Foreign investors feel tax heat in equities, look for options to invest

Convertible debentures emerge as alternative with equities now coming under the tax net

A number of investors from Mauritius and Singapore are looking at alternative avenues for deploying fresh money into India, given that investment into equities will be fully taxed from this financial year. One such alternative that is gaining traction is compulsory convertible debentures (CCDs). 

Sale of shares for investments after April 1, 2017, will now get taxed under the amended treaties. However, the sale of securities such as debentures are still exempt, provided the investor exits the instrument before the conversion to equity.

“Conversion of CCDs into equity is tax-neutral, enabling CCDs to be at par with equity investments while allowing the investor or borrower to enjoy the benefits of a debt instrument till conversion,” said Punit Shah, partner at Dhruva Advisors. 

CCDs are instruments that convert into equity shares of the issuing company based on conditions decided at the time of issuance of the instruments. They generally have a lower rate of interest than non-convertible debentures, and investments into these may be made under the FDI route. 

Let’s say an investor ‘A’ subscribes to a CCD with a 10-year term. ‘A’ exits the CCD in the eight or ninth year, by selling it to one or more third parties at a discount. ‘A’ does not have to pay tax on capital gains as the tax on debt instruments is nil. 

The new buyers get to subscribe to the CCD at a discount and wait for it to convert into equity shares at the end of 10 years. Since the buyer’s cost of acquisition has significantly increased, the tax they pay on the gains, if any, will be much smaller. 

CCDs can carry an interest coupon that facilitates assured profit extraction on a regular basis. Interest on CCDs are taxable in India at 7.5 per cent under the India-Mauritius treaty, and at 15 per cent under the India-Singapore tax treaty. The Indian taxes are generally creditable against taxes in the investor’s home country. 

Further, the Indian borrower is entitled to claim the interest expense as tax-deductible, depending on the applicable corporate tax rate. 

In comparison, dividends on shares are subject to dividend distribution tax (20.56 per cent) after the borrower has paid corporate tax at 25-30 per cent, and is not tax-deductible for the Indian company, thus making CCDs an attractive proposition, according to Shah. 

Not all investors will find CCDs attractive, though. Subscribers may not enjoy all rights of an equity shareholder, with voting rights and right to block resolutions curtailed.  “While CCDs are tax-effective, the downside is that investors may not be able to mirror all the rights of an equity shareholder. So, the instruments may not be a viable alternative for those not solely driven by the motive of saving tax,” said Abhay Sharma, partner at Shardul Amarchand Mangaldas & Co.

The manner in which tax authorities view the transaction will be known only at the time of sale of the instruments, said experts. The authorities, for instance, may view this as a tax avoidance measure. They could also examine the transaction from a GAAR perspective and assess whether there is enough commercial substance behind these investments.

“The tax authorities will look at the nature of the instruments — whether it was in substance equity and classified as debt with the intention to avoid tax. What adds to the uncertainty is that there is no bright line test under the tax avoidance regime for making this determination,” added Sharma. 

Interest on CCDs paid by the Indian company to its related parties are subject to transfer pricing norms too. This puts a cap on the amount that can be repatriated. “India has recently introduced thin capitalisation norms and the deductibility of interest expense is subject to compliance of these norms (if interest is paid to related parties),” said Shah.