Debenture issue expenses are fully allowable even if they are fully or partly convertible in to shares.

[Uma Kothari]

Summary:

On issue of debentures capital is borrowed. A conversion of debenture in to shares may take place later on, however, that will not change the factum of borrowing of capital. Therefore, expenses in connection with issue of fully or partly convertible debentures are to be considered as expenses for borrowing capital. In such a case any part of debenture issue expenses cannot be disallowed as expenses for raising share capital. In this write-up related issues are discussed in light of a recently reported judgment of Madras high Court.

Debenture or bond:

Debenture or bond is an instrument to raise loan by issuing securities. The advantage of raising loan through such instrument is that the security is marketable and the holder can sell it in the market if he wants to realize money before it is due from the issuer on redemption. By issuing debentures and bonds money can be raised from several persons on the same terms and conditions without separate agreements. This is because the terms and condition of the issue of debentures or bonds are equally applicable to all holders of such debentures or bonds. Thus, small savings can also be mobilized by issue of bonds and debentures. 

Convertible debenture (PCD)

Convertible or partly convertible debentures are also instrument to raise money by issue of debenture or bond i.e. loan capital.  The terms of issue prescribes that the money is obtained as a loan bearing some interest and that after some time or on certain intervals, some part or parts of debenture money will be converted into equity shares at the price decided at the time of issue or to be decided in future. The debenture may be fully convertible (FCD) or partly convertible (PCD). 

Money raised is money borrowed:

When debenture or bond is issued, the issuer company does not receive share capital. Money raised by issue of FCD or PCD is in nature of capital borrowed and not in nature of share capital. Therefore, the principles relating to expenses in connection with borrowing of money, apply to the issue of bonds or debentures whether they be fully or partly convertible or non-convertible.

Partly convertible debenture

In case of issue of partly convertible debenture, the following transactions take place in due course of time.

1) Application is made for issue / allotment of debentures / bond.

2) Debenture or bonds are issued or allotted and therefore, issuing company credits the loan account which is taken by way of issue of debenture or bond.

3) On the occasion of conversion, certain part of debenture is paid up by issue of shares and therefore, at this stage, the transaction of discharge liability against debenture or bond and raising of share capital arises. 

Issue of capital is a future and contingent event:

In these cases we find that issue of share capital takes place in future and not at the time of issue of debenture or bond. The expenses incurred at the time of issue of bonds or debentures cannot therefore be considered as expenses for raising of share capital. 

As noted earlier generally in case of convertible debentures FCD/PCD, the terms for issue of shares are decided beforehand and sometimes they are decided later on.  Sometimes, conversion is compulsory and sometimes it may optional. Even in case of compulsory conversion stipulated at the time of issue of debenture, it is in one way optional for the investor because if an investor does not want to wait till the stipulated date of allotment of shares, he can sell debentures.  Therefore, the buyer will be entitled to receive share and not the original subscriber.  In some situations if there is major change in circumstances the terms and conditions of issue of debentures and shares may be altered or varied by the debenture holders through proper legal course by holding debenture holders' meeting and by changing the terms and conditions etc.  Therefore, it can be said that it is not necessary that the person who receives debenture as a subscriber will receive the shares also or that shares will in fact be issued.  Therefore, the issue of shares is not a surety but there remain many contingencies. Longer the period of conversion larger will be contingencies.

Certain conversion at the time of allotment

In past we had seen that several issues of PCD's in which case certain part of debentures was converted into equity shares simultaneously at the time of allotment of debenture.  Therefore, in such a case debenture application money remained as capital borrowed and on allotment of debenture a part of it got converted into equity shares and part into debenture or bond.  But so far the debenture application money was concerned, it was a borrowed capital.

The issue expenses:

In case of issue of debentures certain expenses are incurred for complying with statutory requirements, advertisement, stamp duty, statutory fees and other issue expenses. The controversy arises as to allowability of such expenses. If the debentures are issued then capital is borrowed, and borrowing of capital is in usual course of business and it does not create an advantage of enduring nature, in capital field, and therefore all expenses incurred in connection with issue of debentures or otherwise raising loan are allowable as revenue expenses.

A recent judgment of Madras High Court

In CIT v. South India Corpn.(Agencies) Ltd.

