A compulsorily convertible debenture (CCD) is a type of bond that has a specified time by which the entire value of the debenture must be converted into shares. CCDs are an essential means of financing on which businesses rely to raise funds.
In corporate finance, a debenture is a medium- to long-term debt instrument used by large organisations to borrow money at a fixed rate of interest. The money raised by organisations through debentures becomes a part of the organisation’s capital structure; however, it is not the share capital. Debenture holders could transfer their debentures freely nevertheless, they do not have voting rights in the general body meetings of the shareholders. The interest paid to the debenture holders is a charge against profit in the company’s financial statements.
Section 71 of the Companies Act, 2013 along with Rule 18 of the Companies (Share Capital and Debentures) Rules, 2014, deals with debentures. Section 71 (1) of the Companies Act 2013 grants permission to organisations to issue debentures with the option of converting them into shares, either wholly or partially at the time of redemption. However, it should have been approved by a special resolution passed by the CCD-issuing company at a general meeting. Under Section 42 of the Companies Act 2013, companies have the privilege to issue CCDs through a private placement offer.
Benefits of CCDs
When these instruments are issued, the issuing organisations determine the CCD conversion ratio at the time of issue of the CCDs. They have an underlying characteristic of compulsory conversion into equity after a certain period of time or on happening of a specified event. CCD is a hybrid instrument, which means that it could neither be classified as pure debt or bond nor pure equity or stock. The convertibility feature of the CCDs acts as an incentive for the investors over and above the interest income. With CCDs, the investors are ensured of a fixed return along with a potential upside on conversion. Further, the owners of the CCDs must accept shares of the organisation when it matures rather than a refund.
Though CCDs are usually considered equity, they are structured more like debt. If the investor wants to sell the CCDs, then the issuing company would buy it back from the investor at a fixed price. As CCDs are converted into equity after a stipulated time, they do not pose a credit risk to the issuing company. A pure equity issuance might place on the underlying stock since they are not immediately converted into shares; however, CCDs mitigate some of the downward pressure.
Investors from Mauritius, Singapore, and Cyprus under Taxman’s Lens
Many notices for gains from investments in CCDs issued by Indian firms have been sent to a number of foreign investors from Mauritius, Cyprus, and Singapore. In 2017, tax treaties of Mauritius, Cyprus, and Singapore were amended to tax capital gains on shares in India. CCDs, which are compulsorily converted into equity after a stipulated period, had gained increasing popularity after the tax treaties.
Irrespective of the nature of the instruments being sold, tax authorities are of the opinion that the capital gains accruing to tax resident is now taxable in India. This has led to a confusion as the tax authorities claim that all the capital gains are taxable; however, the foreign investors are of the belief that the sale of securities other than shares remain non-taxable.
Post the amendment of tax treaties in 2017, capital gains on shares are taxable in India. However, debt instruments like debentures do not come under the purview of the amendment and are not taxable. For instance, debentures, CCDs, etc., still fall under the residual clause in the tax treaties. According to the amendment of tax treaties 2017, the gains on these instruments would be taxable only in the countries where the investor of these instruments are based. It means that in India, the investor is not liable to pay any Capital gains tax for the debt instruments that he holds.
The foreign direct investment (FDI) guidelines state that CCDs as equity for the purpose of reporting it to the Reserve Bank of India (RBI). Nevertheless, CCDs are treated as debt instruments for the purpose of income tax till the time they are converted into equities. There may be funds that sell CCDs to a friendly third party when the life of the CCDs is about to end. The fund then takes the treatment of capital gains and claims an exemption under the treaty.
According to the courts in India, the classification of an instrument under income tax laws and RBI need not be the same. There have been attempts made by the tax department, well before the treaties were amended, to treat the gains made out of the sale of CCDs as interest income. The Delhi High Court, in 2014, had held that gains from the CCDs should be treated as capital gains.
As per the India-Mauritius treaty, CCDs are taxable in India at 7.5 per cent and as per the India-Singapore treaty, it is 15 per cent. Investors are apprehensive that taxman might use different means and apply General Anti-avoidance Rule (GAAR) for these transactions. (GAAR is a concept which generally empowers the revenue authority of a country to deny tax benefit of transactions or arrangements that do not have any commercial substance.) The only purpose of such transactions is to achieve the tax benefit. The need for a GAAR is usually justified by a concern that the integrity of the tax system needs to be strengthened.
Similar to shares, CCDs are convertible instruments that are chosen only for tax purposes. Hence, investors legitimately use CCDs and do not have the rights enjoyed by an equity holder until converted.
Conclusion
It is critical to demonstrate substance in the resident country in order to claim tax treaty benefit and claim tax exemption on capital gains on debt instruments. The notices received by the investors of foreign countries in CCDs may be legitimate according to the rule of law of the country. However, this is not a good indication as Indian government has been repeatedly making a stand about ease of doing business in India as it would provide a stable and non-confrontational tax regime for foreign investors.
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