Fully Convertible Debentures in Indian Corporate Law: A Comprehensive Analysis

Introduction

Fully Convertible Debentures (FCDs) represent a significant hybrid financial instrument in the Indian corporate landscape, blending characteristics of both debt and equity. Initially issued as debt, FCDs are mandatorily converted into equity shares of the issuing company at a predetermined time and rate, or as per agreed terms. This unique structure offers companies a flexible mode of financing, often utilized for long-term projects and growth, while providing investors with initial fixed income and subsequent participation in equity appreciation. This article undertakes a comprehensive analysis of FCDs under Indian law, examining their legal nature, regulatory framework, taxation aspects, and treatment in insolvency, drawing extensively from statutory provisions and judicial pronouncements.

Defining Fully Convertible Debentures

A debenture, as defined under Section 2(30) of the Companies Act, 2013, includes 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. FCDs are a specific type of debenture where the entire principal amount is compulsorily converted into equity shares. This contrasts with non-convertible debentures (NCDs), which are redeemed, and optionally convertible debentures (OCDs/OFCDs), where the holder has a choice regarding conversion.

The Supreme Court, in Narendra Kumar Maheshwari v. Union Of India And Others (1990 SCC SUPP 1 440), observed that a compulsorily convertible debenture does not postulate any repayment of the principal and, therefore, "does not constitute a ‘debenture’ in its classic sense." For certain regulatory guidelines, such instruments were treated as "equity" even prior to actual conversion. This perspective was echoed in Banco Products (India) Ltd. v. Deputy Commissioner of Income-tax (ITAT, 1997), where FCDs with automatic and compulsory conversion were deemed to possess characteristics of equity shares from their inception. The National Company Law Tribunal (NCLT) in Betoking Ltd v. Eden Real Estates Pvt Ltd (NCLT, 2022) also referred to Compulsorily Fully Convertible Debentures (CFCDs) as equity instruments in the context of restrictions on interest payments.

The transition from a creditor to a shareholder relationship is a defining feature of FCDs. Initially, the FCD holder is a creditor of the company, entitled to interest. Upon conversion, these creditor rights are extinguished, and the holder acquires rights as a shareholder.

Regulatory Framework and Judicial Scrutiny

The issuance and management of FCDs are governed by the Companies Act, 2013, regulations issued by the Securities and Exchange Board of India (SEBI), and other applicable laws. Historically, the Controller of Capital Issues (CCI) played a significant role in granting consent for capital issues, including convertible debentures, as highlighted in Narendra Kumar Maheshwari v. Union Of India And Others (1990 SCC SUPP 1 440), where the CCI's adherence to guidelines for debt-equity ratios and debenture holder protection was scrutinized.

Under the current regime, Section 71 of the Companies Act, 2013, read with the Companies (Share Capital and Debentures) Rules, 2014, outlines the provisions for issuing debentures. Notably, Section 71(1) stipulates that a company may issue debentures with an option to convert such debentures into shares, either wholly or partly, at the time of redemption, provided that the issue is approved by a special resolution passed at a general meeting. This underscores the importance of shareholder consent in the determination of conversion terms. The principles laid down in Miheer H. Mafatlal v. Mafatlal Industries Ltd. (1997 SCC 1 579), regarding the limited scope of judicial review over the commercial wisdom of shareholders in approving schemes of arrangement, may be analogously relevant to court scrutiny of FCD terms approved by the requisite majority, ensuring procedural fairness and protection of class rights.

SEBI's role is paramount, particularly for listed companies or when FCDs are offered to the public. The Supreme Court's decision in Sahara India Real Estate Corporation Limited And Others v. Securities And Exchange Board Of India And Another (2013 SCC 1 1) is a landmark in this regard. It affirmed SEBI's jurisdiction over Optionally Fully Convertible Debentures (OFCDs) issued by unlisted public companies if such an issue constituted a "public issue" (i.e., made to fifty or more persons, as per Section 67 of the Companies Act, 1956, with similar thresholds under the Companies Act, 2013). The Court held that such public issues necessitate compliance with SEBI's disclosure and investor protection norms and require listing on a recognized stock exchange. SEBI's extensive powers under Sections 11, 11A, and 11B of the SEBI Act, 1992, to regulate the securities market and protect investor interests were reinforced.

Key Legal Issues and Interpretations from Reference Materials

Nature and Classification: Debt or Equity?

The dual nature of FCDs—starting as debt and culminating in equity—gives rise to complexities in their classification. As discussed, Narendra Kumar Maheshwari (1990 SCC SUPP 1 440) and Banco Products (ITAT, 1997) indicated an early leaning towards an equity character for compulsorily convertible instruments for certain purposes. In contrast, the Karnataka High Court in PR COMMISSIONER OF v. M/S SUBEX LTD (Karnataka High Court, 2021), while distinguishing debentures from shares, reiterated the traditional view of debentures as instruments of debt.

