Important Rulings -Section 56 (2) (viia), 56 (2) (x) and 56 (2) (viib) of Income Tax Act 1961

– Qasim Saif and Mahesh Jethani

finserv@vinodkothari.com

Section 56(2) (viia)

  • When shares of closely held company received without consideration or for inadequate consideration
  • Where shortfall in consideration as compared to Fair Market Value (FMV) exceeded Rs. 50,000
  • Recipient is:

(a) Firm

(b) closely held company

  • Then, FMV of such shares exceeding Rs. 50,000/- after reducing the value of consideration paid, if any, was considered as – Income from other Sources.

Section 56(2) (x)

Section 56(2)(vii)/(viia) is inoperative with effect from 1-4-2017

Clause (x) is inserted in section 56(2) to provide that the specified receipts [same as provided in Sec. 56(2)(vii)] will be taxable as income in the hands of any person, under the head ‘Income from Other Sources’

Sub-Clause (c) of Clause (x) of Section 56-Taxation of any property other than Money and Immovable Property: –

  • If received without consideration, the aggregate fair market value of which exceeds fifty thousand rupees, the whole of the aggregate fair market value of such property shall be considered Income from Other Source
  • If there is inadequate consideration whereby the difference between FMV and consideration exceeds Rs.50,000/- then difference in FMV and consideration will be considered as IFOS

Property means the following capital asset of the assessee –

(i) immovable property being land or building or both;

(ii) share and securities;

(iii) jewellery;

(iv) archaeological collections;

(v) drawings;

(vi) paintings;

(vii) sculptures; or

(viii) any work of art.

(ix) Bullion

Reason for amendments

The Memorandum to the section explains the following-

“The existing definition of property for the purpose of this section includes immovable property, jewellery, shares, paintings, etc. These anti-abuse provisions are currently applicable only in case of individual or HUF and firm or company in certain cases. Therefore, receipt of sum of money or property without consideration or for inadequate consideration does not attract these anti-abuse provisions in cases of other assessee.”

Thus, it appears that through insertion of new provision, the scope of the existing anti-abuse provision is widened to make it applicable to all assessee and also clubbing section 56(2)(vii) & section 56(2) (viia).

 

Important Rulings on Section 56(2) (viia) and 56(2) (x)

 

Taxability of the credit to the general reserve by the amalgamated company

Aamby Valley Ltd vs. ACIT (ITAT Delhi)

Date: 22nd February 2019.

Background:

Section 56(2) (viia) is an anti-abuse provision which applies only to cases of bogus capital building and money laundering. It does not apply to an amalgamation where shares are allotted at alleged undervaluation.

Increase in general reserves due to recording of assets of amalgamating company at FMV not give rise to any real income to the assessee. It is capital in nature

Judgement and conclusion:

This is an important judgement by Tribunal which deals with the taxability of the credit to the general reserve by the amalgamated company of the fair valuation of the assets received under the scheme of amalgamation. The Tribunal held that the transaction does not give rise to real income to the assessee and it thus cannot be treated as a business profit.

Provisions of Section 56 (2) (viia) will not be applicable if fair value of the shares received was not higher than the sacrifice suffered by taxpayer under the composition reorganisation scheme, as there is no incremental benefit to the shareholder.

Reserve directly credited to general reserve and not in P&L cannot be subjected to MAT.

Raising of Tax related Objection by RD when Income Tax Authority did not raise the same.

Casby Cfs Private Limited vs Casby Logistics Private Limited (Bombay High Court)

Date: 19th March 2015

Background:

In the instant case the question of law is that whether the RD could raise tax-related objections to the scheme of amalgamation though the ITA raised no objections? Whether the scheme was liable to be rejected based on the RD’s aforesaid objections?

One of the issue that was pointed out that the scheme was devised to evade capital gain tax by virtue of using the device of beneficial ownership and scheme, transferee is acquiring shares without consideration which will attract section 56 (2) (viia)

Judgement and conclusion:

Since the court was required to ensure that the scheme did not contravene any Act, the RD was not only entitled to, but was duty-bound, to bring to the HC’s notice any provision in the scheme that contravened any law. This included the Income tax law and aimed to ensure that the company did not use the HC sanction as a shield to protect itself from consequences of contravention of the law

That the ITA did not object did not prevent the RD from raising objections or making such observations with regard to the scheme as he/ she deemed fit, including those pertaining to tax laws

The HC has held that the RD is entitled to raise objections pertaining to income tax in a merger scheme, even though no objections were raised by the tax authorities.

