Backdrop:

Use of Compulsory Convertible Debentures (CCDs) is widely accepted in investment and transaction structuring, as it helps to achieve varied commercial objectives of deal structuring.

Valuation on issuance and conversion of CCDs is a craftsmanship, as it poses challenges for deal structuring standpoint. While the event of conversion of CCDs into equity shares is not a taxable event, it has created controversy as regards applicability of erstwhile Section 56(2)(viib) of the Income-tax Act, 1961 (ITA 1961).

In a significant recent ruling, the Delhi Tribunal (Tribunal) has delivered a ruling that will reverberate across startup ecosystems, private equity transactions, and closely held company financing structures. In the case of Eduwizards Infosolutions Private Limited v. DCIT [TS-637-ITAT-2026(DEL)], the Tribunal held that Section 56(2)(viib) of the Income-tax Act, 1961 does not apply when equity shares are issued upon the conversion of CCDs. Furthermore, it ruled that the date of issuance of the CCDs and not the date of conversion is the relevant "valuation date" for determining the FMV of shares.

What is Section 56(2)(viib) and Why Does It Matter?:

Section 56(2)(viib) of the ITA 1961, often referred to as the "angel tax" provision, was one of the more contested provisions in Indian tax law. It mandates that when a closely held company receives consideration from a resident for the issuance of shares, and that consideration exceeds the FMV of those shares, the excess amount is taxable in the hands of the issuer company as "income from other sources." Albeit, DPIIT-registered startups were exempt from this provision.

The provision was introduced to curb the practice of routing undisclosed income through inflated share premiums. However, over the years it has created considerable compliance burden and litigation for private companies, particularly startups and businesses that raise capital through instruments such as CCDs, Optionally Convertible Debentures (OCDs), and Compulsorily Convertible Preference Shares (CCPS).

The Finance Act 2023 amended to include investments from non-residents, covering nearly all investors, which created hue and cry in investor fraternity. Finally, the voice of industry prevailed and the Government completely abolished the so called “angel tax” vide Finance Act 2024 w.e.f. FY 2025-26. 

Facts of the Case:

The taxpayer, Eduwizards Infosolutions Private Limited, a private limited company, had issued CCDs to another Indian company during FY 2015-16. These CCDs were to be compulsorily converted into equity shares at a future date. In June 2017 (i.e., FY 2017-18), the CCDs were converted into equity shares at a premium. The FMV of the shares at the time of conversion was determined by an approved valuer in accordance with Rule 11UA read with Rule 11U of the Income-tax Rules, 1962. This valuation was carried out using the audited balance sheet as on 31 March 2016, the latest audited balance sheet available at the time of issuance of CCDs. When the conversion happened in June 2017, the audited balance sheet as of 31 March 2017 had not yet been prepared, it was only signed by the management on 28 September 2017.

The Tax Authorities, rejecting the taxpayer's valuation report, recomputed the FMV using the audited balance sheet as of 31 March 2017, being closure to the date of allotment of shares on conversion. Since the FMV determined using this later balance sheet turned out to be Nil, the entire share premium received upon conversion was treated as income from other sources under Section 56(2)(viib) and brought to tax accordingly.

The Tribunal's Ruling

The moot question before the Tribunal was whether conversion of CCDs into equity shares constitute a "receipt of consideration" in the year of conversion, thereby attracting the provisions of Section 56(2)(viib)?

The Tribunal concurred with prior judicial precedents, notably PCIT v. I.A. Hydro Energy (P) Limited [TS-395-HC-2024(HP)] and DCIT v. Rankin Infrastructure Pvt. Ltd. [2022], and held that Section 56(2)(viib) is triggered only when a company "receives" consideration for the issue of shares during the relevant tax year. In the instant case, the consideration had been received in FY 2015-16 at the time of issuance of CCDs. No fresh consideration flowed into the company at the time of conversion in FY 2017-18. The Tribunal, therefore, concluded that the provision was simply not applicable to the year under assessment.

On the second issue of the relevant date for valuation, the Tribunal interpreted that as per Rule 11U of the Income-tax Rules, 1962, the term "valuation date" is the date on which the property or consideration is received by the taxpayer. Since the funds were received in FY 2015-16 (upon the issuance of CCDs), the valuation date must correspondingly be traced back to that year and consequently, the balance sheet as at 31 March 2016 should be considered for determining the FMV and not the balance sheet of 31 March 2017. The balance sheet to be used for computing FMV should therefore be the audited balance sheet as of 31 March 2016.

The Tribunal also addressed a secondary argument raised in the proceedings concerning the use of unaudited balance sheet. Referring to the Chandigarh Tribunal’s decision in Electra Paper and Board (P.) Ltd. v. ITO [TS-58-ITAT-2022(CHANDI)], it acknowledged that an unaudited balance sheet could suffice where there is no material difference when compared with the audited financials as of that date.

Why this Ruling is Significant:

While the “angel tax” regime has now been abolished, this Delhi Tribunal ruling carries considerable significance for several reasons in respect of transactions consummated prior to FY 2025-26.

First, it brings much-needed clarity to the taxation of hybrid financial instruments as CCDs are a commonly used financing tool, particularly in private equity and venture capital transactions.

Second, this ruling firmly affirms that for the purpose of applying Section 56(2)(viib), the receipt of consideration i.e. when the CCDs are issued is relevant and not the date when CCDs are converted.

Third, by aligning the valuation date with the date of original receipt of funds, the Tribunal has provided a coherent and commercially sensible framework for computing FMV for the purpose of Section 56(viib) read with Rule 11U.

Fourth, the deeming fiction created by Section 56(2(viib) should be interpreted strictly and in consonance with the scheme of taxation.

Summing Up:

This ruling of Delhi Tribunal is a welcome one as it is providing clarity to the investor’s fraternity, help attracting much needed capital for the growth of Indian companies, and minimising tax risks associated with transaction structuring. Albeit, carefully crafted documentation, timing and manner of conversion, and valuation methodology is essential for a defensible tax position in relation to issuance of hybrid instruments.