Published on Mon, Aug 11,2014 | 01:21, Updated at Mon, Aug 11 at 01:32Source : CNBC-TV18 | Watch Video : 
First SEBI, then the RBI and now the Delhi High Court- it's been a good last 6 months for call and put options! Last week, the Delhi High Court gave the much needed clarity to foreign investors and private equity industry when it held that the tax department cannot recharacterize equity as debt ie just because the investment agreement provided for an exit option with minimum return- that doesn't make CCDs fixed return instruments. Payaswini Upadhyay reports.
In 2012, the Authority for Advance Rulings held that gains arising from sale of Compulsorily Convertible Debentures or CCDs is in the nature of interest and so liable to tax in India.
The ruling pertained to AN investment made by Zaheer Mauritius in a subsidiary of Vatika- an Indian real estate development company.
In 2007, Zaheer Mauritius acquired 35% in Vatika's subsidiary SH Tech park by way of equity and zero coupon compulsorily convertible debentures. The Share Subscription Agreement provided Zaheer Mauritius with a put option to sell the debentures or shares to Vatika after a specified period. And Vatika got a call option to purchase the shares and debentures from Zaheer Mauritius which it exercised in 2010. Both options were linked to a pre-determined assured price.
Zaheer Mauritius filed with the Tax Department for a nil withholding certificate expecting that long term capital gains on equity sale would get treaty protection but it was directed to withhold tax at the rate of 20%. The Department held that the entire gain on the transfer of equity shares and debentures would be treated as interest and not capital gains.
The matter reached the Authority for Advance Rulings. The AAR held that compulsorily convertible debentures is in the nature of debt till conversion and the income arising from a CCD should be considered as interest income.
Puneet Shah
Partner, KPMG
"It definitely came as a surprise. There are several transactions especially in real estate- which was the case here as well- that are structured as equity as well as debt. Real Estate requires a lot of debt, they require interest deduction and therefore several transaction are structured in that manner. There are several commercial reasons for structuring it in this way which were ignored by the AAR while coming to this conclusion. So it was a big surprise for industry- the re-characterization of income."
Daksha Baxi
ED, Khaitan & Co.
"They continued to do that with a caveat and the parties being warned that this is one of the things which is there but we don't believe that this would be the ultimate result of this particular type of transaction. So with that caveat, people were using this instrument as a way of investing in India."
Last week, the Delhi High Court reversed the AAR ruling.
The court held that the mere provision of exit options in an investment agreement will not change the nature of the investment. It pointed out that though the agreement enabled an exit at a reasonable return, it would not mean that compulsorily convertible debentures were fixed return instruments as the investor always has the option to continue as an equity shareholder. And most importantly, the Delhi High Court upheld the commercial rationale of Zaheer Mauritius' investment via CCDs saying there is no case of tax avoidance
Puneet Shah
Partner, KPMG
"It is going to pre-dominantly help the real estate industry and in some cases infrastructure industry as well where equity component may not be large but the debt components are typically quite large. So it would definitely help these sectors and also some of the private equity transactions where debt instruments are being used and as per the current regulatory framework, optionally convertible debentures are not permitted because they are ECBs. In fact the High Court order does say that Zaheer Mauritius could not have done OCD because of the regulatory reasons and therefore it had to use CCDs. So it will continue to remain a favorable instrument of funding by foreign investors."
Daksha Baxi
ED, Khaitan & Co.
"If you look at the Delhi High Court decision, it has also analyzed whether there is actually any tax avoidance that is happening which is what was alleged. Where is the tax avoidance – supposing it was not characterized as capital asset but debt- then what happens? Debt- you have to pay interest on that; that interest would be a deductible expense to the company, the company's profit would be reduced to the extent the interest is paid to the investor and that company would have paid that much less tax at the rate of 30%. So Delhi HC has recognized that there was no tax avoidance. So when you're looking at whether this kind of an arrangement would be susceptible to GAAR, what would need to be looked at is there avoidance of taxation."
More specifically- if there is impermissible tax avoidance- one which cannot be supported by a commercial rationale. The Delhi High Court also saw the commercial logic behind an investment company coming to India via Mauritius- thereby implying that such a purpose would qualify for benefits under the tax treaty.
In Mumbai, Payaswini Upadhyay
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