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Foreign Currency Exchangeable Bonds

The Union Finance Minister in his budget speech of 2007-2008 had proposed the introduction of foreign currency exchangeable bonds. Pursuant, to the announcement the RBI has initially issued guidelines with respect to such foreign currency exchangeable bonds in form of a scheme being the Issue of Foreign Currency Exchangeable Bonds Scheme, 2008 (Scheme) . Thereafter, the said Scheme was notified on 3rd
February 2009 by amendments to the Foreign Exchange Management Regulations with retrospective effect from 23rd September 2008.. Under the said Regulations, prior approval of the RBI would be required for issue of Foreign Currency Exchangeable Bonds (FCEB) writes Arkodeb Sinha.

Definition & Explanation

Definition

FCEB as defined in the Regulations inculcates the following salient features:
  • a bond expressed in foreign currency;

  • the principal and interest in respect of which is payable in foreign currency;

  • the bond is issued by an issuing company (as explained below);

  • subscribed by a person resident outside India in foreign currency;

  • the bond is exchangeable into equity share of offered company (as explained below) in any manner.
RBI/2008-09/192 A.P. (DIR Series) Circular No.17 dated 23rd September 2008.

Foreign Exchange Management (Transfer or Issue of any Foreign Security) (Second Amendment) Regulations, 2009 (Regulations) ; Notification No.FEMA 188/2009-RB.

“Foreign Currency Exchangeable Bond” means a bond expressed in foreign currency, the principal and interest in respect of which is payable in foreign currency, issued by an issuing company and subscribed to by a person who is a resident outside India, in foreign currency and exchangeable into equity share of offered company, in any manner, either wholly, or partly or on the basis of any equity related warrants attached to debt instruments.

Explanation

Thus from the definition, it is clear that three parties are primarily involved with issue of FCEB being:
  • Issuing Company ;

  • Overseas Investor; and

  • Offered Company.
A. FCEB is required to be denominated in freely convertible foreign currency. The accruing interest and payment of the principal sum should also be in freely convertible foreign currency.

B. The Issuing Company should be an Indian Company and should also be eligible to issue FCEB. The words “eligible to issue” used in the definition connotes that the Issuing Company satisfies certain conditions and from perusal of the Scheme the conditions can be inferred to refer to the following:
  • compliance with the provisions of the Companies Act, 1956 and necessary approvals of its Board of Directors and shareholders; and

  • compliance with all the applicable provisions of the Securities and Exchange Board of India Act, Rules, Regulations or Guidelines (with respect to disclosures of their shareholding in the Offered Company).
C. Further, the FCEBs should be subscribed by a person resident outside India and also fulfill the conditions of an eligible subscriber under the Regulations. Although the words ‘a person resident outside India’ is not specifically defined in the Regulations, the same could be interpreted within the scope of Foreign Exchange Management Act (FEMA) to mean a person who is not resident in India and would include any person or body
Regulations, Section 2(t): "issuing company" means a company registered under the Companies Act, 1956 (1 of 1956) and eligible to issue Foreign Currency Exchangeable Bond under these regulations;

corporate not registered or incorporated in India or an office, branch or agency outside India owned or controlled by a person resident outside India.

D. Furthermore, the FCEBs subscribed by the person resident outside India (Overseas Investor) can be exchangeable into equity shares of another Indian company (Offered Company) wholly or partly or on the basis of any equity related warrants attached to debt instruments. The FCEBs exchangeable into equity shares should be shares of the Offered Company.

E. The term ‘Offered Company’ is defined in the Regulations to mean ‘a company registered under the Companies Act, 1956 (1 of 1956) whose equity share/s is/are offered in exchange of the Foreign Currency Exchangeable Bond’. In addition, the Scheme provides that the Offered Company must obtain the approval of its Board of Directors in favour of the FCEB proposal of the Issuing Company.

