Introduction: FINANCE, the seven-letter word is a pivotal aspect of each and every business. Various means and modes of financing have been developed so as to meet the demands of the investors as well as generate money for the businessman. In this ever-changing business environment, generating money has been one of the biggest issues faced by the businesses and investing in the right manner in the right business have been one of the biggest challenges for the investors.

With the introduction of various means of financing sources, the regulatory authorities have also updated the financial reporting requirements in order to cater the needs of the investors and avoid the ill-usage of the investor’s fund. The Ministry of Corporate Affairs had introduced the Indian Accounting Standards (‘Ind AS’) which have been prepared in line with the International Financial Reporting Standards.

Ind AS 32, Ind AS 107 and Ind AS 109 deal with the accounting aspects of financial instruments. Before deciphering the tax aspects, it is pertinent to understand the fundamental accounting aspects related to financial instruments.

Overview:

Financial Instruments under Ind AS means any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. The definition clearly states that a financial instrument can be either of the following:

1. Financial asset;

2. Financial Liability; and/or

3. Equity

Ind AS 32 requires an issuer to identify and evaluate the terms of the financial instrument and determine whether it has the characteristics of a liability or an equity instrument. The issuer should identify the components of a financial instrument and classify each component based on the substance of its contractual terms either as a financial liability or an equity instrument.

A financial liability in lucid terms means a contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial assets or financial liabilities with another entity under the conditions that are potentially unfavorable to the entity. Thus, it indicates that a contract that imposes an unavoidable obligation on the part of the issuer to either pay cash or deliver another financial asset would be classified as a financial liability.

On the other hand, equity instrument refers to any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities. Accordingly, where there is an instrument which has the features of a financial liability as well as an equity instrument, it is known as Compound Financial Instrument (‘CFI’). Examples of CFI include the following:

1. A perpetual loan with a mandatory interest component where the principal amount is the equity component, as the entity is not required to shell out any cash or another financial asset and the interest component is the financial liability, as the entity is under a contractual obligation to deliver cash to the lender.

2. Another example is issue of optionally convertible preference shares (‘OCPS’) wherein the payment of dividend is at the discretion of the issuer company. However, the redemption of shares would be a financial liability, as the entity does not have an unconditional right to avoid delivering the cash. Further, the holder of OCPS also has an option to convert the preference shares into the equity shares indicating that the OCPS has an equity component too.

CFIs are a sort of hybrid arrangement having a blend of both financial liability and equity and therefore, Ind AS prescribes split accounting method for accounting of such instruments.

The issuer should determine the initial recognition amount for the liability component and allocate the residual amount (out of the initial fair value of the compound instrument) to the equity component. The sum of the carrying amounts of the liability and equity components on initial recognition would be equal to the initial fair value of the compound instrument and no gain or loss is recognized on separation of these components.

Taxation aspects:

The taxation laws in India are governed by the provisions of the Income Tax Act, 1961 (‘the Act’) read with the Income Tax Rules, 1962 (‘Rules’). The tax impacts as regards the CFIs needs to be analyzed carefully, as the accounting in the books needs to be done based on the various parameters laid down under Ind AS. However, fundamental tax laws follow the real income theory  which is the cornerstone of the taxation system. As per the theory, only actual profits arrived based on commercial principles should be chargeable to tax. The theory has been affirmed by the Hon’ble Apex Court in case of Godhra Electricity Co. Ltd vs. Commissioner of Income-tax [1997] 91 Taxman 351 (SC) and Poona Electric Supply Co. Ltd. vs. Commissioner of Income-tax [1965] 57 ITR 521 (SC). Thus, taxation of CFI needs careful consideration of the following points:

Deduction for interest paid:

Split accounting for CFIs is undertaken by first determining the carrying amount of the liability component. While doing so, net present value of the discounted cash outflows is calculated ignoring the possibility of exercise of conversion option, if any. The discount rate is the market rate at the time of inception of a similar liability which does not have an associated equity component. The carrying amount of the equity instrument is then determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole.

In this case, the amount debited to the finance cost would be the amount of unwinding of discount at the market rate and not at the actual rate of interest paid. However, for taxation purposes that notional interest booked in the books shall not be allowed and only the actual amount of interest paid / payable shall be allowed as deduction u/s 36(1)(iii) of the Act.

To understand the above points in a better manner let us consider an example:

A company issues 8% optionally convertible debentures which are redeemable at the end of 3 years. An investor can decide either to accept the redemption proceeds in cash or shares of the company. The company received INR 10,00,000 as issue proceeds of the debentures. The prevailing market rate of interest for similar debentures without conversion option is 10%.

