Conversion of Loan into Equity

Conversion of Loan into Equity

Converting an outstanding loan into equity shares under the Companies Act, 2013 is a procedurally layered transaction — not simply a journal entry and a board resolution. If the original loan agreement contained a conversion clause, Section 62(3) gives you a clean, faster path. If it did not, you must run the full preferential allotment procedure under Section 62(1)(c), complete with a Registered Valuer's report, a special resolution, and Form PAS-3 on MCA V3 within 30 days of allotment. For any foreign lender or ECB, FEMA pricing rules and FC-GPR on the FIRMS portal add a second compliance layer. This guide walks you through both routes end-to-end, with worked numbers, in the FY 2026-27 context.

Why Companies Convert Loans into Equity

The motivations are almost always a combination of the following:

• Reducing leverage before a funding round — lenders converting to equity improves the debt-equity ratio and makes the cap table cleaner for incoming investors.
• Formalising promoter or related-party contributions — many early-stage promoter loans were advanced informally; converting them into equity puts them on record and reduces the loan liability.
• Resolving stressed exposures — in a restructuring scenario, a lender accepting equity in lieu of repayment is a common settlement mechanic.
• ECB end-use compliance — RBI Master Directions permit ECB proceeds to be converted into equity, which can simplify the reporting burden for eligible borrowers.
• Angel or bridge-round structuring — early investors sometimes advance bridge loans with an understood intent to convert at the next-round price.

Understanding why you are converting matters because it determines which route you take and what tax and FEMA analysis you need.

The Two Legal Routes: Section 62(3) vs Section 62(1)(c)

Route 1 — Section 62(3): When the Loan Agreement Already Provides for Conversion

Section 62(3) of the Companies Act, 2013 is a standalone gateway for converting loans or debentures into shares where the terms of issue of the loan specifically provided for such conversion. Two pre-conditions must be satisfied:

1. The loan agreement (or debenture trust deed) must have included conversion rights — specifying whether conversion is at the company's option, the lender's option, or on the occurrence of a trigger event (e.g., default or a qualifying funding round), along with the conversion ratio or the methodology for computing the conversion price.
2. A special resolution must have been passed before the loan was disbursed authorising the terms of issue including conversion.

If both conditions are met, you do not need a fresh special resolution at the time of conversion. You trigger the conversion mechanism per the agreement, pass a Board Resolution confirming the conversion, and proceed to allotment and filing. This makes Section 62(3) materially faster and cheaper than the Section 62(1)(c) route.

A caution: If you review the original loan agreement and the conversion clause is loosely worded — "convertible at a mutually agreed price" or "at the discretion of the board" — that ambiguity will surface at the PAS-3 filing stage and may invite RoC scrutiny. Tighten the language at the amendment stage before triggering conversion.

Route 2 — Section 62(1)(c): Preferential Allotment When the Agreement Is Silent

Where no conversion clause exists in the original loan agreement, or where the clause does not satisfy the Section 62(3) requirements, the only path is a preferential allotment under Section 62(1)(c) read with Rule 13 of the Companies (Share Capital and Debentures) Rules, 2014. This is a longer process — expect 55 to 65 days — and requires:

• A fresh Registered Valuer report for pricing
• An offer letter in Form PAS-4 to the proposed allottee (the lender)
• A special resolution passed at an EGM or AGM
• Filing of Form MGT-14 with the special resolution within 30 days
• Allotment within 60 days of the offer letter date
• Filing of Form PAS-3 on MCA V3 within 30 days of allotment

This is the default route for the majority of private companies that did not structure their original loans with conversion rights.

