BACKGROUND

In recent years, a multitude of financing avenues have surfaced, adapting to the evolving demands of the economy. Among these, debt instruments such as corporate bonds, convertible debentures, and Non-Convertible Debentures (NCD) are a prevalent mode for capital infusion. These instruments, with little differentiation in their characteristics, have given rise to complexities in their tax treatments. NCD may be issued at face value or discount but redeemed at premium or face value. While the Central Board of Direct Taxes (CBDT) has issued a Circular to clarify on taxability of Deep Discount Bonds, a question may arise as to the taxability of NCDs which are issued at face value but redeemable at a premium. In this regard, recently¹, the Mumbai Tax Tribunal had an opportunity to analyse the tax treatment on redemption of non-convertible debentures.  
We, at BDO in India, have summarised this ruling and provided our comments on the impact of this decision hereunder:

FACTS OF THE CASE

• An individual taxpayer, director of Capricorn Realty Ltd, owned certain 0% NCDs of Bhishma Realty Ltd (BRL) and Capricorn Realty Ltd (CRL).

• BRL and CRL were offshoots from the Rehabilitation Scheme sanctioned by the Board for Industrial and Financial Reconstruction (BIFR) in the case of Hindoostan Spinning and Weaving Mills Ltd (HSWML) which was declared as a sick unit under the Sick Industrial Companies (Special Provisions) Act, 1985.

• The taxpayer had acquired these NCDs in FY 2006-07 from the nationalised banks (being secured lenders of HSWML) who had subscribed to these NCDs for an aggregate consideration of INR 37.347 million.

• In October 2010, the NCDs were redeemed at INR 64.997 million. The taxpayer invested the maturity proceeds in the purchase of a flat (agreement entered on 31 July 2012) under construction and in REC bonds.

• While filing an income tax return for FY 2009-10, the taxpayer offered the gain of INR 27.65 million [INR (64.997- 37.347) million] as long-term capital gains (LTCG) and claimed exemption of INR 26.594 million under section 54F² and 54EC³ of the IT Act.

• The Tax Officer observed that the taxpayer had not received the possession of the flat within the prescribed period of three years. 

• Further, the Tax Officer observed that the profit obtained by the taxpayer on redemption of NCDs was in the range of 18.92% to 31.37%, while the rate of return of Mutual funds worked to 11.5% to 18% only.  Therefore, the tax officer opined that the entire arrangement of the issuance of NCDs by the related companies and redemption thereof appeared to be a make-believe arrangement with an intent to shift profits to the taxpayer.

• In light of this, the tax officer denied exemption and thereby brought the gains to tax.

• The First Appellate Authority was of the view that the difference between the maturity proceeds and the cost of NCDs is taxable as interest income. Hence, it did not consider the question of allowing exemption under sections 54F and 54EC of the IT Act.

• Aggrieved, the taxpayer filed an appeal before the Mumbai Tax Tribunal.

 

MUMBAI TAX TRIBUNAL RULING

The Mumbai Tax Tribunal held that the premium received by the taxpayer on redemption of NCDs is chargeable to tax under the head ‘Income from Other Sources’ and not ‘Capital Gains’. While coming to this conclusion, the Mumbai Tax Tribunal made the following observations:

Re. First Appellate Authority’s power to tax the income as Capital Gains

• First Appellate authority has only changed the ‘head of income’ under which the said gain is required to be assessed.

• Rejected taxpayer’s reliance on Delhi High Court’s ruling in the case of Union Tyres⁴and Sardari Lal & Co⁵ to support his contention that the First Appellate Authority is not empowered to assess any new source of income in the appellate proceedings.

Re. Gains taxable as interest income

• First Appellate Authority assessed a sum of INR 39.396 million being the difference between the sale value and face value of NCDs as interest income. However, the taxpayer was not an original allottee and purchased the NCDs from the bank. Hence, the difference between the sale value and purchase cost (i.e. INR 27.65 million) should be the actual amount of gain.

• Debenture is a capital asset. Its redemption results in the extinguishment of rights. The NCDs were issued by the SPVs on a private placement basis, and they were allotted initially to nationalised banks in lieu of outstanding loans. The debentures were not listed on any of the stock exchanges.

