Debentures to financial institutions are not public issues, and convertible borrowing can still enter capital base

Debentures placed with named financial institutions were not debentures issued to the public and therefore fell outside rule 1(iv) of the Second Schedule to the Companies (Profits) Surtax Act, 1964. Borrowings evidenced by debentures from specified financial institutions remained within rule 1(v) where the funds were used for creating a capital asset in India and the repayment condition did not require discharge within less than seven years. A mere option to convert part of the debenture into equity did not amount to a contractual obligation to repay within seven years. The assessee was entitled to include the full amount in its capital base for surtax purposes.

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Issues: (i) Whether debentures issued to financial institutions could be treated as debentures issued to the public under rule 1(iv) of the Second Schedule to the Companies (Profits) Surtax Act, 1964; and (ii) whether debentures subscribed by financial institutions were includible in the capital base under rule 1(v) notwithstanding the convertible feature and the stipulated redemption period.

Issue (i): Whether debentures issued to financial institutions could be treated as debentures issued to the public under rule 1(iv) of the Second Schedule to the Companies (Profits) Surtax Act, 1964.

Analysis: The expression used in rule 1(iv) is confined to debentures issued to the public. A placement of debentures with named financial institutions, without any public issue, does not satisfy that description. The two provisions also operate in different fields, since rule 1(iv) addresses public issues while rule 1(v) deals with borrowings from specified financial institutions and other lenders.

Conclusion: The debentures in question were not issued to the public and therefore did not fall within rule 1(iv); the finding is against the assessee.

Issue (ii): Whether debentures subscribed by financial institutions were includible in the capital base under rule 1(v) notwithstanding the convertible feature and the stipulated redemption period.

Analysis: Borrowings from specified financial institutions remain within rule 1(v) even when evidenced by debentures, because the decisive test is whether the money was borrowed for creating a capital asset in India and whether the agreement required repayment within less than seven years. An option given to debenture holders to convert the convertible portion into equity does not amount to a contractual obligation on the company to repay within seven years. Where no conversion is exercised, redemption was postponed beyond seven years, and where conversion is exercised, the borrowing becomes equity and enters paid-up capital.

Conclusion: The debentures subscribed by the financial institutions were includible under rule 1(v), and the assessee was entitled to include the full Rs. 60 lakhs in its capital base; the finding is in favour of the assessee.

Final Conclusion: The reference was answered by holding that debentures issued to the public alone are covered by rule 1(iv), while borrowings through debentures from specified financial institutions fall within rule 1(v) if the repayment condition is satisfied, and the assessee was entitled to include the entire Rs. 60 lakhs in its capital base for surtax purposes.

Ratio Decidendi: Debentures issued to specified financial institutions are not debentures issued to the public, and a borrowing evidenced by debentures remains within rule 1(v) unless the agreement obliges repayment within less than seven years; a mere conversion option does not defeat inclusion where the borrowing is otherwise for creation of a capital asset in India.

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