Accounting:

In the instant case, the financial liability would be calculated by discounting the cash outflows at the prevailing market rate i.e. 10%.

Fair value of principal component (INR 10,00,000 discounted at 10% over 3 years) = INR 7,51,315 (approx.)

Fair value of interest component (INR 80,000 discounted at 10% for each of the 3 years) = INR 1,98,948 (approx.)

Fair value of the liability component = INR 7,51,315 + INR 1,98,948 = INR 9,50,263

∴ Fair value of equity component = INR 10,00,000 – INR 9,50,263 = INR 49,737.

Now, each year the liability shall be increased by unwinding of discount at 10% and reduced corresponding payment of interest at 8%. Thus, the Profit and Loss Account for each of those 3 years shall be debited by finance cost of 10% instead of the actual interest amount of 8%.

Taxation:

As mentioned above, only the interest which has actually been incurred is allowed as per the provisions of section 36(1)(iii) of the Act (i.e. INR 10,00,000 x 8% = 80,000). Thus, In the case of CFIs it is pertinent to note that only the interest which is actually incurred shall be admissible under the provisions of the Act and the balance notional interest shall be disallowed (i.e. Carrying value of financial liability x 10% – 80,000).

Changes in fair value debited to Profit and Loss Account:

Under Ind AS, the changes in fair value of the financial liability is recognised in the profit and loss account. However, under the provisions of the Act neither any notional expense related to the change in fair value of the financial liability is deductible nor any notional income with respect to change in fair value of the financial liability is chargeable to tax and thus, any notional gain or loss on change in fair value of the financial liability component of the CFI shall not be considered while computing the taxable income of the entity.

Capital gains on conversion:

Per the provisions of the section 47 of the Act, certain transfer of capital assets is considered as exempt transfer and thus, not chargeable to tax.

“……..

(x) any transfer by way of conversion of bonds or debentures, debenture-stock or deposit certificates in any form, of a company into shares or debentures of that company;

(xa) any transfer by way of conversion of bonds referred to in clause (a) of sub-section (1) of section 115AC into shares or debentures of any company;

(xb) any transfer by way of conversion of preference shares of a company into equity shares of that company;

……..”

The above provisions clearly state that any transfer of asset by way of conversion into equity shares of the company shall be considered as an exempt transfer. Thus, when such convertible instruments are converted into equity shares of the company the conversion shall not be treated as a transfer of capital asset u/s 47 of the Act and hence, would not subject to capital gains tax.

Issue of equity shares on conversion at higher / lower than Fair Market Value (‘FMV’):

Section 56 is the charging section for the head “Income from Other Sources”. Any income or benefit received/earned (as the case may be) which is not chargeable under any other heads of income shall be charged under the head Income from Other Sources unless specifically considered as exempt. Generally, section 56 attempts to cover within its ambit the receipts/amount which may be received by a particular person not fair value or for an inadequate consideration/no consideration.

One of the most critical issue related of taxation of CFIs is the issue of equity shares on conversion at a price which is higher than the FMV.

“…..

(viib) where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:

……”

The above extract of section 56(2)(viib) of the Act states that, when a private limited company issues shares to a resident for a consideration higher than the FMV of the shares, then the issuing company shall be liable to pay tax on the excess amount received (i.e. difference between the FMV and the issue price).

With respect to CFI, it would be important to analyze whether the provisions of section 56(2)(viib) of the Act apply, if the shares are issued at a price which is higher than the FMV of the shares, on the event of conversion.           

In this regard, it is worthwhile to note that the shares would be issued on the date of conversion in accordance with the FMV of shares as per the prescribed method stated under Rule 11UA of the Rules. It is a well settled principle that projections cannot be challenged based on their comparison with the actual results. A recent ruling of the Hon’ble Mumbai Tribunal in case of Vodafone M-Pesa Ltd. vs. DCIT [2020] 114 taxmann.com 323 (Mumbai – Trib.) stated that the valuation of shares cannot be rejected on by comparing factual results of company with projection adopted by valuer.

Thus, it can be fairly concluded that if the shares have been issued as per FMV of the equity shares on the date of conversion on the date of issue of convertible securities, the provisions of section 56(2)(viib) of the Act would not get attracted.

