Compulsorily Convertible Debentures: Debt or Equity

Introduction

For a business entity, securing adequate capital is as crucial as having a solid business plan for successful implementation and operations.

Timely access to capital forms the backbone of any enterprise. A company's capital typically comprises equity and debt. Equity capital is raised through issuing shares, while debt capital is obtained through loans, repayable after a certain period. Companies can raise capital in various forms, one of which is through issuing Compulsorily Convertible Debentures (“CCDs”). CCDs are unique instruments that start as debt and convert into equity. Hence it becomes pertinent to understand whether CCD will fall under the classification of debt or equity.

CCDs and Companies Act, 2013

Section 2(30) of the Companies Act, 2013 1(“Companies Act”) defines a debenture as 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.

Further Section 71 of Companies Act 2states that a company may issue debentures with an option to convert such debentures into shares, either wholly or partly at the time of its redemption and they must be approved by a special resolution. Further under the provision, these debentures do not carry any voting rights until its conversion.

Hence, until the time CCDs are converted into equity shares, Companies Act treats such CCDs as debt instruments and not equity.

CCDs and Foreign Direct Investment

Reserve Bank of India, through its Master Direction titled “Foreign Investment in India” dated January 4, 2018 3(“Master Direction”) views CCDs as equity instruments for foreign direct investment (“FDI”) purposes from the date of issuance of such CCDs. Interpretation of Rule 4.6 of Master Direction considers CCDs as equity instrument in which person not residing in India can invest in.

CCDs and Income Tax Act, 1961

Under Section 36 (1) (iii) of Income Tax Act, 1961 4(“IT Act”), deduction can be claimed for interest that is paid on the capital borrowed by a taxpayer which is borrowed for the purpose of the taxpayer’s profession or business.

Hence, it becomes pertinent to understand whether CCDs issued and the interest paid upon it, will be seen as equity or debt under the IT Act.

CAE Flight Training (India) (P) Ltd. v. Dy. CIT 5lucidly provides an answer to such question and states that until the date of conversion, the interest paid on CCD cannot be treated as interest on equity and that interest paid on debentures are allowable as expenditure under section 36(1)(iii) of the IT Act. Hence, it is held and understood CCDs cannot be treated as equity under IT Act.

Conclusion

CCDs occupy a unique space between debt and equity, with their classification varying across different legal frameworks. While they are treated as debt under Companies Act and IT Ac, on the other hand, for FDI purposes, such CCDs are viewed as equity. This duality necessitates careful consideration of CCDs' implications in financial structuring and tax planning.

Authored by:

Rohit Jain, Managing Partner and Harshit Meena, Associate at Singhania & Co.