Loan Penal Charges: Accounting and GST implications
Abhirup Ghosh, Qasim Saif & Aanchal Kaur Nagpal | finserv@vinodkothari.com
Background
Levying of penal charges or late payment charges are claimed as ‘just’, owing to the underlying breach of contract under the Contract Act, 1972. A breach or a non-performance by one party entitles the other party to receive compensation for any loss or damage suffered due to such breach. Penalties may not only be compensatory; they also have a deterrent element.
In order to ensure compliant behaviour, lenders charge penalties to their borrowers for various ‘events of default’; the predominant ones being penalty for delayed payments (in the form of charges or interest) and prepayment penalties. However, such charges stopped being ‘just’ and ‘reasonable’ when lenders started maneuvering such penalties as revenue enhancement tools, rather than as a deterrent measure and compensation for a breach. Such unreasonable penalties coupled with non-disclosures, compounding of penal interest, etc. were highly prejudicial to consumer interest and accordingly, caught the eye of the regulator.
The RBI introduced guidelines to the lenders to ensure reasonableness and transparency in the disclosure of penal interest vide its Circular on ‘Fair Lending Practice – Penal Charges in Loan Accounts’(RBI Guidelines on penal charges’) dated August 18, 2023. Our article and FAQs[1] on the same may be read here[2].Our YouTube video discussing the guidelines may be viewed here.
However, charging penal interest also raises several practical questions for lenders, mainly indirect taxation and accounting of penal charges, which will be discussed in detail in this article.
GST on penal charges
Goods and Services Tax is applied on taxable supplies of goods and services. In this section, we examine whether charging penal charges for non-performance of obligations emanating from financial contracts will be treated as taxable supplies for the purpose of GST.
Under GST, payment of interest on loan transactions is exempt vide entry no. 27 of Notification No. 12/2017- Central Tax (Rate) dated 28.06.2017. Interest refers to the compensation paid to the lenders by the borrowers as towards the time value of money lent. Further, interest has been defined by the 2017 GST Circular[3] (‘GST circular of 2017’) as “interest payable in any manner in respect of any moneys 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 moneys borrowed or debt incurred or in respect of any credit facility which has not been utilised.”
Penal charges on, the other hand, could be levied for varied reasons such as breach of terms of contract, cheque bounce/ dishonour, delayed payments, prepayment etc.
The GST Circular of 2019[4] provided that penal interest may be charged in two ways (in the form of examples) and the GST implications will vary based on the same:
| Situation 1 | ABC Co (lender/shopkeeper) sells a car to Mr A (borrower) where the selling price of the car is ₹6,00,000. However, ABC Co gives Mr A an option to pay the selling price of the car in 24 months (24 installments) i.e. ₹ 26,250 (Repayment of principal ₹ 25000 + Interest @5% i.e. ₹ 1250). The installment shall be paid every 10th of the month, and any delay on such payment shall be liable for a penal interest of ₹ 500 per day for delay in payment. | The transaction between ABC Co and Mr A is that of supply of taxable goods and not a money-to-money transaction. The shopkeeper has broken down the payment into tranches referred to as the EMI facility. The said EMI includes an ‘interest’ component as well which is subjected to GST. Also a penal interest is charged on the delayed payment. Accordingly, the interest and penal charges paid on the delayed payments shall be included in the value of supply and as a consequence, it will be under the ambit of GST. Also this situation will not be covered under clause 5(e) of the Schedule II of the CGST Act. The expression to tolerate an act cannot be said to include a situation wherein penal charges are imposed on the erring party for delayed or non-payment. Since the above is not covered under serial no 27 of the 2017 GST Circular, the same is not exempt and taxable under GST. Situation |
| Situation 2 | ABC Co sells a car to Mr. A where the selling price of the car is ₹6,00,000. Mr A has an option to avail a car loan at an interest of 12% per annum for purchasing the car from XYZ Co. The term of the loan from XYZ Co allows A, a period of 24 months to repay the loan and an additional /penal interest @1% per annum for every day of delay in payment. | Here the transaction between XYZ co and Mr. A is that of a money-to-money transaction. The penal interest charged will be covered under serial no 27 of the 2017 GST Circular i.e. “services by way of (a) extending deposits, loans or advances in so far as the consideration is represented by way of interest or discount (other than interest involved in credit card services)”is exempted. Accordingly, in this case, the “penal interest” charged thereon on transaction between XYZ Co and Mr. A would not be subject to GST.The value of supply by ABC Co to Mr. A would be ₹ 6,00,000 for the purpose of GST. Whereas there will be no GST charged on the interest and additional/ penal interest charged by the XYZ Co (lender) as the same is considered as an exempt supply. |
Accordingly, as per the 2019 GST Circular, in case of a money-to-money transaction, penal interest will be covered under the definition of ‘interest’. A question arises whether the said stance seems relevant now in light of the RBI Guidelines.
As per the Guidelines on penal charges, the RBI has provided that the penalty charged by lenders is not further interest or additional interest. Penalties are over and above interest, and, even if the penalty is based on the time during which default continues, the RBI clearly mentions that penalties are not to be treated as interest. Since by regulation, penalties are not “interest”, could it be argued that penalties-now to be called as ‘penal charges’, are free from the exemption of GST as enjoyed by ‘interest’?
In order to clear the confusion regarding chargeability of GST on such penal charges, the Ministry of Finance issued a circular on 3rd August 2022[5] clarifying the position. Paragraphs 7.1.6 and 7.3 are of significant importance in the present case, excerpts of which are provided below:
Para 7.1.6 of the circular dated August 3, 2022 states that
“amounts paid for acceptance of late payment, early termination of lease or for pre-payment of loan or the amounts forfeited on cancellation of service by the customer as contemplated by the contract as part of commercial terms agreed to by the parties, constitute consideration for the supply of a facility, namely, of acceptance of late payment, early termination of a lease agreement, of prepayment of loan and of making arrangements for the intended supply by the tour operator respectively. Therefore, such payments, even though they may be referred to as fine or penalty, are actually payments that amount to consideration for supply, and are subject to GST, in cases where such supply is taxable. Since these supplies are ancillary to the principal supply for which the contract is signed, they shall be eligible to be assessed as the principal supply, as discussed in detail in the later paragraphs. Naturally, such payments will not be taxable if the principal supply is exempt.
Para 7.3 states that:
“The fine or penalty that the supplier or a banker imposes, for dishonour of a cheque, is a penalty imposed not for tolerating the act or situation but a fine, or penalty imposed for not tolerating, penalizing and thereby deterring and discouraging such an act or situation. Therefore, cheque dishonor fine or penalty is not a consideration for any service and not taxable.”
Examining the applicability of penal charges in light of the above circular:
- For dishonour of cheques: Para 7.3 is adequately avowed in this regard, and states that the penalty imposed for dishonour of cheques is for not tolerating an act or situation. On the other hand, the term supply as per para 5(e) of Sch. II of the CGST Act includes:
“Agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act”
Therefore, if the penalty is charged for not tolerating an act or situation, it shall not be treated as consideration for any service and hence, shall not be taxed.
- For other penalties: Para 7.6 states that charging penalties for any breach or any event emanating from a contract may be treated as supplies, but they cannot be treated as independent supplies, as they are flowing from a contract. Whether the penalties should be taxed or not would depend on the taxability of the principal supply; if the principal supply is taxable, the ancillary supply will also be taxable. Principal supply is basically the main object of the contract. For instance, if a prepayment penalty is charged under a loan transaction, then loan is the main object of the contract, and the prepayment is the ancillary supply. If the interest paid on loan is not taxable, then the prepayment penalty will also not be taxed. However, if a penalty arose from a lease transaction, it would be chargeable, since, lease itself is a taxable supply.
In the context of penal charges, the penal charges arise from the loan contract. The principal supply is the lending of money. There cannot be a contention that a loan itself is not a supply; however, in case of a loan, the interest on the loan is exempt. The penal charges for not paying the monies on time is related to this loan. No one can contend that the lender would have envisaged a penalty as an independent source of income – in fact, that is the very premise on which the RBI Circular of 18th August is made. If the loan is not paid in time, there is a loss of time value, and therefore, the penalty deters the borrower from causing that loss. This may be said to be a punitive or deterrent measure. Therefore, either by connecting the penalty to the principal supply, which is lending of money on interest, or by treating the penalty as an act of intolerance of a non-compliant behaviour, it seems that penalty will remain exempt from GST.
