By Beni Agarwal (firstname.lastname@example.org)
A recent advance ruling has thrown the financial industry off its balance. The pre-ruling opinion amongst the industry members has been refuted and yet another item has been brought within the ambit of GST, that is, penal interest or overdue interest. Before the aforesaid advance ruling, which we have discussed at length later on, there were various views circulating in the market. Some said penal interest should be charged to GST, while others said that it is nothing but interest for using the amount for the extended period of time.
However, all these speculations have been put to rest, first, by a set of frequently asked questions on GST on financial services, and second, by the aforesaid advance ruling. In this write-up we intend to discuss the outcome of the advance ruling and comment on how justified the decision is.
After the imposition of GST since 1st July, 2017, various supplies have been brought within the ambit of GST. There are some supplies which have been exempted from GST levy vide notification no 12/2017- Central tax (Rate) dated 28.06.2017, by way of powers vested with the Central Government through section 11 of CGST Act 2017. One such supply that is exempted is services by way of extending deposits, loans or advances, in so far as the consideration is exempt by way of interest or discount. Based on the exemption and its interpretation that such penal interest is nothing but additional interest, the view was that penal interest too shall not be subject to GST. However, the FAQs on Banking Sector, issued by GST Council, clarified that additional interest charged on delay or default in payment of installment by the customer shall be included in the taxable value of supply. The recent advance ruling in the case of Bajaj Finance Limited, would give additional weightage to the FAQs.
In case of a loan transaction, it was argued that the overdue interest was merely a stepped-up interest, for the period for which the contractual terms of the loan had been in breach. Overdue interest is, admittedly, nothing but interest, albeit at a higher rate. It could not be argued that a delayed payment for a loan led to any service. Typically, interest is based on the tenure for which the loan is due/overdue. If there is an element which is charged disregarding the tenure, that is, on absolute basis, it may, then, not qualify to be interest, and hence, become chargeable to GST.
Advance Ruling by the Adjudicating Authority
In case of Bajaj Finance Limited, an advance ruling has been passed on 6/08/2018 on imposition of GST on penal interest.
In the said case, BFL gave loan to customers for a specific period repayable in EMIS including principal and interest amount. Failure to pay within the due date attracts penalty charges based on a certain percentage. In the process, BFL agreed to tolerate the act of delayed payment in lieu of penalty.
The following questions were asked and answered:
Q1. Whether the penal interest is to be treated as interest for the purpose of exemption under Sr 27 of Notification no 12/2017- Central tax ( Rate) dated 28.06.2017, Sr no 27 of Maharashtra State Notification No 12/2017- State Tax ( Rate) dated 29.06.2017, and Sr no 28 of Notification No 9/2017 Integrated Tax (Rate) dated 28.06.2017?
Answered in the negative.
Q2. If the answer to the above is negative, whether the activity of collecting penal interest by BFL would amount to a taxable supply under the GST?
Answered in the affirmative. The said activity squarely falls under clause 5(e) of the Schedule II of GST Act, 2018 and therefore such amounts received, would attract tax liabilities under GST.
Hence, basis the above mentioned advance ruling, interest on penal charges shall be liable to GST.
Treatment of Penal Interest under Service Tax Regime
Interest on loans were outside the scope of Service Tax in the pre GST period. Lending as a service was first time brought within the ambit of Service Tax on 10.09.2004 , by an amendment in the definition of banking and other financial services’ under section 65(12) of Finance Act, 1994. At the same time, with effect from 10.09.2004, by virtue of clause (viii) of
Explanation 1 under section 67 of Finance Act, 1994 , the following was added:
“SECTION 67. Valuation of Taxable Services for charging service tax: For the purposes of this chapter, the value of taxable services shall be the gross amount charged by the service provider for such service rendered by him.
Explanation 1. For the removal of doubts, it is hereby declared that the value of taxable service, as the case maybe includes …
But does not include ...
(viii) interest on loans.”
Thus, from 10.9.2004, interest on loan was out of the purview of Service Tax under section 67.