Step-by-Step Procedure: Section 62(3) Route

1. Pull and verify the loan agreement. Confirm that the conversion clause specifies conversion ratio or pricing methodology and that a pre-disbursement special resolution exists. Retrieve the EGM/Board minutes.
2. Issue conversion trigger notice. If conversion is at the lender's option, the lender sends a written notice. If at the company's option, the board passes a resolution invoking the conversion clause.
3. Pass Board Resolution. Record: (a) the outstanding principal and accrued interest to be converted, (b) the number of shares to be issued at the agreed conversion price, (c) the bank account confirmation or letter from the lender acknowledging set-off of the loan.
4. Obtain Registered Valuer report. Even under Section 62(3), it is strongly advisable to obtain a fair market value opinion from a Registered Valuer under Section 247 to support the conversion price. If the conversion price deviates materially from FMV, it may attract Section 56(2)(viib) (angel tax) or transfer pricing questions in related-party scenarios.
5. Allot shares and issue share certificates. Shares must be issued within two months of allotment.
6. File Form PAS-3 on MCA V3 within 30 days of allotment. Attach the Registered Valuer's report, the Board Resolution, and the lender's written consent/trigger notice.
7. Update statutory registers — Register of Members (Form MGT-1) and Register of Share Allotments (Form SH-2) — at the registered office.

Step-by-Step Procedure: Section 62(1)(c) Preferential Allotment

This is the more commonly used route. Follow each step in sequence — skipping or reordering steps is the most frequent source of compliance failure.

1. Day 0 — Board resolution in-principle. The board approves the proposal to convert the outstanding loan into equity, identifies the lender as the proposed allottee, and instructs a Registered Valuer to determine FMV.
2. Day 7–10 — Registered Valuer's report received. The valuer (holding a valid Certificate of Registration from IBBI) issues a report under Rule 13 determining the fair market value of the equity shares. The report should be dated no more than 90 days before the date of allotment — if the process stretches, you may need a refreshed report.
3. Day 12–15 — Board approves offer letter. The board passes a resolution approving the Form PAS-4 Private Placement Offer Letter addressed to the lender, specifying the number of shares, the price (which must not be less than FMV as per the Registered Valuer's report), and the mode of consideration (set-off against the outstanding loan).
4. Day 15–16 — Dispatch Form PAS-4. Send the offer letter to the lender. The lender must respond with Form PAS-5 (Application Form) accepting the offer.
5. Day 20–22 — EGM notice dispatched. Issue notice for an Extraordinary General Meeting (EGM) with a special resolution for preferential allotment under Section 62(1)(c). For private companies, the notice period is 21 days unless shorter notice is consented to by 95% of members.
6. Day 40–45 — Special resolution passed at EGM. The resolution must specify the number of shares, the price, the identity of the allottee (the lender), and the consideration mechanism (set-off of the loan).
7. Day 55 — File Form MGT-14 on MCA V3. The special resolution must be filed within 30 days of passing. Missing this date attracts additional fees on a slab basis under Section 403.
8. Day 55–60 — Allotment. The board passes the allotment resolution. The loan is formally set off against the share consideration. Obtain a banker's certificate or CA certificate confirming the original receipt of the loan proceeds through banking channels.
9. Day 75–80 — File Form PAS-3 on MCA V3 within 30 days of allotment. Attach: Board resolution for allotment, Registered Valuer's report, PAS-4, PAS-5, and banker/CA certificate for consideration.
10. Within two months of allotment — Issue share certificates. Update MGT-1 and SH-2.

> Critical deadline: Shares must be allotted within 60 days of the date on which the PAS-4 offer letter is sent. If allotment does not happen within 60 days, you must restart the entire process — fresh valuation, fresh offer letter, fresh resolution. There is no cure mechanism for this breach.

Valuation: What the Registered Valuer Must Do and Why It Matters

For unlisted private companies, Rule 13 of the Companies (Share Capital and Debentures) Rules, 2014 requires the price to be the fair market value of the shares as determined by a Registered Valuer under Section 247 of the Companies Act. The Registered Valuer must hold a current Certificate of Registration issued by the IBBI in the relevant asset class (Securities or Financial Assets).

