Can a Company capitalize its debts (both current and non-current) by converting it into equity shares?
There are instances when a Company, in order to meet its contractual obligation or to achieve an ideal Debt to Equity ratio, contemplates to convert its debt into equity shares. We are all aware that the Companies can convert its non-current liabilities (loan or debenture) into equity by complying with the applicable laws. However, the same cannot be said for current liabilities (for e.g. trade payables, advances, accrued expense etc.) since nothing has been clearly prescribed under the laws.
In this article, we intend to examine conversion of trade or import payables into equity under the Companies Act, 2013 (“the Act”) and the Foreign Exchange Management Act, 1999 (“FEMA”) read with rules and regulations made thereunder. An amount due against the purchase of goods or service to the creditors is termed as trade payables or account payables. However, when the said amount is due to a non-resident creditor for purchase (import) of goods or services is termed as “import payables”.
Reserve Bank of India (RBI) vide circular “Foreign Direct Investment (FDI) in India – Issue of equity shares under the FDI Scheme against legitimate dues” dated 17th September, 2014, allowed Companies to issue equity shares to non-residents against any funds payable by it to such persons provided that:
remittance of funds against which shares are to be issued should fall under automatic route;
such conversion of shares should be in compliance with FDI guidelines pertaining to pricing, sectoral caps, etc.;
conversion of equity shares against funds payable should be net of applicable taxes (i.e. conversion should take place after netting of tax liability)
Earlier, Indian Companies could issue equity shares or debentures to a person resident outside India only against several non-cash items such as technical know-how fee, royalty, External Commercial Borrowings (ECBs), import of capital goods/machinery/equipment, pre-operative/ pre-incorporation expenses under automatic route or approval route (as maybe applicable) subject to the pricing guidelines and compliance with the applicable laws.
The Companies were required to file an application with the erstwhile Foreign Investment Promotion Board (FIPB) for issue of shares against non-cash consideration which required approval of Government. There were applications filed for issue of shares against trade payables, pre-incorporation expenses, import of capital goods/machinery, etc. The Department of Industrial Policy and Promotion (DIPP) had issued a discussion paper on “issue of shares for consideration other than cash “on 28th September, 2010. According to the discussion paper, only the conversion of capital account transactions* into equity should be allowed, conversion of current account transactions* should be excluded from the purview of foreign direct investment (FDI).
It was perceived that allowing permitting issuance of equity shares against current account transaction would inhibit the fundamental principle of FDI, since FDI is one of the component of capital account. It may be interpreted that FIPB had the same view while approving the FDI proposals as the applications filed with FIPB for approval of issue of shares against current account transaction such as trade payables were generally rejected.
It is pertinent to note that RBI had specifically allowed the Companies to issue shares against amount payable to foreign creditor towards import of capital goods/machinery/ equipment (excluding second-hand machinery) subject to following conditions:
Such import is in accordance with the Foreign Trade Policy notified by the Directorate General of Foreign Trade (DGFT) and the regulations on imports issued under the Act;
There is an independent valuation of the capital goods/ machineries/ equipment by a third party entity, preferably an independent valuer from the country of import along with production of copies of documents/ certificates issued by the customs authorities towards assessment of the fair-value of such imports;
If the Indian Company is engaged in a sector which falls under Government route then the Company shall issue shares only with the prior approval of Government.
*Capital account transactions means those transactions which directly affects the assets and liabilities of the Company whereas current account transactions includes short term transactions of the Company and which have an impact on income of the Company.
As on date, an Indian Company can issue equity share against lump sum technical know-how fee, royalty due for payment, pre-incorporation/ pre-operative expenses, import of capital goods/ machinery/ equipment (excluding second-hand machinery), ECB and any funds payable by it.
Since there is no clarity under FEMA guidelines with respect to, what would be included in “any funds payable”, the question persists whether equity shares can be issued against current account transactions (like payment due in connection with professional services, interest on borrowings, reimbursement of expenses etc.). On the basis of discussion paper issued by the DIPP and the FDI proposal approved or rejected by FIPB, one can form an opinion that a Company cannot issue shares against current account transactions.
