Easy tax norms make CCDs a hit among Mauritian, Singaporean investors

Gains are exempt from taxation provided investors exit before the conversion to equity

Investors from Mauritius and Singapore are turning to compulsory convertible debentures (CCDs) for making fresh investments in India. 

India's tax treaties with Mauritius and Singapore have been amended to give India the right to tax the sale of equity shares for investments after April 1, 2017. The agreements offer exemption in case of sale of other securities such as debentures if an investor exits the instrument before its conversion to equity. 

Conversion of CCDs into equity is tax neutral, which enables these securities to be at par with equity investments, while allowing the investor or borrower to enjoy the benefits of a debt instrument till conversion, says Punit Shah, partner, Dhruva Advisors. 

CCDs are instruments that convert into equity shares of the issuing company on the fulfillment of conditions decided at the time of issuance of the instruments. They generally have a lower rate of interest than NCDs. CCDs are considered as capital instruments and investment in them may be made through the foreign direct investment (FDI) route. 

Let's say an investor A subscribes to a CCD with a 10-year term. A exits the CCD in the eighth 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. A buyer gets to subscribe to the CCD at a discount and waits for it to convert to equity shares at the end of the 10-year tenure. Since the buyer's cost of acquisition has significantly increased, the tax that he/she pays, if any, will be much smaller. 

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

Further, an Indian borrower is entitled to claim their interest expense as tax deductible, depending upon the applicable corporate tax rate. However, dividends -- subjected to a dividend distribution tax of 20.56 per cent after the borrower has paid a corporate tax of 25-30 per cent -- are not tax deductible for the Indian company. This makes CCDs an attractive proposition for investors from Singapore and Mauritius. 

Not all investors will find CCDs attractive. CCD subscribers may not enjoy all the rights of an equity shareholder, curtailing their voting rights and right to block resolutions, among other things. While CCDs are tax effective, one downside is that investors may not be able to mirror all the rights of an equity shareholder. So, they might not be a viable alternative for those not solely driven by the motive of saving tax," says Abhay Sharma, a partner at Shardul Amarchand Mangaldas & Co.

The manner in which the tax authorities view the transaction will be known only at the time of sale of the instruments, according to experts. Tax 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 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, said Sharma. 

Interest on CCDs paid by an Indian company to related parties is subject to transfer pricing norms as well. This puts a cap on the amount that can be repatriated. India has recently introduced thin capitalisation norms and the deductibility of an interest expense is subject to compliance with these norms if interest is paid to related parties, said Shah.