Convertible Debenture is a type of loan issued by a company that can be converted into stock by the holder and, under certain circumstances, the issuer of the bond. By adding the convertibility option the issuer pays a lower interest rate on the loan compared to if there was no option to convert. These instruments are used by companies to obtain the capital they need to grow or maintain the business.
Convertible debentures are different from convertible bonds because debentures are unsecured; in the event of bankruptcy the debentures would be paid after other fixed income holders. The convertible feature is factored into the calculation of the diluted per-share metrics as if the debentures had been converted. A transaction of Compulsory Convertible Debentures (CCD's) gave rise to a legal battle between a Mauritius based company and the Indian Income Tax Department. In order to comprehend this legal battle, it would be appropriate to understand the facts which gave rise to this controversy.
As per facts available a company stood incorporated under the laws of Mauritius having a tax residence status in Mauritius. The Company was engaged in the business of investments in India. The Company entered into a Securities subscription Agreement ("SSA") and a Shareholder's Agreement ("SHA") with an Indian company and its subsidiary ("JV"). The Company agreed to acquire 35% ownership interest in the JV. The company thus agreed to subscribe to 46,307 equity shares having a par value of Rs 10 each and 882,585,590 zero percent CCDs having a par value of Re 1 each in a planned and phased manner. SHA recorded the terms of this relationship and rights and obligations of the parties inter se including matters relating to transfer of equity shares and management and operation of the JV. SHA also provided for call and put options to the subsidiary by the acquiring company. Subsidiary company (JV) partly exercised the call option and purchased equity shares along with CCDs from Mauritius-based company. Mauritius company accordingly transferred equity shares and CCDs to the purchaser.
This Mauritius-based company, after the deal, approached the income tax authorities under Section 197 of the Income Tax Act 2012 requesting for "nil" withholding certificate. The certificate was required to receive the total consideration from the buyer. The income tax officer held that the entire gain on the transfer of equity shares and CCD; is to be treated as an interest and is liable to the taxed @ 20%. The order of the income tax officer was challenged by Mauritius-based company through a constituted petition before the Delhi High Court1.
The petition was contested by the Income Tax Department. The Deptt contended that entire gains on the sale of equity shares including CCDs held by the petitioner are not exempt from income tax in India by virtue of the Double Taxation Avoidance Convention ("DTAA") with Mauritius and that the gains arising on the sale of CCDs are 'interest' within the meaning of Section 2 (28A) of the Income Tax Act, 1961 and Article 11 of the 2012 DTAC and are taxable as such.
AS A CONSEQUENCE, THE COURT WAS CONFRONTED WITH THE FOLLOWING ISSUES:
1. Whether the gains arising in the hands of Mauritius-based company from transfer of its investments in the JV is 'interest' or 'capital gains'.
2. Whether the corporate veil ought to be lifted and that the JV and Indian company were essentially the same entity.
On behalf of the Mauritius based company, it was contended that amount of gains received/ receivable by Mauritius-based company resulting from transfer of the investments held by Mauritius based company in the JV, was NOT 'interest' under Section 2(28A) of the IT Act. There was no debtor and borrower relation between Indian company and Mauritius based company and therefore transaction entered into between Mauritius-based company, Indian company and its subsidiary was NOT a load transaction. The CCDs were held as capital assets by Mauritius-based company and the transfer of the investment was a transfer of a capital asset and any gains arising there from were liable to be treated as capital gains. Therefore, such gains could not be subjected to income tax in India in terms of the DTAA between India and Mauritius.
The Deptt on the other hand contended that: the transaction was essentially in the nature of an external commercial borrowing and Mauritius-based company was entitled to receive a fixed rate of return and that the duration of the investment would determine the quantum of return receivable by the company. The transaction was a load transaction and the returns on the investment were simply interest, liable to be taxed in India. The corporate veil ought to be lifted and in proceeding on the basis that subsidiary company and the JV were, essentially, a single entity. Therefore, debt owed by JV was in reality Company's debt and the amount received by Mauritius-based company in excess of the investment made by them would amount to 'interest' paid or payable by subsidiary company for borrowed funds.
