Procedure for Conversion of Loan into Equity
Companies mainly raise finances through share capital (by issuing equity and preference shares) and loans (by issuing bonds/debentures). While shares and debentures are issued to the investors and can be tradeable on the exchange, both are methods of raising capital – shares are called own capital, and debentures are called borrowed capital.
What are shares
A share is a fraction of ownership in a company. Raising capital through shares is called own capital as the investors get part ownership of the company equivalent to the proportion of share capital they acquire.
Shares are of two types – equity shares and preference shares. While equity shareholders get voting rights, preference shareholders don’t have such rights. On the other hand, preference shareholders get preference over equity shareholders to get back their investment money.
How companies take loans
Issuance of bonds and debentures are the ways of taking loans from the public as borrowed capital.
Which instruments may be converted into equity?
It is mainly the convertible debentures/preference shares that are converted into equity shares on maturity as such debentures/preference shares are issued with the terms and conditions containing the provisions of converting them into shares at a later period of time. On the other hand, without any provision of conversion into equity, other debentures/preference shares – especially a non-convertible debenture (NCD) – can’t be converted into shares.
Section 62 (3) of the Companies Act, 2013 provides Companies with the opportunity to convert their loan into equity, provided that the loan has a feature allowing it to be transformed into equity at a future date, and this feature has been approved by shareholders through a special resolution.
So, a loan may only be converted into equity, which has an option of such conversion and a special resolution has been passed in that respect.
Procedure for conversion of loan into equity
At the time of taking a loan, which will be converted into equity on a future date, a company needs to convene a Board Meeting by giving a proper notice 7 days prior to convening the meeting. A resolution has to be passed in the meeting for accepting the loan and for conversion of the loan into equity.
Compliances to be met at the time of converting the loan into equity:
For the conversion of a loan into equity, the company needs to hold a second board meeting by giving 7 days’ notice for passing a resolution for allotment on the conversion of loan into equity.
Form MGT-14 is to be used for filing board resolution and Form PAS-3 for filing of Return of Allotment within 30 days of passing of the resolution.
How does it affect a company?
The advantage of converting a loan into equity for a company is that no cash exchange occurs in the debt-to-equity swap and it improves the company’s balance sheet by reducing its debts and increasing its shareholder funds.
How does it affect an investor?
For an investor, however, the investment risks increase. This is because debentures provide regular interest at a fixed rate along with principal payment at a fixed date, while dividend payments and appreciation in share prices will depend on the profitability of the company.
As debenture holders are paid interest irrespective of whether the company makes a profit or a loss, the presence of too much debt is considered risky for a company. The fixed obligation during a crisis period may push a company towards liquidation. To make the capital structure a healthy one, a company may convert loans into equity according to the terms and conditions of the issuance of the debentures and in accordance with the provisions of the Companies Act, 2013.
Frequently Asked Questions (FAQs)
Can a company convert any of its loans into the equity?
No, a company can convert that loan into equity only, which has been taken with the provision of converting it into equity at a future point. For example, convertible debentures.
Why do companies want to convert loans into equities?
As loans create a fixed obligation to pay a fixed rate of interest on a periodical basis, a company needs to honour the obligation even if it suffers losses. So, excess debt in the balance sheet raises default risk for a company. To reduce the risk, a good way is to convert the loans into equity as it improves the financial health of the company without any cash outgo.
Is the conversion of a loan into equity good for an investor?
A debt investor enjoys the comfort of getting regular interest at a fixed rate even if the borrowing company is at a loss. However, once the loan is converted into equity, getting dividends and appreciation in share prices will depend only if the company earns profits. So, the conversion of a loan into equity increases investment risks, while increasing the prospect of getting a higher return.
Can a loan without any precondition be converted into equity?
Only the government is allowed to ask a company, which has taken a loan from any government, to convert the loan – or a part of it – into equity if that government considers it necessary in the public interest to do so. If the terms and conditions of such conversion are not acceptable to the company, it may move to Tribunal, which shall – after hearing the company and the government – pass such an order as it deems fit.
Does an investor need to pay tax when a loan is converted into equity?
In accordance with sec 47(x) of the Income Tax Act, any transfer by way of conversion of bonds or debentures, debenture-stock or deposit certificates in any form, of a company into shares of that company would not be regarded as a transfer for the purpose of capital gain computation. Hence the said conversion of bonds into shares does not attract any capital gains tax implications at the point of conversion. However, when such shares are sold off, capital gains tax would be applicable. For the purpose of computing capital gains from such shares, the acquisition cost as well as the period of holding of the debenture would be relevant.