Redemption of Zero-Coupon

Background

Issuing debentures has been a common mode through which a company raises debt capital. The taxability of the surplus received on the redemption of zero-coupon non-convertible debentures (NCDs) is a contentious issue.

As per Section 2(30) of the Companies Act, 20131, debentures are the instruments issued by a company evidencing a debt. A taxpayer may argue that debentures can be considered securities and regarded as capital assets. Under the Income Tax Act of 19612 (Act), profits and gains arising from the “transfer” of a capital asset would be taxable under the head “capital gains” in the year of transfer. The term “transfer” is defined extensively under Section 2(47) of the Act3 to include the sale, exchange, or relinquishment of the asset or the extinguishment of any rights therein. Therefore, the surplus received on the redemption of debentures shall be taxed as capital gains, representing payments received upon the extinguishment of rights in a capital asset.

Further, capital gains taxation is subject to various exemptions4, and generally, the tax rate on long-term capital gains is lower than the tax rate applicable to interest income.

Consequently, it may be argued the profit or surplus received on the redemption of the debenture shall be taxed as interest income earned by the taxpayer under the head “income from other sources” as even though debentures are capital assets, they are essentially debt instruments, as the redemption of the debenture amounts to the realisation of money advanced by the creditors. The term “interest” is defined broadly under the Act to include interest payable in any manner regarding any money borrowed or debt incurred. The redemption of zero-coupon NCDs is nothing but repayment of the debt. Therefore, it could not be regarded as a “transfer” under Section 2(47) of the Act as no extinguishment of any rights in a capital asset takes place during redemption of the debenture. The premium received or surplus gained is not in the nature of capital gains and should be taxed as interest income under the head “income from other sources”.

The Mumbai Bench of Income Tax Appellate Tribunal (ITAT) in Khushaal C. Thackersey v. CIT5 held that the premium or surplus received by the taxpayer from the redemption of zero-coupon NCDs is interest income and not capital gains as there is mere repayment of the debt and no extinguishment of any rights in capital asset takes place during a transaction, hence, cannot be treated as a transfer of capital asset. In the absence of transfer, the redemption of debentures does not give rise to capital gains.

Facts of the case

During the Financial Year 2004-2005, two Indian companies issued redeemable NCDs to nationalised banks against their outstanding loan. The debentures were issued on zero interest but were redeemable at a premium. The taxpayer purchased NCDs from the bank. Subsequently, in 2009, companies redeemed NCDs as per issue and the premium as agreed was paid to the taxpayer. The taxpayer treated the surplus that arises due to the difference between the amount received from redemption and the purchase price as long-term capital gains and claimed exemption under capital gains by investing the amount in certain specified bonds and purchasing a residential property.

During the assessment, the Tax Officer determined that the profit or surplus raised from redeeming zero-coupon NCDs is an interest and not capital gains and should be assessed under the category of “income from other sources”. As a result, the tax liability of the taxpayer was recalculated, which was upheld by the first appellate authority under the Act. Against the order passed by the appellate authority, the taxpayer then filed an appeal before ITAT.

Arguments of the parties

The taxpayer contended that debenture is a capital asset and redemption would amount to the extinguishment of a right in a capital asset, therefore resulting in a transfer as per Section 2(47) of the Act. The surplus received upon redemption is capital gains. Reliance was made on the decision of the Mumbai Tribunal in Perviz Wang Chuk Basi v. CIT6, wherein it was held redemptions of preference shares and capital investment bonds after maturity, resulting in the transfer of capital assets. Hence, gains in transactions are covered under the head “capital gains”.

The taxpayer also relied on the decision of the Supreme Court in Anarkali Sarabhai v. CIT7, wherein the Supreme Court opined that redemption of preference shares results in the extinguishment of rights and transfer of capital assets.

Furthermore, the taxpayer relied on Section 50-AA8, inserted via amendment through Finance Act, 2023, to argue the Act itself recognises debenture as a capital asset and any transfer or extinguishment of any rights in a capital asset, which includes redemption, is to be considered as capital gains. Section 50-AA deems gains arising on transfer, maturity, or redemption of market linked debentures (MLDs) as short-term capital gains income.9

However, revenue, on the other hand, contended that NCDs are simply debt instruments. Thus, the premium received on redemption is nothing but repayment of the money advanced by the creditor. Hence, the profit or surplus received would constitute interest income.

Reference was made to CBDT Circular 2/2002 dated 15-2-200210 , which was issued in respect of a deep discount bond. It has been clarified in the Circular that surplus arises due to the difference between the redemption price and cost of purchase of the bond by the intermediate purchaser is taxable as interest or business income. The revenue also relied on the decision in CIT v. Bennett Coleman & Co. Ltd.11, wherein the Bombay High Court held that the premium received on redemption of debenture is taxable under the head “income from other sources”.

