We are penning this article to give the readers a brief outlook on the potential advantages in respect of the structuring of an investment via compulsorily convertible debentures in comparison to other pure equity instruments.
Compulsorily Convertible Debentures offer taxation benefits arising from classification of receipts as dividend or income in light of favourability of dividend or income in light of favourability of taxation treatment, in addition to allowing an investor the option of tailoring investment exposure as per his risk appetite and allowing for the concerned parties to address valuation at subsequent junctures thereby having an expeditive value.
COMPULSORILY CONVERTIBLE DEBENTURES VIS-A-VIS PURE EQUITY INSTRUMENTS
The potential advantages in respect of the structuring of a capital infusion via compulsorily convertible debentures (“CCDs”) instead of other equity instruments are as explored hereinbelow:
- Taxation: The hybrid debt-equity nature of CCDs may be used to structure a tax efficient mechanism for a cross- border transaction. For instance, the receipts arising from a CCD may be classified as either interest (on account of characterization of the CCD as a debt instrument) or as dividend (on account of characterization of the CCD as an equity instrument) contingent on the applicable law and tax treatment in respect of interest/dividend in the concerned country.
Note: As per the notification issued by the RBI as read with the definition of ‘capital’ under the Consolidated Foreign Direct Investment Policy, compulsorily and mandatorily convertible debentures are to be classified as equity instruments. Further, the decision in AAR No. 1048 of 2011, holding that the recharacterization of the interest income from CCDs as capital gains was resultant of a sham transaction, may cast doubt over the validity of such recharacterization.
- Exposure: An investor can limit the exposure resultant from any investment by structuring the investment as a combination of debt/hybrid and equity instrument as opposed to exposure in the form of pure equity. A hybrid instrument such as a CCD may be convertible upon expiry of a specified time period or achievement of specified milestones.
- Valuation Mismatch: Structuring a convertible note as CCDs allows for the investor and investee entity to post-pone price discovery until a later point (usually the next qualified equity financing funding round participated in by the investee entity) and may be utilized when there is a mismatch between the valuation of the target entity between investor and the investee. The terms of the CCDs may provide for a conversion ratio in respect of the conversion of the CCDs into shares in the investee entity and provide for variation of such conversion ratio in light of the EBIDTA of the investee entity, price at which shares are issued by the entity in the next equity financing round, floor pre-money valuation etc.
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