‘Beneficial ownership’ is a test commonly applied in tax treaties to identify the economic beneficiary in a particular transaction, i.e., the party who has a right to use and enjoy the income. Tax courts have held beneficial ownership to mean exclusive possession and control over the interest income; and absolute freedom for the recipient to utilise interest income received, unconstrained by any contractual, legal, or economic arrangements with any other third party.
While the conversion of the CCDs into equity shares is not treated as a taxable transfer, the transfer of CCDs to a third party is taxed as capital gains where the same are held as capital assets.
Under tax treaties, especially in case of non-resident investors from jurisdictions such as Singapore/ Mauritius, the capital gains tax payable on ‘instruments other than shares’ are not taxable in India. While one may question whether CCDs will be classified as a share or as an instrument other than a share, the better view has been that the same should be classified as an instrument other than shares and accordingly, transfer of CCDs should not be subject to tax in India.
Tax deductibility - Borrower/ issuer perspective
Under the tax laws, the deduction is available to the Indian company if the interest paid is in respect of capital borrowed. However, where the capital borrowed is treated as ‘equity’, no deduction is allowed.
In this context, it is important to take note of a recent decision of the Supreme Court of India wherein the court dealt with the question - whether CCDs are to be treated as ‘debt’ or ‘equity’ under the Insolvency and Bankruptcy laws. Where CCD holders were treated as equity holders, they would not be classified as financial creditors under the insolvency and bankruptcy laws. Finally, the Supreme Court held that in absence of repayment of the principal amount, CCDs must be regarded as equity and not debt.
The recent ruling may have sparked a fresh debate on the qualification of CCDs as ‘debt’ or ‘equity’. As mentioned earlier, the FDI guidelines treat CCDs as equity. Under the tax laws, the re-characterisation of CCDs as equity and the disallowance of the interest expenditure claimed thereof, has been a subject matter of discussion in several cases.
Various courts have held that mere characterising of a debt as equity as per FDI policy would not affect the treatment of interest paid, under the tax laws. The courts have also held that since the CCD holder does not have voting rights and is not eligible for dividends, CCDs cannot be treated as equity under the tax laws.
Based on jurisprudence, the better view should be that CCDs should qualify as debt and the issuing company should be able to claim deductions for the interest payments so long as the borrowed sum was used in the business of the borrower.
Separately, over the years, there has always been a debate on the quantum of interest deduction being claimed by Indian companies in case of CCDs raised from non-resident investors. The tax laws now provide disallowance of interest expenses if a company surpasses a certain prescribed threshold.
In conclusion, as discussed above, investors and issuing entities are able to use CCDs for certain advantages, however, one has to be mindful of the implications that may arise thereunder.
Punit Shah (Partner) and Vishal Lohia (Associate Partner), Dhruva Advisors
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Published: 15 Feb 2024, 01:47 PM IST