However, from 19.04.2006, the valuation provisions contained in Finance Act was shifted to Service Tax ( Determination of Value) Rules , 2006, which provided the following:
“6. Cases in which commission, costs, etc will be included or excluded-
- Subject to the provisions of Section 67, the value of taxable services shall include-
- Subject to the provisions contained in sub rule(1), the value of any taxable services, as the case may be, does not include–
(iv) interest on loan”
Hence from 19.04.2006, interest on loans was excluded from value of taxable services by way of Service Tax (Determination of Value) Rules, 2006.
Further, from 1.07.2012 to 30.06.2017, interest on loan was exempted under Negative List clause(n) of Section 66D of Finance Act, 1994. The same read as under:
“SECTION 66D. Negative List of Services: The negative list shall comprise of the following services, namely-
(n) services by way of-
(i) extending deposits, loans or advance in so far as the consideration is represented by way of interest or discount”
Thus, throughout the period before GST, interest on loan was excluded from levy of tax by way of provisions as stated above.
Rationale behind the current Ruling
Imposition of GST on penalty by the name of penal charges, penal interest or penalty is backed by the following arguments:-
- Schedule II, entry 5 of CGST Act, includes services in the scope of supply as “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act “. Thus, it is contended that there is a service of tolerating an act because there is toleration of the act of default or situation of default of the loanee or borrower by the Lender in exchange for default charges named as penal interest. The nomenclature does not alter the substance of the transaction. Penal charges are charges on over-due amount. Thus, penal charges falls within the scope of supply under the CGST Act, Section 7.
- EMI calculation is done based on the amount of loan and the total tenure of loan. Interest is calculated keeping in mind the total life of the loan over which the principal shall be outstanding as reduced by the installments paid. Delay or default in payment of EMI is not factored in. The contention that it is separately charged and hence it is in the nature of interest, is invalid. This is because, the percentage of charge is on a per month basis of default. It does not encompass the entire life of the loan. It arises only when there is a default or delay and it is calculated for that period of delay. This is obviously not factored in as there is no encouraging effect of the erring activity on the part of the borrower. Hence, it is not an additional interest. Moreover, these are in the form of compensation charged for tolerating the act of default or delay and not in the nature of interest capturing the time value of money.
- Default charges are defined within a specified range, say 2 % to 5 % and varies from customer to customer. Moreover, a specified percentage is generally set beyond which the charges will not go. This is not the characteristic of interest.
Critical Analysis of the Ruling
The ruling has caused a jolt to the financial industry. There are several contentions that seem impractical and not carefully thought of. First of all, to state that penal charge is a compensation to tolerate an act is not completely justified. Penal interest is deterrent in nature as the lender is deterring or discouraging the borrower from delaying the payment by imposing a penalty. It is in the nature of additional interest on overdue amount. Interest charged is exempt from GST ambit which implies that it is not considered as supply to tolerate an act. If that is the case, then how can additional interest be considered as something to tolerate an act of delay or over-due. Its nature is similar to interest and interest is considered as a rate for incorporating time value of money and not classified as an act to tolerate the period in which the lender was devoid of that money.
Further, it is a top up on the rate of interest that is charged on the loan amount. Interest rate is the amount of money charged by the lender for usage of money which is calculated keeping in mind the time value of money. Penal interest is an add-on to the normal interest rate. If interest is considered as time value of money, then how can additional interest be considered any different? Penal interest is the interest rate charged on the over-due amount which is just a notch up on the existing rate.
To contend that the penal interest charged deviates from the nature of interest, because it is varying in nature, is a little funny. This implies that specifying a range of top up like 2% to 4% as against a fixed 10 % is grave enough to challenge the nature of interest. To state that the rate of penalty charged is varying from customer to customer and hence drifts away from the nature of interest is quite strange. The selection of rate of interest and charging them on customer basis should not be a point to declare that penal interest digresses from basic interest. There are a set of factors that determine the rate of interest to be charged from different customers.
