BY YASH MORE AND HITOISHI SARKAR, THIRD-YEAR STUDENTS AT GNLU, GANDHINAGAR
In December 2019, the National Company Law Appellate Tribunal (“NCLAT“) in Joint Commissioner of Income Tax v. Reliance Jio Infocomm Ltd. & Ors., while approving a demerger under s. 230-232 of the Companies Act, 2013, allowed the conversion of preference shares of a company into debt during the scheme of arrangement. However, the tribunal failed to adjudicate and determine the legal validity of such a transaction. The ramifications of such conversion include a considerable reduction in the profitability of the demerged company and a consequent estimated loss of Rs 258.16 crores to the public exchequer which would otherwise have received such payment in the form of dividend distribution tax under s. 2(22)(a) of the Income Tax Act.
The main thrust of the argument before the NCLAT was that by the scheme of arrangement, the transferor company sought to convert the redeemable preference shares into loans, i.e., conversion of equity into debt, which is contrary to the principles in s. 55 of the Companies Act, 2013. However, the NCLAT dismissed this contention stating such a determination is not a subject matter of the Income Tax Department. It noted that such an objection could be raised only by the competent authorities, i.e., Regional Director, North Western Region and the Registrar of Companies.
This article aims to determine the legality of such a conversion of preference shares into debt under the scheme of the Companies Act. In doing so, the authors have first expounded on the nature of preference shares and delineated on the vanishing line of distinction between tax evasion and tax planning. The authors have concluded the discussion by highlighting the problems faced in law while such conversion transactions are carried out.
Preference Shares under Companies Act
As per Explanation (ii) to s. 43 of the Companies Act, 2013, preference share capital refers to those shares which carry a preferential right with respect to (a) payment of dividend, either as a fixed amount or an amount calculated at a fixed rate, and (b) repayment, in the case of a winding-up or repayment of capital, of the amount of the share capital paid-up or deemed to have been paid-up.
The problem that arises when preference shares are converted into a loan is that the shareholders turn into creditors of the company. This leads to two main consequences – firstly, the shareholders who are now creditors can seek payment of the loan irrespective of whether there are accumulated profits or not and secondly, the company would be liable to pay interest on the loans to its creditors, which it otherwise would not have had to do to its shareholders.
Tax Evasion v. Tax Planning
S. 2(22)(a) of the Income Tax Act, 1961, taxes any distribution of accumulated profits by a company to its shareholders, if such distribution entails the release of all or any part of the assets of the company. By way of converting preference shares into loans, there is an “indirect release” of assets by the demerged company to its shareholders without appropriating funds from the accumulated profits of the company. Thus, the conversion aid companies to circumvent payment of dividend distribution tax which would have otherwise been attracted in light of s. 2(22)(a). Further, the payment of interest on such vast amounts of loans would lead to a reduction in the company’s total income in an artificial manner.
The order of the NCLAT reminds one of the Supreme Court’s landmark verdict in Vodafone International Holdings BV v. Union of India wherein the Court had frowned upon artifice, which leads to tax avoidance. However, this has to be read in consonance with the ruling of the Gujarat High Court in Vodafone Essar Gujarat Ltd. v. Department of Income Tax, where it was held that the mere fact that a scheme may result in a reduction of tax liability does not furnish a basis for challenging the validity of the same.
The Supreme Court in McDowell & Co. Ltd. v. CTO had acknowledged and dwelled upon the fine although significant distinction between tax planning and tax evasion and expounded that ‘tax planning may be legitimate, provided it is within the framework of the law.’ Therefore, in order for us to determine the validity of the scheme of arrangement, we must look into the legality of the conversion of equity into debt under the scheme of s. 55 of the Companies Act.
