Decoding CCDs: Taxation, Transfer, Pricing, and Statutory Interaction Under Indian Law

I. Introduction

During the fundraising process, the most critical decision is choosing between equity and debt. Choosing equity will result in dilution of company ownership associated with equity, while debt financing incurs high interest costs. Therefore, a viable alternative is to issue Compulsorily Convertible Debentures (‘CCDs’) that give holders a conversion feature in order to convert their debentures into equity at a specified time or on the happening of a specified event. Indian statutes classify CCDs differently based on the underlying regulatory purpose of the specific legislation. For example, under the Foreign Exchange Management Act, 1999 (‘FEMA’), CCDs are classified as equity to regulate cross-border capital flow. However, in the Income Tax Act, 1961 (‘ITA’), the interest paid on CCDs is tax-deductible and is classified as debt till the exact moment of conversion.

The key feature of a CCD is the lack of optionality for both parties. Both parties are bound in such a way that the holder has no right to demand repayment of principal, and the issuer has no right to refuse conversion of CCDs. From a financial perspective, a CCD is essentially an equity, which has an initial debt phase that serves merely as a temporary safeguard.

II. Jurisprudential Characterization Under the Income Tax Act, 1961

ITA does not contain an exclusive definition for CCDs, but the tax treatment of these instruments is derived entirely from judicial interpretations of “capital borrowed” under Section 36(1)(iii) of ITA. The taxation of CCDs under ITA evolves through three distinct phases: Issuance, Tenure (interest), and Conversion. The issuance of CCDs is regarded as a corporate borrowing and is not chargeable to tax.

Before conversion, the interest paid by the issuer (which is commonly known as the coupon rate) is the interest. In Religare Finvest Ltd Vs DCIT, it was held that CCDs are treated as borrowed funds and do not acquire the characteristics of equity until their actual conversion. Consequently, deduction under Section 36(1)(iii) of ITA is allowed. For the holder, the interest received is fully taxable under the head “income from other sources.”

After conversion, no capital gain tax liability will be levied upon the company because the conversion of CCDs into shares is not considered a ‘transfer’ by virtue of Section 47(x) of ITA. However, if the effective issue price of those CCDs exceeded their Fair Market Value (‘FMV’) on the conversion date, then the tax authorities characterise the excess amount as “income from other sources”, and Section 56(2)(vii)(b) of ITA (commonly known as the Angel Tax provision) can be invoked. Although the Angel Tax provision was abolished in order to grow the Indian start-up ecosystem, it remains highly relevant for handling unresolved disputes from the past decade.

III. Section 94B Constraints and EBITDA Thresholds

Foreign investors frequently use CCDs as the preferred instrument to invest in their associated enterprise (‘AE’) partly because ITA permits interest deductibility during the pre-conversion period of CCDs. By infusing capital into an AE via debt instruments like CCDs rather than equity, the foreign parent company can easily transfer taxable profits out of a high-tax Indian jurisdiction to a low-tax or tax-free nation (like the UAE). To curb the erosion of profits from the country, Section 94B was brought into ITA via the Finance Act, 2017, which was aligned with the OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan 4. The main purpose of introducing Section 94B of ITA is to prevent multinational enterprise groups from eroding India’s taxable profit through inflated inter-group debts.

The deduction is restricted to 30% of the Indian company’s Earnings Before Interest, Taxes, Depreciation, and Amortization (‘EBITDA’) or interest payable or paid to AE for the previous year, whichever is less. For example, if a company’s EBITDA is ₹10 crore, then the maximum interest expense the company can deduct for loans from its foreign parent company is ₹3 crore (30% of ₹10 crore). If the actual interest payment exceeds 30% of EBITDA, then the excess amount is disallowed; however, this disallowed amount is eligible to be carried forward and written off against income of subsequent assessment years (up to 8 assessment years). Moreover, the total interest expenditure incurred by the AE for that year must be greater than ₹1 Crore in order to trigger Section 94B of ITA. Banking and insurance companies (as well as certain NBFCs) are exempted under 94B(3) of ITA due to their high leverage is the business model, where high debt is a necessity, not a choice for operating.