Decision of the Tribunal

The ITAT, while adjudicating on the issue of whether the surplus or profits arising to the taxpayer on redemption of zero-coupon NCDs is in the nature of capital gains or interest income held in the event of redemption of NCDs does not give rise to capital gains as there is no transfer as per Section 2(47) of the Act and transaction involves mere repayment of debts and amounts to the realisation of money advanced by creditor.

The discount on deep discount bonds was the same as the premium paid on redemption of NCDs since both were debt instruments, and the discount/premium was determined by applying a particular interest rate.

Section 50-AA, which pertains to the taxation of MLDs, does not apply in the present set of facts since the interest payable on MLDs is not fixed at the time of issuance. The return on MLDs is dependent on the performance of the underlying market or instrument, whereas a fixed interest or premium was provided to the taxpayer by the company when acquiring NCDs. Therefore, Section 50-AA cannot provide relief to the taxpayer.

While discussing the difference between rights and obligations arising from shares and debentures, the ITAT observed that the ratio of decisions rendered in equity/preference shares cases could not be applied to debt instruments as both stand on different footings regarding different rights arising therein. A shareholder has certain rights, such as the right to vote, and the right to receive dividends whereas debenture-holders are financial creditors entitled to receive only interest as per agreed terms. Debenture-holders do not have the right over the profit or surplus arising from the liquidation of the company.

The ITAT held that the possibility of capital gains from the redemption of debenture can arise only in cases where they are sold in the open market to third parties before their maturity or redemption. Therefore, in such cases, if the market value of debentures increases, the surplus realised by the taxpayer can be taxable under the head “capital gains” whereas in the present case, the ITAT observed that NCDs were not listed on any stock exchanges and were privately placed debentures. They were not sold in the open market and had only been surrendered for redemption. Hence, it amounts to the mere realisation of the amount advanced by the creditor, and therefore premium received on the redemption of zero-coupon NCDs would be taxable as interest income under the head “income from other sources” as no capital gains arise when the debentures are redeemed.

Analysis

The ITAT has emphasised that the existence of “transfer” is a prerequisite for characterising proceeds as capital gains. This decision brings clarity to the principle in the absence of transfer, the redemption of debentures would not amount to capital gains as it is the mere realisation of debt and not the extinguishment of any rights in a capital asset. The characterisation of the premium or surplus received on the redemption of the debenture whether to be classified as capital gains or interest income, depends on the terms of the issuance of the debenture. While the ITAT has differentiated the decision relied by the taxpayer from the present set of facts on the ground that the cases were related to the redemption of preference shares or reduction of equity capital, not the redemption of debentures, the ITAT has not examined why the redemption of debenture cannot be considered as an extinguishment of rights. This decision deals with specific situations where NCDs are issued at zero per cent interest rates, while there can be cases where NCDs were issued at an interest rate and redemption would take place before the maturity period. In such cases, for one-time payments, the taxpayer gives up the right to receive future interest, and in such cases, the transaction can result in the extinguishment of rights and hence would amount to a transfer as per Section 2(47) of the Act. As debentures are capital assets, the extinguishment of such rights or transfers would result in the transfer of capital assets, and the surplus or profit received from such transfers would be taxable under the head “capital gains”. The above decision also did not deal with timing as to whether the interest income received was taxable on an annual basis or at the time of redemption.

Conclusion

The determination of tax liability in the hand of the borrower or investor (taxpayer) for surplus received from redemption of debentures should be done after considering the agreed terms and conditions between the parties at the time of issuance of such debt instruments or after scrutinising the specific facts and considering the nature of debt instruments. The tax authorities and taxpayers need to consider the distinction and principles laid down in this case while determining the tax treatment of such debt instruments.


†5th year student, BA LLB, Gujarat National Law University. Author can be reached at: kanishk20bal043@gnlu.ac.in.

1. Companies Act, 2013, S. 2(30).

2. Income Tax Act, 1961.

3. Income Tax Act, 1961, S. 2(47).

4. Exemptions under Income Tax Act, 1961, Ss. 54-F and 54-EC.

5. I.T.A. No. 367/Mum/201, TS-293-ITAT-2024 (Mum).

6. 2005 SCC OnLine ITAT 8.

7. (1997) 3 SCC 238.

8. Finance Act, 2023, S. 24.

9. Amendments to the Finance Bill, 2023 as passed by Lok Sabha, Deloitte published on 27-3-2023, <http://surl.li/uijah>.

10. Central Board of Direct Taxes (CBDT) Circular 2/2002 dated 15-2-2002.

11. 2013 SCC OnLine Bom 1961.

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