Question:
How are the valuation principles for the issuance of CCPS/CCD by an unlisted company under the Companies Act, 2013, and FEMA NDI Rules applied, and what are the tax implications from both the investee company’s and investor’s perspectives?
Background:
In the issuance of Compulsorily Convertible Preference Shares (CCPS) or Compulsorily Convertible Debentures (CCD) by unlisted companies, the Companies Act, 2013 mandates that the conversion ratio into equity shares should reflect the fair market value (FMV) on a fully diluted basis. The NDI Rules also require that the conversion price for non-resident investors should not be lower than the FMV at issuance.
Conundrum:
The conversion ratio for CCPS/CCD must be at least the FMV of equity shares at issuance. If the FMV at conversion is higher, the conversion is based on this higher value. However, if the FMV is lower at conversion, the minimum conversion price remains the FMV at issuance, which could deter non-resident investors due to potential valuation discrepancies.
Dissection:
Conversion Ratio under NDI Rules:
Example Scenario: If the initial price is INR 100 per share, but the FMV at conversion is INR 110, conversion is based on INR 110.
If the FMV drops to INR 90, conversion must still be at INR 100, resulting in fewer shares for non-resident investors.
Tax – Investee Company’s Perspective:
CCPS: Typically issued at face value with share premium built into the conversion ratio. Section 56(2)(viib) of ITA does not apply at issuance since the issue price would not the exceed face value.
CCDs: Issuance does not trigger Section 56(2)(viib) as CCDs are not “shares” under ITA. Share premium must be justified at conversion based on FMV methods.
However, in both the cases above, the premium on conversion into equity shares would have to be justified on the basis of the valuation methodologies prescribed for section 56(2)(viib) i.e., net book value or DCF for resident investors, and other market methods + net book value + DCF method for non-resident investors
Tax – Investor’s Perspective:
Section 56(2)(x) of ITA: Applies at issuance and conversion. Issuance must be at or above FMV as determined under Companies Act, 2013 or FEMA.
Conversion: Minimum price must be adjusted net book value of the unlisted company. Lower conversion price can lead to unintended tax consequences in the hands of the investor. However, it could be argued that section 56(2)(x) should ideally not apply where an unrelated investor is involved, since it is an anti abuse provision.