To understand the above issue, let us consider an example

Case 1:

Particulars Amount (in INR)
Fair Value of equity shares on the date of conversion (determined on the date of issue of convertible security) 200
Issue price of equity shares 150
Actual value of equity shares on the date of conversion 100

In the instant case, since the equity shares on the event of conversion have been issued in line with the FMV of the equity shares on the date of conversion (determined on the date of issue of convertible security), the difference between the actual market value on the date of conversion and the issue price of shares would not be charged to tax in the hands of the company under the provisions of section 56(2)(viib) of the Act.

Case 2:

Particulars Amount (in INR)
Fair Value of equity shares on the date of conversion (determined on the date of issue of convertible security) 200
Issue price of equity shares 100
Actual value of equity shares on the date of conversion 150

In the instant case, the provisions of section 56(2)(viib) of the Act would not get attracted, but one could argue that the provisions of section 56(2)(x) of the Act would get triggered, as the shareholder received the shares worth INR 150 for a consideration of INR 100 which could be considered as an inadequate consideration.

Below is the extract of section 56(2)(x) of the Act

“…….

(x) where any person receives, in any previous year, from any person or persons on or after the 1st day of April, 2017,—

…….

 (c) any property, other than immovable property,—

  (A) without consideration, the aggregate fair market value of which exceeds fifty thousand rupees, the whole of the aggregate fair market value of such property;

 (B) for a consideration which is less than the aggregate fair market value of the property by an amount exceeding fifty thousand rupees, the aggregate fair market value of such property as exceeds such consideration :

…….”

In the instant case, prima facie the provisions of section 56(2)(x) of the Act would not be attracted since, the shares have been issued at a price which is less than the FMV of the shares.

The above case is similar to fresh issue of equity shares and therefore, one needs to deliberate whether the provisions of section 56(2)(x) of the Act applies to fresh issue or not. On careful perusal of the provisions, one could observe that the section 56(2)(x) of the Act would be attracted only in case where the person “receives” something for an inadequate consideration. In cases of conversion, the holder does not receive any new asset, the event of conversion merely changes the form of the instrument. Further, the word “receive” has not been defined in the Act; therefore plain, natural, grammatical meaning needs to be attached. The ordinary dictionary meaning of the word “receive” shows that word “receive” supposes a transfer and consequently a transferor.

In the context of shares, allotment takes place by way of appropriation out of previously unappropriated capital of a company, of a certain number of shares, to a person and till such allotment, the shares do not exist. In case of Khoday Distilleries Limited vs. Commissioner of Income Tax [2009] 176 Taxman 142 (SC) the Hon’ble Supreme Court explained that there is a vital difference between “creation” and “transfer” of shares. The words “allotment of shares” has been used to indicate the creation of shares by appropriation out of the unappropriated share capital to a particular person. There is thus a distinction between a case where there is an allotment of shares (involving a creation of a share) and a share purchase (where there is a transfer of an existing share). Therefore, it can be said that fresh issue / allotment of shares is not covered by provisions of section 56(2)(x).

Date of acquisition for determination of capital gain on sale of equity shares received on conversion:

Another issue with relation to CFIs is what would be the date of acquisition of the shares issued on conversion. While determining the amount of capital gains on sale of a capital asset, one of the most important aspect of the transaction is the date of acquisition, since it depends on the date of acquisition whether the asset is a long term capital asset or a short term capital asset.

As per the provisions of section 49 of the Act, in the case of shares issued on conversion, the date of acquisition has to be considered to be the date of acquisition of the convertible security, since the equity shares have originated from the convertible security. The said view has been upheld by the Hon’ble Punjab and Haryana High Court in case of CIT vs. Naveen Bhatia [2015] 62 taxmann.com 87 (P&H HC).

Expenses incurred on issue of optionally convertible bonds / debentures:

An issue which arises with respect to CFIs, is the allowability of expenditure incurred on issue of optionally convertible debentures / bonds. In this regard, it could be held that as the expense is incurred for expansion of capital base of the company and hence, the expenditure is for a capital field transaction and thereby, no deduction would be allowed under the provisions of the Act.

However, there are various judgements which state that the expenditure incurred on issue of convertible debenture/bond is a revenue expenditure on the ground that the issue of shares is a future event which may or may not happen, and therefore, expenditure incurred is on issue of debenture/bond only. Some of the judgements have been mentioned below:

1. CIT vs. First Leasing Co. of India Ltd. [2008] 304 ITR 67 (Mad. HC);

2. CIT vs. Secure Meters Ltd. [2010] 321 ITR 611 / [2008] 175 Taxman 567 (Raj. HC);

3. CIT vs. Sukhjit Starch & Chemicals Ltd. [2010] 326 ITR 29 (P&H HC);

4. CIT vs. ITC Hotels Ltd. [2011] 334 ITR 109/[2010] 190 Taxman 430(Kar. HC).

However, Hon’ble High Court of Gujarat in case of Torrent Pharmaceuticals Ltd. vs. ACIT [2015] 55 taxmann.com 170 (Guj. HC) took a contrary view, stating that the expenditure incurred on issue of convertible debenture / bond is a capital expenditure since, is directly related to expansion of capital base of company and hence, not admissible under the provisions of the Act.

