Preference Shares in India: Decoding the Nexus of the Companies Act, FEMA, and the Income Tax Act

The structural evolution of India’s corporate finance landscape over the last two decades has been defined by a decisive shift from traditional debt-equity binaries to sophisticated hybrid instruments. The surge of the venture capital and private equity ecosystem led to an environment wherein investors sought instruments that could offer the downside protection of debt specifically, priority in liquidation and fixed dividends, while simultaneously retaining the upside potential of equity ownership.

This commercial necessity catalyzed the widespread adoption of preference share capital. The legal jurisprudence surrounding preference shares in India is governed by a triad of statutes:

1. Companies Act, 2013 (“Act”);
2. Foreign Exchange Management Act, 1999 (“FEMA”); and
3. Income Tax Act, 1961 (“IT Act”).

This article provides an exhaustive analysis of the legal, regulatory, and commercial dimensions of preference shares in India. So, let us get started.

Companies Act – The Catalyst

1. Section 43 of the Act serves as the bedrock for share capital classification in companies limited by shares. It explicitly bifurcates share capital into two distinct categories, removing the ambiguities that arguably existed under previous regimes:

• Equity Share Capital: This is defined residually as all share capital that is not preference share capital.
• Preference Share Capital: The Act defines preference share capital not by what it is, but by what rights it carries. According to Explanation (ii) to Section 43, capital is deemed preference share capital if it carries a preferential right with respect to two specific triggers:

(i) Payment of Dividend: The instrument must carry a preferential right to be paid a dividend, either as a fixed amount or an amount calculated at a fixed rate, before any dividend is paid to equity shareholders.

(ii) Repayment of Capital:In the event of winding up or repayment of capital, the instrument must carry a preferential right to be repaid the amount of the paid-up share capital before any payment is made to equity shareholders.

2. Section 55 of the Act mandates that a company limited by shares cannot issue irredeemable preference shares. The legislature has imposed a strict temporal cap on the life of a preference share, mandating that all preference shares must be liable to be redeemed within a period not exceeding 20 years from the date of their issue (except issued by infrastructure companies for which special provisions have been provided).

3. Voting Rights: Unlike equity shareholders, who possess inherent voting rights on all resolutions, preference shareholders are generally disenfranchised regarding the day-to-day operations of the company. Section 47 of the Act delineates these voting rights. The general rule is that preference shareholders have a right to vote only on resolutions which directly affect the rights attached to their class of preference shares, or on resolutions for the winding up of the company or for the repayment or reduction of its equity or preference share capital. However, Section 47(2) provides that if the dividend in respect of a class of preference shares has not been paid for a period of two years or more, such class of preference shareholders acquires the right to vote on all resolutions placed before the company.

Types of Preference Shares

The commercial utility of preference shares lies in their extraordinary flexibility viz. cumulation, participation, convertibility which creates bespoke instruments that align with specific risk profiles.

1. Cumulative Preference Shares: These instruments offer the highest degree of dividend security. If a company fails to declare a dividend in a particular financial year typically due to insufficient profits or a strategic decision to reinvest cash, the investor’s entitlement to that dividend does not lapse. Instead, it accumulates as “arrears of dividend.” The company is statutorily barred from paying any dividend to its equity shareholders until all accrued arrears on cumulative preference shares have been fully discharged. Risk-averse investors in early-stage companies often insist on cumulative dividends. Even if the startup cannot pay cash dividends for five years, the liability accrues. Upon a liquidity event (like an acquisition), these accumulated dividends must be paid out from the proceeds before equity holders receive a cent.
2. Non-Cumulative Preference Shares: Non-cumulative shares operate on a “use it or lose it” basis. The right to receive a dividend is contingent upon the company declaring it in that specific year. If the company skips a dividend payment, the right to that year’s dividend is permanently extinguished and does not carry forward to future years.
3. Non-Participating Preference Shares: These are straight preference shares. The holder is entitled strictly to their fixed dividend rate and, upon liquidation or winding up, the return of their capital (plus any accrued dividends). They have no claim on the surplus assets or surplus profits of the company remaining after these payments. In a massive exit event (e.g., a 100x return), a non-participating preference shareholder is disadvantaged. To capture the upside, they must convert their preference shares into equity shares before the liquidity event. This forces a choice: take the safe, fixed return OR convert and take the risky, high-return equity position.
4. Participating Preference Shares: These instruments allow the holder to double dip. First, they exercise their preferential right to receive their capital back (plus dividends). Second, they retain a right to participate in the remaining surplus assets or profits alongside the equity shareholders, typically in proportion to their shareholding as if converted. This structure is highly dilutive to founders and employees. If a company is sold for $100 million, a participating investor with a INR 10 million investment (and 20% stake) first takes their INR 10 million back. Then, they take 20% of the remaining INR 90 million (INR 18 million). Their total exit is INR 28 million.
5. Non-Convertible Preference Shares: These instruments remain as preference shares until maturity, at which point they must be redeemed for cash. They are functionally identical to debt but legally classified as share capital. They do not dilute equity ownership.
6. Optionally Convertible Preference Shares: These provide an option, usually to the investor, sometimes to the issuer, to convert the shares into equity or redeem them for cash at a future date.
7. Compulsorily Convertible Preference Shares: Conversion into equity is mandatory upon the occurrence of a specified date or a triggering event (e.g., an IPO). There is no option for cash redemption at the end of the tenure.