Legal Validity of the Conversion under the Companies Act, 2013
The pertinent question that needs to be addressed is whether such a conversion of preference shares to a loan is in contravention of s. 55 of the Companies Act, 2013. It deals with the issue and redemption of preference shares. However, it does not state anything about the conversion of preference shares. In fact, in the event where a company is not in a position to redeem any preference shares or to pay dividend, it may either (a) further issue redeemable preference shares equal to the amount due, including the dividend thereon, or (b) convert the preference shares into equity shares.
S. 55(2)(a) of the Companies Act, 2013, necessitates the requirement that preference shares cannot be redeemed except out of the profits of the company. Likewise, s. 80(1) of the Companies Act, 1956, provided a similar requirement. Thus, when the preference shares are converted into loans, the problem lies in the fact that shareholders who would now have become the creditors of the company will have to be paid irrespective of the availability of profits, thereby presenting a prima facie conflict with provisions of the Companies Act, 2013.
However, the courts have refused to construe such a conversion as a contravention of company law. In PSI Data Systems Ltd., the Kerala High Court while adjudicating upon a conversion held that the requirement under s. 80(1) of the Companies Act, 1956, is to protect the preference shareholders from a company’s unilateral action. However, if the preference shareholders consent to such a conversion of preference shares into loans, no contravention of s. 80(1) can be established. The same has been affirmed by the Andhra Pradesh High Court in In Re: SJK Steel Plant Ltd., where the Court refused to read a conversion of preference shares into Funded Interest Term Loan (FITL) as a contravention of the law.
Did the NCLAT erroneously sanction the Scheme of Arrangement?
It is beyond doubt that any scheme of arrangement needs to satisfy the requirements of s. 230-232 of the Companies Act, 2013, so as to be sanctioned by a competent court. The corresponding provisions of the erstwhile Companies Act, 1956 in this regard were s. 391-394 of the Companies Act, 1956. Thus, for a scheme of arrangement to be denied sanction, a violation of the aforementioned statutory provisions must be established.
It is a well-settled position of law post the Supreme Court’s ruling in Miheer H. Mafatlal v. Mafatlal Industries that a scheme of compromise and arrangement which is in violation of any provision of law cannot be sanctioned and the Court has to first satisfy itself that any scheme of arrangement does not contravene any law or such compromise is not entered into in breach of any law. However, juxtaposing the legal pronouncements in PSI Data Systems Ltd. and SJK Steel Plant Ltd., it is evident that s. 55 nowhere prohibits conversion of the preference shares into a loan.
A pertinent objection which was raised before both the NCLT and NCLAT was that the conversion of preference shares by canceling them and converting them into a loan would substantially reduce the profitability of the demerged company. The Andhra Pradesh High Court in In Re: T.C.I. Industries Ltd., laid down that while exercising powers under s. 391 and 394 of the Companies Act, 1956 the Court cannot sit in appeal over the decision arrived at by the shareholders or the secured creditors or the unsecured creditors, and minutely examine whether the proposed scheme as approved by the shareholders should be sanctioned or not. Thus, it is beyond the powers of a court under s. 230-232 of the Companies Act, 2013, to examine the implications of a particular scheme on the profitability of the company.
The authors duly acknowledge that conversion of preference shares into loans may lead to a massive loss to the public exchequer as the payment of loans to the creditors (who were formerly preference shareholders) cannot be taxed as opposed to payment of dividend under s. 2(22)(a) of the Income Tax Act. However, as detrimental as it may be to the exchequer, the courts have not found any explicit or implicit statutory provision that prohibits such transactions. The opposite, i.e., conversion of loan into shares, although, has statutory recognition under s. 62(3) of the Companies Act, 2013 by way of issuance of convertible debentures.
Nevertheless, the NCLAT should have been careful while allowing such conversion and must not have dismissed the contention of Income Tax Authorities merely on the grounds of locus standi. The NCLAT alone is empowered and responsible for ensuring that no scheme of arrangement is carried out in contravention of any law even though shareholders or creditors agree to such terms. At the same time, there is a need to further deliberate upon the legality of such conversion and courts must not approve of such transactions merely because they have not been expressly prohibited.