1. Shaping debentures for equity

Shaping debentures for equity

Certain compliances and complexities need to be carefully understood and dealt with

By: | Published: March 16, 2015 12:39 AM

The term ‘debenture’ has become synonymous with equity investments. Commercial considerations guide the structure of investments as well as type of instruments. One of the reasons for structuring traditional equity investments either partly or fully to include debentures is that the promoter gets to retain the equity-holding to that extent, which would have otherwise been required to be issued to the investor. Another commonly understood commercial reason for including debentures is that, typically, the interest paid on debentures is allowable as an expense in the books of the issuer company. This reduces the tax burden of the issuer company to that extent and increases the distributable amounts in the hands of the shareholders or stakeholders, which include both the promoter and the investor.

There are certain challenges, compliances and consequences required to be borne in mind while structuring traditional equity investment transactions to include debentures.

Where a non-resident party is the potential stakeholder and the investment is via the FDI route, the provisions in the Foreign Exchange Management Act (FEMA), 1999, read with the Consolidated FDI Policy, permit issue of debentures by an Indian company provided inter alia that the debentures are fully, compulsorily and mandatorily convertible. Under FEMA, such debentures are considered as capital, i.e., akin to shares. Hence, both promoters and foreign investors, while looking at equity investments, also started considering debentures as an option, given the benefits described above.

The Companies Act, 2013, contains provisions to the effect that a company may issue debentures with an option to convert such debentures into shares, either wholly or partly, at the time of redemption. The condition, however, is that any issue of debentures with an option to convert them into shares, wholly or partly, is required to be approved by a special resolution passed at a shareholders meeting, since, upon conversion, there would be dilution of the stake of the existing equity shareholders.

Except under FEMA, for other purposes, i.e., for company law and tax law compliance, even fully, compulsorily and mandatorily convertible debentures are considered as debt until they are converted into shares.

With the above as the basis, when structuring investment transactions, the stakeholders tend to subscribe to instruments in a way such that their economic interest is also reflected in the instruments held by them and the distribution rights attached to such instruments, so that there is parity of instruments and distributions.

This approach is also common where both the promoter and investor are resident Indian parties. In addition to the benefit of the promoter continuing to hold a larger equity pie and the reduced tax burden, one other benefit attached to debentures from the perspective of the investor (being either a resident party or a non-resident party investing via the non foreign direct investment route) is that unlike equity shares, debentures can be secured as in the case of any other debt, though secured investments are typically considered quasi-equity. The Companies Act, 2013, stipulates that the issuer company create a debenture redemption reserve account out of its profits available for dividend. The amounts so credited cannot be utilised except for the redemption of debentures. There is also the statutory requirement to appoint a debenture trustee who would protect the interests of the debenture holders. The debenture trustee is appointed solely to act in the interest of the debenture holders and has the right to file a petition before the authorities if the trustee believes that the assets of the company are, or are likely to become, insufficient to discharge the principal amount. In such a case, there could be restrictions imposed on the company from incurring any further liabilities.

Under the Companies Act, 2013, the term debenture is defined in an inclusive manner to mean “debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not”. Amounts raised by the issue of debentures are also exempt from the definition of deposit under the Companies (Acceptance of Deposit Rules) 2014. The conditions however attached to the exemption are that the debentures should either be secured in the manner stipulated or be compulsorily convertible into shares of the company within 5 years. If either of the conditions is not met, the amount received by the Company would qualify as a deposit, unless the benefit of other exemptions are available. The statutory provisions governing deposits include tenure of deposit, availing of deposit insurance, etc. which are considered quite stringent.

This poses a challenge while considering parity of instruments, since typically in joint venture transactions, the security is provided to the investor and the promoters would subscribe to unsecured optionally convertible debentures. Therefore, it is necessary for the debentures subscribed to by individual promoters to be compulsorily convertible, to avoid being considered a deposit. If however the investment/funding for debentures by the promoters is through a company, the same would not be of concern since any amount received by a company from another company is not considered a deposit. In such a case, the nature of the investment vehicle of the promoter becomes critical to ensure there are no additional levels of taxes, including distribution taxes.

While including debentures as one of the instruments in equity investment transactions has certain advantages, certain compliances and complexities as illustrated above will require to be carefully understood and dealt with.

The author is partner, J Sagar Associates. Views are personal

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