OPTIONAL CONVERTIBLE INSTRUMENTS Implications under Accounting Standards, Company Law, FEMA and Income Tax
CA Bhawna Grover
CA Shivam Gupta
Parth Chourikar
Manager - Research and Advisory, Taxmann
Assistant Manager, Taxmann
CS, B.Com, Taxmann’s Advisory & Research Team (Corporate Laws)
OPTIONAL CONVERTIBLE INSTRUMENTS Implications under Accounting Standards, Company Law, FEMA and Income Tax
CA Bhawna Grover
CA Shivam Gupta
Parth Chourikar
Manager - Research and Advisory, Taxmann
Assistant Manager, Taxmann
CS, B.Com, Taxmann’s Advisory & Research Team (Corporate Laws)
Contents 1.
Introduction
5
2.
Accounting For Optionally Convertible Instruments
5
3.
Provisions Under Company Law For Optionally Convertible Instruments
16
4.
FEMA Provisions Governing OCPS and OCDs
21
5.
Income-Tax Implications
23
1. Introduction Optionally convertible instruments have emerged as one of the most widely used financing mechanisms in private equity, venture capital, strategic investments and structured financing transactions. Unlike compulsorily convertible instruments, these hybrid instruments give the investor, the issuer, or both the contractual option to convert the instrument into equity shares of the issuing company. This flexibility enables companies to structure fund-raising arrangements that balance their capital requirements with investors’ expectations regarding downside protection, liquidity and participation in the future growth of the business. Although Optionally Convertible Preference Shares (OCPS) and Optionally Convertible Debentures (OCDs) may appear similar from a legal perspective, their accounting treatment under Indian Accounting Standards (Ind AS) can vary considerably depending on the contractual terms governing conversion and settlement. Merely describing an instrument as an OCPS or an OCD does not determine its accounting classification. Instead, the classification depends on the contractual rights and obligations embedded in the instrument and the substance of the arrangement. The accounting framework is primarily governed by Ind AS 32 (Financial Instruments: Presentation), which determines whether an instrument should be classified as an equity instrument, a financial liability or a compound financial instrument. Where the instrument contains embedded derivative features, Ind AS 109 (Financial Instruments) may also be relevant for recognition and subsequent measurement. Since the initial classification determines the basis for subsequent accounting, an incorrect assessment may significantly affect an entity’s reported liabilities, finance costs, net worth, earnings per share and profitability throughout the life of the instrument. Unlike compulsorily convertible instruments, optionally convertible instruments often incorporate redemption rights, put and call options, valuation-linked conversion formulas, anti-dilution provisions, guaranteed returns and other investor-protection mechanisms. These contractual features frequently determine whether the instrument qualifies as equity or financial liability and whether the conversion option itself requires separate accounting. Consequently, the accounting for OCPS and OCDs often involves a more nuanced analysis than that for compulsorily convertible instruments. This article examines the legal framework governing optionally convertible financial instruments under the Companies Act, 2013; their accounting treatment under Ind AS; the FEMA implications for foreign investments; and the tax consequences arising from their issuance, conversion, and transfer.
2. Accounting For Optionally Convertible Instruments OCPS and OCDs are hybrid financial instruments that combine characteristics of both debt and equity. Unlike compulsorily convertible instruments, these instruments do not inevitably result in the issue of equity shares. Accordingly, the accounting assessment
Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
5
must identify which party controls the conversion or settlement decision, since this may significantly affect whether the issuer has a contractual obligation to deliver cash or another financial asset. Consequently, merely describing an instrument as an OCPS or an OCD does not determine its accounting classification. The accounting treatment depends upon the contractual rights and obligations embedded in the instrument, particularly whether the issuer has a present obligation to deliver cash or another financial asset and whether the conversion feature satisfies the fixed-for-fixed criterion prescribed under Ind AS 32. Where the instrument contains both a financial liability and an equity conversion feature, it is generally classified as a “compound financial instrument”. The issuer first measures the financial liability component by reference to a comparable non-convertible instrument, and recognises the residual amount as the equity component. However, where the conversion feature does not satisfy the fixed-for-fixed criterion or the instrument contains settlement mechanisms linked to future valuations or other variables, the conversion feature may itself require classification as a financial liability or an embedded derivative under Ind AS 109.
2.1. Accounting for Optionally Convertible Preference Shares (OCPS) Depending upon who controls the conversion decision, the contractual terms may either create or eliminate an obligation on the issuer to settle the instrument in cash. Accordingly, the accounting classification depends not merely on the existence of a conversion option but on the rights and obligations arising from the option arrangement.
2.1-1. OCPS classified as Equity Where the issuer has no contractual obligation to redeem the preference shares or otherwise deliver cash or another financial asset, and the conversion option satisfies the fixed-for-fixed criterion, the OCPS qualifies as an equity instrument. Accordingly, the proceeds are recognised within equity; no financial liability is recognised; and the amount recognised in equity is not subsequently remeasured. For Example, a company issues 10,000 OCPS of Rs. 100 each for a total consideration of Rs. 10,00,000. The terms of issue provide that the holder has the option to convert each OCPS of Rs. 100 into 10 equity shares at any time within five years. The OCPS do not carry any redemption right and, if the conversion option is not exercised, they continue as preference shares indefinitely. Settlement of the instrument can occur only through the issuance of a fixed number of the company’s own equity shares. Since the issuer has no contractual obligation to redeem the preference shares or otherwise deliver cash or another financial asset, the instrument does not give rise to a financial liability. Further, the holder’s conversion option permits the exchange of a fixed amount for a fixed number of equity shares, thereby satisfying the fixed-for-fixed criterion under Ind AS 32. Accordingly, the OCPS represent a residual interest in the company and are classified entirely as an equity instrument.
