Consider this situation: Company A acquires Company B by way of an amalgamation of Company B into Company A. As consideration, shareholders of Company B are allotted redeemable preference shares (RPS) of Company A, effectively a deferred payout structure, preserving liquidity of Company A at the time of the merger, while providing an assured exit price to the shareholders of Company B.
While the merger appears to be straightforward, the treatment of RPS diverges across different laws:
1. Income-tax: An amalgamation is tax-neutral when shareholders of the amalgamating company receive shares of the amalgamated company in consideration. The income-tax law does not distinguish between equity and preference shares, and therefore, the amalgamation should be considered as a tax neutral merger even upon issuance of RPS.
2. Company Law: Redeemable preference shares constitute share capital, forming part of the company’s net worth and regulatory capital base. However, redemption is only possible out of distributable profits or proceeds of a fresh issue. If neither exists at the time of redemption, the obligation remains deferred, not enforceable. In other words, it represents a capital instrument with contingent payout, not a debt obligation.
3. Commercial Risk: Therefore, in case of a merger with issuance of RPS as consideration, the seller’s realization depends on the merged entity’s future profitability. If profits are inadequate, redemption may be postponed indefinitely. A put option on the continuing shareholders may mitigate commercial risk, but enforcement of the same may be protracted.
4. FEMA: If RPS are sought to be issued to non-resident shareholders, prior RBI approval is required since RPS are considered as debt instruments under the NDI Rules. Yet, for ODI (i.e., outbound investment) purposes, RPS forms a part of regulatory capital to computing the available ODI limits.
5. Ind AS 32 / 109: Under Ind AS, classification depends on the substance of the contractual terms. Redeemable preference shares with a fixed redemption obligation and coupon are treated as financial liabilities, not equity. Accordingly, the dividend on such RPS is recognised as interest expense, affecting PBT, and not “below-the-line” distributions. On the balance sheet, these appear under borrowings, not under share capital. Hence, while legally share capital, Ind AS treats RPS as debt, altering key ratios and distributable profit calculations.
6. IBC: Recently, the Supreme Court reaffirmed that preference shareholders are not creditors. RPS does not constitute financial debt, even if it is due for redemption.
Key Takeaway: The same RPS can simultaneously be: a) share capital under tax law, company law, and IBC; and b) Debt under FEMA (under NDI) and Ind AS.