Compulsory Convertible Debentures: The "Chameleon" Problem

INTRODUCTION

Compulsory convertible debenture (“CCDs”) occupies a unique and increasingly contentious space in corporate law and allied fields of practice. These instruments are structured to start as debentures as was fundamentally contemplated under in the language of Section 71¹ of the Companies Act 2013 (“Companies Act”) which treats Debentures as ‘debt’. However, due to the hybrid nature, often resembling debt in form, but are mandatorily convertible into equity shares at a future date. Their appeal lies in their “chameleon-like” nature since they offer the fixed-income security of a debt instrument in the short term while guaranteeing an equity stake in the long term. However, this hybridity creates a significant legal vacuum. Unlike optionally convertible debentures, where the investors can choose to demand repayment, CCDs must convert into equity. This mandatory conversion feature forces a clash between “form” (the instrument is a debenture) and “substance” (when the instrument will inevitably become equity).² In view of the conversion into equity, it is interesting to reflect upon the contours of the nature and treatment of CCDs in form and substance under different laws. It is prudent to state at the outset that once the conversion is actually effected, a CCD is treated as part of equity share capital of the Company. However, what is sought to be explored jurisprudentially is whether such CCDs can be treated as equity even before conversion, and in particular, the point or stage at which the treatment afforded to the instrument is classified either as equity or debenture viz. at the inception/issuance or under different circumstances and laws including winding up or insolvency. Further, the interpretations done by the courts will also be briefly assessed in light of practical implications of differential treatment toward CCDs.

CCDS AS HYBRID SECURITY: GENESIS

Section 2(30)³ of the Companies Act, 2013 defines “debenture” broadly to include debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not. Section 71⁴, read with Rule 18⁵ of the Share Capital and Debentures Rules, 2014, permits companies to issue debentures with an option to convert them into equity shares at the time of redemption. The Companies Act does not create a separate category for convertible debentures. While the amount which is raised by a company through debentures becomes part of its capital structure, the same does not become part of share capital.⁶ The presence of a conversion feature, even when mandatory, does not automatically transform the instrument into equity. Conversion is treated as a future, contingent event. Until it actually occurs, the debenture remains a debt instrument, and the relationship between the company and the holder is that of debtor and creditor.

However, judicial discourse has occasionally blurred this distinction. In Narendra Kumar Maheshwari v. Union of India,⁷ decided in the context of capital issues control, the Supreme Court observed that an instrument compulsorily convertible into shares cannot be regarded as a debenture in the “classic sense” because it does not contemplate repayment of principal. On this reasoning, the Court characterized CCDs as equity rather than debt. The court laid down the two-pronged test of ‘Repayment of Principle’:

1. Do the terms of the convertible debenture postulate repayment of the borrowed principal amount? If the answer is yes, then the convertible debenture is treated as a debt instrument, even though such repayment may be optional and may not occur upon maturity.
2. Conversely, if the convertible debenture’s terms do not contemplate repayment of the principal amount (e.(/), conversion into equity shares upon maturity is mandatory), it is to be regarded as an equity instrument.

From a strict company law perspective, this classification is problematic. Under Section 2(30)⁸, a debenture is explicitly defined as an instrument “evidencing a debt.” Until conversion, the CCD holder is a creditor, not a member of the company. This distinction matters because Section 71(2)⁹ prohibits debentures from carrying voting rights, the defining feature of equity ownership. CCD holders receive interest, which is a fixed contractual obligation, whereas equity shareholders receive dividends, which are discretionary. Furthermore, if the company is wound up before conversion, CCD holders rank as creditors, not as residual claimants like equity shareholders.

The Narendra Kumar Maheshwari judgment appears to adopt a “substance over form” approach by focusing solely on the ultimate outcome (conversion into equity) while ignoring the interim legal rights and obligations. The most important fact to be taken into consideration, it was decided in the context of control of capital issues a specific regulatory concern and should not be read as laying down a universal rule applicable across all areas of law. The Court was addressing whether CCDs required approval under capital control regulations, not whether they should be treated as equity for all legal purposes. Moreover, the court in its reasoning relied on the

The judgment also casually observed that all compulsorily convertible instruments, including Compulsorily Convertible Preference Shares (CCPS), should be treated as “equity”. This observation is legally indefensible when examined against Section 43¹⁰ of the Companies Act, which establishes share capital is either “equity share capital” or “preference share capital.” Equity share capital is defined by exclusion; it is all share capital that is not preference share capital. CCPS, before conversion, possess all the statutory hallmarks of preference capital i.e., preferential rights to dividends and repayment during winding up. To label CCPS as “equity” before conversion contradicts the express definitions in Section 43 and undermines the specific regulatory protections (such as redemption requirements under Section 55) applicable to preference shares.