Application of Section 56(2)(viia)/56 (2) (x) in case of Buy Back

Vora Financial Services P. Ltd vs. ACIT (ITAT Mumbai)

Date:29th June 2018

Background:

Section is a counter evasion mechanism to prevent laundering of unaccounted income under the garb of gifts. The primary condition for invoking the section is that the asset gifted should become a “capital asset” and property in the hands of recipient. If the assessee-company has purchased shares under a buyback scheme and the said shares are extinguished by writing down the share capital, the shares do not become capital asset of the assessee-company and hence s. 56(2) (viia) cannot be invoked in the hands of the assessee company

Judgement and conclusion:

A combined reading of the provisions of sec. 56(2)(viia) and the memorandum explaining the provisions show that the provisions of sec. 56(2)(viia) would be attracted when “a firm or company (not being a company in which public are substantially interested) “receives a property”, being shares in a company (not being a company in which public are substantially interested)”.

Therefore, it follows the shares should become “property” of recipient company and in that case, it should be shares of any other company and could not be its own shares. Because own shares cannot be become property of the recipient company.

Accordingly, Tribunal was of the view was that the provisions of sec. 56(2) (viia) should be applicable only in cases where the receipt of shares become property in the hands of recipient and the shares shall become property of the recipient only if it is “shares of any other company”. In the instant case, the assessee herein has purchased its own shares under buyback scheme and the same has been extinguished by reducing the capital and hence the tests of “becoming property” and also “shares of any other company” fail in this case.

The tax authorities are not justified in invoking the provisions of sec. 56(2) (viia) for buyback of own shares.

Valuation of Share to be done as per Rule 11UA

Minda SM Technocast Pvt. Ltd vs. ACIT (ITAT Delhi)

Date: 7th March 2018

Background:

Section 56(2)(viia) read with Rule 11UA, The “Fair Market Value” of shares acquired has to be determined by using the values of the underlying assets and not their market values

In the present case, the assessee has acquired shares of TEPL at Rs.5 per shares. The assessee claimed to have valued the shares of TEPL as per the provisions of Rule 11UA of the Rules. AO was of the view that the assets are to be valued at the fair market value which will increase the value of shares to 45.72 and difference Rs. 40.72 being subjected to tax.

Judgement and conclusion:

“Fair Market Value” of a property, other than an immovable property, means the value determined in accordance with the method as may be prescribed”

On the plain reading of Rule 11UA, it is revealed that while valuing the shares the book value of the assets and liabilities declared by the TEPL should be taken into consideration. There is no whisper under the provision of 11UA of the Rules to refer the Fair Market Value of the land as taken by the Assessing Officer as applicable to the year under consideration. Therefore, ITAT was of the view that the share price calculated by the assessee of TEPL for Rs. 5 per shares has been determined in accordance with the provision of Rule 11UA.

Applicability of section in case of “Gift” by one company to another.

Gagan Infraenergy Ltd vs. DCIT (ITAT Delhi)

Date: 15th May 2018

Background:

Huge volume of shares in a company were transferred by assessee to another company without any consideration and without any proper documentation being executed as per law, giving it name of “Gift”.

Question raised: Will the said transaction be covered by section 56(2)(viia) or is exempt from tax u/s 47(iii) of the Income Tax Act, 1961 (the Act)

Judgement and conclusion:

After considering all the facts and circumstances of the case, it is held that the AO has correctly observed that gift by a corporation to another corporation is a strange transaction as there cannot be a gift between artificial entities/persons. The submissions filed by the Appellant are considered and not found to be tenable.

The assessee has to establish to the hilt, the factum, genuineness and validity of the transaction, the right to enter into such transaction especially when, revenue challenges its genuineness. There is no agreement/document that has been executed between group companies forming part of family realignment. To postulate that a company can give away its assets free to another even orally, can only be aiding dubious attempts at avoidance of tax payable under the Act unless it is supported by documentary evidence

It has been vehemently contested by authorities. CIT (DR) contented that transaction has been effectuated for avoiding payment of tax and to get out of the ambit of section 56 (2) (viia) of the Act. Hence benefit of exemption under section 47 (iii) can not be granted.