[2007] 164 Taxman 249(Mad.) section 37(1) of the Income-tax Act, 1961 relating to allowability of business expenditure in assessment years 1989-90 and 1992-93 was  considered. The assessee claimed full deduction of expenses incurred on debenture issue. The Assessing Officer on consideration of partly convertible nature of debentures, treated 60 per cent of issue expenses as capital expenditure and  balance as revenue expenditure. He was of the view that at time of redemption, debenture holders  would be entitled to certain shares, therefore expenses were partly to raise share capital. In  appeal before the Tribunal, it was  held that issue of shares was a future event which may or may not happen, and as in instant case, expenditure incurred was on issue of debenture only, such expenditure was revenue expenditure.

The revenue challenged the order of Tribunal on issue whether Tribunal was justified in allowing entire expenses as revenue expenses by way of following question:

"Whether, on the facts and circumstances of the case, the Tribunal was right in holding that the 60 per cent of the expenses incurred on partly convertible debentures had to be allowed as deduction?"

The Assessing Officer as well as the Commissioner of Income-tax (Appeals) considered 60 per cent of the claim of debenture issue expenses as capital expenditure. Thus the assessee filed an appeal before the Income-tax Appellate Tribunal. On consideration of facts, the Tribunal held as follows:

"The last of the issues is with regard to expenses incurred on debenture issue being treated as capital expenditure.  The authorities have treated part of the expenditure as capital expenditure on the reasoning that at the time of redemption of the debenture, the holders of the debentures were entitled to certain shares.  The issue of shares is a future event which may or may not happen. At present, the expenditure incurred was on the issue of debentures only and hence the expenses incurred on obtaining a loan is revenue expenditure.  We accordingly uphold the claim of the assessee."

On revenues appeal the High Court considered the facts found by the Tribunal and decided cases laws on the issue of expenses in connection with borrowing and noted as follows: 

The Assessing Officer bifurcated the expenditure and allowed only 40 per cent as revenue expenditure, without any basis.

The Tribunal correctly held that the disallowance of 60 per cent is without any basis and the Assessing Officer was wrong in treating part of the expenditure as capital expenditure on the reasoning that at the time of redemption of debentures, the holders of the debentures would be entitled to certain shares.

The issue of shares is a future event which may or may not happen.

The Tribunal considered and followed the principles enunciated in the Apex Court judgment in India Cements Ltd. V. CIT [1966] 60 ITR 52, which in fact, followed by the Delhi High Court in CIT v. Thirani Chemicals Ltd. 2005 -TMI - 13276 - (DELHI High Court) holding that expenditure incurred on the issue of debentures is a permissible deduction under section 37 of the Act.

During course of hearing Learned counsel appearing for the Revenue has not produced any material or evidence to take a different view.

The reasoning of the Tribunal was based on relevant materials and evidence.

There is no error or infirmity in the order of the Tribunal to warrant interference.

In view of the above, the High Court held that no substantial question of law arises for consideration by the court and hence, the appeal in respect of the question on this issue (Question no. 1) was dismissed.

Conclusion:

Debenture issue expenses are normal revenue expenses incurred to raise borrowed capital. In case of an existing business, or for extension of the business borrowing is a normal activity therefore expenses incurred for borrowing of capital are allowable. However, in view of fact that tenure of loan may spread over a period beyond the year of accrual of such expenses, specific provision can be made to amortize such expenses over the period of loan raised by way of loan or by way of debentures or bonds. In absence of specific prohibition or specific method of amortization, such expenses preferably need to be claimed fully in the year of accrual. Amortization over the period of instrument or loan, if followed in accounts can be another way of claiming the expenses following matching principal of accounting. The fact that a portion of debenture amount may be converted into share capital in future, will not change the character of expenses.

Immediate conversion or conversion after short period:

Author remember that in some cases there was part conversion of debentures into equity immediately on allotment of debenture or shortly thereafter. In such cases the revenue authorities can possibly take view that the issue of shares has been made in a disguised manner. Therefore, it is always advisable that the terms and conditions should be such that bonafide cannot be questioned. An option to covert debenture into shares can be a reasonable safeguard to establish bonafide terms and conditions. A compulsory conversion immediately on allotment or after a short spell of time, may draw adverse inference.