Compulsorily Convertible Debentures Companies Act 2013

Compulsorily Convertible Debentures (CCD): Meaning, Features, Benefits, and Risks

Introduction

Compulsorily Convertible Debentures (CCDs) are a hybrid financial instrument that combines features of both debt and equity.

They are a popular means of raising capital, especially for startups and companies looking to attract investors.

Unlike regular debentures, CCDs are mandatorily converted into equity shares after a predetermined period, making them an attractive option for both issuers and investors.

This article explores the meaning, features, benefits, and risks associated with CCDs.

What are Compulsorily Convertible Debentures (CCDs)?

CCDs are a type of debenture that must be converted into equity shares of the issuing company at a pre-determined time and ratio.

Unlike non-convertible debentures (NCDs), which remain a fixed-income instrument, CCDs provide investors with the potential for capital appreciation upon conversion into equity.

CCDs are governed by regulatory frameworks such as the Companies Act, 2013, and Securities and Exchange Board of India (SEBI) regulations.

Key Features of CCDs

• Mandatory Conversion: Unlike other convertible debentures, CCDs must be converted into equity shares at the end of a fixed period.
• Interest Component: Until conversion, CCDs may offer a fixed interest rate, providing initial income to investors.
• No Redemption: Unlike traditional debentures, CCDs do not require repayment in cash as they convert into shares.
• Regulated Instrument: CCDs are subject to RBI and SEBI guidelines, ensuring compliance with financial regulations.

How Do CCDs Work?

1. A company issues CCDs to investors at a fixed interest rate.
2. Investors hold the debentures and receive interest payments (if applicable) during the tenure.
3. Upon maturity, the CCDs are mandatorily converted into equity shares based on a pre-determined conversion ratio.
4. Investors become shareholders in the company, benefiting from potential equity appreciation.

Benefits of CCDs

For Companies:

• Attracts Investment: Helps raise capital without immediate equity dilution.
• Enhances Cash Flow: Unlike traditional debt, CCDs reduce the burden of cash repayment.
• Investor Confidence: Investors are assured of future equity ownership, making CCDs an appealing fundraising tool.

For Investors:

• Fixed Returns Pre-Conversion: Investors may earn interest before conversion, reducing risk.
• Equity Appreciation Potential: CCD holders benefit from any increase in the company’s stock value post-conversion.
• Lower Risk than Equity: Unlike direct equity investment, CCDs provide some stability before conversion.

Risks and Challenges of CCDs

• Valuation Uncertainty: Share price fluctuations at the time of conversion can impact returns.
• Equity Dilution: Existing shareholders may face dilution when CCDs convert into equity.
• Regulatory Compliance: Issuers must adhere to legal and regulatory requirements, which can be complex.
• Tax Implications: Interest earned before conversion may be taxable, and capital gains tax may apply after conversion.

CCDs vs. Other Financial Instruments

Feature	CCDs	NCDs	PCDs
Conversion to Equity	Mandatory	Not Convertible	Partial
Interest Earnings	Yes (Pre-Conversion)	Yes	Yes (Partial)
Risk Level	Moderate	Low	Medium
Equity Dilution	Yes	No	Partial

 

Taxation and Regulatory Aspects

• Tax Treatment: Interest received before conversion is typically taxable as income. Post-conversion, capital gains tax applies based on the holding period of equity shares.
• RBI & SEBI Regulations: Companies must comply with Indian financial regulations governing CCD issuance and conversion.
• Foreign Investment Considerations: Foreign investors must follow Foreign Direct Investment (FDI) guidelines when subscribing to CCDs.

Frequently Asked Questions (FAQs)

1. What is the main difference between CCDs and NCDs?

CCDs must be converted into equity after a fixed period, while NCDs remain as debt instruments and do not convert into equity.

2. Are CCDs a safe investment?

CCDs carry moderate risk. While they offer fixed returns before conversion, the final equity value depends on the company's stock price at the time of conversion.

3. How is the conversion ratio of CCDs determined?

The conversion ratio is typically pre-determined in the issuance agreement and depends on factors such as the company's valuation and the terms of the debenture.

4. Can CCDs be traded in the stock market?

Yes, in many cases, CCDs can be traded in the secondary market before conversion, subject to regulatory approvals.

5. What are the tax implications for CCD holders?

Interest earned before conversion is taxable as income, and capital gains tax applies if the converted equity shares are sold.

