FCCDs Issued Prior to Conversion Not “Shares” for Section 56(2)(viib): Analysis of PH4 Food and Beverages Private Limited Vs DCIT (ITAT Bangalore)

1. Background and Core Issue

The Bangalore Bench of the ITAT in PH4 Food and Beverages Private Limited Vs DCIT examined whether amounts received against Fully and Compulsorily Convertible Debentures (FCCDs) during AY 2021-22 could be brought to tax as “angel tax” under Section 56(2)(viib) of the Income Tax Act 1961.

The dispute centered on the following question:

Can consideration received on issue of FCCDs—convertible into equity in a future year—be treated as consideration “for issue of shares” so as to trigger Section 56(2)(viib)?

The Assessing Officer (AO) treated the FCCDs as akin to equity and made an addition of Rs. 3,88,31,457 under Section 56(2)(viib). The Commissioner of Income Tax (Appeals) [CIT(A)] upheld this view.

The Tribunal reversed the CIT(A), holding that:

  • FCCDs, which had not yet converted into equity in the relevant previous year, could not be brought within the ambit of “issue of shares” under Section 56(2)(viib).
  • There is no deeming fiction in the provision or in Rule 11UA to treat unconverted FCCDs as shares.
  • Consequently, the addition of Rs. 3,88,31,457 was directed to be deleted.

2. Facts in Brief

2.1 Capital Raising Structure in AY 2021-22

The assessee, a private company engaged in the food and beverages sector, raised funds during AY 2021-22 through two distinct instruments:

  • Equity shares issued at Rs. 352 per share; and
  • FCCDs issued at Rs. 704 per debenture.

Valuations adopted were:

  • For equity shares: An internal Discounted Cash Flow (DCF) working showed a value of about Rs. 352 per share.
  • For FCCDs: A registered valuer’s report (IBBI-registered) applying the DCF method arrived at Rs. 703.89 per FCCD.

The assessee explained that:

  • The equity issuance was comparatively small and undertaken amid acute Covid-19 related cash stress, primarily to keep the business afloat.
  • Subsidiary entities which had not commenced operations were taken at book value/investment value, without future cash flow projections, in this internal exercise.

Subsequently, FCCDs were issued to raise about Rs. 18.15 crore with specific objectives:

  • Investment into subsidiaries,
  • Expansion of operations,
  • Repayment of existing borrowings,
  • Meeting urgent funding requirements, and
  • Completing a brewery project.

In valuing the FCCDs, the registered valuer considered:

  • Improved market and business outlook,
  • Proposed expansion projects,
  • Anticipated inflows from subsidiaries once operations commenced.

2.2 AO’s Approach

The AO noted that both valuations (equity and FCCD) used the DCF method and were carried out roughly six months apart, yet resulted in:

  • Enterprise/business value of about Rs. 69.99 crore for the earlier equity valuation; and
  • About Rs. 142.02 crore for the FCCD valuation.

The AO held that:

  • The assessee did not establish any accounting standard, SEBI regulation or legislative framework that would justify treating subsidiaries differently in two DCF exercises so close in time.
  • The later registered valuer’s report was unreliable.
  • Based on RBI guidelines and FDI policy, FCCDs are “quasi-equity” and should be treated at par with equity.

Accordingly, the AO:

  • Took Rs. 352.60 (derived from the earlier internal DCF) as the fair market value (FMV) per instrument;
  • Compared this against the FCCD issue price of Rs. 704;
  • Noted that 1,10,505 FCCDs were issued to resident investors;
  • Calculated the excess of about Rs. 351.40 per FCCD; and
  • Added Rs. 3,88,31,457 as income from other sources under Section 56(2)(viib).

2.3 Assessee’s Stand Before AO

The assessee submitted that:

  • Covid-19 had severely impacted operations, leading to heavy losses; equity issue was a survival measure.
  • The equity raise was modest in size; subsidiaries were valued at book/investment value as they were yet to commence operations and therefore not modeled for projected cash flows.
  • The larger FCCD issuance was for expansion, investment into subsidiaries and repayment of loans; consequently, projected cash flows and improved business prospects were appropriately factored into the FCCD valuation.
  • The FCCD valuation was carried out by an independent IBBI-registered valuer following International Valuation Standards under the DCF method.
  • Under Rule 11UA, the assessee is free to choose the prescribed valuation methodology; the AO could not simply disregard a registered valuation report without identifying concrete defects.
  • FCCDs remain debt instruments until actual conversion; hence, Section 56(2)(viib) (which covers “issue of shares”) does not apply at the stage of their issue.
  • Reliance was placed on the Kolkata ITAT ruling in Milk Mantra Dairy (P.) Ltd. v. DCIT [2022] 140 taxmann.com 163.
  • Further, certain FCCDs were allotted to non-resident investors, and for the year in question, Section 56(2)(viib) did not extend to consideration received from non-residents.

The AO rejected these submissions and completed the assessment with the addition.

3. Findings of the CIT(A)

On appeal, the assessee reiterated: