Businesses nowadays are coming up with pioneering strategies to keep afloat amidst financial stress. One of the common modes of financial structuring these days is conversion of loans into equity shares. The said option not only results in significant interest cost savings but also elevates the financial position for attracting new investments.
While there could be commercial motivations to convert the outstanding loan to equity, such conversion could result in adverse implications under the Income Tax Act, 1961 (‘Act’). Firstly, the conversion of loans into equity shares may have certain tax implications under Section 56(2)(viib) of the Act. Then, there could be allegations that the re-payment of loan by way of conversion to equity is not in accordance with Section 269T of the Act and may result in penalty under Section 271E. In this article, we have discussed the legal position in relation to these aspects and the judicial precedents in relation thereto.
Section 56(2)(viib) of the Act provides that when the shares are issued at premium by closely held company[1] for a consideration which exceeds the fair market value (‘FMV’) of the shares, the excess consideration shall be taxed as income from other sources in the hands of the company issuing the shares.
An interesting point to be noted here is that Section 56(2)(viib) of the Act applies to companies which receive “any consideration for issue of shares that exceeds the face value of such shares”. A question therefore arises whether conversion of loan into equity shares being non-monetary in nature will attract Section 56(2)(viib) of the Act. In the past, the issue whether conversion of convertible securities into equity shares will attract angel tax has been dealt by few Tribunals. The Kolkata Tribunal in Milk Mantra Dairy (P.) Ltd. v. Deputy Commissioner of Income-tax[2], held that ‘consideration’ in respect of Section 56(2)(viib) has a wider import when compared with words ‘amounts’ or ‘money’. Thus, ‘consideration’ encompasses consideration in all forms and is not limited to only receipt of money. However, Mumbai Tribunal in Rankin Infrastructure Pvt. Ltd.[3] has held that Section 56(2)(viib) of the Act will not apply when there is no receipt of monetary consideration.
Recently, the question of invoking the aforesaid provisions on conversion of loan into equity shares has been dealt by the Chandigarh Tribunal in ACIT v. I.A. Hydro Energy Pvt. Ltd.[4]. In the instant case, post conversion of partnership firm to company, loan provided by partners of the erstwhile partnership firm were converted into equity shares of succeeding company at premium. The Tribunal held that in the absence of receipt of any monetary consideration during the relevant year, Section 56(2)(viib) of the Act will not be applicable. The Tribunal went a step further to determine whether the legislative intention behind introducing the provisions relating to Section 56(2)(viib) of the Act (which is to curb tax abuse) was met and held that since the conversion of partner loans to equity of succeeding company was a genuine transaction, there was no abuse of tax which would warrant application of angel tax provisions.
This finding of Chandigarh Tribunal though will bring some sigh of relief to the taxpayers, it will be interesting to see the fate of the findings by the Tribunal before higher forums. Particularly, the taxpayers may seek to apply this order in other cases involving issue of shares at premium (like in conversion of securities) where the genuineness of transaction is not doubted. However, where loan is converted to shares, the department will seek to apply the provisions in cases where the consequential shares have been issued at a premium.
Besides this, one may also consider the implications in the hands of the lender of loan who receives shares on its conversion. Section 56(2)(x) provides that where any person receives any property being shares, either without consideration or for inadequate consideration, then the FMV or its excess, shall be taxed as income from other sources in the hands of the recipient of such shares. It needs to be analyzed whether the ratio of the judgment passed by Chandigarh Tribunal can be equally applied to Section 56(2)(x) of the Act to contend that the said section should not apply in genuine transactions.
Another hurdle to the loan conversion to equity shares is Section 269T of the Act, which was introduced to curb the practice of cash settlement of loans. The said provision prohibits repayment of any loan otherwise than by banking channels or through prescribed electronic mode, if the amount of loan (inclusive of interest) is INR 20,000 or more. The Act under Section 271E also provides for levy of penalty of a sum equivalent to the loan repaid in case of contravention of Section 269T of the Act. Seemingly, the language employed in Section 269T of the Act suggests that repayment made in any mode other than the specified modes i.e., squaring of balances through book adjustments may attract penalty. The Bombay High Court[5] held that netting of payables by way of book entries will attract Section 269T of the Act. However, in certain cases[6] it has held that the loan balance squared off by conversion into equity shares at premium would not attract implications under Section 269T of the Act as it is a mere book entry which does not involve any cash repayment.
To sum up, the question of application of income tax upon receipt of non-monetary consideration against issue of equity shares is far from settled. Though the financial structuring by way of conversion of loan into equity shares has some added benefits for businesses, one needs to holistically consider the tax costs involved in such structuring to make it effective.
[The authors are Associate Partner, Principal Associate and Associate, respectively, in Direct Tax Team at Lakshmikumaran and Sridharan Attorneys, New Delhi]
[1] “Not being a company in which public is substantially interested” as provided in section 2(18) of the Act.
[2] [2022] 196 ITD 333 (Kolkata - Trib.).
[3] (2022) 142 taxmann.com 37 (Mumbai Trib.).
[4] ITA No. 548/CHD/2022.
[5] CIT v. Triumph International Finance Ltd., [2012] 345 ITR 270 (Bombay).
[6] Arkit Vincom Pvt. Ltd. v. ACIT, I.T.A No. 2397/Kol/2016.