The valuation approach typically used is:

• Discounted Cash Flow (DCF) — for companies with a visible revenue/profit trajectory
• Net Asset Value (NAV) — for holding companies or asset-heavy businesses
• A combination, with the valuer justifying the weightage

Why the price matters beyond just compliance: If shares are issued at a price above the FMV determined by the valuer, the excess is treated as income in the hands of the company under Section 56(2)(viib) of the Income-tax Act, 1961 (commonly called the angel tax provision). If shares are issued below FMV, the difference may be a deemed gift in the hands of the allottee under Section 56(2)(x). Getting the conversion price exactly at FMV — or within a narrow range that can be justified — is therefore essential from both perspectives.

Converting Foreign Loans and ECBs: The FEMA Layer

When your lender is a foreign entity or a non-resident, the conversion is subject to the FEMA (Non-Debt Instruments) Rules, 2019 and the RBI Master Direction on External Commercial Borrowings. The key requirements are:

• Pricing: The conversion price must be at or above the FMV of the shares computed using an internationally accepted pricing methodology (DCF, comparable transactions) on an arm's length basis. A SEBI-registered Merchant Banker or a Chartered Accountant with the requisite expertise typically certifies this.
• Sectoral caps and entry route: The resulting FDI post-conversion must not breach the sectoral FDI caps or entry-route conditions (Government vs. Automatic route) applicable to the company's industry.
• Form FC-GPR on the FIRMS portal: File within 30 days of allotment. The FIRMS portal (firms.rbi.org.in) requires the allotment details, the consideration value, the FMV certificate, and the board resolution.
• Form ECB-2: The monthly ECB-2 return filed on the FIRMS portal must reflect the conversion event in the month it occurs — show the outstanding ECB as reduced/extinguished by the converted amount.
• Compounding: Late or non-filing of FC-GPR is a FEMA contravention that requires compounding with the RBI regional office. The compounding amount is computed on the transaction value, with minimum charges as notified, and the process typically takes 3–6 months. Avoid it by calendaring the 30-day FC-GPR deadline from the date of allotment.

Tax Implications on Both Sides

Company (Issuer) Side

• Angel tax — Section 56(2)(viib): Applies to a closely held company receiving consideration for shares from a resident person at a price exceeding FMV. The excess is treated as income of the company in the year of receipt. DPIIT-recognised startups are exempt, as are allotments to Category I and Category II AIFs registered with SEBI, and to notified classes of persons under the Income-tax Rules. If your company does not qualify for an exemption, ensure the conversion price does not exceed the Registered Valuer's FMV.
• Interest set-off and Section 43B: When accrued but unpaid interest is converted along with the principal, the question is whether that interest qualifies as "paid" for deductibility under Section 43B(d). The general position (subject to the specific terms of the conversion and AY 2027-28 developments) is that a conversion to equity is not a "payment" in the Section 43B sense. Do not claim the converted interest as a deduction without a specific tax opinion for the year of conversion.
• TDS reconciliation: If TDS was deducted on interest accrued under Section 194A, confirm that the TDS certificates are issued and reflected in Form 26AS / AIS before the conversion is recorded.

Lender (Allottee) Side

• The cost of acquisition of the newly allotted equity shares is the face value of the loan being converted (plus any premium paid to the extent not treated as income under Section 56).
• On subsequent transfer of the shares, capital gains will be computed with reference to this cost. Holding period for long-term capital gains (LTCG) under Section 112A (listed) or Section 112 (unlisted) runs from the date of allotment.
• For a foreign lender, the treaty position and withholding obligation on any future capital gain distribution should be analysed separately.

Worked Example: Rs. Numbers on a Real Conversion

Facts: Oakline Technologies Pvt Ltd (Delhi, unlisted, FY 2026-27) has an outstanding inter-corporate loan from its holding company, Oakline Holdings Pvt Ltd. The loan balance is Rs. 80,00,000 principal and Rs. 12,00,000 accrued interest — total Rs. 92,00,000. Both parties agree to convert the full amount into equity.

Registered Valuer's determination: FMV of one equity share = Rs. 184 (face value Rs. 10).