The classification becomes particularly crucial in insolvency proceedings. In M/S IFCI LIMITED v. SUTANU SINHA (Supreme Court Of India, 2023), the Supreme Court analyzed Compulsorily Convertible Debentures (CCDs) under the Insolvency and Bankruptcy Code, 2016 (IBC). While acknowledging that a "simpliciter debenture" would typically fall under "financial debt," the Court emphasized that the specific terms of the CCD agreement, including conversion mechanisms, buy-back options, and the role of sponsor companies, are determinative. The formal issuance of shares post the stipulated conversion date was also a factor. Similarly, the National Company Law Appellate Tribunal (NCLAT) in INDIAN RENEWABLE ENERGY DEVELOPMENT AGENCY LIMITED v. WAAREE ENERGIES LIMITED (NCLAT, 2024) held that CCDs, which provided the investor an option for conversion or repayment with interest, constituted 'financial debt' under Section 5(8) of the IBC, primarily due to the "time value of money" inherent in the transaction, especially when an event of default triggered repayment claims.

Conversion Mechanism

The terms of conversion are central to FCDs and must be clearly stipulated in the offer document and debenture trust deed. These terms typically include the conversion ratio, the timing of conversion, and any conditions precedent. The Supreme Court in Narendra Kumar Maheshwari v. Union Of India And Others (1990 SCC SUPP 1 440, second reference) noted instances where conversion premiums were to be determined by the CCI at later stages, highlighting potential uncertainties if terms are not fixed upfront. The case of Integrated Finance Company Limited v. Reserve Bank Of India And Others (Supreme Court Of India, 2013) illustrated a scheme where deposit-holders and bond-holders were converted into FCD holders and subsequently into equity shareholders, aiming to secure their interests and provide an exit route through listed shares.

The act of conversion involves the extinguishment of the debenture holder's rights as a creditor and the acquisition of rights as a shareholder. This process can be viewed through the lens of "transfer" or "extinguishment of rights" as defined in Section 2(47) of the Income Tax Act, 1961, a concept explored in cases like Anarkali Sarabhai, Shahibag House, Ahmedabad v. Commissioner Of Income Tax, Ahmedabad (1997 SCC 3 238) (concerning redemption of preference shares) and Deputy Commissioner Of Income-Tax v. Bpl Sanyo Finance Ltd. (2008 SCC ONLINE KAR 661).

Stamp Duty Implications

The issuance and transfer of debentures, as well as shares, are subject to stamp duty under the Indian Stamp Act, 1899, and relevant state stamp acts. The Bombay High Court in Greaves Cotton & Company Limited & Another v. State Of Maharashtra & Another (2004 SCC ONLINE BOM 752) dealt with the question of whether stamp duty is chargeable on the mere allotment of an FCD if no formal debenture instrument is issued, and a share certificate is issued only upon conversion. The case suggested that stamp duty liability arises upon the execution of an instrument. Thus, if debenture certificates are issued, they would attract stamp duty. Subsequently, the issuance of share certificates upon conversion would be a separate event potentially attracting stamp duty on shares, subject to the specific provisions of the applicable stamp act.

Taxation Aspects of Fully Convertible Debentures

Expenditure on Issue of FCDs

The tax treatment of expenses incurred by a company on the issue of FCDs has been a subject of litigation. The core issue is whether such expenditure is revenue or capital in nature. The Supreme Court's decision in India Cements Ltd. v. CIT ((1966) 60 ITR 52 (SC)), which held that expenditure on raising loans (including debentures) is generally revenue expenditure, has been influential. Several High Courts have applied this principle to FCDs. For instance, the Gujarat High Court in PRINCIPAL COMMISSIONER OF INCOME TAX-1 v. ATUL LIMITED (Gujarat High Court, 2018) and the Rajasthan High Court in Commissioner Of Income Tax, Jaipur-Ii, Jaipur v. M/S. Modern Denim Ltd. (2016 SCC ONLINE RAJ 10450) held that expenditure on the issue of FCDs is allowable as revenue expenditure, irrespective of the accounting treatment.

However, there are instances where a different view has been taken, particularly if the FCDs are seen as augmenting the capital base. The Income Tax Appellate Tribunal (ITAT) in Gruh Finance Ltd. v. Cit (ITAT, 2016) and The DCIT, Circle-4,, Ahmedabad v. Gruh Finance Ltd.,, Ahmedabad (ITAT, 2016) referred to certain Gujarat High Court judgments (e.g., *Gujarat Ambuja Cotspin*) that treated expenditure on convertible debentures as capital expenditure if directly related to the expansion of the company's capital base. Furthermore, in Willard India Ltd. v. Dy. Cit (Delhi High Court, 2003), expenses on an FCD issue for a sugar division still under construction (i.e., pre-commencement expenditure) were not allowed as revenue expenditure.

