Compulsory Convertible Debentures (CCDs) are one of the sources for raising funds for the corporate sector. CCDs is a type of security that gives holders the option to convert their debentures into a fixed number of equity shares after a specified date.
Raising funds through equity would dilute the stake in the company whereas, the debt will carry a huge rate of interest. Thus, the other alternative is the issuance of Compulsory Convertible debentures [‘CCDs’] which can be converted into equity at a specified time or on the happening of specified events, into equity. CCDs, as the name suggests, are a “debt” instruments which are to be compulsorily converted into equity after a certain period. That is, CCDs are hybrid instruments, being debt at the time of issue along with a certainty to get converted into equity. Hence, Companies go to issue Compulsory Convertible Debentures (CCDs) to maintain control of the company and avoid diluting the shareholding of existing equity shareholders.
Legal Framework-CCDs
The Companies Act 2013: Section 71 of the Companies Act, 2013 read with Rule 18 of Companies (Share Capital and Debentures) Rules, 2014 authorizes the company to issue debentures with an option to convert such debentures into shares, either wholly or partly at the time of redemption which will be subject to the approval by a special resolution passed at a general meeting. Rule 13(2)(h) also deals with the issue of convertible securities.
The Income Tax Act, 1961:
Section 36(1)(iii) of the Income-tax Act, 1961 (‘IT Act’) provides for the deduction of interest paid in respect of capital borrowed by a taxpayer for its business or profession. Given that, if CCDs are treated as capital ‘borrowed’ for the IT Act, then the interest paid thereon shall be allowable as a deduction, whereas if the same is treated as ‘equity’, no deduction would be permissible for return paid on equity investment.
56(2)(viib) of the Income Tax Act, 1961 which states that where an unlisted 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 shall be chargeable to income-tax under the head Income from other sources.
Rule 11UA (2) provides determination of FMV of unquoted equity shares issued by closely held companies as provided under section 56(2)(viib) of the Act. The options granted to assesses are through NAV(Net Assets Value) or through FMV decided by a merchant banker as per Discounted Cash Flow Method.
Section 47(x) of The Income Tax Act, deals with the definition of “transfer” for it be leviable of Capital Gains.
Pre-requisites of issuance:
Introduction-CCPs
Compulsory Convertible Preference Shares (CCPs) is one of the sources for raising funds for the corporate sector. It is an advance version of equity shares. CCPS is a type of bond/stock that gives holders the option to convert their preference shares into a fixed number of equity shares after a specified date.
Raising funds through equity would dilute the stake in the company whereas, the debt will carry a huge rate of interest. Thus, the other alternative is the issuance of Compulsory Convertible Preference Shares [‘CCPs’] which can be converted into equity at a specified time or on the happening of specified events, into equity.
CCPs, as the name suggests, are instruments which are to be compulsorily converted into equity after a certain period. That is, CCPs are hybrid instruments, being preferential at the time of issue along with a certainty to get converted into equity.
Legal Framework-CCPs
The Companies Act 2013: The Issue of CCPS is primarily governed by provisions of Section 42, 55 and 62 of Companies Act, 2013 read with Companies (Prospectus and Allotment of Securities) Rules, 2014 and Companies (Share Capital and Debentures) Rules, 2014.
The Income Tax Act, 1961: The valuation of CCPS shall be subject to provisions of Section 56(2)(viib) of the Income Tax Act, 1961 which states that where an unlisted 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 shall be chargeable to income-tax under the head Income from other sources.
Rule 11UA (2) provides determination of FMV of unquoted equity shares issued by closely held companies as provided under section 56(2)(viib) of the Act. The options granted to assesses are through NAV (Net Assets Value) or through FMV decided by a merchant banker as per Discounted Cash Flow Method.
Pre-requisites of issuance:
Conclusion:
CCPS offer fixed income to the investors and compulsorily convert into Equity Shares of the issuing company after a predetermined period. The terms of conversion are also pre-decided at the time of issue.
CCPS are particularly offered to fill the gap between the valuation expectations of the founder and the investors that are generally linked to the performance of the Company. These offer investors the opportunity to participate in the growth of companies while mitigating the risk of lower valuation of companies that underachieve the targets. Issuing CCPS further benefits the Company’s promoters to raise funds without diluting the ownership at the initial period.
As regards to CCDs, Convertible debentures are hybrid products that try to strike a balance between debt and equity. Investors gain the benefit of fixed interest payments while also having the option to convert the loan to equity if the company performs well, rising stock prices over time.
The risk to investors is that there is little insurance in case of default if they’re holding shares of common stock. However, during bankruptcy liquidation, if an investor is holding a convertible debenture, the debenture holder gets paid before common shareholders.
Authors:
Kinjal Paresh Shah | Associate Consultant
Email: [email protected] Contact: +91 88987 73607