6. Can foreign investors invest in CCDs?

Yes, foreign investors can invest in CCDs, but they must adhere to FDI regulations and obtain necessary approvals.

7. What happens if a company defaults on CCD payments?

If a company defaults on interest payments before conversion, legal actions may be taken as per the debenture agreement. However, since CCDs must convert into equity, there is no cash repayment obligation.

8. Is a Valuation Report Required for Issuing CCDs to Foreign Investors?

Yes, a valuation report is mandatory when issuing Compulsorily Convertible Debentures (CCDs) to foreign investors. The issuance of CCDs falls under the purview of Foreign Direct Investment (FDI) regulations and is governed by the Foreign Exchange Management Act (FEMA) and the Reserve Bank of India (RBI) guidelines.

Below is a detailed explanation of why a valuation report is required, who conducts it, and the applicable regulations.

Regulatory Framework for CCD Issuance to Foreign Investors

When an Indian company issues CCDs to a foreign investor, the transaction is considered an FDI transaction since CCDs are treated as equity instruments (as per RBI guidelines). The key regulatory frameworks applicable include:

• Foreign Exchange Management Act (FEMA), 1999
• Reserve Bank of India (RBI) – FDI Regulations
• Companies Act, 2013
• Income Tax Act, 1961

These regulations mandate that the issuance of CCDs to foreign investors must comply with the prescribed valuation norms to ensure fair pricing and transparency in cross-border transactions.

Why is a Valuation Report Required?

A valuation report is required for the following reasons:

A. Ensuring Fair Pricing for Foreign Investment

The pricing of CCDs must be at or above the Fair Market Value (FMV) determined by an independent valuation report. This prevents undervaluation or overvaluation of securities, ensuring compliance with FDI rules.

B. FEMA & RBI Compliance

• Under FEMA regulations, the issue price of CCDs must be determined following internationally accepted pricing methodologies.
• RBI requires that CCDs be issued at a price not lower than the valuation determined by a SEBI-registered Merchant Banker or a Chartered Accountant.

C. Tax Implications – Avoidance of Undervaluation

• If CCDs are issued at a value lower than their fair market value, tax authorities may consider it a means of tax evasion.
• Under the Income Tax Act, 1961, the difference between the issue price and FMV could be treated as income in the hands of the recipient.

D. Foreign Exchange Regulations & Anti-Money Laundering Compliance

The government ensures that all foreign investments comply with anti-money laundering (AML) regulations. A proper valuation report provides documentary evidence that the transaction is fair and legal.

Who Conducts the Valuation?

As per RBI and FEMA guidelines, the valuation report must be prepared by:

1. A SEBI-registered Merchant Banker
• Required for transactions involving FDI in startups, private companies, or cases requiring high compliance scrutiny.
• Uses methods like the Discounted Cash Flow (DCF) method to determine fair market value.
2. A Chartered Accountant (CA) using Internationally Accepted Pricing Methods
• Can conduct valuation for smaller transactions where merchant banker involvement is not mandatory.

The company issuing CCDs must obtain a certificate of valuation and submit it to regulatory authorities when reporting the transaction.

Methods Used for Valuation of CCDs

The valuation of CCDs is typically performed using the following methods:

A. Discounted Cash Flow (DCF) Method

• Used to determine the present value of future cash flows generated by the company.
• Most commonly used by Merchant Bankers for FDI transactions.

B. Net Asset Value (NAV) Method

• Based on the book value of a company's assets and liabilities.
• Suitable for companies with significant tangible assets.

C. Comparable Company Analysis (CCA)

• Compares the issuing company's financial metrics with similar listed companies in the market.

The method used must comply with internationally accepted standards and be documented in the valuation report.

Key RBI & FEMA Guidelines on CCD Issuance to Foreign Investors

Regulation	Requirement
Valuation Requirement	CCDs must be issued at a price not lower than the Fair Market Value (FMV).
Valuation Authority	SEBI-registered Merchant Banker or Chartered Accountant.
Pricing Methodology	Discounted Cash Flow (DCF) or other internationally accepted methods.
Reporting Requirement	The issuing company must file an FC-GPR (Foreign Currency-Gross Provisional Return) form with RBI within 30 days of CCD allotment.
Lock-in Period	CCDs issued under FDI rules may have a lock-in period of 1 year in certain cases.
Sector-Specific Restrictions	Some sectors have FDI limits and approval requirements before CCD issuance.

