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CONVERTIBLE AND NON-CONVERTIBLE DEBENTURES: MULTIPLE NUANCES IN TAX TREATMENT

2017-01-17

MR SMARAK SWAIN
IRS

Debentures are popular as instruments used by foreign portfolio investors (FPIs) to invest in India. Debentures are debt
instruments. However, varieties of debentures also have some equity features. Broadly, the popular debenture
instruments used by FPIs are of three kinds: Non-convertible debentures (NCD), Compulsorily Convertible Debentures
(CCDs), and Optionally Convertible Debentures (OCD).

NCDs are pure debt instruments. NCDs are very much like a bank loan, except in the way NCDs can be redeemed. Funds
invested through NCDs will be redeemed at a future point of time as per conditions provided for in the NCD agreement.
NCDs also carry a ‘coupon rate’, which is an annual interest payable on the NCD. The interest payable to NCDs is subject
to withholding tax. If the NCD holder is from a foreign country, then the withholding tax is based on DTAA norms
between India and the country of residence. The amount received by the NCD owner at the time of redemption is equal
to principal (the book value of NCD) plusinterest. The payer is required to withhold TDS at the time of redemption too.

CCDs are hybrid instruments, in the sense that they can be treated as debt as well as equity. This is also a reason why
CCDs are so popular – the hybrid nature of CCDs can be used to avoid taxes and dive through regulatory loopholes. For
instance, a FPI from country X invests in CCDs of a company in country Y. Country X is the residence country while
country Y is the source country. As per the DTAA between X and Y, dividend is taxable in X while interest is taxable in Y.
The portfolio investor can claim in country X that CCDs are debt instruments (and hence any receipt is interest – not
taxable in X as per DTAA) while claiming in country Y that CCDs are equity instruments (and hence any receipt is
dividend – not taxable in Y as per DTAA). They carry the flexibility of assuming different colours in different regulatory
offices.

CCDs are compulsorily Convertible debentures, i.e. they are debt instruments which will compulsorily get converted into
equity at a future point of time. The formula for conversion, time of conversion, and terms & conditions for conversion
are duly enumerated in the CCD agreement. CCDs pose interesting challenges from taxation point of view. To be clear,
CCDs are debt till the point of conversion. After conversion, they become equity. Before conversion, CCDs are declared
under liabilities in Balance Sheet. After conversion, they are declared as part of share capital.

Before conversion, the interest paid by the issuer (at the coupon rate agreed upon) is interest. The point of conversion of
CCD into share capital is interesting. As per Section 45 of IT Act, the conversion of debentures into shares is not a
transfer. Hence no capital gain arises on the conversion. However, the conversion of CCD into share capital is a
transaction. The subject company gives equity shares to the creditor in exchange for squaring off the debt. Say I have
taken a loan with principal P. I pay a fixed interest every year for five years, and give a lumpsum amount of R at the end
of five years to square off the debt. The lumpsum payment R consists of the principal repayment and an interest. The
interest paid to the bank is equal to “R – P”.

Similarly, the investor in a CCD is a creditor and the company issuing CCD is a debtor. At the time of conversion, the
company is squaring off its debt by paying the creditor in kind (equity shares). The payment in kind consists of
repayment of principal and payment of interest. The interest paid is FMV of equity shares issued minusbook value of
CCD. Conversion of CCDs into equity shares is, plainly speaking, repayment of debt with interest. Going by this logic,
TDS should be withheld by the issuing company when issuing shares.

The difference in “fair market value of shares issued” and “book value of CCDs” can be taxed under another section of IT
Act. This is Section 56(2)(viia) introduced in 2010. This section is applicable only to unlisted companies. It states that if
FMV of shares of an unlisted company received by an entity is more than the consideration paid, then the difference
amount is deemed to be income from other sources of the receiver of shares. It is interesting to note that the same
transaction is taxable under income tax act as interest income (u/s. 56) and deemed income (u/s. 56(2)(viia)).
An alternate view on this is that conversion of CCDs into equity shares is not a transfer u/s. 45. Since it is not a transfer,
it should not be treated as a transaction at all. Whenever the shares allotted to the CCD investor are sold, the date of
issue of CCD is taken as date of acquisition. The price at which CCDs were issued is considered the cost of acquisition of
the shares. Hence, the Act considers the CCDs and resultant shares after conversion as a single instrument. Further, the
same profit cannot be taxed twice. If the profit on conversion is taxed as interest income, and later capital gains arises on
the same profit at the time of sale of shares, it amounts to double taxation.

The author could not find any reported judgment dealing specifically with this issue. It is however seen that if the CCD
issuer and owner were AEs, then conversion clearly falls within the definition of ‘international transaction’ u/s. 92B.

What if a CCD is sold at a premium before its conversion? Is the difference between sale price and book price an interest
or a capital gain? This issue had come up for consideration of the Delhi High Court in the case of Zaheer Mauritius
[TS-464-HC-2014(Delhi)-O] Hon’ble HC held that the profit from the transaction is capital gain. A CCD is not a purely
debt instrument. The underlying value of a CCD is not merely the book value of loan forwarded. Because it will yield
shares in the future as per a pre-agreement, its intrinsic value may be more than or less than the book value, depending
on the issuing company’s performance. In this sense, it is like a bond. Sale or purchase of bonds is a transfer u/s. 45;
hence the profit is capital gains.

What if an individual or a HUF purchases CCD from an institutional investor before its maturity? We are getting into
deeper nuances. The seller is liable to pay capital gains tax on difference between sale value and indexed cost of
acquisition. Cost of acquisition is the face value of CCDs. However, if the sale value is less than the Fair Market Value
(FMV) of the CCDs, then the difference becomes income from other sources in the hands of the purchaser – under
section 56(2)(vii)(c). Determining the FMV of a CCD is a nightmare in itself. CCDs are not tradable instruments and
terms and conditions of each CCD agreement are unique. One has to severely rely on probabilistic models to find FMV.
The valuer has to study the CCD agreement and compute the number of shares that the CCDs will yield, then estimate
the value of shares at the time of conversion by using discounted free cash flow projections of the issuing company, then
discount the resultant value from date of conversion to present date to find the Present Value. This represents the FMV
of CCDs.

What about Optionally Convertible Debentures? OCDs as financial instruments are quite similar to options. The tax
treatments are similar to that of CCDs, if conversion happens. The tax treatments are similar to that of NCDs if
redemption happens