Purchase of own debentures
In the current day the entire world is grappling with COVID-19 pandemic. The outbreak was declared a Public Health Emergency of International Concern on 30 January 2020 by the World Health Organization. All economic activity has come to a halt. Revenues have fallen flat. There is national lockdown in the country. Mckinsey and company and various other management firms like Boston Consulting Group and Harvard business Review have had presented their report on global health and economic crisis and advocated companies around the world in the Covid situation to act promptly to protect their employees, customers, supply chains and their financial results by de-leveraging and protecting liquidity.
In this scenario man a companies may wish to purchase its own debentures to de-leverage its debts. Lets us review tax implication to such an action.
As to the true nature and character of a debenture, the Supreme Court in R. D. Goyal v. Reliance Industries Ltd.  113 Comp Cas 1 (SC) ;  1 SCC 81 explained as under (page 8 of 113 Comp Cas) :
“‘Share’ has been defined in section 2(46) of the Companies Act to mean a share in the share capital of a company which in turn would mean that it would represent contribution of the shareholder towards the share capital of the company. On the other hand, a debenture is an instrument of debt executed by the company acknowledging its receipt to repay the same at a specified rate and also carrying an interest. It is in sum and substance a certificate of loan or a bond evidencing the fact that the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the company’s capital structure yet it does not become a share capital. In any event, a debenture would not come within the purview of the definition of goods, inasmuch as, although the shares and stocks are included in the definition of goods but debentures are not.”
Thus, though debentures are securities these are essentially speaking an instrument of debt, by the company acknowledging its indebtedness to pay the amount specified.
The Bombay High Court in Reliance Industries Limited v. CIT-LTU (2019) 102taxmann.com142 held that any extinguishment of liability in a transaction involving purchase by the company of its own bonds would not give rise to applicability of sub-section (1) to Section 41 of the Act. On the applicability the High Court held that sub-section (1) of Section 41 provides that where an allowance or deduction has been made in the assessment for any year in respect of loss, expenditure or trading liability incurred by the assessee and subsequently, during any previous year, such liability ceases, the same would be treated as the assessee’s income chargeable to tax as income for previous year under which subject extinguishment took place. The foremost requirement for applicability of sub-section (1) of Section 41, therefore, is that the assessee has claimed any allowance or deduction which has been granted in any year in respect of any loss, expenditure or trading liability. In the present case, the Revenue has not established these basic facts. In other words, it is not even the case of the Revenue that in the process of issuing the bonds, the assessee had claimed deduction of any trading liability in any year. Any extinguishment of such liability would thus not give rise to applicability of sub-section (1) to Section 41 of the Act.
It is at an earlier stage that the Karnataka High Court in CIT vs. Industrial Credit and development Syndicate Limited (2006) 285ITR310 held that the inclusive definition of the word “income” in section 2(24) of the Income-tax Act, 1961adds several artificial categories to the concept of income, but on that account, the expression does not lose its natural connotation. It has to be construed as comprehending only such things which are income according to the natural import of the term.
This case involved a finance company which dealt in securities, shares, debentures, etc., and granted loans and advances and issued debentures of Rs. 10 each at par. The debentures were redeemable during the accounting years corresponding to the assessment years 1984-85, 1985-86 and 1986-87 at the rate of 30 per cent., 30 per cent. and 40 per cent. respectively. During the period of redemption, the assessee-company purchased some of these debentures through a nominee at a price less than the face value thereof and credited the difference between the face value and the cost thereof in its books as surplus arising on redemption of debentures. Although it credited these sums in the three years to the profit and loss account, it claimed deduction of the sums on the ground that they did not form part of its income. The Assessing Officer rejected the claim holding that the surplus amounts held by the nominees of the assessee on behalf of the assessee-company constituted its revenue receipt.
The Tribunal in this case held that the debentures of the company could not be considered to form a part of its stock-in-trade. The purchase and sale of its own debentures was not permissible in law and hence it was not possible to consider the assessee- company as having attempted to make a business out of the purchase and sale of the said debentures. The issue of debentures initially meant receiving of loan from the debenture-holders and that by repurchasing of the debentures, before their redemption at discount, a portion of the loan to be refunded by the company was merely cut down. The loan which is ultimately not required to be paid certainly constitutes a gain in the hands of the debtor, but such transaction will not result in any revenue gain. The gain is merely of the nature of capital receipt. Though the assessee might have credited the surplus amount to its profit and loss account for the three years, if the Department wanted to stick to its version that the gain out of the transaction arose from repurchase of debentures, such gain should have been assessed to tax actually in the years of repurchase. Therefore, the Tribunal held that the surplus amounts were not chargeable to tax either as revenue profits or even as capital gain.