 

Application of Section in case of Bonus Issue

Commissioner of Income-Tax vs Dalmia Investment Co. Ltd (Supreme Court)

Date:13th March 1964

Background

There has been a constant flip flop by the CBDT on the issue that whether the provisions of the given section would apply on fresh issue of shares. As the ambiguity prevails the highly celebrated case can be referred for determining applicability of section on Bonus Issue.

Judgement and Conclusion

The apex court in the given case while adjudicating the issue of taxability on transfer of shares held that the Bonus shares were acquired “Without Payment of price and not without consideration” hence it can be implied that Section 56(2) (viia) would not apply in case of bonus issue.

Whether it is valid in law to assess the difference between the value of the shares allotted to the taxpayer and the consideration paid by it, as the taxpayer’s income?

Sudhir Menon HUF vs. ACIT (ITAT Mumbai)

Date: 12th March 2014

Background:

Section 56(2)(vii) (c) (ii) provides that where an individual or a HUF receives any property for a consideration which is less than the FMV of the property, the difference shall be assessed as income of the recipient. The section does not apply to the issue of bonus shares because there is a mere capitalization of profit by the issuing-company and there is neither any increase nor decrease in the wealth of the shareholder as his percentage holding remains constant. Similar view can be taken while considering rights issue as well.

Judgement and conclusion:

Since Right Shares are allotted on the basis of original holding, it cannot be said that same have been allotted at a price less than the fair market value without consideration. Therefore, provisions of Section 56(2)(x) of the Act are not applicable. Moreover, in view of specific provisions of Section 55(2)(aa)(iii) cost of acquisition of these shares will be taken to be the actual price paid by the shareholder and same is not to be adjusted by the amount of deemed income in terms of section 49(4) of the Act, applicability of provisions of section 56(2)(x) is not intended. However it shall be noted that in case the right is assigned to a person the given section would apply.

Valuation of share can be done only on basis of FMV and Not Market Value:

DCIT Mumbai vs Ozoneland Agro Pvt Ltd (ITAT Mumbai)

Date: 2nd May 2018

Background

A.O. observed that two persons transferred their shares to the assessee at Rs.75.49 per share whereas, on the same day all the other shareholders transferred their shareholdings to the assessee at Re.1 per share. He observed that when the market rate is Rs.75.49/share, the assessee has purchased the shares at less than the market price i.e., Re.1 per share and therefore, the transactions attract provisions of section 56(2) (viia) of the I.T. Act.

The assessee however argued that under section 56(2)(viia) FMV as calculated under Rule 11U is to be considered and not market price. And FMV of the shares were negative and hence the section has no applicability in the given case.

Judgement and Conclusion

The Tribunal on due consideration ruled that the action of AO was outside the ambit of law and only FMV under Rule 11U can be considered and not Market price. Hence dismissing appeal by the AO.

Application of Section on acquisition of shares before 1st July 2010.

M/S Nathoo Ram Nityanand Timber vs Department of Income Tax (ITAT Lucknow)

Date: 30th August 2016

Background

In the given case the assessee had acquired shares prior to notification of section 56(2) (viia), that is before 1st July 2010 however the said case came into consideration after the notification of said section the Assessing officer, reassessed the income of assessee giving impact of section 56 (2)(viia). Which was challenged by the assessee

Judgement and Conclusion

The ITAT upheld the argument forwarded by the assessee and ruled that in case transaction had been undertaken before the notification that is to say before 1st July 2020 that income would not be readjusted based on provisions of section 56(2)(viia).

Section 56 (2) (viib)

Where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:

Explanation. – For the purposes of this clause,—

(a)  the fair market value of the shares shall be the value—

(i)  as may be determined in accordance with such method as may be prescribed; or

(ii)  as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature,

whichever is higher

Important Ruling on Section 56(2) (viib)

 

Discretion of Assessee to choose method of Valuation

Cinestaan Entertainment P. Ltd vs. ITO (ITAT Delhi)

Date: June 27, 2019 

Background:

The assessee has the option under Rule 11UA (2) to determine the FMV by either the ‘DCF Method’ or the ‘NAV Method’. The AO has no jurisdiction to tinker with the valuation and to substitute his own value or to reject the valuation. He also cannot question the commercial wisdom of the assessee and its investors.