IV. What India Should Do About It

Transfer pricing in India is governed by Chapter X of ITA (Sections 92 to 92F). It requires that every international transaction and specific domestic transactions held between an AE should be conducted at Arm’s Length Price (‘ALP’), which refers to the actual or intended price for a transaction between persons other than AE under free market conditions. For years, Transfer Pricing Officers (TPOs) have relied on London Interbank Offered Rate (LIBOR) as a base rate for determining the ALP of CCDs because the true cost of funds for a foreign investor operating in a foreign market is tied to LIBOR. However, LIBOR carries inflation risks and is subject to economic conditions of the US or UK, and there was a need for a new standard for benchmarking Indian Rupee (‘INR’) denominated transactions. Through a combination of statutory rules and binding judicial precedents, it was clarified to use State Bank of India’s Prime Lending Rate (‘SBI PLR’) as the standard benchmark for INR-denominated transactions. As per the recent ruling of Hyderabad Infratech Pvt. Ltd v. DCIT, it was held that benchmarking of CCDs is to be done by applying the SBI PLR rate, not LIBOR.

Moreover, there are several discrepancies regarding secondary adjustment of CCDs. Secondary adjustment is covered under Section 92CE of ITA; it refers to an adjustment to the accounts of the AE to ensure that the profits allocated to India because of the primary adjustment are also reflected in the actual transactions. It means that the deemed income resulting from the transfer pricing adjustment is treated as a notional interest in the hands of an Indian Entity. The interaction between Section 92CE and CCDs is complex because the adjustment of the interest on a CCD (which itself is a hybrid instrument) and the mechanics of the secondary adjustment are still unclear.

V. Comparison with Other Indian Statutes

a) CCDs under the Insolvency and Bankruptcy Code, 2016

The classification of CCDs under the Insolvency and Bankruptcy Code, 2016 (‘IBC’) as either “Financial Debt” or “Equity” is perhaps one of the most litigated issues in Indian corporate insolvency. As per the ruling of Narendra Kumar Maheshwari vs Union of India & Ors, it was held by the Hon’ble Supreme Court that since a CCD does not require any repayment of the principal amount, it is recognized as “equity” and not a loan or debt. However, in a recent ruling, the National Company Law Appellate Tribunal (‘NCLAT’) approved the treatment of CCDs as equity. Therefore, under the IBC, there exist divided opinions on the classification of CCDs and the one that provides relief to the creditors is given a preference.

b) Establish clear safe harbours for open and transparent AI systems

Under FEMA, CCDs are classified as equity instruments from the date of issuance. Under rule 2(k) of FEMA regulations, CCDs fall within the ambit of ‘equity instruments'. However, only those debentures fall within the ambit of ‘Convertible Debentures’ which are fully and mandatorily converted into shares; optional or partially convertible debentures are still treated as a form of debt instruments under the FEMA Regulations.

Considering the equity nature of CCDs under FEMA, the Income Tax Appellate Tribunal (‘ITAT’), Bangalore bench clarified in the case of CAE Flight Training Pvt. Ltd. v. DCIT that FEMA regulations do not override ITA. The equity nature of CCDs cannot be extended to tax laws when determining whether interest on CCDs is an allowable deduction or not.

VI. A Way Forward

Ultimately, CCDs as a hybrid instrument have been subject to different statutory interpretations under different legislation. Even though CCDs provide an excellent tool for attracting investors, this fragmented legal landscape mandates extreme caution from investors and issuers alike. In order to successfully leverage the advantages of CCDs, one must deal with the anti-abuse restrictions of Section 94B of ITA and carefully align transfer pricing benchmarks with the PLR of SBI.

In conclusion, while CCDs remain as one of the most important tools for optimising the capital structure of an organisation and managing cross-border fund flows, they require complex structuring and expert planning in order to balance the contradictory mandates of taxation, foreign exchange and insolvency laws.

About the Author

Raj Jaiswal is a third-year law student at Lloyd Law College.

Editor

Aahini Gandhi, Senior Editor