The Department on the other hand contended that: The transaction was essentially in the nature of an External Commercial Borrowing Mauritius-based company and was entitled to receive a fixed rate of return and that the duration of the investment would determine the quantum of return receivable by Mauritius-based company. The transaction was a loan transaction and the returns on the investment were simply interest, liable to be taxed in India. The corporate veil ought to be lifted and in proceeding on the basis that subsidiary company and the JV were, essentially, a single entity. Therefore, debt owed by JV was in reality subsidiary company's debt and the amount received by Mauritius-based company in excess of the investment made by them would amount to 'interest' paid or payable by subsidiary company for borrowing funds.
THE COURT AFTER REVIEWING THE ARGUMENTS OF THE PARTIES CONCLUDED THAT AS REGARDS ISSUE NO 1, THE LEGAL POSITION IS AS UNDER:
I. Gains arising from sale of capital assets would not be in the nature of interest. The expression 'interest' as defined under Section 2(28A) of the Income Tax Act cannot apply to all gains that are received by a debenture holder (lender) irrespective of the transaction resulting in such gains.
II. Whether a Compulsorily Convertible Debenture is a loan simply or whether it is in the nature of equity, is not material in determining whether the gain on the sale of the debentures by its holder is a capital gain or not. This depends entirely on whether the debentures are capital assets in the hands of its holder.
III. Call and Put Options in the Share holder's agreement cannot be read to mean that Mauritius-based company was only entitled to a fixed return on the investments made by it in the equity and CCDs issued by JV. The Call option also contemplated that if the option is exercised after the expiry of three years from the First Closing Date, the price to be computed would also include a component of "equity payment" (10% of the project value).
IV. SHA only provided for options either to Indian company to buy out the stake of Mauritius-based company in JV, or to Mauritius-based company, to exit the JV by calling upon Indian company to buy its shares. It was not necessary that either Indian company or Mauritius-based company exercise the options as available to them. By the very definition, call and put options were only options that were available to the contracting parties. In the event none of the options were exercised, the CCDs held by Mauritius based company would mandatorily be convertible into equity shares and Mauritius based company would be entitled to the benefits that would accrue to an equity shareholder in respect of the equity shares issued by the JV on conversion of the CCDs.
V. The SHA was essentially a joint venture agreement and it is common in any joint venture agreement for the co-ventures to include covenants for buying each-others' stakes.
VI. Although, the SHA enabled Mauritius-based company to exit the investment by receiving a reasonable return on it, and in that sense it assured a minimum return, the same cannot be construed to mean that the CCDs were fixed return instruments, as Mauritius based company also had the option to continue with its investment as an equity shareholder of JV. Merely because an investment agreement provides for exit options to an investor, would not change the nature of the investment made.
VII. The rights with regard to options as well as additional rights under the SHA were the mutual rights and obligations between Indian company and Mauritius-based company and not the JV.
VIII. Assuming that the gains were payment of interest by Indian company, the same would also mean that the quantum of interest is a deductible expenditure in the hands of Indian company and viewed from this perspective, it would be erroneous to conclude that the whole transaction had been structured to ensure avoidance of tax on income.
On issue No 2, the Court was of the view that notwithstanding the JV being managed as a joint venture between Mauritius-based company and by the Indian-based company, the affairs of JV were to be managed separately and distinctly from that of Indian company and therefore JV was not an alter ego of the said company alone. There were clean and sufficient indications in the agreements that all transactions with related parties were to be conducted on an Arm's Length basis. All decisions that could be considered important required the consent of both Mauritius-based company as well as Indian company. In certain matters where there could have been possibility of a conflict of interest between Indian company and JV, the nominee directors of Indian company were obliged to refrain from participating or influencing the decision of JV. Mauritius based company was entitled to participate in the management and affairs of JV, not only by appointing its nominee directors but also by ensuing independent auditors and an independent Asset Manager. Since Indian company was also involved in the project, the Shareholder's agreement ensured that no payments could be made by JV to its parent company under the relevant contract without the authority of an independent Asset Manager. (The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates Karachi) 1 Zaheer Mauritius V Director of Income Tax. W.P no C 1648/ 2013 decided by Delhi High Court on 30.7.2014.
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