• As per Section 2(30) of the Companies Act, 2013, “debenture” includes debenture stock, bonds, or any other instrument evidencing a debt. Hence, even though debentures would fall under the definition of “securities”, yet they are essentially debt instruments evidencing a debt.

• Reliance placed by the tax officer on Circular No 002 of 2002 dated 15 February 2002 is affirmed. The said circular provides for the tax treatment to be given on the gains realised on redemption of DDBs.

• DDBs are issued by discounting the face value of debenture or bond and the same will be redeemed at par value, so that the maturity proceeds equal to face value. On the contrary, in the case of NCDs redeemable at a premium, the premium amount is determined by applying a particular interest rate. Thus, both the amount of discount or premium, in effect are “interest” amounts only. Hence, the companies issuing both types of bonds or debentures usually claim discounts or premiums as interest expenditure and their claim has been allowed.

• Section 50AA⁶ of the IT Act is applicable to market-linked debentures (MLDs). In the case of MLDs, the interest rate payable on them is not determined at the time of issuing them. Instead, the return on those market-linked instruments is determined on the basis of the performance of an underlying market index or instrument.

• The Parliament by a legal fiction introduced in section 50AA of the IT Act has stated that the said gain is taxable as short-term capital gains, even though the MLD might have been held for more than three years. This may be due to the fact that the tax payable on short-term capital gains is computed at regular rates as applicable to interest income.

• In the instant case, the taxpayer purchased NCDs, and they are materially different from MLDs.  Therefore, the taxpayer’s contention that the provisions of Section 50AA of the IT Act will be applicable in this case is not tenable.

• Reliance placed by the taxpayer on the Hon’ble Supreme Court Ruling in the case of Anarkali Sarabhai⁷, Kartikeya V Sarabhai⁸ and Bombay High Court Ruling in the case of Sath Gwaldas Mathurdas Mohata Trust⁹ wherein it was held that extinguishment of rights in preference shares is transferred is not accepted. The ratio of the said decisions rendered in case of preference or equity shares cannot be applied to debt instruments.

• Shares and debentures are different types of instruments having different types of rights and liabilities. Equity shareholder is an owner of the company, who has right over the surplus available on the liquidation of the Company. On the contrary, a debenture holder is a financial creditor to the Company and is entitled to receive interest and principal amount as per agreed terms. The debenture holder does not have the right to receive anything extra.

• Further, reliance placed by the taxpayer on Mrs Perviz Wang Chuk basi¹⁰ decision wherein it was held that the redemption of the capital investment bond after maturity is a transfer under section 2(47) of the IT Act and not the case of debenture issued on private placement.

• Redemption of debentures is nothing but repayment of debt and not extinguishment.

• In the instant matter, the NCDs are privately placed and not listed on the stock exchange. Further, the taxpayer has not sold the NCDs in the open market but only surrendered them to the issuer Company for redemption. Therefore, it is a case of money advanced by a creditor since debentures are debt instruments only. Thus, the question of capital gains will not arise when the debentures are redeemed by the issuing companies. Further, whatever is received by the taxpayer in the form of a premium is nothing but interest income only.

 BDO IN INDIA COMMENTS

The Mumbai Tax Tribunal has distinguished the tax treatment in the case of preference shares, equity shares, MLDs, Capital Investment Bonds and NCDs, by laying down their distinct features. The ruling clarifies that since the return on MLDs is based on the underlying market index, the treatment applicable to MLDs cannot be applicable to NCD. While this Ruling is pronounced in the case of an individual, the principle laid down here may be relevant for the NCD subscribed by the Company. The impact of this Ruling may be more relevant when the investor/ lender/ subscriber is a Foreign Company/ Non-resident. One needs to evaluate its impact while applying Double Tax Avoidance Agreement provisions.

Further, in the instant case, the NCDs carried zero per cent interest. However, it is pertinent to note that zero coupon bonds also do not carry any interest element but they are specifically covered by the definition of ‘transfer’ under section 2(47)(iva) of the IT Act i.e. the gains on transfer of zero-coupon bonds are taxable under the head capital gains. One will need to evaluate the tax impact of this decision on such zero-coupon bonds.