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Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
Thus, at the date of issue, the proceeds received are recognised directly in equity: Particulars
Debit (Rs.)
Bank
10,00,000
To OCPS (Equity)
Credit (Rs.)
10,00,000
Being issue of 10,000 OCPS classified as equity under Ind AS 32 Since the instrument is classified as equity, no finance cost is recognised, and the carrying amount is not subsequently premeasured. If the holder exercises the conversion option, the amount recognised as preference share capital is reclassified within equity by transferring it to Equity Share Capital and Securities Premium, as appropriate, without affecting the Statement of Profit and Loss.
2.1-2. OCPS classified as Financial Liability or Compound Financial Instrument Where the contractual terms require the issuer to redeem the instrument in cash upon the exercise or non-exercise of the conversion option, whether such option is exercisable by the holder, the issuer or both, the issuer has a present obligation to transfer economic resources. In such circumstances, the instrument may be classified entirely as a financial liability; or where the conversion option satisfies the fixed-for-fixed criterion, the instrument is classified as a compound financial instrument comprising separate liability and equity components. The liability component is measured first, while the residual amount attributable to the conversion option is recognised in equity. For example, a company issues 10,000 OCPS of Rs. 100 each for a total consideration of Rs. 10,00,000, with a tenure of three years. The terms of issue provide that the holder may, at any time during the tenure, convert each OCPS into 10 equity shares (face value Rs. 10 per share) at a predetermined conversion ratio. Alternatively, if the holder does not exercise the conversion option, the company is contractually obliged to redeem the OCPS in cash at the end of the three-year period. Since the issuer has a contractual obligation to deliver cash if the holder opts for redemption, the instrument contains a financial liability component. At the same time, the holder has the right to convert each OCPS into a fixed number of equity shares for a fixed amount of consideration, thereby satisfying the fixed-for-fixed criterion under Ind AS 32. Accordingly, the OCPS are classified as a compound financial instrument, comprising both a liability component and an equity component. At initial recognition, the liability component is measured at the fair value of a comparable financial liability without the conversion feature, and the residual amount is recognised as the equity component representing the holder’s conversion right.
Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
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However, where the investment agreement provides that the conversion price or conversion ratio will be determined by reference to future valuations, market prices, guaranteed internal rates of return (IRR), anti-dilution adjustments or similar variable mechanisms, the conversion feature generally does not satisfy the fixed-for-fixed criterion. This is because the issuer is not required to exchange a fixed amount of consideration for a fixed number of its own equity shares. Consequently, the conversion option ordinarily does not qualify as an equity component and may instead require separate accounting as a financial liability or an embedded derivative in accordance with Ind AS 109. Illustration ABC Limited issues 1,00,000 OCPS having a face value of Rs. 100 each at par on 1 April 20X1, raising total proceeds of Rs. 1 crore. The terms of issue are as follows: (a) The holder may, at any time during three years (up to 31 March 20X4), elect to convert each preference share into equity shares of ABC Ltd. (b) The number of equity shares receivable on conversion is determined by dividing the face value of each preference share (Rs. 100) by the market price of ABC Ltd.’s equity shares prevailing on the conversion date. (c) If the holder does not exercise the conversion option, ABC Ltd. is contractually required to redeem the preference shares in cash at the end of three years for Rs. 1.33 crore, representing a contractual annual return of 10%. (d) The market borrowing rate for a comparable non-convertible instrument is also 10% per annum. The instrument contains a contractual obligation to deliver cash because the holder may require redemption instead of conversion. Consequently, ABC Ltd. does not have an unconditional right to avoid settling the instrument in cash, giving rise to a financial liability. Although the instrument contains a conversion option, the conversion feature does not satisfy the fixed-for-fixed criterion under Ind AS 32. Although the amount receivable on conversion (Rs. 100 per preference share) is fixed, the number of equity shares to be issued varies with the market price of the company’s shares on the date of conversion. Accordingly, the conversion option does not represent an exchange of a fixed amount for a fixed number of the issuer’s own equity instruments. Because the instrument contains a financial liability but no equity component, the entire OCPS is classified as a financial liability under Ind AS 32. Since the market borrowing rate equals the contractual return of 10%, the present value of the redemption amount equals the issue proceeds.
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Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
Particulars
Debit (Rs.)
Bank A/C
Credit (Rs.)
1,00,00,000
To Financial Liability- OCPS A/c
1,00,00,000
Being issue of 1,00,000 Optionally Convertible Preference Shares classified as a financial liability under Ind AS 32 Since the instrument is classified entirely as a financial liability, it is subsequently measured at amortised cost using the Effective Interest Rate (EIR) method prescribed under Ind AS 109. Because the instrument does not pay any periodic dividends, the finance cost recognised each year increases the carrying amount of the liability until redemption. Amortisation Schedule Year
Opening Liability (Rs.)
Finance Cost @ 10%
Closing Liability (Rs.)
20X1-20X2
1,00,00,000
10,00,000
1,10,00,000
20X2-20X3
1,10,00,000
11,00,000
1,21,00,000
20X3-20X4
1,33,10,000
1,21,00,000 12,10,000 Accounting entry at the end of Year End 1 Particulars Finance Cost A/C
Debit (Rs.)
Credit (Rs.)
10,00,000
To Financial Liability- OCPS A/c
10,00,000
(Being finance cost recognised using the effective interest method) Accounting entry at the end of Year End 2 Particulars Finance Cost A/C
Debit (Rs.)
Credit (Rs.)
11,00,000
To Financial Liability- OCPS A/c
11,00,000
(Being finance cost recognised using the effective interest method)
Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
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Accounting entry at the end of Year End 3 Particulars
Debit (Rs.)
