Compulsorily Convertible Debentures (CCDs), a hybrid instrument, has gained prominence in the last two decades. However, its classification as equity or debt has been the subject of discussions, mainly due to conflicting perspectives under different laws. This initial divergence surfaced from the framework of guidelines under the Foreign Exchange Management Act, 1999 (
This issue recently resurfaced in
Factual background
The facts in this case were that
Judgment
The Apex Court while arriving at the conclusion that the nature of the CCDs is equity and not debt, analyzed the definition of "debt" under the Code and held that the definition of debt under section 3(11) of the Code is a liability or obligation in respect of a claim which is due from any person. The
The Apex Court also interpreted the various clauses of the debenture subscription agreement executed between the parties and held that the liability to pay coupon payment was on the sponsor and thus, the
While interpreting the documents (including the concessional agreement and loan agreement between the parties), the Apex Court held "that a contract means as it reads. It is not advisable for a Court to supplement it or add to it", which view was arrived by relying on an earlier precedent in
In light of the above discussions, the Apex Court affirmed the decision of NCLAT, wherein it was held that treating CCDs as a debt, would tantamount to breach of the concessional agreement and the common loan agreement. The investment was clearly in the nature of debentures which were compulsorily convertible into equity and nowhere is it stipulated that these CCDs would partake the character of financial debt on the happening of a particular event.
Thus, the Apex Court conclusively determined that CCDs did not fall within the purview of a financial debt. Thus,
CCDs under Insolvency and Bankruptcy Code:
The determination of whether CCDs are debt or equity plays a vital role in the Code. Firstly, under CIRP, creditors form a part of the
Secondly, during liquidation of a corporate debtor, proceeds from the liquidation estate are distributed among stakeholders based on an order of priority known as the waterfall mechanism. As per the Code, creditors are ranked higher than equity investors. Equity investors are the last in line to receive the residue of proceeds after distribution to all stakeholders mentioned undersection 53 of the Code.
Various NCLT and NCLAT judgments have dealt with this issue with a common ratio coming out that the treatment of CCDs and accrued interests as a financial debt under the Code is to be determined on the facts of each case. One of the key factors determining the nature of the CCDs is the treatment in the financial statements, if the CCDs are termed as a debt (long term borrowings), then such CCDs are required to be treated as debt and not equity3.
NCLAT in
CCDs under
Under the Foreign Exchange Management (Non-Debt Instruments) Rules of 2019, the term "equity instruments" means "equity shares, convertible debentures, preference shares, and share warrants issued by an Indian company". "Convertible debentures" within this framework pertains to debentures that are fully, compulsorily and mandatorily convertible. Therefore, under
"It has been noticed that some Indian companies are raising funds under the FDI route through issue of hybrid instruments such as optionally convertible/ partially convertible debentures which are intrinsically debt-like instruments. Routing of debt flows through the FDI route circumvents the framework in place for regulating debt flows into the country. It is clarified that henceforth, only instruments which are fully and mandatorily convertible into equity, within a specified time would be reckoned as part of equity under the FDI Policy. "
CCDs under Income-tax:
Under the Income-tax Act, 1961 (ITA), in the context of CCDs, a primary issue which arises is whether interest paid on CCDs is an allowable deduction or not i.e., whether it is a loan on which interest should be allowed as a deduction. In accordance with section 36 of the ITA, interest paid on "borrowed capital" is eligible for deduction from taxable income. The question which arises for consideration is whether CCDs falls within the ambit of "borrowed capital". In this context, the Hon'ble
Considering CCDs are regarded as equity under FDI, the
Accounting treatment of CCDs:
Reference is drawn to Indian Accounting Standard (Ind AS) 32, which addresses the accounting treatment of financial instruments including CCDs.
In accordance with Ind AS 32, the classification of CCDs primarily is based on the contractual terms agreed between the parties. The broad determinative factor as per Ind AS 32 to term CCDs as equity or liability, amongst others, is whether the conversion is pre-determined or undetermined.
Conclusion
CCDs as a hybrid instrument has seen a challenging journey, considering its nature has been subject to varied interpretations under different legislations. Each legislation had a different intent in treating CCDs in a particular manner. For
With the above discussion, it can be stated that the nature of CCDs depends on the contractual terms, a fact-finding exercise of such terms and accounting treatment. Rather than terming difference of treatment under various laws as contradictory, the Courts have made it clear that each law operates autonomously. A fact-centric approach is imperative for a comprehensive understanding of the nature of CCDs.
It would be interesting to note that though CCDs may appear to be a lucrative instrument, the exact terms of CCDs will determine where an investor/creditor will stand in an insolvency proceeding. Documentation plays a significant role in determining the outcome on the nature of CCDs and as rightly observed by the Apex Court, while interpretating commercial documents, Courts should not endeavor to look into the implied terms of the contract. Thus, a contract means as it reads. In conclusion, an effort should be made to ensure that interests are protected in case of any contingency, insolvency being at the forefront.
Footnotes
1. CIVIL APPEAL NO.4929/2023
2. (2018) 11 SCC 508.
3.
4. MANU/NC/2096/2023.
5. RBI/2006-2007/435 A.P. (DIR Series) Circular No.74, Available here.
6. [2010] 321 ITR 611 (Raj)
7. Recently followed by the
8. IT(TP)A No. 520/Bang/2022
Note: This Article was published by Law Street India on
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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