Hence, in our view, the change of regulatory stance on penalties does not cause any change in the GST exigibility.
Accounting for penal charges
Another major aspect that needs consideration is in respect to accounting of penal charges. Here it shall be pertinent to consider that accounting for any transaction depends on the characteristics of the transaction. Same is the case with penal charges as well.
Here the question that first arises is whether the penal charges, in the character of income from financial instruments, hence becoming a part of EIR or being a charge to be treated separately.
Character of Penal Charges: Beyond Financial Terms
Penal charges are imposed as a consequence of a breach of material terms in financial agreements. This breach can encompass a range of violations, with non-adherence to repayment schedules being a prominent example. These charges, however, hold a distinctive position in financial arrangements. Unlike interest charges that are primarily associated with the financial terms of an instrument, penal charges serve as a deterrent against potential defaults.
The economic substance of penal charges is inherently punitive in nature. They do not serve the purpose of compensation against credit risk or contribute to the pre-agreed cash flow. The intent behind penal charges is to discourage borrowers from defaulting on their obligations. Consequently, their character aligns more with a deterrent charge rather than a component of interest.
Penal Charges and Interest: Distinct Categories
The distinction between penal charges and interest is reaffirmed by RBI Circular itself. Circular explicitly states that penal charges should be treated as charges of punitive nature rather than interest. This directive reinforces the idea that penal charges are a distinct entity with a purpose different from that of interest.
Moreover, when evaluating whether these charges align with the character of interest, it becomes evident that their punitive nature sets them apart. They do not cater to the compensation aspect characteristic of interest. Thus, their categorization as interest would not be accurate.
Accounting Standards and Treatment of Penal Charges
The Ind AS 109 standard provides guidance on the recognition and measurement of financial instruments, including their associated charges. However, in respect to accounting of Penal charges, we may refer to Para B5.4.3 of Ind AS 109 which states that:
“Fees that are not an integral part of the effective interest rate of a financial instrument and are accounted for in accordance with Ind AS115 include:
XX”
Further Para 5.4.1 of Ind AS explicitly states that interest revenue is computed using an effective interest rate method. Consequently, penal charges, which are not within the ambit of the effective interest rate (EIR) calculation, are then encompassed by the guidelines of Ind AS 115. This standard focuses on revenue recognition and outlines how revenue should be accounted for in contracts with customers.
Recognition of Penal Charges under Ind AS 115
When applying Ind AS 115 to penal charges, the discussion can be divided into two segments: defaulted loans and standard loans.
For defaulted loans, where interest recognition is not permissible due to default, the question of recognizing other income, including penal charges, does not arise. The income from penal charges cannot be accrued in such cases.
For standard loans, a crucial consideration arises due to the stipulation in Ind AS 115 paragraph 9(e) which states as follows:
“ it is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. In evaluating whether collectability of an amount of consideration is probable, an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due. The amount of consideration to which the entity will be entitled may be less than the price stated in the contract if the consideration is variable because the entity may offer the customer a price concession (see paragraph 52).”
Given the fact that borrowers on whom penal charge is levied are delinquent in respect to the EMI itself, reasonable certainty is surely lacking regarding the payment of penal charges. As a result, accounting for the income associated with penal charges should not be done on accrual instead, it should only be recognized when received in cash.
It is important to note that the recognition of regular interest on overdue amounts remains unaffected and continues to be accounted for as per the agreed-upon terms.
[1] http://vinodkothari.com/2023/08/faqs-on-penal-charges-in-loan-accounts/#:~:text=Can%20such%20penal%20charges%20be,the%20nature%20of%20non%2Dcompliance.
[2] https://vinodkothari.com/2023/04/penal-charges-not-a-cash-cow-for-lenders/
[3] https://cbic-gst.gov.in/hindi/pdf/central-tax-rate/Notification12-CGST.pdf
From the Article it is still not clear whether as per RBI circular for Fair Lending Practice, wherein penal interest replaced by penal charges, whether GST is to be charged or not.
Can you please provide the clarification in this regard.
Banks charge GST on non maintenance of Average Minimum Balance in Saving and Current Bank Accounts on
the penal charges amount @ 18%