Finance Cost A/C
Credit (Rs.)
12,10,000
To Financial Liability- OCPS A/c
12,10,000
(Being finance cost recognised using the effective interest method) Accounting entry on conversion Assume instead that the holder elects to convert the OCPS into equity shares at the end of Year 3. Although the instrument was classified as a financial liability throughout its tenure, the liability is extinguished upon conversion and equity shares are issued in accordance with the contractual conversion formula. Suppose the market price of ABC Ltd.’s equity share on the conversion date is Rs. 20 per share. Particulars
Amount (Rs.)
Face value of each OCPS
100
Market price per equity share
20
Equity shares issued per OCPS (Rs. 100 ÷ Rs. 20)
5
Number of OCPS converted
1,00,000
Total equity shares issued
5,00,000
Assuming the equity shares have a face value of Rs. 10 each: Particulars
Amount (Rs.)
Equity Share Capital (5,00,000 × Rs. 10)
50,00,000
Securities Premium (Balancing figure)
83,10,000
Total carrying amount of liability extinguished
1,33,10,000
Accounting entry at conversion Particulars Financial Liability- OCPS A/c
Debit (Rs. )
Credit (Rs. )
1,33,10,000
To Equity Share Capital
50,00,000
To Securities Premium
83,10,000
(Being financial liability settled through issue of equity shares in accordance with the contractual terms of conversion)
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Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
Accounting on Redemption If the holder does not exercise the conversion option, ABC Ltd. redeems the OCPS in cash at the end of the third year. Particulars Financial Liability- OCPS A/c To Bank
Debit (Rs.)
Credit (Rs.)
1,33,10,000 1,33,10,000
(Being redemption of OCPS on maturity) Thus, the redemption obligation, together with the variable conversion ratio, prevents the instrument from qualifying as either an equity instrument or a compound financial instrument under Ind AS 32. Consequently, the entire OCPS is classified as a financial liability, initially recognised at fair value and subsequently measured at amortised cost using the effective interest method under Ind AS 109. Upon conversion, the carrying amount of the liability is settled by issuing equity shares, whereas upon redemption, it is discharged in cash. This illustration demonstrates that the accounting classification depends not on the legal form of the instrument as a preference share, but on its contractual rights and obligations.
2.1-3. Accounting where the contractual interest rate differs from the market rate Under Ind AS 109, a financial liability is initially recognised at fair value. Ordinarily, in an arm’s length transaction, the issue price represents the fair value of the instrument. This is consistent with Ind AS 113, which presumes that the transaction price equals fair value at initial recognition unless evidence indicates otherwise. Consequently, where the contractual return differs from the prevailing market borrowing rate, the entity must assess whether the transaction price still represents fair value. If it does not, the difference may require accounting as a day-one gain or loss or another adjustment in accordance with Ind AS 109. However, in most arm’s length financing arrangements, the issue price is structured to approximate fair value, thereby avoiding such differences.
2.2. Accounting for Optionally Convertible Debentures (OCDs) Optionally Convertible Debentures (OCDs) are debt instruments that provide the holder, the issuer or both with the contractual option to convert the debentures into equity shares instead of redeeming them in cash. Since OCDs ordinarily require repayment of principal together with contractual interest or redemption premium unless conversion takes place, they generally contain a financial liability component in addition to the conversion feature. Where the conversion option satisfies the fixed-for-fixed criterion, the OCD is classified as a compound financial instrument. And, where the conversion option fails the fixed-forfixed criterion or permits settlement through a variable number of equity shares or cash determined by future events, the conversion feature ordinarily does not qualify as equity.
Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
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Depending upon the contractual terms, either the entire instrument or the embedded conversion option may therefore require measurement as a financial liability under Ind AS 109.
2.2-1. Initial Measurement Allocating issue proceeds generally involves three steps. (a) Determine the Issue Proceeds The fair value of the compound financial instrument is generally represented by the consideration received from investors. (b) Measure the Liability Component The liability component is determined by discounting the contractual cash flows using the market interest rate applicable to a comparable debt instrument without the conversion feature. Where the instrument contains embedded derivative features such as put or call options, their effect is also considered while measuring the liability component. (c) Determine the Equity Component Once the liability component has been measured, the residual amount represents the value attributable to the conversion option. Accordingly, Equity Component = Fair Value of Compound Instrument − Fair Value of Liability Component 2.2-2. Subsequent Measurement Following initial recognition, each component follows its own accounting model. (a) The debt component is subsequently measured at amortised cost using the Effective Interest Rate (EIR) method. (b) Interest expense is recognised in the Statement of Profit and Loss over the life of the instrument. (c) The equity component recognised on initial recognition is not subsequently remeasured and remains in equity until conversion or extinguishment. (d) Where the holder exercises the conversion option in accordance with the original contractual terms, the issuer derecognises the liability component; issues equity shares based on the predetermined conversion ratio; and retains the original equity component within equity, which may subsequently be transferred to Securities Premium or another appropriate component of equity. An important principle under Ind AS 32 is that the market price of the issuer’s shares on the conversion date is irrelevant. The issuer issues shares strictly in accordance with the original contractual terms agreed at the date of issue. Accordingly, the market value of shares on the conversion date is ignored; no gain or loss is recognised on conversion; and the original equity component remains within equity.
