The funding landscape over the years has given rise to a variety of hybrid devices, each with its own complexities. Often, companies (usually startups) are issuing convertible instruments (also known as quasi-equity instruments) such as Compulsorily Convertible Preference Shares (CCPS) or Compulsorily Convertible Debentures (CCDs) to shareholders/investors. Generally, these carry nominal interest or dividends, which should be taxed as ‘any other income’ for an investor at the applicable slab rates.
The terms of these instruments are generally governed by the respective shareholder’s agreement and, unless modified, will take precedence over equity shareholders under the liquidation hierarchy. Holding period of two years CCPS will be treated as long-term capital asset, but in case of CCD, the period will be three years. Conversion of these CCPS or CCDs into equity shares is not treated as transfer under section 47 of the Income Tax Act, 1961, and hence will not be subject to any capital gains tax, which will be payable only at real time. sales.
These instruments also present some other tax challenges, in particular, that investors or the companies issuing these instruments need to consider when they are unlisted. The valuation of the instruments is prescribed under Rule 11UA of the Income Tax Rules. The rules regarding the choice of methods for issue of equity shares are very clear. At the time of issue, either the net asset value (NAV) method or the discounted cash flow (DCF) method is used to determine a limit on valuation. An example is new-age companies, which are usually asset-light, typically using the DCF method. At the time of transfer by an investor, it is necessary to follow the NAV method of valuation with certain adjustments. The purpose of this provision is to set a floor for transactions for the purpose of taxation.
However, when it comes to instruments other than equities (including quasi-equities), the said rule suggests the use of open market value (OMV). This is the most ambiguous term because for non-quoted securities, it will be very difficult to determine the OMV in many cases. The available jurisprudence and literature on the subject place it on a par with FMV and therefore evaluators often use the available methods of evaluation. However, this leaves room for ambiguity as the tax department may challenge the company’s approach which could eventually lead to litigation. For example, an appraiser may use the DCF method to value a CCPS whose face value is Reach a valuation of 100 more for a special round 1,000 per share but the tax department can challenge it, stating that DCF may not be suitable as it is not equity per se and should be treated as preference share only and valued at its redemption value ( including any dividends paid/payable therein (interim) and hence the difference of 900 can be treated as income in the hands of the company.
Another issue is the disclosure of such shares in the tax returns of investors. One of the tables in the General Schedule of Income Tax Return Forms specifically requires disclosure of ‘unlisted equity shares’ held by the taxpayer at any time during the financial year. As mentioned earlier, startups usually issue CCPS/CCDs, but the use of the term ‘unlisted equity shares’ makes this somewhat unclear and if these are required to be disclosed in this table or not. An explanation may be made that this table does not require reporting to the CCPS/CCD, but this may defeat the intention behind its introduction.
It is important to note that taxpayers whose income . More than 50 lakh is required to report all assets in Schedule AL, but only figures on aggregate investments and not individual investments are required to be reported. While no disclosure is required for taxpayers below this level of income, reporting of unlisted equity shares is mandatory for each individual taxpayer in the tax return. It is better to be on the conservative side and it is generally recommended to report to CCPS/CCD in this table as well. Therefore, considering the widespread use of these instruments, there is an urgent need to make suitable amendments in the tax provisions and remove the anomalies to bring these instruments at par with equity shares, which is their essential nature.
Sandeep Sehgal is Partner-Tax at AKM Global, a tax and consulting firm.
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