Judgement and Conclusion:

It is a well settled position of law with regard to the valuation, that valuation is not an exact science and can never be done with arithmetic precision.

Also, an important angle to view such cases, is that, here the shares have not been subscribed by any sister concern or closely related person, but by an outside investors like, Anand Mahindra, Rakesh Jhunjhunwala, and Radhakishan Damani who are one of the top investors and businessman of the country and if they have seen certain potential and accepted this valuation, then how AO or Ld. CIT(A) can question their wisdom.

Read our related write ups on the subject –

Companies under IBC-quarantine, get GST-rebirth

-Vinod Kothari 

[vinod@vinodkothari.com]

Resolution is not a re-birth of an entity – it is simply like nursing a sick entity back to health. It is almost akin to putting the company under a quarantine – immune from onslaught of creditor actions, while the debtor and/or the creditors prepare a revival plan. The objective is that the entity revives – in which case, it is out of the isolation, and is back as a healthy entity once again.

This process is not unknown in insolvency laws world-over. However, in India, revival under insolvency framework has taken a completely unique trajectory. First was section 29A, cutting the company from its promoter-lineage for all time to come. The next was section 32A – redeeming the company from the past burden of civil as well as criminal wrongs, thereby giving it a new avatar, with a new management.

Now, the initiation of a CIRP proceeding will be akin to a new birth to the company, at least for GST purposes. Therefore, irrespective of whether the revival process succeeds or not, at least for GST purposes, the entity becomes clean-slate entity. This is the result of the new GST rule announced on 21st March, 2020. However, the new rules do not seem to have envisaged several eventualities, and we opine the intent of giving an immunity from past liabilities might have better been carried out by appropriate administrative instructions, rather than the new registration process.

Read more

Bridging the gap between Ind AS 109 and the regulatory framework for NBFCs

-Abhirup Ghosh

(abhirup@vinodkothari.com)

The Reserve Bank of India, on 13th March, 2020, issued a notification[1] providing guidance on implementation of Indian Accounting Standards by non-banking financial companies. This guidance comes after almost 2 years from the date of commencement of first phase of implementation of Ind AS for NBFCs.

The intention behind this Notification is to ensure consistency in certain areas like – asset classification, provisioning, regulatory capital treatment etc. The idea of the Notification is not to provide detailed guidelines on Ind AS implementation. For areas which the Notification has not dealt with, notified accounting standards, application guidance, educational material and other clarifications issued by the ICAI should be referred to.

The Notification is addressed to all non-banking financial companies and asset reconstruction companies. Since, housing finance companies are now governed by RBI and primarily a class of NBFCs, this Notification should also apply to them. But for the purpose of this write-up we wish to restrict our scope to NBFCs, which includes HFCs, only.

The Notification becomes applicable for preparation of financial statements from the financial year 2019-20 onwards, therefore, it seems the actions to be taken under the Notification will have to be undertaken before 31st March, 2020, so far as possible.

In this article we wish to discuss the outcome the Notification along with our comments on each issue. This article consists of the following segments:

  1. Things to be done by the Board of Directors (BOD)
  2. Expected Credit Losses (ECL) and prudential norms
  3. Dealing with defaults and significant increase in credit risk
  4. Things to be done by the Audit Committee of the Board (ACB)
  5. Computation of regulatory capital
  6. Securitisation accounting and prudential norms
  7. Matters which skipped attention

1.   Things to be done by the BOD

The Notification starts with a sweeping statement that the responsibility of preparing and ensuring fair presentation of the financial statements lies with the BOD of the company. In addition to this sweeping statement, the Notification also demands the BOD to lay down some crucial policies which will be essential for the implementation of Ind AS among NBFCs and they are: a) Policy for determining business model of the company; and b) Policy on Expected Credit Losses.

(A) Board approved policy on business models: The Company should have a Board approved policy, which should articulate and document the business models and portfolios of the Company. This is an extremely policy as the entire classification of financial assets, depends on the business model of the NBFC. Some key areas which, we think, the Policy should entail are:

There are primarily three business models that Ind AS recognises for subsequent measurement of financial assets:

(a) hold financial assets in order to collect contractual cash flows;

(b) hold financial assets in order to collect contractual cash flows and also to sell financial assets; and

(c) hold financial assets for the purpose of selling them.