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Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
Illustration ABC Limited issues 1,000 OCDs of Rs. 100 each on 1 April 20X1, raising total proceeds of Rs. 1,00,000. The debentures carry a coupon interest of 6% per annum and have a tenure of three years, maturing on 1 April 20X4. The prevailing market borrowing rate for similar non-convertible debentures is 9% per annum. Under the terms of issue, the holder may, at any time during the three-year period, convert the OCDs into 10,000 equity shares of ABC Limited (face value Rs. 5 per share). Alternatively, if the holder does not exercise the conversion option, the company must redeem the debentures in cash on maturity. In this case, the issuer has a contractual obligation to repay the principal together with contractual interest if conversion does not occur. Accordingly, the instrument contains a financial liability component. At the same time, the holder has the right to convert the debentures into a fixed number of equity shares (10,000 shares) for a fixed amount (Rs. 1,00,000). Since the conversion feature satisfies the fixed-for-fixed criterion under Ind AS 32, it qualifies as an equity component. Accordingly, the OCDs are classified as a compound financial instrument, comprising both a financial liability and an equity component. Initial Recognition In accordance with Ind AS 32, the liability component is measured first by discounting the contractual cash flows using the market borrowing rate applicable to a similar nonconvertible debenture. The residual amount is recognised as the equity component. (a)Calculation of fair value of Liability component of Compound Financial Instrument (CFI): Year
Cash Outflow
Present value factor @ 9%
Present value of cash flow ( Rs. )
1.
6000 (1,00,000 * 6%)
.917
5,502
2.
6000
.842
5,052
3.
1,06,000
.772
81,832
Present value of contractual cash flow
92,386 (approx.)
Thus, the present value of the liability component of the Compound Financial Instrument = Rs. 92,386 (approx.) (b)Calculation of equity component of Compound Financial Instrument (CFI): Proceeds from CFI =Rs. 1,00,000 Less Fair value of liability component = Rs. 92,386 Value of Equity Component =Rs. 7,614
Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
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Accounting Entry at 01.04.20X1 Particulars
Debit (Rs. )
Bank A/C
Credit (Rs. )
1,00,000
To Financial Liability (Liability component of OCD)
92,386
To Equity (Equity component of OCD)
7,614
Being issue of OCDs and recognition of the liability and equity components as a CFI under Ind AS 32 Subsequent recognition After initial recognition, the liability component is measured at amortised cost using the Effective Interest Rate (EIR) of 9% prescribed under Ind AS 109. The contractual coupon of 6% is paid annually, while the difference between the interest expenses computed using the EIR and the coupon paid is added to the liability’s carrying amount. The equity component of Rs. 7,614 recognised at initial recognition is not subsequently remeasured and remains in equity until the debentures are either converted into equity shares or otherwise extinguished. Amortisation Table Year
Opening Liability (A)
Finance Cost (B)(@9%)
Interest P (C) (@ 6%)
Closing Liability (D= A+B-C)
20X1-X2
92,386
8,315
6,000
94,701
20X2-X3
94,701
8,523
6,000
97,224
20X3-X4
97,224
8,750
6,000
1,00,000 (Approx.)
Accounting Entry at Year End 1 Particulars Finance Cost A/C
Debit (Rs.)
Credit (Rs.)
8,315
To Bank A/c
6,000
To Financial Liability (Bal. Fig.)
2,315
Being finance cost recognised using the effective interest method under Ind AS 109 The same accounting treatment is applied through year-end 3. Accounting on Conversion If the holder exercises the conversion option at any time before maturity, the liability component is first measured up to the date of conversion using the original effective interest rate. Thereafter, the liability is derecognised, and equity shares are issued in accordance with the original conversion terms. Any difference between the conversion value and the
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Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
carrying value of the liability component of the compound financial instrument shall be adjusted in Security Premium Reserve. No gain or loss is recognised on conversion, and the equity component of Rs. 7,614 continues to remain within equity. Accounting on Redemption If the holder does not exercise the conversion option, the liability component continues to be measured using the effective interest method until maturity. On 1April 20X4, the carrying amount of the liability equals the contractual redemption amount of Rs. 1,00,000, which is settled in cash. The equity component recognised at initial recognition remains within equity and may subsequently be transferred within equity, in accordance with the entity’s accounting policy, without affecting profit or loss.
2.3. Accounting for OCDs with Multiple Embedded Features In practice, convertible instruments frequently contain contractual rights extending beyond a simple conversion option. These may include issuer call options, investor put options, early redemption rights, repurchase provisions or other embedded derivative features. Such instruments require a more comprehensive analysis because each contractual feature must be evaluated separately to determine whether it: (a) forms part of the host debt instrument; (b) qualifies as an equity component; or (c) requires separate accounting under Ind AS 109. Accordingly, before separating a compound financial instrument into liability and equity components, the issuer must identify all embedded derivative features and evaluate their accounting implications.
2.4. Early redemption or repurchase of a convertible instrument Ind AS 32 also prescribes accounting for cases where a convertible instrument is repurchased or redeemed before maturity while the original conversion privileges remain unchanged. In such cases: (a) The consideration paid and any related transaction costs are allocated between the liability and equity components using the same basis adopted on initial recognition; (b) Any gain or loss relating to the liability component is recognised in the Statement of Profit and Loss; and (c) The portion attributable to the equity component is recognised directly in equity.
Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
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2.5. Accounting classification of optionally convertible instruments The accounting classification of an optionally convertible instrument depends primarily on the identity of the party holding the conversion right and the contractual settlement mechanism. The following table provides a broad overview of the accounting outcomes under different contractual structures: Conversion Option
Cash Settlement Likely Classification
Holder may convert; otherwise perpetual No OCPS
Equity
Holder may convert; otherwise issuer Yes must redeem
Compound /Liability
Issuer may convert; otherwise Issuer can avoid Generally (subject to issuer may redeem (issuer has cash settlement fixed) unconditional discretion) Issuer conversion linked to variable Yes/Variable ratio or future valuation
Equity fixed-for-
Liability / Embedded Derivative
2.6. Accounting of OCPS and OCDs under AS Framework Under the Accounting Standards (AS) framework, no guidance equivalent to Ind AS 32 exists for separating liability and equity components of convertible instruments. Consequently, OCPS and OCDs are accounted for according to their legal form until conversion or redemption. Preference shares are ordinarily recognised as share capital, whereas debentures are recognised as borrowings. Accordingly, the concept of compound financial instruments and the fixed-for-fixed criterion discussed under Ind AS do not ordinarily arise under the AS framework.
