Compulsorily convertible debentures remain debt-like until conversion, so contractual interest cannot be set at nil without valid benchmarking.

Compulsorily convertible debentures were treated as debt-like instruments until conversion, so contractual interest could not be disallowed by recharacterising them as equity for transfer pricing purposes. The Tribunal held that a nil arm's length price for the interest component, based only on the view that the instrument resembled share capital and carried no repayment obligation, was not justified without a valid benchmarking exercise. On that reasoning, the transfer pricing adjustment was found unsustainable and the addition was deleted in full in favour of the assessee.

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Issues: Whether interest paid on compulsorily convertible debentures could be disallowed by recharacterising the debentures as equity and determining the arm's length price at nil, and whether the resulting transfer pricing adjustment was sustainable.

Analysis: The assessee had issued compulsorily convertible debentures carrying contractual interest. The transfer pricing authorities disregarded the assessee's benchmarking and treated the instrument as equity-like on the premise that, in substance, it resembled share capital and carried no repayment obligation. The Tribunal followed the consistent line of authority that compulsorily convertible debentures are not to be recharacterised as equity for the purpose of disallowing interest or making a transfer pricing adjustment at nil merely on a notional view of substance. It accepted that the instrument remained a debt-like instrument until conversion, and that the authorities below were not justified in deleting the interest component on that basis.

Conclusion: The transfer pricing adjustment made by determining the arm's length price of interest on compulsorily convertible debentures at nil was unsustainable, and the entire addition was deleted in favour of the assessee.

Final Conclusion: The appeal succeeded and the assessed adjustment on interest paid on compulsorily convertible debentures was removed in full.

Ratio Decidendi: Compulsorily convertible debentures cannot be recharacterised as equity for transfer pricing purposes so as to disallow contractual interest or adopt a nil arm's length price without a valid benchmarking exercise.

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