Shares to be allotted: Rs. 92,00,000 ÷ Rs. 184 = 50,000 shares

Angel tax check: Conversion price = Rs. 184 per share = FMV. No excess; Section 56(2)(viib) does not apply. ✓

If the conversion had been set at Rs. 200 per share (e.g., to match a concurrent fundraise price), the computation would have been:

• Shares allotted: Rs. 92,00,000 ÷ Rs. 200 = 46,000 shares
• Excess consideration over FMV: (Rs. 200 − Rs. 184) × 46,000 = Rs. 7,36,000 taxable as income under Section 56(2)(viib) in AY 2027-28. This is avoidable with careful pricing.

MGT-14 late-filing cost: If the special resolution was passed on Day 40 and MGT-14 was filed on Day 75 (5 days late, i.e., 35 days after the resolution — breach of the 30-day window), additional fees apply on MCA V3 under Section 403's tiered slab. The additional fee escalates with each bracket; a 5-day delay is Category I (up to 30 days beyond due date) and carries a 2× fee multiplier on the normal filing fee. File MGT-14 on or before Day 70 from the EGM date to stay within the standard window.

FC-GPR missed deadline (hypothetical ECB variant): If this had been a foreign lender and FC-GPR was filed 45 days late, the compounding charge is computed at 5% per annum (approx.) on the transaction value for the late period: Rs. 92,00,000 × 5% × (45/365) ≈ Rs. 56,500 in compounding fees, plus professional costs of the compounding application. The lesson: one missed deadline costs more than the entire legal fee for timely compliance.

Common Mistakes That Stall or Void the Process

• Allotting shares after the 60-day PAS-4 offer window expires. The entire procedure must restart — new valuation, new offer letter, new EGM. There is no waiver.
• Setting off the loan without a banker's certificate or CA certificate for original inflow. The Income-tax Department may treat the consideration as unexplained credit under Section 68, even in a genuine conversion. Always have documentation of the original loan receipt through banking channels.
• Using a Registered Valuer whose IBBI registration has lapsed. The report will be rejected at the PAS-3 filing stage on MCA V3. Verify the valuer's registration number on the IBBI public registry before engaging.
• Ignoring accrued interest. Many conversions are structured for principal only, leaving the accrued interest outstanding. This creates a continuing loan balance, additional TDS obligations, and an ambiguous balance sheet. Decide upfront whether to convert interest along with principal or waive/write off it separately.
• FEMA pricing analysis done after the fact. For a foreign lender, the conversion price must be determined before the board passes the allotment resolution. A post-facto valuation report does not cure the FEMA contravention.
• Special resolution passed without proper quorum or notice period. If a member subsequently challenges the meeting, the entire allotment can be voided. Ensure 21-day notice (or valid shorter notice consent) and correct quorum under the Articles.
• Valuation report older than 90 days at the date of allotment. If the process stretches — due to regulatory queries or lender delays — commission a fresh valuation before allotment to ensure the report reflects FMV as close to the allotment date as possible.

Key Takeaways

• Choose the route first: Section 62(3) is available only if the original loan agreement contained a conversion clause and a pre-disbursement special resolution was passed — verify both before assuming you can skip the preferential allotment steps.
• The 60-day allotment window under Section 62(1)(c) is absolute — plan the EGM date and valuation timeline backwards from the intended allotment date, not forwards.
• Form PAS-3 must be filed on MCA V3 within 30 days of allotment — for Section 62 routes; failure triggers compounding fees under Section 403 and can stall subsequent fundraising due diligence.
• Angel tax under Section 56(2)(viib) is avoidable if the conversion price equals the Registered Valuer's FMV — the risk arises only when you price the conversion above FMV (e.g., to match a higher fundraise round price).
• For any foreign lender or ECB, Form FC-GPR on the FIRMS portal must be filed within 30 days of allotment; late filing is a FEMA contravention requiring compounding, and the compounding costs escalate quickly.
• Always obtain a banker's certificate or CA certificate confirming the original loan inflow through banking channels before setting off the loan against share consideration — this is your primary defence against a Section 68 unexplained-credit notice.
• Document the accrued interest position explicitly in the board resolution and the lender's conversion notice — silence on interest creates ambiguity in statutory registers, tax filings, and any future investor due diligence.