14 September 2017

Compulsorily Convertible Debentures - Loan Or Investment

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An age-old question debated for long and of utmost importance for structuring is whether subscription to compulsorily convertible debentures by any person would be considered as a loan or an investment.
India Corporate/Commercial Law
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An age-old question debated for long and of utmost importance for structuring is whether subscription to compulsorily convertible debentures by any person would be considered as a loan or an investment.

Section 185 of the extant (Indian) Companies Act 2013 ("Act") imposes a restriction on companies for providing loans, either directly or indirectly, to directors or any other person in whom a director is interested subject to certain exceptions set out therein. The expression 'any other person in whom director is interested' includes a body corporate (which can be a company incorporated outside India) where at least 25% of the voting power vests with a director or jointly with any other directors of the Indian lending company. Hence, if compulsorily convertible debentures are to be considered as a loan, an Indian company cannot subscribe to compulsorily convertible debentures of a company/foreign company (subject to extant foreign exchange regulations relating to overseas direct investments) where director(s) of the lending company holds equal to or greater than 25% of the voting power.

The Act defines 'security' by a reference to Section 2 (h) of the Securities Contracts (Regulation) Act, 1956 ("SCRA") whereby 'securities' include "shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate; ...".

The term 'debenture' is defined in the Act to include "debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not".

The extant foreign direct investment policy of 28 August 2017 includes compulsory convertible debentures within the meaning of 'capital' and the term 'FDI' is defined to mean an investment by a non-resident in the 'capital' of an Indian company. Hence, the intent is explicit that a compulsory convertible debenture is treated akin to equity shares for the purposes of foreign direct investments in India.

The Indian judiciary has discussed this query at multiple occasions and some of their findings have been set out below.

  1. CIT v Motor Industries Co. Ltd. ILR 1992 Karnataka 345: It was held that the debentures were subscribed to acknowledge the debt owed to financial institutions from which loans were obtained and the amounts were utilised for creation of capital assets in India.
  2. Deputy Commissioner of Income Tax v Modern Syntex (India) Ltd. and Modern Syntex (India) Ltd v Dy. CIT (2005)95TTJ(JP)161: Similarly, the tribunal had held that the expenditure incurred was on 'issue of debentures in other words, for raising of loan' and the debentures were 'issued by the company and it is in the form of certain indebtedness'. This was irrespective of the fact that these debentures were convertible into equity shares.
  3. Kirloskar Pneumatic Co. Ltd v Commissioner of Surtax (1994)118CTR(Bom)13 and Ganesh Banzoplast Limited v Assistant Commissioner of Income Tax (2007)111TTJ(Mum)385: The courts have held that debentures, either convertible or non-convertible, are an acknowledgment of indebtedness.
  4. However, the Supreme Court of India in Sahara India Real Estate Corporation Limited v SEBI (2013) 1 SCC (Civ) 1 had analysed the characteristics of a hybrid instrument in detail and took a contrary view that a hybrid instrument such as optionally convertible debentures are securities for the purposes of the Act and the SCRA. The Supreme Court held that 'it is clear, that "hybrids" are included within the term "securities" not only for the purposes of Companies Act, but also, under the SEBI Act'.
  5. Subsequently, this Supreme Court judgment was relied on by the Income Tax Appellate Tribunal, Delhi ("ITAT") in DCIT vs Sahara India Commercial Corporation Limited 2013(28)ITR(Trib)108(Delhi) wherein the ITAT clearly distinguished between the 'securities' on the one hand and 'loans' and 'deposits' on the other hand. The ITAT held that optionally convertible debentures are 'securities' and not 'loans' or 'deposits' for the purposes of the Income Tax Act, 1961 and rules made thereunder.

Further, the term 'loan' is not defined under the Act. Blacks law dictionary defines the term 'lending' as 'delivery by one party to and receipt by another party, sum of money upon agreement, express or implied to repay it with or without interest'. The above definition may be interpreted to say that it does not cover the money received from subscription of debentures.

Similarly, as per the Act, the term 'deposit' includes any receipt  of money by way of deposit or loan or in any other form by a company, but does not include certain categories of amounts including amount raised vide subscription of bonds or debentures subject to conditions set out in the rules made under the Act. Thus, it can be argued that the intent of the legislature is to differentiate among the meaning of 'loan', 'deposit' and 'debenture'.

The terms 'loan' and 'subscription of securities' have been used separately in the Act. As an example, Section 185 of the Act uses the word 'loan' as distinct from the word 'securities' or 'subscription of securities'. Further, Section 186(2) of the Act uses the words 'loan' and 'subscription of securities' separately in two different sub-clauses. Also, debenture being a security may be of marketable nature which may not be correct for a loan.

Hence, in view of the above and placing reliance on the judgments of the Supreme Court of India and the ITAT Delhi, the argument that subscription to compulsory convertible debentures constitutes an investment and not grant of a loan gains substantial strength.

Going forward, this discussion may take a turn as the Companies (Amendment) Bill 2016 ("Bill") (yet to come into force) proposes to amend Section 185 of the Act pursuant to which a company will be permitted to advance a loan to any person in whom a director is interested provided that the said loan is approved by a special resolution passed in a general meeting and the loan will be used by the borrowing company for its principal business activities. The intent appears to emphasize on adequate disclosure to the shareholders and to not prohibit loans to the entities in which directors are interested. 

The content of this document do not necessarily reflect the views/position of Khaitan & Co but remain solely those of the author(s). For any further queries or follow up please contact Khaitan & Co at

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