Also, it is very important to note that charging GST in a sector that is already under the brunt of Non-Performing Assets (NPAs) is quite damaging to the banking and financial sector. We are talking of a sector where default or NPAs is a norm. The sector is already burdened with NPA and the problem is aggravated further by imposition of GST. Penal charges are collected by banks and it is their liability to pay to the Government. Whether or not they can shift the burden to the customers is a matter left on the banks. We are speaking about the customers who have made the delay or default and hence they are not the ones with best payment ability or willingness. Indeed it is very much possible that the ultimate burden may not be shifted to the customers and stay with the banks only. This burden of GST in addition to NPAs is definitely not a welcome change for banks and banking sector.
Argument for the earlier view taken
By way of notification no 12/2017- Central tax ( Rate) dated 28.06.2017, under serial no 27, services by way of extending deposits, loans or advances, in so far as the consideration is exempt by way of interest or discount( other than interest in connection with credit card services) have been excluded from the levy of GST.
Further clause (zk) of para 2 of the said notification defines interest as “interest payable in any manner in respect of monies borrowed or debt incurred (including a deposit, claim or other similar right or obligation) but does not include any service fee or other charge in respect of the monies borrowed or debt incurred or in respect of any credit facility which has not been utilized.”
Penal Interest are meant to include overdue charges on non-payment of installment on the due date. This was meant for compensating the lender for the time value lost for the extended use of loan proceeds. EMI amount factors in the interest portion for the tenure of the loan, but these additional charges are over and above the interest factored in.
Section 7 (1)(d) of CGST Act refers to Schedule II to include services that shall be considered supply. Entry 5 of Schedule II, includes the following as supply “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act “.
It was argued that the expression to tolerate an act cannot be said to include situation wherein penal charges are imposed on the erring party for delayed or non-payment. This is because, this is not the intention at the very inception, to undertake the activity of default or delay with no hindrance from the other party. The clause of penalty is created with a deterrent effect so that the activity is not repeated by the erring party.
Furthermore, the international laws like Australian Law does not impose GST on penal interest.
Potential impact of the Ruling on the Financial Industry
Penal Interest shall be subject to GST as per the recent AAR ruling, as it is not ruled to be in the nature of additional interest, but it is classified as supply under GST. The AAR ruling has adopted a position which is contrary to the historical approach adopted by financial services industry.
– Increase the working capital burden of Financial Institutions: The output GST liability shall block the working capital thereby increasing the working capital requirements. 18% GST on penal interest amount shall be required to be paid to the government by the banks. The output GST shall be recorded in the books as a liability payable. This liability did not arise till now and hence there was no additional burden on the working capital of financial institutions. But with the new ruling, financial institutions will face a working capital crunch.
– Pinch on the customers’ pocket: The amount of interest on loans or deposits or advances did not attract service tax during pre GST era and does not attract tax during the current GST tax regime as well. However, the penal interest is not in the nature of interest and hence shall be chargeable to GST. The banks may transfer the GST payable on penal charges to customers. This will pinch the pocket of the customers.
– Increased litigation: The ruling has gone against the long standing opinion in the financial industry and it is not going to be accepted without any further appeals. This may give rise to potential dispute and may register appeals in higher platforms. Also as these rulings serve as precedents for other cases, it will give rise to several related litigations in the process.
Putting an end to the industry-wide confusion , AAR has ruled, based on the provision in Schedule II, entry 5 of CGST Act 2017, that penal charges shall be considered a supply under GST and hence be a part of value of taxable supplies. According to the ruling, imposition of penal charges indicate a clear understanding between the parties that in case of delay in payment of the agreed upon amount, a penal charge shall be imposed which will be payable by the person in default as consideration for act of tolerance done by the lender. The consideration is clearly in monetary terms. Penalty by whatever name called, be it penal charges or penal interest or additional interest shall be subject to GST as a taxable supply. The ruling does not appear to be practical as it defies the very basic concept of time value of money.
Moreover, it might turn out to be an impediment for the banks and other financial institutions in the NPA-laden finance industry, due to the added disadvantage of GST on penalty. Given the current situation in the country, in most of the cases, it is the banks or the lenders who will have to take the hit. In case of distressed loans, where recovery of principal itself is questionable, expecting the borrower to cough up another 18% on the penal interest is highly irrational.
In all likelihood, this might call for further appeals in the higher forums, as the decision most likely, shall not go down well amongst the industry players.