The assessment of the business model should not be done at instrument-by-instrument level, but can be done at a higher level of aggregation. But at the same time, the aggregation should be not be done at an entity-level because there could be multiple business models in a company.

Further, with respect the first model, the Ind AS states that the business model of the company can still be to hold the financial assets in order to collect contractual cash flows even if some of the assets are sold are expected to be sold in future. For instance, the business model of the company shall remain unaffected due to the following transactions of sale:

(a) Sale of financial assets due to increase in credit risk, irrespective of the frequency or value of such sale;

(b) Sale of cash flows are made close to the maturity and where the proceeds from the sale approximate the collection of the remaining contractual cash flows; and

(c) Sale of financial assets due to other reasons, namely, to avoid credit concentration, if such sales are insignificant in value (individually or in aggregate) or infrequent.

For the third situation, what constitutes to insignificant or infrequent has not been discussed in the Ind AS. However, reference can be drawn from the Report of the Working Group of RBI on implementation of Ind AS by banks[2], which proposes that there could be a rebuttable presumption that where there are more than 5% of sale, by value, within a specified time period, of the total amortised cost of financial assets held in a particular business model, such a business model may be considered inconsistent with the objective to hold financial assets in order to collect contractual cash flow.

However, we are not inclined to take the same as prescriptive. Business model of an entity is still a question hinging on several relevant factors, primarily the profit recognition, internal reporting of profits, pursuit of securitization/direct assignment strategy, etc. Of course, the volume may be a persuasive factor.

The Notification also requires that the companies should also have a policy on sale of assets held under amortised cost method, and such policy should be disclosed in the financial statements.

(B) Board approved policy on ECL methodology: the Notification requires the companies to lay down Board approved sound methodologies for computation of Expected Credit Losses. For this purpose, the RBI has advised the companies to use the Guidance on Credit Risk and Accounting for Expected Credit Losses issued by Basel Committee on Banking Supervision (BCBS)[3] for reference.

The methodologies laid down should commensurate with the size, complexity and risks specific to the NBFC. The parameters and assumptions for risk assessment should be well documented along with sensitivity of various parameters and assumptions on the ECL output.

Therefore, as per our understanding, the policy on ECL should contain the following –

(a) The assumptions and parameters for risk assessment – which should basically talk about the probabilities of defaults in different situations. Here it is important to note that the assumptions could vary for the different products that the reporting entity offers to its customers. For instance, if a company offers LAP and auto loans at the same time, it cannot apply same set of assumptions for both these products.

Further, the policy should also lay down indicators of significant increase in credit risk, impairment etc. This would allow the reporting entity in determining classifying its assets into Stage 1, Stage 2 and Stage 3.

(b) Backtesting of assumptions – the second aspect of this policy should deal with backtesting of the assumptions. The policy should provide for mechanism of backtesting of assumption on historical data so as to examine the accuracy of the assumptions.

(c) Sensitivity analysis – Another important aspect of this policy is sensitivity analysis. The policy should provide for mechanism of sensitivity analysis, which would predict the outcome based on variations in the assumptions. This will help in identifying how dependant the output is on a particular input.

Further, the Notification states that any change in the ECL model must be well documented along with justifications, and should be approved by the Board. Here it is important to note that there could two types of variations – first, variation in inputs, and second, variation in the model. As per our understanding, only the latter should be placed before the BOD for its approval.

Further, any change in the assumptions or parameters or the ECL model for the purpose of profit smothering shall seriously be frowned upon by the RBI, as it has clearly expressed its opinion against such practices.

2.   Expected Credit Losses (ECL) and prudential norms

The RBI has clarified that whatever be the ECL output, the same should be subject to a regulatory floor which in this case would be the provisions required to be created as the IRAC norms. Let us understand the situation better:

The companies will have to compute two types of provisions or loss estimations going forward – first, the ECL as per Ind AS 109 and its internal ECL model and second, provisions as per the RBI regulations, which has to be computed in parallel, and at asset level.

The difference between the two will have to be dealt with in the following manner:

(A) Impairment Reserve: Where the ECL computed as per the ECL methodology is lower than the provisions computed as per the IRAC norms, then the difference between the two should be transferred to a separate “Impairment Reserve”. This transfer will not be a charge against profit, instead, the Notification states that the difference should be appropriated against the profit or loss after taxes.

Interestingly, no withdrawals against this Impairment Reserve is allowed without RBI’s approval. Ideally, any loss on a financial asset should be first adjusted from the provision created for that particular account.

Further, the continuity of this Impairment Reserve shall be reviewed by the RBI going forward.

A large number of NBFCs have already presented their first financial statements as per Ind AS for the year ended 31st March, 2019. There were two types of practices which were followed with respect to provisioning and loss estimations. First, where the NBFCs charged only the ECL output against its profits and disregarded the regulatory provisioning requirements. Second, where the NBFCs computed provisions as per regulatory requirements as well as ECL and charged the higher amount between the two against the profits.

The questions that arise here are:

(a) For the first situation, should the NBFCs appropriate a higher amount in the current year, so as to compensate for the amount not transferred in the previous year?

(b) For the second situation, should the NBFCs reverse the difference amount, if any, already charged against profit during the current year and appropriate the same against profit or loss?

The answer for both the questions is negative. The provisions of the Notification shall have to be implemented for the preparation of financial statements from the financial year 2019-20 onwards, hence, we don’t see the need for adjustments for what has already been done in the previous year’s financial statements.

(B) Disclosure: The difference between the two will have to be disclosed in the annual financial statements of the company, format of which has been provided in the Notification[4]. Going by the format, the loss allowances created on Stage 1, Stage 2 and Stage 3 cases will have to be shown separately, similarly, the provisions computed on those shall also have to be shown separately.

While Stage 1 and Stage 2 cases have been classified as standard assets in the format, Stage 3 cases cover sub-standard, doubtful and loss assets.

Loss estimations on loan commitments, guarantees etc. which are covered under Ind AS but does not require provisioning under the RBI Directions should also be presented.

3.     Dealing with defaults and significant increase in credit risk

Estimation of expected losses in financial assets as per Ind AS depends primarily on credit risk assessment and identifying situations for impairment. Considering the importance of issue, the RBI has voiced its opinion on identification of “defaults” and “significant increase in credit risk”.

(A)Defaults: The next issue which has been dealt with in the Notification is the meaning of defaults. Currently, there seems to be a departure between the Ind AS and the regulatory definition of “defaults”. While the former allows the company to declare an account as default based on its internal credit risk assessments, the latter requires that all cases with delay of more than 90 days should be treated as default. The RBI expects the accounting classification to be guided by the regulatory definition of “defaults”.

 If a company decides not to impair an account even after a 90 days delay, then the same should be approved by the Audit Committee.

This view is also in line with the definition of “default” proposed by the BASEL framework for IRB framework, which is:

“A default is considered to have occurred with regard to a particular obligor when one or more of the following events has taken place.

 (a) It is determined that the obligor is unlikely to pay its debt obligations (principal, interest, or fees) in full;

 (b) A credit loss event associated with any obligation of the obligor, such as a charge-off, specific provision, or distressed restructuring involving the forgiveness or postponement of principal, interest, or fees;

 (c) The obligor is past due more than 90 days on any credit obligation; or

 (d) The obligor has filed for bankruptcy or similar protection from creditors.”

Further, the number of cases of defaults and the total amount outstanding and overdue should be disclosed in the notes to the financial statements. As per the current regulatory framework, NBFCs have to present the details of sub-standard, doubtful and loss assets in its financial statements. Hence, this disclosure requirement is not new, only the sub-classification of NPAs have now been taken off.

(B) Dealing with significant increase in credit risk: Assessment of credit risk plays an important role in ECL computation under Ind AS 109. Just to recapitulate, credit risk assessments can be lead to three possible situations – first, where there is no significant increase in credit risk, second, where there is significant increase in credit risk, but no default, and third, where there is a default. These three outcomes are known as Stage 1, Stage 2 and Stage 3 cases respectively.

 In case an account is under Stage 1, the loss estimation has to be done based on probabilities of default during next 12 months after the reporting date. However, if an account is under Stage 2 or Stage 3, the loss estimation has to be done based on lifetime probabilities of default.