3. Provisions Under Company Law For Optionally Convertible Instruments 3.1. Why do investors prefer investing through OCPS or OCDs instead of ordinary equity shares? The answer lies in the commercial flexibility that these instruments provide. Consider a company undertaking a large expansion project whose future prospects remain uncertain. While an investor may be willing to provide capital, it may not yet be prepared to assume the risks associated with equity ownership. Instead, the investor may prefer to retain the flexibility to decide later whether to become an equity shareholder or recover the investment through redemption. This is where OCPS and OCDs come into play. The investor does not subscribe to ordinary equity shares. Instead, the investment is structured through OCPS or OCDs.
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Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
Unlike CCPS and CCDs, where conversion into equity is mandatory, OCPS and OCDs merely confer an option to convert. If the business performs as expected, the holder may choose to convert into equity and participate in the company’s future growth. If not, the holder may remain a preference shareholder or creditor under the terms of issue.
3.2. What are OCPS and OCDs? At their core, both OCPS and OCDs are hybrid securities. They begin their life in one form but carry an option to be converted into equity shares. Unlike compulsorily convertible instruments, the conversion is not mandatory. Whether the instrument ultimately becomes equity depends upon the exercise of the conversion option in accordance with its terms of issue. OCPS are preference shares that carry an option to be converted into equity shares upon the occurrence of specified events or within a specified period. Until such option is exercised, the holder enjoys the rights attached to preference share capital. The legal foundation of an OCPS originates from Section 43 and Section 55 of the Companies Act, 2013, which classifies the share capital of a company limited by shares into equity share capital and preference share capital. The Explanation to Section 43 further clarifies that preference share capital carries preferential rights in respect of payment of dividend and repayment of capital. Accordingly, OCPS remain preference share capital in law unless they are converted into equity shares. On the other hand, OCDs begin as debt instruments. Section 2(30) of the Companies Act, 2013 defines a debenture to include debenture stock, bonds or any other instrument evidencing a debt, whether constituting a charge on the assets of the company or not. Accordingly, an OCD holder occupies the position of a creditor, unless the conversion option is exercised. If the holder elects to convert, the debt stands extinguished, and equity shares come into existence. Otherwise, the instrument continues as a debenture and is redeemed in accordance with its terms of issue.
3.3. Why do Investors choose OCPS and OCDs? While governance rights such as board representation, reserved matters, affirmative voting rights and exit rights can largely be negotiated through a Shareholders’ Agreement, OCPS provide investors with a preferential economic position under the Companies Act, 2013. They enjoy priority over equity shareholders in the payment of dividends and repayment of capital. Similarly, an OCD holder enjoys the rights of a creditor until conversion and is entitled to repayment of the debt if the conversion option is not exercised. At the same time, the optional conversion feature lets investors defer the decision to become equity shareholders until greater commercial certainty emerges, allowing them to participate in the company’s upside while preserving downside protection.
3.4. The Journey of OCPS and OCDs The lifecycle of OCPS and OCDs begins much before the investor subscribes to the instrument. It commences with corporate authorisations, statutory approvals and compliance with the provisions of the Companies Act, 2013.
Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
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The first step is to examine the company’s Articles of Association (AoA). OCPS constitute preference share capital under Section 43 of the Companies Act, 2013. Preference share capital carries preferential rights in respect of payment of dividend and repayment of capital in the event of winding up or repayment of capital. Such preference shares may also carry additional rights to participate in dividends or surplus capital, without losing their character as preference share capital. OCDs, on the other hand, constitute debentures within the meaning of Section 2(30) of the Companies Act, 2013. Accordingly, the Articles should contain enabling provisions authorising the company to issue the proposed instrument. If the Articles do not contain such provisions, they should first be amended in accordance with Section 14 of the Companies Act, 2013. For private companies, Section 43 does not apply where the memorandum or articles provide otherwise, as clarified under the Notification No. GSR 464(E) [F.NO.1/1/2014-CL-V], Dated 5-6-2015. 3.4-1. Board approval and shareholders’ consent Thereafter, the Board approves the issue, finalises its key terms and convenes the shareholders’ meeting. The issuance of OCPS or OCDs by way of a preferential issue is governed by: a) Section 62(1)(c) of the Companies Act, 2013, read with Rule 13 of the Companies (Share Capital and Debentures) Rules, 2014. b)
In the case of OCDs, Section 71, which specifically permits debentures with an option to convert into shares subject to approval by special resolution, would also apply.
c)
Rule 13 treats an issue of shares or other securities convertible into or exchangeable with equity shares at a later date as a preferential offer.
Accordingly, the following requirements must be complied with in relation to the issue of such securities: a)
The issue must be authorised by the Articles of Association and approved by a special resolution of the members.
b)
The explanatory statement accompanying the notice must contain prescribed disclosures, including the objects of the issue, number and price of securities, basis of pricing and valuation, relevant date, proposed allottees, proposed timeline, change in control, if any, and the pre- and post-issue shareholding pattern.
c)
The price of the securities must be determined in accordance with the prescribed valuation requirements, while the price of resultant equity shares on conversion of convertible securities must be determined in the manner prescribed under Rule 13.
d)
The allotment pursuant to the special resolution must be completed within twelve months from the date of its passing. Since Rule 13 requires a preferential issue to comply with Section 42, the transaction is also subject to the applicable private placement requirements. Accordingly, the following requirements shall apply:
The offer must be made only to identify persons, without any public advertisement or marketing to the public.