However, as per our understanding, the government has taken a liberalized view here and decided to keep the options open. The point is not whether the shares can be issued against the capital account transactions or the current account transactions. The important factors would be whether it is under the automatic route, the conversion is in compliance with the pricing guidelines, sectoral caps, etc. There is no requirement to take approval if the issue falls under the automatic route and is in compliance with the pricing guidelines, sectoral caps, etc.
Crux: An Indian Company can issue shares to non-residents against aforesaid expenses, payable or dues under automatic route if:
the Company is operating in a sector which falls under automatic route; and
issue is in compliance with pricing guidelines, sectoral caps and other conditions as provided specifically for issue of shares against such expense, payable or due
However, if Company is operating in a sector which falls under approval route or issue is not in compliance with the prescribed conditions, then the Company would be required to obtain the prior approval of Government for such issue.
There is no explicit provision under the Act which provides for conversion of trade or import payables into equity. The Companies Act only deals with the conversion of loan or debentures into equity under Section 62(3) of the Act provided that the issue of such debenture or loan containing such an option should have been approved prior to issue of debenture or raising of loan by special resolution passed by the Company in general meeting.
However, the Act provides an option to Companies under Section 62(1)(c) of the Act to issue shares for non-cash consideration against purchase of any asset or contract of services provided:
Save as above; there are no other conditions prescribed under the Act for issue of shares for consideration other than cash. Hence, we understand that there is no such requirement to get the terms of issue approved by the members before entering into a transaction of purchase of goods or services, unlike in case of conversion of loan or debentures.
Therefore, it may be interpreted that the Company can issue shares against trade or import payables; if the same is approved by the members of the Company in general meeting, and is backed by the valuation report.
The issue of equity instruments to a creditor against the payment of financial liability is an extinguishment of financial liability, and the debtor pursuant to such issue de-recognise the liability in its books. Thus, issue of shares for non-cash consideration is in a way conversion itself by way of extinguishment of liability.
Since nothing is clearly provided under the Act regarding conversion of trade payables into equity, the question persists if trade/import payables can be converted into equity by following the procedure provided under Section 62(3) of the Act for conversion of loan or debenture?
In general parlance, trade payable is an amount billed to a company by its suppliers for goods delivered to or services consumed by the company in the ordinary course of business. Trade payables are considered as the current liability of the Company as they are normally part of the working capital of the company and are required to be settled within 12 months or as per operating cycle of the business.
In cases, where trade payables are not settled within the timeline of 12 months or operating cycle are classified as non-current liabilities or debt. However, it would be incorrect to consider it as a loan.
The term “loan” is nowhere defined under the Companies Act, however in the case of Saradindu Sekhar Banerjee Vs. Lalit Mohan MANU/WB/0045/1941, AIR 1941 Cal. 538, the Calcutta High Court clarified that “every loan is a debt but every debt is not a loan”.
Further, Division Bench of Allahabad High Court in the case of M/s Laxmi & Co. Vs. Commissioner of Income Tax MANU/UP/0063/1960, AIR 1960 ALL. 278 decided that a transaction of supply of goods on credit to the assesse and acceptance by him of the liability to pay the price of goods in future along with interest on the price cannot be considered as loan.
Hence, in light of the above quoted case laws, it would be imprudent to consider long term trade payables as loan. Hence, it can be safely assumed that conversion of trade payables into equity under the provisions of Section 62(3) would be unreasonable.
After examining the provisions of FEMA and Companies Act, it may be interpreted that the notification issued by the Reserve Bank of India permitting Companies to issue shares against any funds payable was introduced in consonance with the provisions of Section 62(1)(c) of the Companies Act, 2013 i.e. issue of shares for consideration other than cash.
In absence of such notification, the Companies were bound to go through the approval route for issue of shares for non-cash consideration to non-residents. However, the said notification has provided a relief to the Companies and it has also reduced the burden of authorities.