The above contention finds it supports, later judicial pronouncements have corrected this confusion and reaffirmed the debt nature of CCDs during the pre-conversion phase. In DGIR v. Deepak Fertilisers and Petrochemicals Corporation Ltd.¹¹, the Court held that compulsorily convertible debentures retain the fundamental characteristics of ordinary debentures until conversion occurs. Importantly, the Court observed that if a company is wound up before conversion, the debenture holder remains entitled to repayment of principal along with interest. This entitlement is inconsistent with equity and reinforces the debtor-creditor relationship. The practical implication is clear, in liquidation scenarios before conversion, CCD holders do not lose their money to equity shareholders; they stand as creditors with a prior claim.

Similarly, in CWT v. Spencer and Co.¹², the Supreme Court clarified that the nature of debt does not change merely because of a future transfer into shares. If the original nature of the instrument was debt, it remains debt until the conversion actually happens. This principle prevents companies and investors from manipulating the characterization of instruments to gain tax advantages or evade regulatory requirements.

Tax Law Perspective

The Income Tax Appellate Tribunal (ITAT) Bangalore provided perhaps the most thorough analysis of CCDs in CAE Flight Training (India) Pvt. Ltd. v. ACIT¹³. The Tribunal emphasized that the legal nature of an instrument is determined by the rights it confers during its tenure, not just its ultimate destination. The Tribunal noted that “convertible debentures cannot be granted voting rights at par with voting rights of shareholders during the pre-conversion period.”¹⁴

Central to the Tribunal’s reasoning was the “test of repayment of principal”. Legally, debt is defined by the issuer's obligation to return the principal. While CCDs are meant to convert rather than be repaid in cash, the absence of immediate equity rights (voting, participation in surplus) means they fail the "equity test" during the pre-conversion phase. The Tribunal ruled out three core features of equity in the context of CCDs before conversion i.e., dividends are payable only to shareholders, and CCD holders are not entitled to dividends before conversion, voting rights are inherent to shareholding, but CCD holders cannot vote like shareholders during the pre-conversion period; and equity does not earn interest, whereas the payment of interest on CCDs confirms their debt character.

The Tribunal concluded that CCDs constitute borrowed capital and retain the character of debt until actual conversion. Consequently, interest paid on them qualifies as an allowable deduction under Section 36(1)(iii)¹⁵ of the Income Tax Act.

CCDs Under the Insolvency and Bankruptcy Code

Section 5(8) of the Insolvency and Bankruptcy Code, 2016 ¹⁶ defines “financial debt” to include “any amount raised pursuant to any note purchase facility or the issue of bonds, notes, debentures, loan stock or any similar instrument.” Recently, in IFCI Ltd. v. Sutanu Sinha¹⁷, the Supreme Court held that amounts raised through CCDs, which are compulsorily convertible into equity, may not always qualify as “financial debt” under the IBC in certain circumstances. This creates an interesting exception during insolvency proceedings, CCDs may be treated as having an “equity-like” priority, potentially subordinating them to operational creditors and other financial creditors.

However, this insolvency-specific treatment does not change the fundamental debt character of CCDs during normal operations. The IBC ruling addresses the unique policy considerations of insolvency resolution, where the law seeks to maximize value for all stakeholders and facilitate corporate revival. When a company is a going concern, CCDs continue to function as debt instruments with all the attendant rights and obligations. The Sutanu Sinha¹⁸ decision should therefore be understood as carving out a narrow exception for the insolvency context rather than redefining the nature of CCDs across all legal frameworks.

In essence, we understand that case specific requirements, basis the various statutes have often cloaked and treated CCDs as equity relying on Narendra Maheshwari ruling, it does not change the basic character of CCDs as debt per the statute.

CCDs and Net Worth

The determination of whether CCDs form part of a company's “Net Worth” requires strict adherence to statutory definitions. Under Section 2(57) of the Companies Act, 2013,¹⁹ “Net Worth” is defined by the aggregate value of paid-up share capital and reserves. Since CCDs are debt instruments until conversion, their inclusion in net worth is legally questionable.

Applying the “test of repayment of principal”, while it can be said that due to a certainty in conversion of CCDs into equity after maturity, without any scope of repayment of principal except in case of bankruptcy, it should be treated as equity and thus part of the share capital of a company (relying on Narendra Maheshwari ruling). However, it gives rise to a food for thought, that where CCDs lack the essential characteristics of equity specifically, immediate ownership rights and participation in surplus to be classified as "paid-up capital”, whether the funds raised through CCDs automatically become share capital upon issuance,  or they remain part of the company's capital structure as a distinct category until conversion actually takes place? It is argued that if the Companies Act explicitly excludes even CCPS from the definition of "equity share capital" under Section 43²⁰, then CCDs, which are debentures rather than shares, certainly cannot be treated as part of net worth or equity capital prior to conversion.

