Interest on Debentures, Characteristics, Entries

Interest on debentures is the periodic payment made by a company to debenture holders as a return on the funds borrowed through the issue of debentures. It is a fixed charge against profits, meaning it must be paid regardless of the company’s profitability. Interest is usually calculated on the face value of debentures at a predetermined rate and paid semi-annually or annually. As per the Companies Act and relevant tax provisions, interest is treated as a business expense and is deductible for tax purposes. Payment must comply with terms in the debenture trust deed, and tax is often deducted at source (TDS) before payment to debenture holders.

Characteristics of Interest on Debentures:

• Fixed Obligation

Interest on debentures represents a fixed financial obligation for the company, payable at a predetermined rate irrespective of profit or loss. Unlike dividends on shares, it is not dependent on earnings but must be paid as per the terms of the debenture agreement. This fixed nature ensures debenture holders receive a stable return, making debentures a secure investment. For the company, however, it adds a constant financial burden, and failure to pay can lead to legal consequences or damage to creditworthiness, as it is a contractual liability.

• Priority in Payment

Interest on debentures has priority over dividends to shareholders. It is classified as a charge against profits, meaning it must be paid before any distribution of profits to equity or preference shareholders. This priority is due to the debt nature of debentures, where debenture holders are creditors, not owners. Even in financial difficulties, interest payment is legally binding unless the company is under formal restructuring. This feature provides security to investors but creates a fixed commitment for the company’s cash flow management and overall financial planning.

• Periodicity of Payment

Interest on debentures is paid at regular intervals, typically half-yearly or annually, as specified in the debenture trust deed. This periodicity allows investors to plan their income flow and makes debentures attractive for those seeking predictable returns. The company must maintain sufficient liquidity to meet these periodic payments on time. The fixed schedule also helps in accounting and budgeting, as companies can anticipate and allocate resources accordingly. Delays or defaults in such payments can lead to penalties, legal action, or loss of investor confidence in the company.

• Tax-Deductible Expense

Interest on debentures is treated as a business expense for the company and is deductible while calculating taxable profits. This tax-deductibility reduces the company’s overall tax liability, making debt financing via debentures more attractive compared to equity financing, where dividends are not tax-deductible. However, the company must comply with tax rules, including the deduction of tax at source (TDS) before paying the interest to debenture holders. This characteristic benefits the company financially but also requires careful compliance to avoid tax penalties or disallowances in future assessments.

• Legal Obligation

Payment of interest on debentures is a legal obligation under the Companies Act and the terms mentioned in the debenture agreement or trust deed. Failure to pay can lead to legal proceedings, damages, or enforcement of security by debenture trustees. Since debenture holders are creditors, the company is bound by law to fulfill this obligation. This legal enforceability ensures protection for investors but increases the risk for the company if its earnings or liquidity position deteriorates, as non-payment can affect reputation and borrowing capacity.

• TDS Applicability

Interest on debentures is subject to Tax Deducted at Source (TDS) as per the Income Tax Act. The company must deduct TDS at the prescribed rate before making the payment to debenture holders and deposit it with the government within the stipulated time. Failure to comply can result in penalties, interest charges, or disallowance of the expense for tax purposes. TDS compliance ensures tax collection at the source, providing a steady flow of revenue to the government, while also giving debenture holders credit for the tax deducted in their annual filings.

Journal Entries of Interest on Debentures: