(First published on Linkedin)
If equity investments come with exit rights, such as a put option on the founders or a provision for the company to buy back shares at an agreed IRR or FMV FMV, they introduce a potential debt-like characteristic into an otherwise equity instrument. These exit rights blur the lines between pure equity and debt, leading to the possibility of equity being classified as financial debt under certain legal frameworks.
NCLT’s Decision: In a recent case, the NCLT held that equity investments encumbered with exit rights resembling assured returns (like IRR or FMV) can be treated as financial debt under the IBC, since this would have the commercial effect of borrowing, involving a time value of money.
Key Takeaways:
1. Multifarious treatment of financial instruments under different laws: The classification of financial instruments like equity shares with exit rights varies depending on the governing legal framework. What might be treated as pure equity under one law could carry debt-like characteristics under another, depending on the specific terms of the agreement—such as exit rights, guaranteed returns, and the purpose of the investment.
2. Companies Act: Under the Companies Act, equity shares are generally treated as pure equity instruments. Equity shares with exit rights or guaranteed returns may still be treated as equity without triggering any classification as financial debt under this framework.
3. Income Tax Act: For income tax purposes, equity investments are treated as pure equity – meaning any gains realized upon the sale of shares are subject to capital gains tax, and the “redemption premium” should not be considered as tax deductible interest in the hands of the company buying back such shares. Exit rights or guaranteed returns do not affect this classification.
4. IBC: Under the IBC, equity investments encumbered with exit rights—such as an assured IRR or FMV—can be classified as financial debt. This is because these exit rights introduce the commercial effect of borrowing, making the investor a financial creditor with a claim in insolvency proceedings.
5. IndAS 109/32: Instruments that combine both equity and debt characteristics—like equity shares with mandatory exit rights—can be classified as hybrid instruments under IndAS. If the instrument includes an assured return, it may partly be classified as a liability (debt) and partly as equity for accounting purposes, reflecting its hybrid nature.
6. FEMA: Under FEMA, equity investments with guaranteed returns or exit rights could be treated as debt instruments in cross-border transactions. This was underscored in the Hubtown case, where it was held that an assured return effectively resembled debt, and did not carry an equity risk.