Prematurely including CCDs in net worth could give a misleading picture of a company's financial position and potentially allow companies to circumvent important regulatory safeguards, including in bypassing critical Bidding parameters in securing tenders for large scale public infrastructure projects. Until conversion is completed and shares are formally allotted, CCDs should remain classified as a liability on the balance sheet.

Reconciliation of Competing Frameworks

The apparent inconsistency in the treatment of CCDs across different legal frameworks can be reconciled by recognizing that each statute serves a distinct purpose and operates within its own policy context. The Narendra Kumar Maheshwari²¹ observation that CCDs are “not debentures in the classic sense” was made in the specific context of capital issues control and should not be universally applied. The Companies Act treats CCDs as debentures (debt) until conversion because their structural features viz., interest payments, lack of voting rights, and creditor status in liquidation align with debt. The Income Tax Act follows the same approach, allowing interest deductions because the relationship is one of borrowing and lending.

Each framework is internally consistent when understood within its own domain. The problem arises only when courts or practitioners attempt to transplant the classification from one legal regime into another without considering the underlying policy objectives. A CCD can be debt for company law purposes, debt for tax purposes, equity-like for insolvency purposes, and equity for FEMA purposes all at the same time without logical contradiction, because each classification serves a different regulatory goal.

However, in its truest sense, emanating from the basic company law jurisprudence, the conversion of a debenture is an event rather than a condition that alters its character from inception. The mandatory nature of conversion does not extinguish the debt character of CCDs; it merely fixes the timeline for their eventual transformation into equity. Until conversion actually occurs, the instrument continues to retain its debt attributes and should be treated accordingly.

CONCLUSION

While the ultimate destiny of a CCD is its transformation into equity, its legal and functional identity during the pre-conversion phase remains firmly in the realm of debt. The statutory framework, judicial pronouncements, and practical treatment across tax, insolvency, and company law all converge on this conclusion, until the moment of actual conversion, CCDs are debt instruments.

The Supreme Court ruling in Narendra Maheshwari ruling, making the basic nature of CCD as a ‘debt’ contingent upon a categorical term in the agreement postulating repayment of principal opens a pandoras box of possibilities and variety of case-to-case based interpretation, which we have seen throughout the varied kind of statutes. However, whether it upholds the spirit and fundamental understanding of debenture as a ‘debt’ until its conversion, as per Companies Act, is a question left to ponder upon.

Footnotes

1. The Companies Act, 2013, s. 71.

2. Compulsory Convertible Debentures (CCDs): Debt or Equity — Interplay Between Income-Tax and Other Laws: Experts’ Opinion, Taxmann (Mar. 27, 2025), https://www.taxmann.com/research/income-tax/top-story/105010000000023805/compulsory-convertible-debentures-ccds-debt-or-equity-interplay-between-income-tax-and-other-laws-experts-opinion.  (13, Feb 2026)

3. The Companies Act, 2013, s. 2(30).

4. Supra note 1.

5. Companies (Share Capital and Debentures) Rules, 2014, r. 18.

6. R.D. Goyal & Anr v. Reliance Industries Ltd., AIRONLINE 2002 SC 621.

7. Narendra Kumar Maheshwari v. Union of India, AIR 1989 SC 2138.

8. Supra note 3.

9. Supra note 1.

10. The Companies Act, 2013, s. 43.

11. DGIR v. Deepak Fertilisers and Petrochemicals Corporation Ltd., (1994) 81 Comp Cas 605 (MRTPC).

12. CWT v. Spencer and Co. Ltd., (2004) 267 ITR 114 (SC).

13. CAE Flight Training (India) Pvt. Ltd. v. ACIT, (2019) 178 ITD 577.

14. Compulsorily Convertible Debentures – Debt or Equity? Tribunal Rules & Experts’ Opinion (Taxmann Research, online), available at: https://www.taxmann.com/research/income-tax/top-story/105010000000016828/compulsorily-convertible-debentures--debt-or-equity-tax-tribunal-rules-experts-opinion. (13, Feb 2026)

15. The Income Tax Act, 1961, s. 36(1)(iii).

16. The Insolvency and Bankruptcy Code, 2016, s. 5(8).

17. IFCI Ltd. v. Sutanu Sinha, 2023 SCC OnLine SC 1529.

18. Ibid.

19. The Companies Act, 2013, s. 2(57).

20. Supra note 10.

21. Supra note 7.

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