 

Consequences of Non-Compliance

Failing to obtain a valuation report before issuing CCDs to foreign investors may result in:

1. Rejection of FDI Reporting by RBI – If the valuation is not as per FEMA guidelines, the RBI may reject the transaction.
2. Legal Penalties & Fines – Non-compliance with valuation norms can lead to penalties under FEMA.
3. Tax Scrutiny – Issuing CCDs below FMV may attract additional tax liabilities and scrutiny under the Income Tax Act.
4. Investor Disputes – Foreign investors may raise concerns over incorrect pricing, leading to legal complications.

How to Obtain a Valuation Report for CCD Issuance?

To comply with FEMA and RBI regulations, companies issuing CCDs to foreign investors should follow these steps:

1. Engage a SEBI-registered Merchant Banker or Chartered Accountant for valuation.
2. Obtain a Valuation Report using an approved methodology (DCF, NAV, or Comparable Company Analysis).
3. Submit the Valuation Report along with Form FC-GPR to RBI within 30 days of CCD issuance.
4. Maintain Compliance Records for audit and regulatory scrutiny.

A valuation report is mandatory when issuing CCDs to foreign investors to ensure compliance with FEMA, RBI, and tax regulations. The valuation must be conducted by a SEBI-registered Merchant Banker or Chartered Accountant using internationally accepted pricing methodologies. Failing to adhere to these requirements can lead to legal penalties, tax issues, and rejection of FDI transactions.

By ensuring proper valuation and regulatory compliance, companies can attract foreign investments seamlessly while avoiding legal complications.

9. Is Valuation Report still required if the CCD is issued the person who is holding NRO account?

Yes, a valuation report is still required when issuing Compulsorily Convertible Debentures (CCDs) to a person holding a Non-Resident Ordinary (NRO) account, but the regulatory requirements may vary based on the residential status and purpose of investment.

Key Considerations:

NRO Account & Residential Status of the Investor

• An NRO account is used by Non-Resident Indians (NRIs) or Overseas Citizens of India (OCIs) to manage income earned in India (such as rent, dividends, or pension).
• If the NRI is investing from an NRO account, the investment is considered a domestic investment, and FDI regulations may not apply. However, if the investment is repatriable, FDI norms will be applicable.

Applicability of Valuation Report Based on Investment Type

Scenario	Valuation Report Required?	Regulatory Basis
CCDs issued to an NRI on a repatriation basis (Investment from NRE/FCNR account)	✅ Yes	FEMA & RBI FDI Regulations apply. Pricing must be as per Fair Market Value (FMV) with a SEBI-registered Merchant Banker/CA report.
CCDs issued to an NRI on a non-repatriation basis (Investment from NRO account)	❌ No	Treated as a domestic investment. FEMA FDI rules do not apply, but the company may still require a valuation for internal compliance and tax purposes.

 

Why Valuation May Still Be Required for NRO Investments?

Even if FDI norms do not apply to NRO-based investments, a valuation report may still be needed for:

1. Company Law Compliance – The Companies Act, 2013, requires that CCD issuance is done at a fair price to avoid unfair benefits to investors.
2. Taxation Purpose – The Income Tax Department may scrutinize undervaluation, considering it as a taxable gift or deemed income.
3. Corporate Governance – To maintain transparency, companies may voluntarily obtain a valuation report.

• If CCDs are issued to an NRI investing on a repatriation basis, a valuation report is mandatory as per FEMA and RBI FDI regulations.
• If CCDs are issued from an NRO account on a non-repatriation basis, FDI norms do not apply, but valuation may still be required for tax and corporate governance reasons.

Conclusion

Compulsorily Convertible Debentures are a strategic financial tool that benefits both companies and investors.

While they offer advantages such as fundraising efficiency and potential equity gains, they also come with risks like valuation uncertainty and equity dilution.

Understanding the regulatory and tax implications is crucial before investing in CCDs.

For businesses looking to raise capital and investors seeking balanced risk-reward opportunities, CCDs remain a viable investment avenue.

By evaluating the features, risks, and benefits of CCDs, companies and investors can make informed financial decisions, ensuring long-term value and compliance with financial regulations.

Read more on: Section 8 Company Under the Companies Act, 2013