Section 35D of the Income Tax Act, 1961, provides for the amortization of certain preliminary expenses, including expenditure "in connection with the issue, for public subscription, of shares in or debentures of the company." This provision may allow for a deduction over a period if the expenditure is not allowed in full as revenue expenditure in the year it is incurred. The *Gruh Finance* cases also touched upon the applicability of Section 35D.

Interest on FCDs

Interest paid on FCDs, during the period they retain their debt character, is generally deductible as business expenditure under Section 36(1)(iii) of the Income Tax Act, 1961, provided the capital is borrowed for the purpose of business or profession. The case of Aryan Arcade Ltd., Petitioner(S) v. Deputy Commissioner Of Income Tax (S) (2016 SCC ONLINE GUJ 6683) involved a claim for deduction of interest paid on OFCDs, where the allowability was being examined in relation to the utilization of funds. Contractual terms can also affect interest payments; for example, Betoking Ltd v. Eden Real Estates Pvt Ltd (NCLT, 2022) noted agreements restricting interest on CFCDs until project completion.

Taxability of Conversion

A critical question is whether the conversion of an FCD into equity shares constitutes a "transfer" under Section 2(47) of the Income Tax Act, 1961, thereby triggering capital gains tax for the debenture holder at the point of conversion. The inclusive definition of "transfer" encompasses sale, exchange, relinquishment of an asset, or the extinguishment of any rights therein (*Anarkali Sarabhai, 1997 SCC 3 238*; *Deputy Commissioner Of Income-Tax v. Bpl Sanyo Finance Ltd., 2008 SCC ONLINE KAR 661*).

However, Section 47(x) of the Income Tax Act, 1961, explicitly states that any transfer by way of conversion of bonds or debentures, debenture-stock, or deposit certificates in any form, of a company into shares or debentures of that company shall not be regarded as a transfer for capital gains purposes. Consequently, the conversion itself is generally not a taxable event for the FCD holder. Furthermore, Section 49(2A) of the Act provides that the cost of acquisition of the shares received upon conversion of a debenture shall be deemed to be that part of the cost of the debenture which has been converted into shares. Capital gains tax liability arises only upon the subsequent sale or transfer of these shares by the holder.

FCDs in Insolvency and Restructuring

The treatment of FCDs under the Insolvency and Bankruptcy Code, 2016 (IBC) depends heavily on their terms and whether conversion has occurred or is imminent. Section 5(8) of the IBC defines "financial debt" broadly to include amounts raised via debentures. As discussed earlier, the Supreme Court in M/S IFCI LIMITED v. SUTANU SINHA (2023) and the NCLAT in INDIAN RENEWABLE ENERGY DEVELOPMENT AGENCY LIMITED v. WAAREE ENERGIES LIMITED (2024) have provided nuanced interpretations. If FCDs are yet to be converted and retain their debt characteristics (e.g., entitlement to interest, eventual repayment if conversion fails under specific clauses), they are likely to be treated as financial debt, allowing FCD holders to participate in the Committee of Creditors. If, however, the FCDs have been converted into equity, or if their terms unequivocally treat them as equity or quasi-equity from a very early stage (as suggested in *Narendra Kumar Maheshwari* for certain regulatory purposes), their holders would be treated as shareholders. The specific contractual stipulations within the FCD agreement and the debenture trust deed are paramount in determining their status in an insolvency scenario.

Conclusion

Fully Convertible Debentures are versatile financial instruments that play a crucial role in the Indian capital market, offering a pathway from debt to equity participation. Their legal and regulatory framework, primarily under the Companies Act, 2013, and SEBI regulations, aims to balance corporate financing needs with investor protection. Judicial pronouncements have progressively clarified various aspects, including their classification, regulatory oversight, tax implications of issuance expenses and conversion, and their status in insolvency proceedings.

The hybrid nature of FCDs necessitates careful drafting of their terms, particularly concerning conversion mechanisms, interest payments, and rights of holders. While the tax treatment of conversion itself is largely settled by statutory provisions (Section 47(x) of the Income Tax Act, 1961), areas such as the deductibility of issuance expenses continue to see varied interpretations based on specific facts and prevailing High Court views. The evolving jurisprudence under the IBC further highlights the importance of the precise terms of FCDs in determining their character as debt or equity in distress situations. As Indian corporate finance continues to innovate, a clear understanding of the multifaceted legal dimensions of FCDs remains essential for issuers, investors, and legal practitioners alike.