The Features of FCEB
i) The Regulations provides for a straight forward note on the relationship between the Issuing Company and Offered Company stating that the Issuing Company should be part of the promoter group of the Offered Company and shall hold the equity shares that are being offered to the Overseas Investor at the time of issuance of FCEB.

Under the Regulations the definition of the words ‘promoter group’ has been interpreted to mean the definition as stated in SEBI (Disclosure and Investor Protection) Guidelines, 2000.

ii) The Offered Company is required to be a listed company. The definition of Offered Company thus excludes those promoter group which are not listed. Further, the Regulations specifically provide that the Offered Company should belong to a sector permitted to receive Foreign Direct Investment and should also meet eligibility conditions to issue or avail Foreign Currency Convertible Bond (FCCB) or External Commercial Borrowings (ECB). Thus, a promoter group company doing business in sector not permitted to receive FDI (like Atomic Business, Lottery Business, etc) would fall outside the purview of Offered Company and as such its shares cannot be exchanged.

Under Foreign Exchange Regulations, the following entities inter-alia are permitted to avail ECB or FCCB:
  • Companies incorporated in India;
  • Units in Special Economic Zones (SEZ) are allowed to raise ECB for their own requirement. However, they cannot transfer or on-lend ECB funds to sister concerns or any unit in the Domestic Tariff Area;
Restrictions on Issue of FCEB

A. The Regulations prohibits issue of FCEB by certain companies on the following grounds:
  • an Indian Company not eligible to raise funds from the Indian securities market;

  • a company restrained from accessing the securities market by the Securities and Exchange Board of India;
B. The Regulations provides for certain restrictions on subscribers of FCEB as follows:
  • subscribers to the FCEB are required to comply with FDI policy and sectoral caps at the time of issuance of FCEB. Hence, prior approval of FIPB would be required in those sectors which require such approval under FDI policy;

  • entities prohibited to buy, sell or deal in securities by SEBI are not allowed to subscribe to FCEB.
C. The Scheme also provides for certain restrictions on the Issuing Company in the following manner:
  • the Issuing Company is not permitted to transfer, mortgage or offer as collateral or trade in the Offered Shares from the date of issuance of the FCEB till the date of exchange or redemption; and

  • the Issuing Company must keep the Offered Shares free from all encumbrances from the date of issuance of the FCEB till the date of exchange or redemption.
Permissible End Use
A. The Issuing Company is allowed to invest the proceeds of FCEB in promoter group companies.
B. The promoter group companies receiving such investment out of proceeds of FCEB are allowed to invest in those activities allowed under the ECB policy and which inter-alia includes the following:

i) Permissible end uses:
  • import of capital goods;
  • new projects;
  • modernization/expansion of existing production units in real sector, industrial sector and infrastructure sector;
  • overseas investment in Joint Ventures/Wholly Owned Subsidiaries in accordance with law, development of integrated townships in terms of the regulations prescribed by the RBI;
  • development of Special Economic Zones for infrastructure facilities;
  • NBFC Sector;
  • Integrated Township;
  • payment for spectrum allocation (telecommunication sector).
A.P. (DIR Series) Circular No.19 dated 9th December 2009
Ibid
Ibid

ii) Promoter group companies inter-alia cannot use the loan amount for the following purposes:
  • investment in capital (stock) market;
  • real estate;
Pricing
Pricing has been any important component in transactions involving foreign investors and the same is covered under the Regulations and since the offered shares in lieu of FCEB are listed shares the mechanism for arriving at the share price has inevitably taken the same into consideraion. Under the Regulations, at the time of issue of FCEB the exchange price of the offered equity shares shall not be less than the higher of the following two :
  • the average of the weekly high and low of the closing prices of the shares of the offered company quoted on the stock exchange during the six months preceding the relevant date ;

    and

  • the average of the weekly high and low of the closing prices of the shares of the offered company quoted on a stock exchange during the two week preceding the relevant date.
Maturity
The minimum maturity of FCEB to redeem the same is prescribed for a period of five years and during which time the exchange option can be exercised. The offered shares
Ibid
Regulations, Schedule IV Clause 10: "Relevant date" means the date on which the Board of directors of the issuing company passes the resolution authorizing the issue of FCEB.

have to be delivered to the holder of FCEB at the time of exercise of option. However, cash (net) settlement of FCEB is prohibited.

