Debentures may not be part of the capital of a company. But they do form part of the capital structure of the company.

When a company redeems its own debentures ahead of time at a discount to the issue price, it gets a surplus representing the difference between the issue and redemption prices.

What is the nature of this surplus? Can it be brought to tax as the company's income? Is it in the nature of a trading receipt liable to tax?

There can be no doubt that purchase of debentures at a rate lower than the issue rate should be understood as a benefit, but is it the business of the company to deal in its own debentures?

Issue vs redemption

There have been decisions that discount offered at the time of issue of debentures will represent revenue expenditure deductible in the computation of the business income of the company. But surplus arising out of such redemption seldom come up for debate.

Redemption is different from issue of debentures. Redemption means repayment of debt, which discharges its security. No company can be its own debtor. Discharging the liability to the debenture-holder who has sold the debentures amounts to repayment of the loan.

A debenture is, in sum and substance, a certificate of loan or bond evidencing the fact that the company is liable to pay a specific amount with interest.

Income of company?

The question whether surplus on redemption of debentures can be brought to tax as income in the hands of the company was considered by the Karnataka High Court in CIT vs Industrial Credit and Development Syndicate Ltd (285 ITR 310).

In this case, a finance company dealing in shares, securities and debentures and in granting loans and advances had issued debentures at par value of Rs 10 each.

They were redeemable after 10 years. But ahead of the due date of redemption, the company purchased some of these debentures through a nominee at a price less than the face value thereof and credited the difference in the amount between the face value of the debentures purchased and the cost thereof in its book as surplus arising out of redemption of debentures.

The Revenue taxed such surplus as income, contending that repetitive transactions of buying and selling debentures should be considered as business transactions.

The Tribunal held against the Revenue on the ground that debentures cannot be considered to form a part of the company's stock-in-trade. The transaction did not result in any revenue gain.

The surplus was not chargeable either as income or capital gain. The Revenue took up the matter in appeal before the Karnataka High Court.

No real income, profit

The court ruled that there was no real income or profits in the transactions after redemption. The company was only able to discharge its liability at a lesser amount as against the face value of the debentures.

No person can make a profit out of himself. Mere redemption of loan cannot result in income. Nomenclature adopted in the balance-sheet as surplus was of no consequence.

The company saved its liability, and in this saving no real income or profit is derived. It was able to discharge its liability at a lesser amount as against the face value of the debentures. There is, therefore, no income element in the transaction of redemption of debentures. It was nothing more than repayment of a loan.

Opening up tax planning avenues

This ruling of the Karnataka High Court bristles with interesting possibilities. The Supreme Court had held that the discount on issue of debentures is part of borrowing cost allowable on spread-over basis during the life of the debentures. Propionate amount relating to the spread-over period was found deductible by the Supreme Court. The court treated the discount of debentures at the time of issue as normal interest, which is an outgo to be deducted, in the computation of taxable profits (Madras Industrial Investment Corporation Ltd vs CIT 225 ITR 802 SC). This decision was not cited before the Karnataka High Court.

Is it possible to argue that discount on issue of debentures should be allowed as revenue deduction based on the aforementioned Supreme Court judgment, and surplus on redemption treated as capital receipt not liable for any tax on the basis of the Karnataka High Court ruling discussed?

Such difficult situations arise, opening up immense possibilities for tax planners.

It is not easy to resolve the conflict in the ultimate ratio decidendi of the Supreme Court's judgment in the Madras Industrial Investment Corporation case and in the Karnataka HC ruling in the ICDS case.

The Karnataka HC ruling is quite persuasive. It will be interesting to watch the reaction of other High Courts to this ruling.

T. C. A. Ramanujam
(The author is a former Chief Commissioner of Income-Tax.)