Article on debentures for focus by CA. Sudha G. Bhushan


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Article on debentures for focus by CA. Sudha G. Bhushan

  1. 1. DEBENTURES: Indian FDI PolicyContributed by CA. Sudha G. Bhushan and CS. A. Sekar This article was published in magazine of WIRC, ICSI, in DEC 2012 editionDebentures are defined under Section 2(12) of the Companies Act, 1956. Debenture includesdebenture stock, bonds and any other securities of a company, whether constituting a chargeon the assets of the Company or not. In other words, it is a type of loan issued by acompany that may or may not be converted into stock by the holder and, under certaincircumstances, the issuer of the bond. By adding the convertibility option the issuer pays alower interest rate on the loan compared to if there was no option to convert. Theseinstruments are used by companies to obtain the capital they need to grow or maintain thebusiness.There are many types of debentures. This article concentrates on the debentures issued to thenon-residents. Broadly debentures can be classified in two types - Fully, mandatorily convertible debentures - partially/optionally debenturesGoing forward we have discussed the difference between the fully/compulsorily convertibledebentures and partially/optionally convertible debentures from the perspective of ForeignDirect Policy in India. The transaction between resident and non resident are regulated byForeign Exchange Management Act , 1999 (FEMA) and the foreign direct investment policy.Not only regulatory but also from taxation point of view the two type type of debentures aredifferent therefore before issuing the either fully/compulsorily convertible debentures orpartially/optionally convertible debentures organization should keep in mind its objective.While in partially/optionally convertible debentures organization will have to pay interest whichshall be tax deductible in case of fully/compulsorily convertible debenture although it willprovide for long term capital but the pricing guidelines shall be required to be met.Taxpert professionals ||||Get in touch with us at 09769134554 || ||
  2. 2. It is quite common for foreign investors to take up convertible instruments in Indian companies.These instruments are issued as either preference shares or debentures to begin with and areconvertible into equity shares of the Indian company at a later date. The conversion may occurin one of two ways: either at the option of the investor, or compulsorily (without any optionwhatsoever). Such instruments carry characteristics of multiple securities and hence take onnomenclatures such as “hybrids” and “quasi-equity”.From a legal and regulatory (more specifically, foreign direct investment) standpoint, however,the question is whether such convertible instruments constitute debt, thereby falling within thepurview of regulations governing external commercial borrowings (ECBs), or whether theyconstitute equity, thereby falling under the guidelines pertaining to foreign direct investment(FDI). As per the FEMA regulations and FDI policy, where fully/compulsorily convertibledebentures are considered as equity, the partially/optionally convertible debentures areconsidered as debt. Where fully/compulsorily convertible debentures are considered as equity,the partially/optionally convertible debentures are considered as debt.As per Consolidated FDI Policy “Other types of Preference shares/Debentures I,e. non convertible, optionally convertible orpartially convertible for issue of which funds have been received on or after May 1, 2007 areconsidered a debt. Accordingly all norms applicable for ECBs relating to eligible borrowers,recognized lenders, amount and maturity, end use stipulations etc. shall apply. Since theseinstruments would be denominated in rupees, the rupee interest rate will be based on the swapequivalent of London Interbank offered rate (LIBOR) plus the spread as permissible for ECBs ofcorresponding maturity.”We have below discussed in detail the difference between the two types of debentures . Forthe ease of comparison the tabular form has been used.Issue of Debentures to Non Residents DebenturesTaxpert professionals ||||Get in touch with us at 09769134554 || ||
  3. 3. Fully and mandatorily Convertible Debentures Non-Convertible/Optionally Convertible DebenturesA type of debt security where the whole value of A type of debt security where the whole value ofthe debenture is convertible into equity shares. the debenture is not convertible into equity shares or convertible at the issuers notice.If debentures are fully and mandatorily convertiblein that case it is considered as Equity Investment. If debentures are Non-Convertible/Optionally Convertible Debentures in that case it is considered as External Commercial Borrowings. Regulatory frameworkMaster Circular on Foreign Investment in India Master Circular on External Commercial BorrowingsForeign Exchange Management (Transfer or Issue Foreign Exchange Management (Borrowing orof Security by a Person Resident Outside India) Lending in Foreign Exchange) Regulations, 2000Regulation, 2000Companies Act, 1956 (Section 292(1)(b)) Section 292(1)(b) of the Companies Act, 1956)Companies Act, 1956 (Section 293(1)(d)) - only in Companies Act, 1956 (Section 293(1)(d)) - only incase of Public Company case of Public CompanyPublic Companies (Terms of Issue of Debenturesand Raising of Loans with Option to Convert suchDebentures or Loans into Shares) Rules, 1977 -Applicable only in case of Public Company Who can InvestA person resident outside India (other than a Company can issue debentures to internationallycitizen of Pakistan) and Entity incorporated outside recognized sources, such asIndia, (other than an entity incorporated in (i) international banks,Pakistan) (ii) international capital markets,Taxpert professionals ||||Get in touch with us at 09769134554 || ||
  4. 4. Indian Company can receive consideration by (iii) multilateral financial institutions (such as IFC, ADB, CDC, etc.) / regional financial institutions and(i) Debiting the NRE / FCNR account of a person Government owned development financialconcerned maintained with an AD category I bank. institutions,(ii) through normal banking channels. (iv) export credit agencies,(iii) conversion of royalty / lump sum / technical (v) suppliers of equipment,know how fee due for payment or conversion of (vi) foreign collaborators andECB, shall be treated as consideration for issue of (vii) Foreign equity holders [other than erstwhileshares. Overseas Corporate Bodies (OCBs)].(iv) conversion of import payables / pre (i) If paid-up equity capital of 25%incorporation expenses / share swap can be directly held – avail ECB upto USDtreated as consideration for issue of shares with 5million under automatic route;the approval of FIPB. (ii) If paid-up equity capital of 25%(v) debiting to non-interest bearing Escrow directly held and ECB liability-account5 in Indian Rupees in India which is opened equity ratio does not exceed 4:1 –with the approval from AD Category – I bank and is avail ECB more than USD 5millionmaintained with the AD Category I bank on behalf under automatic route.of residents and non-residents towards payment ofshare purchase consideration.Taxpert professionals ||||Get in touch with us at 09769134554 || ||
  5. 5. Maximum Permissible AmountSince it is considered to be FDI. Therefore the Since non convertible debentures areSectoral caps prescribed under the FDI policy as considered as external commercialapplicable to it. Sectoral cap have to be seen at the borrowing therefore as mentioned abovetime of allotment of convertible debentures only. it is governed by the terms and conditions mentioned in ECB regulations viz.The investment is allowed either under automatic Recognised lender, recognized borrowerroute or approval route. etc. The amount that can be raised through issue of non convertible debentures/ECB is as follows (without taking the approval from Reserve Bank of India) : a) The maximum amount of ECB which can be raised by a corporate other than those in the hotel, hospital and software sectors is USD 750 million or its equivalent during a financial year. b) Corporates in the services sector viz. hotels, hospitals and software sector are allowed to avail of ECB up to USD 200 million or its equivalent in a financial year for meeting foreign currency and/ or Rupee capital expenditure for permissible end-uses. c) ECB up to USD 20 million or its equivalent in a financial year with minimum average maturity of three years d) ECB above USD 20 million or equivalent and up to USD 750 million or its equivalent with a minimum average maturity of five years. Maturity PeriodNo minimum or maximum conversion period ECB up to USD 20 million or its equivalent in aprovided by law. financial year – minimum average maturity period of 3 yearsTaxpert professionals ||||Get in touch with us at 09769134554 || ||
  6. 6. ECB above USD 20 million or equivalent and up to USD 750 million or its equivalent – minimum average maturity period of 5 years TaxationTax liability shall be governed by the Indian Income Tax Act, 1961. However, the countries with whichIndia has Double taxation avoidance agreement ,as per section 90(2) of the Income Tax Act, in thosecases the DTAA or the Domestic Income Tax Act,1961 whichever is more favorable to the assesse shallbe applicable.Interest shall be payable till the time the Interest paid by the company is tax deductible asdebentures are converted into shares. After expense in the hands of company as per theconversion holder shall be entitled to receive Income tax Act,1961dividend (if any). Interest is tax deductible.On any amount declared, distributed or paidby such company by way of dividend, theDividend distribution tax shall be payable bythe company under Section 1150 of theIncome tax Act,1961. However, such dividendis exempt in the hands of shareholder undersection 10(34) of the Income Tax Act, 1961. End use of fundingFully and mandatorily Convertible Debentures ECB proceeds cannot be used for:cannot be raised by the entity which is engaged orproposes to engage in the following activities:Taxpert professionals ||||Get in touch with us at 09769134554 || ||
