(First published on Linkedin)
In a recent decision, the NCLAT held that the conversion of share capital into a loan was permissible through a capital reduction under Section 66 of the Companies Act, 2013.
A company in the infrastructure sector, facing financial losses, undertook a capital reduction involving the cancellation of a large portion of the original equity shares. Instead of a direct payout, the cancelled shares were converted into interest-bearing unsecured loans at a 14% coupon rate. While the NCLT, Mumbai Bench, initially rejected the proposal, the NCLAT approved it, emphasizing the company’s discretion under Section 66 to reduce share capital “in any manner” with shareholder approval.
Key Takeaways
1. Indirect Private InvIT Mechanism: The structure effectively mirrors an Infrastructure Investment Trust (InvIT). Unlike formal InvITs regulated by SEBI, this mechanism results in consistent income streams to the shareholders through loan repayments, providing a simplified alternative for upstreaming income from infrastructure assets.
2. Capital Gains Tax / Deemed Dividend: Since the company was loss-making, deemed dividend taxation under Section 2(22)(d) was not attracted. Additionally, no capital gains tax arose as the consideration (loan amount) matched the acquisition cost of shares. Upon loan repayment, the principal would not trigger the newly introduced buyback tax (which is considered deemed dividend, irrespective of the cost of acquisition), and while interest income would be taxed for shareholders, the company could claim interest deductions — which is absent in dividend payouts.
3. Corporate Law Flexibility: Unlike share buybacks which are subject to regulatory caps and procedural restrictions, repayment of loans going forward (effectively return of share capital) will not be subject to such caps.
4. FEMA Considerations: This route may not be feasible for companies with foreign shareholders. Converting non-debt instruments into External Commercial Borrowings (ECBs) is impermissible under FEMA. Moreover, assured returns on equity instruments are not permissible under FEMA.
5. IndAS Implications: Since the share capital is now reclassified as a financial liability, with interest payments treated as an expense, this will adversely impact the company’s debt-to-equity ratio and reduce its Profit After Tax (PAT). While the company may benefit from interest expense deductions for tax purposes, the increased leverage and lower profitability could affect future fundraising, lender covenants, and credit ratings.
Broader Industry Impact
This ruling is particularly relevant for the infrastructure sector, where companies often face financial challenges due to high capital expenditure and long gestation periods. Converting shares into loans could help manage cash flows while providing investor returns in a structured manner.