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Optional Convertible Instruments
Implications under Accounting Standards, Company Law, FEMA and Income Tax
a)
Subscription money must be received through permitted banking channels and not in cash.
b)
The securities must generally be allotted within sixty days of receipt of application money.
c)
The prescribed return of allotment must be filed with the Registrar within fifteen days of allotment.
d)
No fresh offer can be made until the earlier offer has been completed, withdrawn or abandoned.
3.4-2. Pricing and valuation for unlisted companies For an unlisted company, Rule 13(2)(g) requires the issue price to be supported by a Registered Valuer’s report. The terms of issue generally specify the conversion price or the methodology for determining it, together with the period or events upon which the conversion option may be exercised. These commercial terms are often among the most negotiated aspects of an investment transaction.
3.4-3. A different framework for listed companies The framework changes significantly for listed companies. The second proviso to Rule 13(1) exempts them from obtaining a Registered Valuer’s report, as the pricing of preferential issues is governed by Chapter V of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 rather than the Companies Act. Accordingly, listed companies must comply with the pricing methodology, relevant date, lock-in requirements, in-principle stock exchange approvals, listing of the resultant equity shares and the continuing disclosure requirements under the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015.
3.4-4. Allotment and post-issue compliance Upon receipt of the subscription money, the Board proceeds to allot the OCPS or OCDs in accordance with the Companies Act, 2013. The company thereafter issues the relevant certificates under Section 46 and Section 56 in the case of OCPS or OCDs, after filing the Return of Allotment (Form PAS-3) with the Registrar of Companies and updating the Register of Members. Further, where the company is required to comply with the provisions relating to dematerialisation under Section 29 of the Companies Act, 2013 read with Rule 9A or Rule 9B of the Companies (Prospectus and Allotment of Securities) Rules, 2014, the OCPS or OCDs shall be issued and held only in dematerialised form, and the allotment shall be credited to the respective demat accounts of the allottees through the depository system instead of issuing physical certificates.
3.4-5. Rights during the OCPS/OCD phase From this stage onwards, the legal position depends upon the nature of the instrument. An OCPS holder is a preference shareholder and enjoys the rights attached to preference share capital under Sections 43 and 47 of the Companies Act, 2013. An OCD holder, on the
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other hand, occupies the position of a creditor and is entitled to the rights conferred by the terms of issue and the applicable provisions governing debentures. Until the conversion option is exercised, neither holder acquires the rights of an equity shareholder.
3.4-6. Conversion into equity Unlike CCPS and CCDs, conversion is not automatic. It occurs only if the holder exercises the conversion option in accordance with the terms of issue. Upon such exercise, the Board approves the conversion and equity shares are allotted in accordance with the agreed conversion ratio or formula. Following conversion, the holder ceases to be a preference shareholder or creditor, as the case may be, and assumes the status of an equity shareholder with all rights attached to equity shares under the Companies Act, 2013.
3.4-7. Mode of redemption of preference shares Rule 9(6) of the Companies (Share Capital and Debentures) Rules, 2014 provides that a company may redeem its preference shares only in accordance with the terms on which they were issued or as subsequently varied with the approval of the preference shareholders under section 48 of the Companies Act, 2013. Thus, the company cannot unilaterally alter the redemption terms after issuing preference shares. The rule recognises three modes of redemption. First, preference shares may be redeemable at a fixed time or upon the occurrence of a specified event, such as completion of a project or expiry of a stipulated period. Secondly, they may be redeemable at any time at the company’s option, enabling the company to redeem the shares when commercially desirable and in accordance with the agreed terms. Thirdly, they may be redeemable at any time at the shareholder’s option, allowing the holder to require redemption in the manner and within the period specified in the terms of issue.
3.5. Can a company buy back OCPS instead of redeeming them? Section 68 of the Companies Act, 2013 permits a company to buy back its own shares, and since preference shares are a class of shares, OCPS may prima facie fall within its scope. However, Section 55 specifically governs the issue and redemption of redeemable preference shares and lays down the statutory framework for their extinguishment. Further, Rule 9(6) of the Companies (Share Capital and Debentures) Rules, 2014 reinforces this position by providing that a company may redeem its preference shares only in accordance with the terms on which they were issued or as subsequently varied with the approval of the preference shareholders under Section 48 of the Act. The Rule further recognises only three modes of redemption, namely: (i) redemption at a fixed time or on the happening of a specified event, (ii) redemption at any time at the company’s option, or (iii) redemption at any time at the shareholder’s option. Accordingly, Rule 9(6) contemplates redemption as the statutory mechanism for extinguishing preference shares and does not refer to buy-back as an alternative mode. The question is whether a company can resort to the general buy-back provisions under Section 68 when Section 55 provides a specific mechanism for redemption. The Companies
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Act, 2013 does not expressly address this issue, and no reported judicial precedent directly examines the buy-back of OCPS before their redemption. Accordingly, in the absence of legislative or judicial clarity, a conservative view would favour extinguishing OCPS through the redemption mechanism under Section 55 rather than by way of buy-back under Section 68, unless the transaction is clearly supportable under the Act and the terms of issue.
3.5-1. Redemption where the conversion option is not exercised If the conversion option is not exercised within the period specified in the terms of issue, the instruments ordinarily retain their original character. Accordingly, an OCPS is redeemed in accordance with Section 55 of the Companies Act, 2013, while an OCD is redeemed in accordance with the terms of issue and the applicable provisions governing debentures. Thus, unlike CCPS and CCDs, the lifecycle of OCPS and OCDs may conclude either by conversion into equity or by redemption, depending upon whether the conversion option is exercised.