  7. 7. (a) Business of chit fund, or • On lending;(b) Nidhi company, or • Investment in the capital market;(c) Agricultural or plantation activities, or • Acquisition of a company;(d) Real estate business, or construction of farm • Real estate;houses, or • Working capital;(e) Trading in Transferable Development Rights • General corporate purposes;(TDRs). • Repayment of existing Rupee loans except under the Approval route, under a scheme of ‘take-out’ finance, subject to conditions. PricingThe Price/ conversion formula for convertible Under automatic route, The All in cost of thecapital instruments should be determined upfront company issuing the debentures shall not exceedat the time of issuance of the instruments. the following -Conversion price should not be less than the fairvalue worked out, at the time of issuance of suchinstruments, in accordance with the FEMAregulations.Price for issue of Fully and mandatorily Convertible Where the Minimum Shall not exceed LIBOR*Debentures shall be : average maturity Period + 350 basis points  Listed Companies - as per SEBI (ICDR) is 3-5 years Regulations Minimum average LIBOR* + 500 basis  Unlisted Companies - not less than fair maturity Period of more points value of shares determined by a SEBI than 5 years - * for the respective currency of registered Merchant Banker or a Chartered borrowing or applicable benchmark Accountant as per the Discounted Free Cash Flow Method (DCF) All-in-cost includes rate of interest, other fees and expenses in foreign currency except commitment fee, pre-payment fee, and fees payable in Indian Rupees. The payment of withholding tax in Indian Rupees is excluded for calculating the all-in-cost. Compliance Requirements(1) Ensure that Articles of the Company allows (1) Ensure that Articles of the Company allowsissue of debentures, if not then alter articles of issue of debentures, if not then alter articles ofassociation by passing Special Resolution association by passing Special Resolution(2) Drafting of Investor Agreement (2) Drafting of Debenture AgreementTaxpert professionals ||||Get in touch with us at 09769134554 || ||
  8. 8. (3) Board Resolution under Section 292(1)(b) of the (3) Board Resolution under Section 292(1)(b) ofCompanies Act, 1956* the Companies Act, 1956*(4) In case of Public Company, borrowing should (4) In case of Public Company, borrowing shouldnot exceed aggregate of paid-up capital and free not exceed aggregate of paid-up capital and freereserve as per Section 293(1)(d)** reserve as per Section 293(1)(d)**(5) Board Resolution for allotment of Debentures (5) Submit Form 83 (in duplicate) certified by(Note : It has to be allotted within 180 days of CA/CS to Authorised Dealer within 7 days from thereceipt of funds) date of signing agreement to obtain Loan Registration Number from RBI(6) Issue of duly signed, stamped and sealedDebenture Certificate to Investor***(7) Advance Reporting for receipt of fundsIndian companies are required to report the details (6) Board Resolution for allotment of Debenturesof the receipt of the amount of consideration forissue of convertible debentures, through an ADCategory - I bank, together with a copy/ies of theFIRC/s evidencing the receipt of the remittancealong with the KYC report as specified in the (7) Issue of duly signed, stamped and sealedregulation on the nonresident investor from the Debenture Certificate to Investor***overseas bank remitting the amount within 30daysof receipt of fund.(8) FC-GPR filingIndian companies are required to file Form FC-GPRof FEMA through AD Category I bank, not laterthan 30 days from the date of issue of shares. (8) Updation of Register of Debenture holders****(9) Updation of Register of Debenture holders**** (9) Transfer to Debenture Redemption Reserve till the date of conversion (10) Submit ECB-2 (Reporting of actual transactions of External Commercial Borrowings (ECB) under Foreign Exchange Management Act, 1999) Return certified by the designated AD bank on monthly basis so as to and Information Management (DSIM), Reserve Bank of India within seven working days from the close of month to which it relates.Taxpert professionals ||||Get in touch with us at 09769134554 || ||
  9. 9. * As per Section 292(1)(b) of the Companies Act, 1956, the Board can exercise power of issue ofDebentures in Board Meeting. Thus, the Board cannot take decision for issue of debentures throughcircular.** Public limited company/ a private company which is a subsidiary of a public company cannot borrowmoneys (through loan or issue of debt instrument) in case proposed borrowing together with themoneys already borrowed by the company (apart from temporary loans obtained from the companysbankers in the ordinary course of business) exceeds aggregate of the paid- up capital of the companyand its free reserves except with the consent of such public company or subsidiary in general meeting.(Section 293(1)(d) of the Companies Act, 1956)*** Section 113 of the Companies Act. 1956 provides for issue of debenture certificate within threemonths from the date of allotment of debentures.****This is one of the Statutory Register under Section 152 of the Companies Act, 1956.Appointment of debenture trustee not mandated if conversion is happening within 18 months.Otherwise, debenture trustee is required to be appointed by a company to which SEBI regulations areapplicable.==================================================================================Taxpert professionals ||||Get in touch with us at 09769134554 || ||
  10. 10. This article was published in magazine of WIRC, ICSI, in DEC 2012 edition.It is contributed by CA. Sudha G. Bhushan and CS. A. Sekar CA. Sudha G. Bhushan is a Chartered Accountant and Company Secretary. She is known to be expert in FEMA, International Tax and FDI policy. CS. A. Sekar is Company Secretary. He is an expert of Company law.Taxpert professionals ||||Get in touch with us at 09769134554 || ||