FEMA Perspective

The distinction between these types is critical under the FEMA. RBI considers only CCPS and Compulsorily Convertible Debentures (CCDs) as “Equity Instruments” compliant with the Foreign Direct Investment route. Non-convertible or optionally convertible preference shares are treated as debt and fall under the stringent External Commercial Borrowing guidelines, which impose caps on interest rates and restricted end-uses. Consequently, nearly all foreign VC/PE investment in India is structured as CCPS.

CCPS: The Instrument of Choice

In the Indian startup and investment ecosystem, CCPS has emerged as the de facto standard. It is a sophisticated legal instrument that harmonizes the conflicting needs of founders (who want to retain control) and investors (who want asset security and upside potential). Some essential features of CCPS are as follows:

1. Pre-Conversion Phase: During the term of the CCPS (must be less than 20 years), the investor holds a preference share. They are entitled to a fixed dividend (often set at a nominal 0.01% or 0.001% primarily to satisfy the statutory definition of preference shares). They enjoy priority over equity shareholders in the event of liquidation.
2. Post-Conversion Phase: Upon a specific trigger – typically a “Qualified Financing” round (which is essentially expressed in terms of valuation and minimum amount raised), an IPO filing, or the expiry of a term, the preference shares convert into equity shares. The investor then becomes a common shareholder, pari passu with the equity shareholders.

IT Act Perspective

Taxation acts as a friction cost at every stage of the CCPS lifecycle: Issuance, Conversion, and Sale.

1. Issuance: For years, Section 56(2)(viib) of the IT Act infamously known as “Angel Tax” taxed the premium received by unlisted companies if it exceeded the Fair Market Value (FMV). This provision haunted CCPS issuances, as high premiums are standard in startup funding. The Finance Act 2024 abolished Angel Tax for all classes of investors. This deregulation significantly de-risks the issuance of CCPS at high valuations based on future growth potential.
2. Conversion: A critical feature of CCPS is the tax treatment of the conversion event itself. Section 47(xb) of the IT Act specifically exempts the conversion of preference shares into equity shares from being treated as a “transfer.” Thus, no capital gains tax is triggered at the moment of conversion. The cost of acquisition of the new equity shares is deemed to be the cost of the original CCPS as per Section 49(2AE) of the IT Act. Furthermore, as per Section 2(42A) of the IT Act, the period of holding includes the period for which the CCPS was held. This becomes vital for qualifying for LTCG rates as there is significant difference between tax slabs for LTCG and STCG.
3. Sale/Exit: The Finance Act 2024 drastically restructured capital gains taxation, impacting CCPS exits. For unlisted shares (like CCPS in startups), the holding period to qualify as a Long-Term Capital Asset remains 24 months. For residents, the LTCG rate has been reduced from 20% (with indexation) to 12.5% (without indexation). While the rate is lower, the loss of indexation (inflation adjustment) can increase the effective tax burden in inflationary environments. For Non-Residents, the new rate is 12.5%. More critically, the benefit of foreign currency fluctuation adjustment (which protected investors from Rupee depreciation) has been removed/modified, effectively increasing the tax cost for foreign investors exiting Indian positions.

Conclusion

CCPS have cemented their status as the backbone of the Indian private equity and venture capital ecosystem. They represent a sophisticated legal compromise: satisfying the regulator’s demand for equity, the investor’s need for priority and protection, and the founder’s desire for operational control.