3.6. Is it mandatory to redeem preference shares? Section 55 of the Companies Act, 2013 permits a company limited by shares to issue redeemable preference shares, while simultaneously prohibiting the issue of irredeemable preference shares. As a general rule, such preference shares are required to be redeemed within twenty years from the date of their issue, subject to the specific relaxation available to companies engaged in infrastructure projects, which permits issuance for a period not exceeding thirty years, subject to redemption of at least ten per cent of such shares annually from the twenty-first year onwards.
3.7. How are OCPS Different from CCPS? Unlike a CCPS, an OCPS is not issued with the certainty that it will become equity. Instead, it confers upon the holder a contractual option either to convert the preference shares into equity or to continue as a preference shareholder in accordance with the terms of issue. Consequently, if the conversion option is not exercised, the company ordinarily fulfils its obligation by redeeming the preference shares in accordance with Section 55 of the Companies Act, 2013. Thus, while a CCPS necessarily culminates in the issue of equity shares, an OCPS may conclude either by conversion into equity or by redemption, depending upon whether the holder elects to exercise the conversion option.
4. FEMA Provisions Governing OCPS and OCDs The legal framework governing OCPS and OCDs changes significantly once the proposed investor is a person resident outside India. In such cases, the transaction must comply not only with the Companies Act, 2013 but also with the Foreign Exchange Management Act, 1999, the FEM (Non-Debt Instruments) Rules, 2019 (NDI Rules) and, where applicable, the External Commercial Borrowing (ECB) framework.
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4.1. Do OCPS and OCDs qualify as equity instruments? One of the most significant features of the NDI Rules is that only equity shares, fully paid, compulsorily and mandatorily convertible preference shares (CCPS), and fully, compulsorily and mandatorily convertible debentures (CCDs) are recognised as equity instruments for the purposes of the foreign investment regime. The regulatory position is also reflected in Paragraph 4.7 of the RBI Master Direction – Foreign Investment in India, dated January 4, 2018, which provides that “Preference shares” means fully and mandatorily convertible preference shares, which are fully paid. Further, Paragraph 4.7.2 clarifies that preference shares which are not fully, compulsorily and mandatorily convertible are debt instruments, and accordingly, their issuance is not governed by the FEM (Non-Debt Instruments) Rules, 2019 (NDI Rules). Since OCPS and OCDs merely confer an option to convert into equity, they do not satisfy the requirement of compulsory conversion. Accordingly, they do not qualify as equity instruments under the NDI Rules. This distinction has important regulatory consequences. While CCPS and CCDs may be issued to non-residents as equity instruments under the FDI framework, OCPS and OCDs cannot be issued under the same regime merely because they carry a conversion option. In the case of preference shares, the RBI Master Direction expressly classifies OCPS as debt instruments by excluding them from the definition of “preference shares” recognised under the NDI framework. Therefore, their issuance falls outside the FDI regime and must comply with the regulatory framework applicable to debt instruments.
4.2. Regulatory Implications Since OCPS and OCDs are not recognised as equity instruments under the NDI Rules, any issuance of such instruments to a person resident outside India would ordinarily be under the ECB framework, wherever applicable, rather than the FDI regime. Accordingly, before issuing such instruments to a person resident outside India, the issuer must ensure compliance with the applicable ECB framework. This includes, inter alia, verifying the eligibility of the Indian issuer (borrower) and the recognised lender, ensuring that the proposed instrument is a permitted form of borrowing, complying with the applicable minimum average maturity period, all-in-cost ceiling and end-use restrictions, and ensuring that the borrowing remains within the applicable borrowing limits. Under the ECB framework, eligible borrowers could raise ECB up to USD 750 million or equivalent per financial year under the automatic route, subject to the applicable conditions, including the ECB liability-equity ratio where applicable. The issuer must also fulfil the prescribed reporting requirements, including obtaining a Loan Registration Number (LRN) prior to drawdown and filing periodic ECB returns, wherever applicable. The issuer should further ascertain whether the borrowing qualifies under the automatic route or requires prior approval from the Reserve Bank of India. The distinction between compulsory and optional convertibility therefore matters far more than merely determining whether the holder ultimately becomes an equity shareholder. It also determines the entire regulatory framework governing foreign investment into the company.
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4.3. Can the conversion pattern of OCPS and OCDs be modified after their issuance? The conversion terms of OCPS and OCDs, including the conversion ratio, conversion price or other conversion mechanics, can be modified after their issuance, provided such modification is permitted under the terms of issue, the Shareholders’ Agreement (SHA) or Subscription Agreement (as the case may be) and the Articles of Association. In the case of OCPS, any modification that varies the rights attached to the preference shares would be subject to Section 48 of the Companies Act, 2013 relating to variation of shareholders’ rights. Accordingly, where the proposed modification affects the conversion rights attached to the existing preference shares, the company would be required to obtain the consent in writing of the holders of not less than three-fourths of the issued preference shares of that class or pass a special resolution at a separate meeting of the holders of that class, in accordance with Section 48. In the case of OCDs, Section 71 of the Companies Act, 2013 governs the issuance of debentures but does not expressly deal with subsequent modifications to the conversion terms. Accordingly, any change in the conversion ratio, conversion price or other conversion mechanics would primarily be governed by the terms of issue, the Subscription Agreement (if any), the Debenture Trust Deed (where applicable) and the Articles of Association. Where OCPS or OCDs are held by a person resident outside India, any modification to the conversion terms must also comply with the applicable provisions of the FEMA, 1999 and the regulations or directions issued thereunder, wherever applicable. Such modification may also extend to replacing an optional conversion feature with a compulsory conversion feature, thereby converting an OCPS into a CCPS or an OCD into a CCD, where permitted by the terms of issue. Thus, although the conversion mechanics of OCPS and OCDs may be modified after issuance, such modifications are not purely contractual. They must also satisfy the applicable requirements under the Companies Act, 2013 and, where relevant, FEMA.
