3 October 2022
CCDs characterized as debt not equity


The taxpayer is engaged in providing training and operational support solutions to global defense and security customers. During the year, the taxpayer paid interest on Compulsory Convertible Debentures (CCDs) to its Associate Enterprises (AE) and the same was supported by the benchmarking analysis carried out by the assessee using the comparable uncontrolled price method in its Transfer Pricing study report. The only issue raised is in respect of treating CCDs as equity and holding that no interest is payable on equity capital, thereby computing the Arm's Length Pricing (ALP) of interest as Nil.

Taxpayer's contentions

Before the Income Tax Appellate Tribunal (ITAT), the taxpayer submitted that CCDs are nothing but debt till the date of conversion and the said view is supported by various judicial precedents. The taxpayer further contended that the benchmarking analysis carried out was also rejected by the Learned (Ld.)Transfer Pricing Officer (TPO) without providing a cogent reason. Also, the Ld. TPO did not follow the Hon'ble ITAT's order in the assessee's own case, for earlier assessment years having similar facts, accepting the CCDs as debt and thereby erred in redetermining the ALP as 'Nil'.

Revenue's contentions

The AO placed reliance on the Reserve Bank of India's (RBI) FDI policy and recognized CCDs as equity instruments since it was compulsorily converted to equity shares. Also, the TPO was of the view that the whole arrangement amounted to thin capitalization because of the poor credit rating, and no third party would invest in CCDs. The DRP placed reliance on the orders passed by the authorities below.

Held by the ITAT

The ITAT held that the RBI's definition of CCDs cannot be applied regarding the allowability of interest on such debentures. The ITAT, while referring to the case of Besix Kier Dabhol, SA held that re-characterization of debt capital as equity capital and accordingly disregarding the interest payments as tax deductibles are not in order. The issue has been considered in favor of the assessee by observing that before the date of conversion, the interest paid on convertible debentures cannot be treated as interest on equity and that such interest paid on the debentures is allowable as expenditure u/s 36(1)(iii) of the Act.

CAE Flight Training (India) Pvt Ltd [TS-517-ITAT-2022(Bang)-TP]
Our Comments
There are certain key aspects linked to a debt instrument, which are as follows:
(i) debt instrument will not dilute the ownership structure of existing shareholders
(ii) does not have any voting rights
(iii) no interference in the management of the company etc.

Furthermore, as enunciated in the OECD Guidelines, it is important to accurately delineate the actual transaction, which should typically begin with a thorough understanding of the economically relevant characteristics of the transaction. This consists of the commercial or financial relations between the related parties and the conditions and economically relevant circumstances attached to those relations, including, an examination of the contractual terms of the transaction, the functions performed, assets employed, and risks assumed, the characteristics of the financial instruments, the economic circumstances of both the related parties and of the market, and the business strategies pursued by the said related parties.

The treatment of CCD's as a debt or an equity instrument has been dealt with by the Tax Authorities in India in numerous instances and the stand taken above, i.e., to characterize the CCD's as debt instead of equity, has been upheld by the Tribunal as well.

Furthermore, with the introduction of the thin capitalization rules introduced in India vide Section 94B of the Income-tax Act, 1961, it becomes even more integral for the taxpayers to be mindful of its implications while determining the debt-equity mix of a company.
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