All-in-cost
The rates of all-in-cost have been prescribed to be such rates as prescribed for ECB policy as revised from time to time by RBI.

Retention of proceeds of FCEB
The proceeds of FCEB are required to be retained and/or deployed in the manner as prescribed under the ECB policy by RBI from time to time. At present the ECB policy prescribes that the proceeds may be either parked off-shore or kept with overseas branches / subsidiaries of Indian banks abroad or to remit the proceeds to India to the credit of Rupee account of the Issuing Company pending utilization for permissible end-uses.

Under the existing ECB policy, the proceeds parked off-shore are allowed to be invested in the following liquid assets:
  • deposits or certificate of deposit offered by banks rated not less than AA (-) by Standard and Poor / Fitch IBCA or Aa3 by Moody’s;
  • deposits with overseas branches/subsidiaries of Indian Bank; and
  • treasury bills and other monetary instruments of one year maturity having minimum rating of not less than AA (-) by Standard and Poor / Fitch IBCA or Aa3 by Moody’s;
Taxation
Although the Regulations do not provide for any provsion on the taxation of FCEB, it would be pertinent to note that the Scheme includes provisions on the taxability of FCEB. The Scheme provides as follows :
  • Until the exchange option is exercised, interest payments on the bonds shall be subject to deduction of tax at source in accordance with the provisions of Income Tax Act, 1961.
  • Tax on dividend on the exchanged portion of the bond shall be in accordance with the provisions of Income Tax Act, 1961.
  • Exchange of FCEB’s into shares shall not give rise to any capital gains liable to income-tax in India.
  • Transfers of FCEB’s made outside India by an investor who is a person resident outside India to another investor who is a person resident outside India shall not give rise to any capital gains liable to tax in India.
Conclusion
It can be concluded that FCEB’s are another form financial tool available to corporates for raising capital having its own characteristics and distinct from the External Commercial Borrowings (ECB) and Foreign Currency Convertible Bonds (FCCB). FCEB would enable holding companies to assist its subsidiary companies with capital. The significant distinctive feature of FCEB over FCCB is lies in the fact that the company issuing the FCCB subsequently issues its own shares at the time of redemption whereas in FCEB the company issuing the bonds subsequently exchanges the shares of another company provided that both the companies belong to the promoter group. An area of introspection could be the permissible end-uses and there is ample scope for widening its ambit. Although FCEB has its own identity however there are certain features which it shares with ECB or FCCB like permissible end uses that restricts it to certain activities, pricing, reporting requirements.

Although the Scheme lays down the incidence and chargeability of tax on FCEB, it has to read with the corresponding provisions of the Income Tax Act, 1961. Dividend paid by companies (Offered Companies) on shares as dividend distribution tax continue to be free (no tax) in the hands of shareholder (Overseas Investor). However under the Income Tax Act to enjoy the provisions therein the Scheme is required to be notified for such purposes.

Thus it can be said that FCEB has its own appeal in the financial sector and is definitely worth examining and there is enough scope for refining its features.
ARKODEB SINHA is an Advocate and also associated with Fox & Mandal, Advocates in Kolkata.

REFERENCES
  • Foreign Exchange Management Manual, Taxmann.

  • Income Tax Act & Rules, Taxmann.

  • Reserve Bank of India through www.rbi.org.in (last accessed on 18th December 2009).

  • Department of Commerce and Industry through http://dipp.nic.in/ (last accessed on 18th December 2009).

  • Income Tax Department through http://www.incometaxindia.gov.in/(last accessed on 18th December 2009).
Section 115AC Income Tax Act, 1961.
 
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