5. Income-Tax Implications The income-tax implications arising from the transfer, redemption and conversion of unlisted OCDs and OCPS under the Income-tax Act, 2025 (‘ITA 2025’) are discussed below.
5.1. Tax implications on the transfer of unlisted OCDs Where a holder transfers unlisted OCDs to another person by way of a secondary sale, the transaction constitutes the transfer of a capital asset. Because an OCD retains the character of a debenture until it is converted into equity shares, the transfer is governed by the capital gains provisions under the ITA 2025. Section 76 of the ITA 2025 contains a special provision applicable to unlisted debentures. It provides that any gains arising from the transfer, redemption or maturity of unlisted debentures shall be deemed to be short-term capital gains, irrespective of the period for which such debentures have been held.
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Accordingly, while computing the capital gains, the holder is entitled to deduct the cost of acquisition and any expenditure incurred wholly and exclusively in connection with the transfer. Such gains are taxable at the normal rate applicable to the assessee, together with the applicable surcharge and cess, and are not eligible for any concessional rate of tax. Accordingly, the consideration received on the transfer of unlisted OCDs is taxable as short-term capital gains under Section 76 of the ITA 2025.
5.2. Tax implications on the transfer of unlisted OCPS An OCPS remains a preference share until it is converted into equity shares. Accordingly, where a holder transfers unlisted OCPS by way of a secondary sale, the transaction constitutes the transfer of a capital asset and is chargeable to tax under the head “Capital Gains”. Unlike unlisted debentures, no special provision applies to the transfer of OCPS. Therefore, the taxability of the gains is governed by the general provisions relating to capital gains. While computing the capital gains, the holder is entitled to deduct the cost of acquisition and any expenditure incurred wholly and exclusively in connection with the transfer. The nature of the capital gains depends upon the period of holding. Where the OCPS are held for more than 24 months, the resultant gains constitute long-term capital gains. Conversely, where they are held for 24 months or less, the gains constitute short-term capital gains. In terms of Section 197 of the ITA 2025, long-term capital gains arising from the transfer of unlisted OCPS are taxable at the rate of 12.5% without the benefit of indexation. Shortterm capital gains are taxable at the normal rate applicable to the assessee, together with the applicable surcharge and cess.
5.3. Tax implications on the redemption of unlisted OCDs Section 76 of the ITA 2025 specifically provides that any gains arising from the redemption or maturity of unlisted debentures shall be deemed to be short-term capital gains, irrespective of the period for which such debentures have been held. Accordingly, upon redemption of unlisted OCDs, the holder is entitled to deduct the cost of acquisition while computing the capital gains. Such gains are taxable at the normal rate applicable to the assessee, together with the applicable surcharge and cess, and are not eligible for any concessional rate of tax. Accordingly, the gains arising on the redemption of unlisted OCDs are taxable as shortterm capital gains under Section 76 of the ITA 2025.
5.4. Tax implications on the redemption of unlisted OCPS The redemption of unlisted OCPS is governed by the general provisions relating to capital gains, as no special provision similar to Section 76 applies to preference shares. Accordingly, while computing the capital gains, the holder is entitled to deduct the cost of acquisition. The character of the capital gains depends upon the period of holding. Where
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the OCPS have been held for more than 24 months, the gains constitute long-term capital gains. Where they are held for 24 months or less, the gains constitute short-term capital gains. In terms of Section 197 of the ITA 2025, long-term capital gains arising on redemption of unlisted OCPS are taxable at the rate of 12.5% without indexation. Short-term capital gains are taxable at the normal rate applicable to the assessee, together with the applicable surcharge and cess.
5.5. Tax implications on the conversion of OCDs into equity shares Section 70(1)(z) of the ITA 2025 provides that the conversion of bonds, debentures, debenture stock or deposit certificates of a company into shares or debentures of the same company shall not be regarded as a transfer. Accordingly, converting OCDs into equity shares does not give rise to any capital gains tax liability at the time of conversion. The tax liability arises only when the equity shares received upon such conversion are subsequently transferred, in accordance with the applicable provisions of the ITA 2025.
5.6. Tax implications on the conversion of OCPS into equity shares Section 70(1)(zb) of the ITA 2025 provides that the conversion of preference shares of a company into equity shares of the same company shall not be regarded as a transfer. Accordingly, converting OCPS into equity shares does not give rise to any capital gains tax liability at the time of conversion. Any tax liability arises only upon the subsequent transfer of the equity shares received on such conversion, in accordance with the applicable provisions of the ITA 2025.
5.7. Tax implications of a change in the conversion ratio A revision in the conversion ratio of OCDs or OCPS, whether resulting in an increase or a decrease in the number of equity shares receivable upon conversion, does not, by itself, give rise to any capital gains or capital loss. Until conversion, the holder continues to hold the same OCDs or OCPS, and the revision merely modifies the terms governing the number of equity shares to be allotted upon conversion. Further, when the revised conversion ratio is implemented, and the OCDs or OCPS are converted into equity shares, such conversion continues to be covered by Sections 70(1)(z) and 70(1)(zb) of the ITA 2025, respectively. Accordingly, the conversion is not regarded as a transfer and does not attract any capital gains tax at the time of conversion. Any capital gains shall arise only upon the subsequent transfer of the equity shares received pursuant to such conversion, in accordance with the provisions of the ITA 2025. Accordingly, a mere revision in the conversion ratio neither results in any taxable income nor gives rise to any allowable capital loss under the ITA 2025.
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