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1/30/2017 ConvertibleandNonConvertibleDebentures:MultipleNuancesInTaxTreatment

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ConvertibleandNonConvertibleDebentures:MultipleNuancesInTaxTreatment

Jan17,2017

MrSmarakSwain,Dy.CommissionerofIncomeTax,IRS

Debentures are popular as instruments used by foreign portfolio investors (FPIs) to invest in
India.Debenturesaredebtinstruments.However,varietiesofdebenturesalsohavesomeequity
features. Broadly, the popular debenture instruments used by FPIs are of three kinds: Non
convertible debentures (NCD), Compulsorily Convertible Debentures (CCDs), and Optionally
ConvertibleDebentures(OCD).

NCDsarepuredebtinstruments.NCDsareverymuchlikeabankloan,exceptinthewayNCDs
canberedeemed.FundsinvestedthroughNCDswillberedeemedatafuturepointoftimeas
perconditionsprovidedforintheNCDagreement.NCDsalsocarryacouponrate,whichisan
annualinterestpayableontheNCD.TheinterestpayabletoNCDsissubjecttowithholdingtax.
IftheNCDholderisfromaforeigncountry,thenthewithholdingtaxisbasedonDTAAnorms
betweenIndiaandthecountryofresidence.TheamountreceivedbytheNCDowneratthetime
ofredemptionisequaltoprincipal(thebookvalueofNCD)plusinterest.Thepayerisrequired
towithholdTDSatthetimeofredemptiontoo.

http://orange.taxsutra.com/articles/4dce37519f2bdab114ad70bc6a5908/expert_article 1/4
1/30/2017 ConvertibleandNonConvertibleDebentures:MultipleNuancesInTaxTreatment

CCDsarehybridinstruments,inthesensethattheycanbetreatedasdebtaswellasequity.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
sourcecountry.AspertheDTAAbetweenXandY,dividendistaxableinXwhileinterestis
taxableinY.TheportfolioinvestorcanclaimincountryXthatCCDsaredebtinstruments(and
henceanyreceiptisinterestnottaxableinXasperDTAA)whileclaimingincountryYthat
CCDs are equity instruments (and hence any receipt is dividend not taxable in Y as per
DTAA).Theycarrytheflexibilityofassumingdifferentcoloursindifferentregulatoryoffices.

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.CCDsposeinterestingchallengesfromtaxationpointofview.Tobeclear,CCDsare
debt till the point of conversion. After conversion, they become equity. Before conversion,
CCDsaredeclaredunderliabilitiesinBalanceSheet.Afterconversion,theyaredeclaredaspart
ofsharecapital.

Before conversion, the interest paid by the issuer (at the coupon rate agreed upon) is interest.
ThepointofconversionofCCDintosharecapitalisinteresting.AsperSection45ofITAct,
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
takenaloanwithprincipalP.Ipayafixedinteresteveryyearforfiveyears,andgivealumpsum
amountofRattheendoffiveyearstosquareoffthedebt.ThelumpsumpaymentRconsistsof
theprincipalrepaymentandaninterest.TheinterestpaidtothebankisequaltoRP.

Similarly,theinvestorinaCCDisacreditorandthecompanyissuingCCDisadebtor.Atthe
timeofconversion,thecompanyissquaringoffitsdebtbypayingthecreditorinkind(equity
shares). The payment in kind consists of repayment of principal and payment of interest. The
interest paid is FMV of equity shares issued minus book value of CCD. Conversion of CCDs
intoequitysharesis,plainlyspeaking,repaymentofdebtwithinterest.Goingbythislogic,TDS
shouldbewithheldbytheissuingcompanywhenissuingshares.

ThedifferenceinfairmarketvalueofsharesissuedandbookvalueofCCDscanbetaxed
underanothersectionofITAct.ThisisSection56(2)(viia)introducedin2010.Thissectionis
applicable only to unlisted companies. It states that if FMV of shares of an unlisted company
receivedbyanentityismorethantheconsiderationpaid,thenthedifferenceamountisdeemed
tobeincomefromothersourcesofthereceiverofshares.Itisinterestingtonotethatthesame
transactionistaxableunderincometaxactasinterestincome(u/s.56)anddeemedincome(u/s.
56(2)(viia)).

AnalternateviewonthisisthatconversionofCCDsintoequitysharesisnotatransferu/s.45.
Since it is not a transfer, it should not be treated as a transaction at all. Whenever the shares
allottedtotheCCDinvestoraresold,thedateofissueofCCDistakenasdateofacquisition.

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1/30/2017 ConvertibleandNonConvertibleDebentures:MultipleNuancesInTaxTreatment

ThepriceatwhichCCDswereissuedisconsideredthecostofacquisitionoftheshares.Hence,
theActconsiderstheCCDsandresultantsharesafterconversionasasingleinstrument.Further,
thesameprofitcannotbetaxedtwice.Iftheprofitonconversionistaxedasinterestincome,and
latercapitalgainsarisesonthesameprofitatthetimeofsaleofshares,itamountstodouble
taxation.

The author could not find any reported judgment dealing specifically with this issue. It is
howeverseenthatiftheCCDissuerandownerwereAEs,thenconversionclearlyfallswithin
thedefinitionofinternationaltransactionu/s.92B.

WhatifaCCDissoldatapremiumbeforeitsconversion?Isthedifferencebetweensaleprice
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 [TS464HC2014(Delhi)O] Honble HC
heldthattheprofitfromthetransactioniscapitalgain.ACCDisnotapurelydebtinstrument.
TheunderlyingvalueofaCCDisnotmerelythebookvalueofloanforwarded.Becauseitwill
yield shares in the future as per a preagreement, its intrinsic value may be more than or less
thanthebookvalue,dependingontheissuingcompanysperformance.Inthissense,itislikea
bond.Saleorpurchaseofbondsisatransferu/s.45hencetheprofitiscapitalgains.

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,thenthedifferencebecomesincomefromothersourcesinthehandsofthepurchaser
undersection56(2)(vii)(c).DeterminingtheFMVofaCCDisanightmareinitself.CCDsare
nottradableinstrumentsandtermsandconditionsofeachCCDagreementareunique.Onehas
to severely rely on probabilistic models to find FMV. The valuer has to study the CCD
agreementandcomputethenumberofsharesthattheCCDswillyield,thenestimatethevalue
ofsharesatthetimeofconversionbyusingdiscountedfreecashflowprojectionsoftheissuing
company,thendiscounttheresultantvaluefromdateofconversiontopresentdatetofindthe
PresentValue.ThisrepresentstheFMVofCCDs.

WhataboutOptionallyConvertibleDebentures?OCDsasfinancialinstrumentsarequitesimilar
to options. The tax treatments are similar to that of CCDs, if conversion happens. The tax
treatmentsaresimilartothatofNCDsifredemptionhappens

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byMrSmarakSwain,Dy.CommissionerofIncomeTax,IRS

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