When convertible bonds or debentures are issued, the question, which arises, is whether the amount paid to the investor is to be treated as interest or dividend. If it is in the nature of a dividend, it would be exempt from tax under section 10(34) of the Income Tax Act, 1961.

This issue is relevant for the period where the convertible bonds are in existence because there is no doubt that after the bonds are converted into equity shares, the amount would be in the nature of a dividend. During the pre-conversion period when the bonds or debentures exist, it would be reasonable to take the view that the amount earned is in the nature of interest and, therefore, taxable.

Yet, this issue came up before the Authority for Advance Rulings in LMN India Ltd, In re (307 ITR 40). In this case, the applicant, an Indian non-banking financial company, made investments in various businesses in India and abroad in the form of securities including shares, stocks and debentures. For the purpose of funding its business activities, it proposed to borrow money from LMCC of the US by issuing fully convertible bonds under the foreign direct investment schemes. The bonds were convertible into equity shares at the end of five years, unless extended for a further period of five years.

Interest was payable on the bonds by the applicant in rupee currency in cash on a half-yearly basis, irrespective of whether the applicant made profits or not. Until conversion, the bonds ranked in priority to equity shares in the event of its liquidation. On these facts, the applicant sought the ruling of the authority regarding the taxability of the income from the convertible bonds, and whether it was obliged to deduct tax at source.

Section 2(28A) defines “interest” to mean interest payable in any manner in respect of any moneys borrowed or debt incurred (including a deposit, claim or other similar right or obligation) and includes any service fee or other charge in respect of the moneys borrowed or debt incurred or in respect of any credit facility which has not been utilised.

Article 11 of the Indo-US double tax avoidance agreement defines “interest” as follows: “(4) the term ‘interest’ as used in this Convention means income from debt-claims of every kind, whether or not secured by mortgage, and whether or not carrying a right to participate in the debtor’s profits, and in particular, income from government securities, and income from bonds or debentures, including premiums or prizes attaching to such securities, bonds, or debentures.”

In Halsbury’s Laws of England, 4th edition, 7th volume, at paragraph 813, the meaning of “debenture” is given as under:

“No precise definition of the word ‘debenture’ can be found, but various forms of instruments are called debentures. A debenture is a document, which either creates or acknowledges a debt. A document may be a debenture, although under its terms, the debt is only to be repaid out of a part of the profits.”

In the Sebi (Disclosure and Investor Protection) Guidelines 2000, a “debt instrument” is defined to mean “an instrument, which creates or acknowledges indebtedness and includes debenture, stock, bonds and such other securities of a body corporate, whether constituting a charge on the assets of body corporate or not.”

In Laxman Bharmaji v Emperor, (AIR 1946 Bom 18), a Division Bench of the Bombay High Court pointed out that notwithstanding the fact that the bonds are not styled as debentures, the substance of the instrument has to be looked into. The test of creation or acknowledgment of debt was applied.

In Narendra Kumar Maheswari v Union of India, (AIR 1989 SC 2138 at 2178), the Supreme Court observed that “debenture” is essentially an acknowledgment of a debt with commitment to repay the principal with interest. The Supreme Court further observed that a compulsorily convertible debenture does not postulate any repayment of the principal. Therefore, “it does not constitute a ‘debenture’ in its classic sense”. The expression “repayment of principal” has been used obviously in the sense of repayment in cash.

Stroud’s Judicial Dictionary of Words and Phrases (5th Edition, Volume 2), while stating that the term “debenture” has no definite meaning, referred to the observations of Charles J in Brown v Inland Revenue Commissioners (64 LJM C 211), which are quite apposite. The judge said: “A debenture, though never, I believe, legally defined, is included under one or other of the three descriptions laid down by Bowen LJ, in English and Scottish Mercantile Investment Co Ltd v Brunton (2 QB 700 (CA)) as: (1) a simple acknowledgment under seal of the debt ; (2) an instrument acknowledging the debt and charging the property of the company with repayment ; (3) an instrument acknowledging the debt, charging the property of the company with repayment, and further restricting the company from giving any prior charge.”

The common thread running through the various definitions referred to above is the inseverable relation between debenture and debt. An acknowledgment of indebtedness is inherent in it. That apart, the agreement itself refers to execution of bonds “in the nature of promissory notes”. Acknowledgment of debt and an undertaking to discharge it are the usual features of such promissory notes.

The payment of interest pre-supposes the borrowing of money or the incurring of a debt. That is what the definition of “interest” in specific terms states. The question to be asked and answered is whether the money has been borrowed and the amount paid by way of interest is directly related to that money. The allied and integral question is whether by reason of execution of debenture bonds for the moneys advanced to it, the debtor incurred a debt.

The raising of funds by means of fully convertible debentures is a well-known commercial and business practice. Debenture creates or recognises the existence of a debt, which remains to be so till it is repaid or discharged. Does it cease to be a debt merely because the bonds are redeemed not by returning the money but by getting shares of the equivalent value? If the mode of discharging the debenture debt is by issuing equity shares in lieu of payment in cash, it does not in any way detract from its legal character as debt. This legal position has been succinctly stated by the Supreme Court in CWT v Spencer and Co Ltd (88 ITR 429).

Based on these principles, the AAR ruled in LMN India Ltd’s case that the money was advanced as a financial package for which the applicant executed the debenture bonds and till they were converted into shares, the applicant kept paying interest on the amount covered by bonds. Obviously, the interest was paid in respect of a debt.

The obligation to repay the amount is embedded in the concept of debt but the repayment need not be in the form of cash; it could be in kind. Conversion of bonds into fully paid-up equity shares at the end of the specified period at the stipulated price amounts to constructive repayment of debt.

The aforesaid AAR ruling is correct in law and should set the controversy at rest once and for all.

The author is advocate, Supreme Court