Consider a case: an Indian parent funds its overseas subsidiary through preference shares. The instrument is share capital in law, and structured funding with an assured return in commercial reality. That gap between legal form and economic substance is where different regulatory frameworks reach different conclusions, simultaneously.
a) Transfer Pricing (Tata Chemicals): Where preference shares issued to an associated enterprise carry the economic characteristics of debt i.e., fixed return, assured redemption, absence of genuine equity risk, transfer pricing principles may require re-characterisation of the instrument as a loan.
b) Interest Cost Deductibility on Dividend: Return on preference shares is taxed as dividend. Earlier partial deduction of interest stands removed entirely; hence, returns remains fully taxable with no cost offset, unlike structured debt where interest is deductible.
c) ODI Regulations: “Control” and Debt Funding: Under the FEMA ODI Regulations, an Indian entity can extend debt to a foreign entity only if it has control over that entity, i.e., inter alia, at least, 10% equity holding. Preference shares, which are considered as debt under FEMA ODI Regulations, are permitted only if the 10% equity threshold is met.
d) Computation of ODI limits, however: FEMA ODI Rules cap an Indian entity’s total financial commitment at 400% of net worth. While preference shares are considered as debt instruments for outbound investments, the permissible limit of total financial commitment i.e., (equity + debt + non-fund based commitments) is linked to net worth which includes share capital of any kind i.e., preference shares is also included while reckoning the 400% limit.
e) FEMA Inbound Investments: NDI rules define equity instruments to include CCPS only, mirroring equity like instruments. Any redeemable preference shares or OCRPS are not equity instruments, and are treated as debt, requiring compliance with the ECB Regulations.
f) IndAS 32 / 109: Where a preference share carries a contractual redemption obligation and a fixed or linked coupon, it is classified as a financial liability, impacting leverage ratios and debt covenants. Coupon paid is recognised in the P&L, and distributable profits reduce.
g) IBC: Even where redemption is overdue, preference shareholders are not financial creditors and are still treated as “shareholders”.
h) Companies Act, 2013: Preference share capital aides regulatory net worth. However, the redemption conditions, i.e., redemption out of profits of fresh issuance of shares only, treat this only as share capital and not debt.
Preference shares do not have a single legal identity; they assume a different identities under different regulatory frameworks. Structuring the instrument without mapping all frameworks would result in a multiple personality disorder.