Following the ratio of decision by the Supreme Court in the case of R. D. Goyal v. Reliance Industries Ltd.  113 Comp Cas 1, the Karnataka High Court held that a debenture is in sum and substance an instrument of debt or certificate of loan or a bond evidencing the fact that the company is liable to pay a specific amount with interest and that the money raised by the debentures although becomes a part of the company’s capital structure, yet it does not become a share capital. Thus any repayment of such loan by purchase the company only discharges its security and that by discharging it in this manner would not make the company its own debtor. Thus the transaction remains one for repayment of loan. (Paragraphs 7 and 8 in the judgment).
After summing up its discussions on income the High Court held as under :- ( paragraph 13)
“From the foregoing what emerges is that income-tax is a levy on income. The Income-tax Act takes into account two points of time at which the liability to tax is attracted, viz., the accrual of the income or its receipt. It is the income which has really accrued or arisen to the assessee that is taxable. Whether the income has really accrued or arisen to the assessee must be judged in the light of the reality of the situation. Income is what comes in from outside. Given its ordinary and natural meaning, the word income will take in any monetary return “coming in”. When in reality there is neither accrual nor receipt of income by the assessee, even though an entry to that effect might, in certain circumstances have been made in the books of account, it would not constitute income for the purpose of levy of tax. In other words, income means real income and not fictional one. This involves really two aspects. One is that the receipt should connote a real or tangible coming and not something notional or fictional. A rebate obtained by the purchaser or remission of debt by a creditor would not result in the creation of income in the hands of the purchaser or debtor. As in those instances the assessee does not receive any income to his nets though by such rebate or remission he is benefited to the extent of the rebate or remission.”
In the concluding paragraph the High Court held as under :- ( paragraph 19)
“In the instant case, admittedly the assessee had issued debentures which are redeemable after a period of ten years at the face value thereof. Though the debenture-holders sold the debentures before the stipulated period at a discounted price to the nominee of the assessee, the consideration paid to those debenture-holders was paid by the assessee as reflected in the books of account by a loan advanced to the nominee. Thereafter, on the due dates the assessee has redeemed those debentures for the purpose of accounting, the entire liability was shown as a liability at the price paid by the nominee of the assessee. In the balance-sheet, the entire amount due under the debentures was shown as a liability. After redemption, the difference in the amount was transferred to the profit and loss account and it was shown as surplus. It is obviously on the ground that after redemption so much liability is saved by the assessee and actually the same has to be shown as surplus though there is no real income or profit derived. Notwithstanding the nomenclature adopted in the balance-sheet to depict that amount and the place where it is shown in reality the assessee did not receive the said amount as income. The assessee was only able to discharge its liability at a lesser amount as against the face value of the debentures. It is well recognised that in revenue cases regard must be had to the substance of the transaction rather than to its mere form. It is wholly unreal and artificial to separate the business from its owner and treat them as if they were separate entities trading with each other and then by means of a fictional sale introduce a fictional profit which in truth and in fact did not exist. Cut away the fictions and you reach the position that the man is supposed to be selling to himself and thereby making a profit out of himself which on the face of it is not only absurd but against all canons of mercantile and income-tax law. Merely because the aforesaid amount was shown as a surplus amount in the profit and loss account, when the assessee did not actually receive any income, we are unable to accede to the submission of Sri Seshachala that it constitutes income under section 2(24) of the Act. Having regard to the reality of the situation, as the assessee has not derived any income, he is entitled not to treat it as an income. Therefore, the Tribunal was fully justified in its conclusion that the said surplus amount reflected in the balance-sheet cannot be treated as an income of the assessee. We do not find any error in the said conclusion reached by the Tribunal.”
Yet again the Hon’ble Karnataka High Court in their judgment rendered in the case of CIT v. Manipal Finance Corporation in ITA No. 150/2010 dated 20.11.2018 held the following substantial questions of law in favour of the respondent assessee following their previous decision in ITA Nos 794 and 795 dated 7.10.2014 in CIT v Manipal Finance Corporation Ltd. (2015) 53 taxmann.com 313:
- Whether the appellate authorities were correct in holding that the principal portion of the deposit and debentures forfeited and cessation of bank is a capital receipt in the hands of the assessee and not liable to tax ?
- Whether the appellate authorities were correct in holding that the principal portion of the deposit/ debentures taken by the company and subsequently foregone by the depositor and cessation of bank liability does not constitute income contrary to section 28 (iv ) read with section 41 of the Act and the judgments of the Apex Court in the case of Lakshmi Vilas bank reported in 220ITR305 and in the case of T.V. Sundaram Iyenger and Son Ltd. reported in 222ITR344?
The High Court further noted that the appeal filed against their previous decision in ITA Nos 794 and 795 dated 7.10.2014 stands dismissed on the ground of monetary limits.
Further in a recent decision in Principal CIT v SICOM Limited (2020) (1) TMI 1147/15ITR-OL 353 the Bombay High Court following Supreme Court decision in Commissioner Vs. Mahindra And Mahindra Ltd [2018 (5) TMI 358/404ITR 1 held that section 28(iv) of the IT Act does not apply to a transaction of waiver or cessation of principal amount of loan. Likewise it held that section 41(1) of the IT Act also does not apply since waiver of loan does not amount to cessation of trading liability.
Further in CIT v ChamanlalMangaldas& Co (1960) 39 ITR 8 (SC) & CIT v ShoorjiVallabhdas& Co (1962) 46 ITR 144 (SC), the SC has, inter alia, said that “income can be said not to have resulted at all when there is obviously neither accrual nor receipt of income even though an entry to that effect might, in certain circumstances, have been made in the books of account.”
Also income chargeable under the Act is only real income and not hypothetical or notional income as has been the age old law. The Apex Court in CIT v. ShoorjiVallabhdas& Co.  46 ITR 144 held:-
“Income-tax is a levy on income. No doubt, the Income-tax Act takes into account two points of time at which liability to tax is attracted, viz., the accrual of its income or its receipt; but the substance of the matter is income, if income does not result, there cannot be a tax, even though in book-keeping an entry is made about a hypothetical income, which does not materialize.”
Reading out from the settled law the Mumbai bench of the ITAT in Late ShriGordhandas S. Garodia vs. DCIT in ITA No. 5097/Mum./2015 dated 1.11.2017 observed that the entire purpose of the Income Tax Act, 1961 is to assess the real income of the assessee. Therefore, the Departmental Authorities cannot assess any hypothetical or notional income to tax.
In any buy-back program the price that is derived is based on a market driven negotiated price viz., the yield curve for the relevant tenor of the debenture. It represents the time value of money and more particularly defined as under:-
What is Yield Curve ?
The relationship between time and yield on a homogenous risk class of securities is called the Yield Curve. The relationship represents the time value of money – showing that people would demand a positive rate of return on the money they are willing to part today for a payback into the future. It also shows that a Rupee payable in the future is worth less today because of the relationship between time and money. A yield curve can be positive, neutral or flat. A positive yield curve, which is most natural, is when the slope of the curve is positive, i.e. the yield at the longer end is higher than that at the shorter end of the time axis. This results, as people demand higher compensation for parting their money for a longer time into the future. A neutral yield curve is that which has a zero slope, i.e. is flat across time. This occurs when people are willing to accept more or less the same returns across maturities. The negative yield curve (also called an inverted yield curve) is one of which the slope is negative, i.e. the long term yield is lower than the short term yield.
The buyback price could be higher than, or lower than, or equal to the face value of NCDs. In the event the buyback price is higher than the face value the difference would not be admissible as deduction under the Act in view of prohibition for allowance of capital expenditure in as much as a loan is a capital receipt. Section 37(1) begins with the words ‘Any expenditure (not being expenditure of the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee)—-,’. In the reverse situation when the face value exceeds the buyback price the difference yielding would therefore assume the character of a receipt of capital nature. Also importantly any buyback program does not yield any gain to the company in real terms as the difference in the face value and purchase price factor is nothing but time value of money by which count the difference between the face value and purchase price would be in the nature of a capital receipt.
CA Gopal Nathani