Taxation under the provisions of Minimum Alternative Tax (‘MAT’):

The Finance Act, 2017 inter-alia carried out amendments in Section 115JB of the Act to accommodate the changes in calculation of ‘book profits’ pursuant to Ind-AS adoption by companies. Sub-section 2A principally provides for adjustments to be made to such book profits computed in accordance with the mechanism as stated before such amendment. Sub-section 2C provides for adjustments to be made to ‘book profits’ during the year of convergence for one fifth of the ‘transition amount’.

Broadly, ‘transition amount’ means the amounts adjusted in Other Equity (excluding capital reserve and securities premium reserve) on transition, leaving aside specified items. However, the equity component of compound financial instruments does not feature in the list of excluded items. As a result, the value of equity component of CFI reflected in the ‘Other Equity’ section, is liable to be taxed for MAT purpose, over a period of five years.

Further, even under the accounting treatment, there would be no related debit to the statement of Profit and Loss in future neither in the form of increased debit for interest or otherwise, nor on conversion to equity shares. Accordingly, if taxed under section 115JB(2C) of the Act, it would lead to a MAT burden that would not balance out over a time span. Further, there is no provision to claim deduction in respect of the amount taxed. The issue therefore deserves greater attention. Moreover, the equity component of the CFI is capital in nature which ideally should not be taxed. Besides, CFIs issued after adoption of Ind AS would not lead to a similar impact on bifurcation of the value into equity and debt component since, tax would not be levied on any changes in the ‘Other Equity’ section. Therefore, it appears that literal interpretation may lead to an unfair and unintended outcome in this case. If one looks deeper into the language of the Finance Bill and the Memorandum thereto, it may be possible to infer that the lawmakers did not intend such taxation. Yet, in the absence of specific provisions or clarifications in relation to CFIs, companies may have no choice but to litigate the matter, or to suffer MAT on the transition impact.

DEFERRED TAX ASPECTS:

Issue of CFIs give rise to temporary differences at various stages which thus, warrants careful consideration of various implications with respect to accounting for deferred tax implication in line with Ind AS 12.

Few instances where deferred tax needs to be accounted w.r.t. CFIs are mentioned below:

  • The liability component of a compound financial instrument would be measured at a discount to the amount repayable on maturity. However, the tax base of the asset would be the actual value of the liability thereby, creating a taxable temporary difference which in turn would lead to the need for recognising a deferred tax liability;
  • Further, Ind AS 12 also specifies that if a temporary difference relates to an item charged or credited directly to equity in the same or a different period then, the temporary difference resulting from separation of a compound instrument would be charged to equity.

Conclusion:

The financial instruments are issued for a substantial time period and hence, before issuance of such instruments there are various aspects apart from taxation which needs to be considered by the management of the company. Insofar as the compliance is concerned an entity issuing financial instruments needs to ensure that it complies with the provisions of various regulatory authorities like Registrar of Companies, Reserve Bank of India (in case funds are received from outside India), stamp duty compliance, etc.  However, taxation being one of the most important aspects with regards to evaluation of a proposal, due care needs to be taken so as to avoid unintended negative consequences.

CFI in today’s ever growing business environment would be one of the most important modes of raising finance, wherein, the company would get a long term finance and the investor would get a fixed return, along with an option to reap the fruits of bearing the risk by converting its investment into an equity stake in the company in the event the company’s business flourishes. Given the potential interplay of the various regulatory and tax provisions with the accounting framework, one would have to navigate the issue judiciously.

Disclaimer:

Any views expressed in this article are personal belong solely to the author and do not represent those of people institutions or organizations that the person may or may not be associated with in personal or professional capacity, unless explicitly stated.

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One Comment

  1. VatsaT says:

    Dear readers,

    There is an inadvertent mistake in the point related to deduction of interest paid. The correct treatment is as under.

    In the case of CFIs it is pertinent to note that only the interest which is actually incurred shall be admissible under the provisions of the Act and the balance notional interest shall be disallowed (i.e. Carrying value of financial liability x 10% – 80,000).

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