Conversion of OCRPS into Equity Not Taxable Under Section 56(2)(x): ITAT Mumbai Gives Relief in Fairbridge Capital Case

 

In an important ruling for foreign investors and companies using structured capital instruments, the Mumbai Bench of the Income Tax Appellate Tribunal has held that conversion of Optionally Convertible Preference Shares into equity shares, when done as per pre-agreed terms, does not trigger taxation under Section 56(2)(x).

In Fairbridge Capital (Mauritius) Ltd. vs ACIT for AY 2022-23, the Tribunal ruled that such conversion cannot be treated as receipt of property for inadequate consideration merely because the Assessing Officer later computes a higher fair market value under Rule 11UA.

The decision offers significant clarity for transactions involving hybrid securities, private equity investments, and cross-border capital structuring.

Facts of the Case

The assessee, a Mauritius-based investment holding company, had subscribed to Optionally Convertible Preference Shares issued by an Indian listed company.

At the time of issuance:

•The conversion terms were contractually defined
• The conversion price into equity was predetermined
• Pricing was based on fair market value at the time of issue
• The investment formed part of a structured commercial arrangement

Subsequently, when the OCRPS were converted into equity shares, the Assessing Officer recomputed the fair market value of the equity under Rule 11UA and treated the difference between that value and the conversion price as income under Section 56(2)(x), alleging that the assessee received shares for inadequate consideration.

Issue Before the Tribunal

The key question before the Tribunal was:

Does conversion of a convertible instrument into equity, as per pre-agreed terms, amount to receipt of property attracting tax under Section 56(2)(x)?

The Tribunal answered this in the negative.

Tribunal’s Reasoning

The ITAT held that conversion of OCRPS into equity pursuant to contractual terms agreed at the time of subscription is not a fresh transaction of receipt of shares.

The Tribunal made three important observations:

1.  Conversion Is Not a Fresh Receipt of Property

The Tribunal observed that when an investor subscribes to convertible instruments, the right to receive equity upon conversion is embedded in the original investment itself.

Therefore, the eventual conversion is merely the implementation of an existing contractual right, not a new acquisition of shares.

Since Section 56(2)(x) applies to receipt of property, its trigger condition itself was absent.Valuation Rules Cannot Override Commercial Agreements

The Tribunal cautioned against mechanical application of Rule 11UA valuation provisions in such cases.

Where pricing is fixed through a genuine commercial arrangement at the time of investment, subsequent recomputation of FMV cannot automatically convert the transaction into a deemed income event.

Tax law, the Tribunal noted, must recognise commercial substance rather than relying solely on formula-driven valuation.

3.Tax Cannot Be Based on Notional Income

Another important principle highlighted was that taxation under Section 56(2)(x) should not be based on hypothetical or notional differences unless there is a real receipt of income.

In this case, the assessee merely exercised a contractual conversion right. No real income accrued to it at the time of conversion.

Accordingly, the addition was deleted.

Why This Ruling Is Significant

This decision is particularly relevant in today’s investment environment where hybrid instruments are widely used.

Private equity funds, venture capital investors, foreign holding companies, and even domestic promoters often structure investments using instruments such as:

• Optionally Convertible Preference Shares
• Compulsorily Convertible Debentures
• Convertible warrants
• Hybrid capital securities

The ruling confirms that where conversion terms are predetermined and commercially justified, tax authorities cannot treat conversion as a fresh taxable receipt merely by applying valuation formulas.

Practical Takeaways for Investors and Companies

This judgment highlights several important compliance lessons:

First, conversion terms should be clearly documented at the time of issuance.
Second, pricing should be supported by contemporaneous valuation evidence.
Third, subscription agreements should demonstrate commercial rationale.
Fourth, tax exposure increases if conversion pricing is vague or discretionary.

Well-structured documentation remains the strongest defence in valuation disputes.

Conclusion

The ITAT Mumbai ruling in the Fairbridge Capital case reinforces an important boundary on anti-abuse provisions.

Section 56(2)(x) cannot be applied mechanically to commercial investment transactions where no real income arises and conversion merely follows pre-agreed contractual terms.

For investors and companies using convertible instruments, the decision provides welcome certainty that genuine capital structuring will not automatically be treated as taxable income.

The copy of the order is as under:

1770877570503