Conversion of Loan into Equity

Converting an outstanding loan into equity is one of the most common balance-sheet manoeuvres in Indian companies — used to reduce leverage, satisfy lender covenants, restructure stressed exposures and bring promoter contributions on-record. The Companies Act, 2013 read with the FEMA framework for foreign lenders sets out a layered procedure that founders must follow precisely.

The legal framework

Section 62(3) of the Companies Act, 2013 specifically enables conversion of any debenture or loan into shares of the company on terms that were either provided in the original loan agreement or approved by a special resolution before issue of the loan. Where the original terms did not envisage conversion, Section 62(1)(c) — preferential allotment — is the typical route, with valuation and pricing requirements under SEBI ICDR Regulations (for listed) or Rule 13 of the Companies (Share Capital and Debentures) Rules (for unlisted).

Foreign lenders and ECB conversion

• External Commercial Borrowings can be converted into equity under the RBI Master Direction on ECBs and the FEMA NDI Rules.
• Pricing must be at the fair market value determined as per the prescribed methodology — usually IndAS-based DCF or Net Asset Value, as applicable.
• Reporting in Form FC-GPR within 30 days of allotment.
• Reporting in Form ECB-2 reflecting the conversion event.
• Conversion must not breach sectoral FDI caps or entry-route conditions.

Procedure under Section 62(3) — terms in the original agreement

1. Verify that the loan agreement clearly provides for conversion at lender's option / company's option / on default, with conversion ratio or methodology.
2. Special resolution must have been passed before the loan was disbursed; check the EGM/AGM record.
3. Trigger conversion as per agreement, communicate to lender and pass a Board Resolution recording the conversion.
4. File Form PAS-3 (Return of Allotment) within 15 days of allotment with valuation report and lender confirmation.
5. Issue share certificates within two months of allotment.
6. Update statutory registers including Form MGT-1 and Form SH-2.

Procedure under Section 62(1)(c) — preferential allotment route

1. Identify the lender as the proposed allottee and obtain Board approval to issue the offer letter in Form PAS-4.
2. Obtain valuation report from a Registered Valuer under Section 247.
3. Pass a special resolution under Section 62(1)(c) at a duly convened general meeting.
4. File Form MGT-14 with the special resolution within 30 days.
5. Receive the consideration through banking channels — the loan amount is set off against the issue consideration, with banker confirmation of the original loan inflow.
6. Allot shares within 60 days of receipt of consideration; file Form PAS-3.

Tax and accounting considerations

• Conversion at a premium above fair market value can trigger Section 56(2)(viib) — angel tax — for the company, particularly if the lender is a resident, subject to exemptions for DPIIT-recognised startups and notified investor categories.
• Interest accrued and converted along with principal is generally treated as paid for Section 43B purposes (subject to specific facts).
• TDS on interest already deducted should be matched against the converted amount.
• Lender side: capital gain may arise on subsequent transfer of converted shares, with the cost being the converted loan amount.

Practical timeline for an unlisted private company

1. Day 0 — Board approves in-principle conversion; instructs valuer.
2. Day 10 — Registered Valuer's report received.
3. Day 15 — Board approves PAS-4 offer letter (preferential allotment route).
4. Day 20 — Send PAS-4 to lender; obtain acceptance in PAS-5.
5. Day 25-30 — Notice of EGM despatched; special resolution passed.
6. Day 45-50 — File MGT-14 within 30 days of special resolution.
7. Day 55 — Set off loan against consideration; allot shares; pass Board resolution recording allotment.
8. Day 60 — File PAS-3 within 15 days of allotment; update statutory registers; issue share certificates within 2 months.

Pitfalls to avoid

• Allotment beyond 60 days from PAS-4 offer date — entire process must be redone.
• Set-off of loan against consideration without banker certification of original inflow — invites Section 68 unexplained credit scrutiny.
• Valuation report older than 90 days at allotment — Rule 13 timelines.
• Cross-border conversion without prior FEMA pricing analysis — RBI compounding consequences.

Conclusion

Loan-to-equity conversion is procedurally precise. Decide early which route applies — Section 62(3) is cleaner if the loan agreement provided for it; Section 62(1)(c) is the default fallback. Get the valuation right, run the resolutions in correct sequence, file PAS-3 within 15 days, and complete FEMA reporting where foreign capital is involved. Done well, it strengthens the balance sheet without inviting tax or regulatory friction.