Over the years and more recently (especially since the rise in the number of startups in India), hybrid instruments have gained recognition. Hybrid instruments such as compulsorily convertible bonds (CCD), as the name suggests, are bonds that must be compulsorily converted into equity shares after a certain period. For investors, CCDs provide a way to earn regular interest income while also participating in the potential appreciation of the company’s equity. Also, the holder of CCD has no voting rights and is not entitled to receive dividends.
Regulatory considerations – An investor’s perspective
Foreign investors are also allowed to invest in CCDs issued by Indian companies under the foreign direct investment (FDI) route in any sector except those sectors which are prohibited. The FDI guidelines treat CCDs as equity for the purposes of Indian exchange control laws. CCD investments by foreign investors are subject to pricing guidelines. According to the FDI pricing guidelines, the price/conversion formula is to be determined before the 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. oh
Tax considerations – An investor’s 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 like any other income in the hands of the investors.
Taxability of interest income on CCDs is also a key consideration for the investors. Under tax laws, typically, interest income on CCDs is taxed as other income at applicable slab rates/maximum marginal rates (in the case of resident investors) or at relevant tax treaty rates (in the case of non-resident investors).
In the case of non-resident investors, an important aspect for taking advantage of beneficial tax rates under the tax treaties is whether the investor is a “beneficial owner” of interest income. “Beneficial ownership” is a test often applied in tax treaties to identify the economic beneficiary in a particular transaction, ie, the party that has the right to use and enjoy the income. Tax courts have held beneficial ownership to mean exclusive possession and control of the interest income; and absolute freedom for the recipient to utilize interest income received, unrestricted 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 is held as capital assets.
Under tax treaties, particularly in case of non-resident investors from jurisdictions such as Singapore/Mauritius, the capital gains tax payable on “instruments other than shares” is 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 was that the same should be classified as an instrument other than shares and therefore, transfer of CCDs should not be subject to tax. in India.
Tax deduction – 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 in which the court addressed 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 the 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 about the qualification of CCDs as “debt” or “equity”. As mentioned earlier, the FDI guidelines treat CCDs as equity. Under the tax laws, the recharacterization of CCDs like equity and the disapproval of the interest expense required by that, was a subject of discussion in several cases.
Various courts have held that mere characterization of debt as equity under FDI policy would not affect the treatment of interest paid, under the tax laws. The courts also held that because 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 as long as the borrowed amount was used in the business of the borrower.
In particular, over the years, there has always been a debate about the amount of interest deduction being claimed by Indian companies in case of CCDs acquired by non-resident investors. The tax laws now provide for a ban on interest expenses if a company exceeds a certain prescribed threshold.
In conclusion, as discussed above, investors and issuing entities can use CCDs for certain advantages, however, attention must be paid to the implications that may arise under this.
Punit Shah (Partner) and Vishal Lohia (Associate Partner), Dhruva Advisors
Unlock a world of Perks! From insightful newsletters to real-time stock tracking, breaking news and a personalized news feed – it’s all here, just a click away! Login Now!
Catch all Business News, Market News, Breaking News and Latest News Updates on Live Mint. Check out all the latest action on Budget 2024 here. Download The Mint News App to get Daily Market Updates.
More or less
Published: 15 Feb 2024, 13:47 IST