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Sunday, February 26, 2012

Tata Power's perpetual bonds-tax deductible 'interest' with equity treatment?

While reading the 3Q'12 financials of Tata Power(http://www.tatapower.com/investor-relations/pdf/q3-results-31-dec-11.pdf), I was intrigued at a note which mentioned that

This issue was of Non Convertible Debuntures in Jun-11, and the features(subordinate, perpetual, deferred interest possibility, not redeemable at option of holders) do make it like the quasi equity instruments that banking regulators are demanding for banks to issue as part of their Tier I capital. As long as the company is a going concern, it will pay interest(remember this is a TATA group company which has never defaulted), and hence the substance of the obligation is debt-indeed that is why the holders are willing to trust it with such a risky instrument. However, optimism and past history does not guide accounting more than the legal form, and therefore the instrument is classed as equity, with corresponding effect as interest.

What really interests me is the below questions. I could not download the prospectus, so had to make do with its summary and CRISIL's rating FAQs here(http://www.crisil.com/Ratings/Commentary/CommentaryDocs/CRISIL-ratings_tata-power-faqs_may11.pdf).
  1. Banks & rating agencies treat this as equity or debt. I think they would make proforma adjustments at the bare minimum, likening this to preferred stock which is routinely classed as debt in models. For instance, CRISIL said that it would 50 per cent equity content to this instrument. It implies that  its analysis of Tata Power's capital structure and financial ratios, will treat 50 per cent of the principal amount as equity and the remaining as debt.  The reason for the partial debt treatment is CRISIL's belief that the the high fixed coupon of up to 11.6 per cent and a step-up of up to 200 basis points (bps) would prompt Tata Power to exercise  the first call option date after 10 years
  2. Does the company deduct withholding tax as interest or dividend:-Since form rules over substance, I guess the company would treat this as interest for tax purposes, which would give the best of two worlds-tax deductible interest but not expensed. So far, India does not have GAAR rules to re-characterize financial instruments in this manner-although the Direct Tax Code 2011 would certainly arm the taxman powers to so. Since the bond issue is new, this matter has not been litigated yet, and the result would be interesting.
Thought the total debt is a pittance compared to Tata Power's existing debt and equity base, investors should watch out in case other issuers adopt this for a larger proportion of their capital structure.So before taking the debt numbers from that free online service, just take a note of these things also

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