Technically, both Stage 1 and Stage 2 cases would fall under the definition of standard assets for the purpose of RBI Directions, however, from accounting purposes, these two stages would attract different loss estimation techniques. Hence, the RBI has also voiced its opinion on the methodology of credit risk assessment for Stage 2 cases.

The Notification acknowledges the presence of a rebuttable presumption of significant increase in credit risk of an account, should there be a delay of 30 days or more. However, this presumption is rebuttable if the reporting entity has reasonable and supportable information that demonstrates that the credit risk has not increased significantly since initial recognition, despite a delay of more than 30 days. In a reporting entity opts to rebut the presumption and assume there is no increase in credit risk, then the reasons for such should be properly documented and the same should be placed before the Audit Committee.

However, the Notification also states that under no circumstances the Stage 2 classification be deferred beyond 60 days overdue.

4.   Things to be done by the ACB

The Notification lays down responsibilities for the ACB and they are:

(A) Approval of any subsequent modification in the ECL model: In order to be doubly sure about that any subsequent change made to the ECL model is not frivolous, the same has to be placed before the Audit Committee for their approval. If approved, the rationale and basis of such approval should be properly documented by the company.

(B) Reviewing cases of delays and defaults: As may have been noted above, the following matters will have to be routed through the ACB:

(a) Where the reporting entity decides not to impair an account, even if there is delay in payment of more than 90 days.

(b) Where as per the risk assessment of the reporting entity, with respect to an account involving a delay of more than 30 days, it rebuts that there is no significant increase in credit risk.

In both the cases, if the ACB approves the assumptions made by the management, the approval along with the rationale and justification should be properly documented.

5.   Computation of Regulatory Capital

The Notification provides a bunch of clarifications with respect to calculation of “owned funds”, “net owned funds”, and “regulatory capital”, each of which has been discussed here onwards:

(A) Impact of unrealised gains or losses arising on fair valuation of financial instruments: The concept of fair valuation of financial instruments is one of the highlights of IFRS or Ind AS. Ind AS 109 requires fair valuation of all financial instruments. The obvious question that arises is how these gains or losses on fair valuation will be treated for the purpose of capital computation. RBI’s answer to this question is pretty straight and simple – none of these of gains will be considered for the purpose of regulatory capital computation, however, the losses, if any, should be considered. This view seems to be inspired from the principle of conservatism.

 Here it is important to note that the Notification talks about all unrealised gains arising out of fair valuation of financial assets. Unrealised gain could arise in two situations – first, when the assets are measured on fair value through other comprehensive income (FVOCI), and second, when the assets are measured on fair value through profit or loss (FVTPL).

In case of assets which are fair valued through profit or loss, the gains or losses once booked are taken to the statement of profit or loss. Once taken to the statement of profit or loss, these gains or losses lose their individuality. Further, these gains or losses are not shown separately in the Balance Sheet and are blended with accumulated profits or losses of the company. Monitoring the unrealised gains from individual assets would mean maintenance of parallel accounts, which could have several administrative implications.

Further, when these assets are finally sold and gain is realised, only the difference between the fair value and value of disposal is booked in the profit and loss account. It is to be noted here that the gain on sale of assets shown in the profit and loss account in the year of sale is not exactly the actual gain realised from the financial asset because a part of it has been already booked during previous financial years as unrealised gains. If we were to interpret that by “unrealised gains” RBI meant unrealised gains arising due to FVTPL as well, the apparent question that would arise here is – whether the part which was earlier disregarded for the purpose of regulatory capital will now be treated as a part of capital?

Needless to say, extending the scope of “unrealised gains” to mean unrealised gains from FVTPL can create several ambiguities. However, the Notification, as it stands, does not contain answers for these.

In addition to the above, the Notification states the following in this regard:

  • Even unrealised gains arising on transition to Ind AS will have to be disregarded.
  • For the purpose of computation of Tier I capital, for investments in NBFCs and group companies, the entities must reduce the lower of cost of acquisition or their fair value, since, unrealised gains are anyway deducted from owned funds.
  • For any other category of investments, unrealised gains may be reduced from the value of asset for the purpose of risk-weighting.
  • Netting off of gains and losses from one category of assets is allowed, however, netting off is not allowed among different classes of assets.
  • Fair value gains on revaluation of property, plant and equipment arising from fair valuation on the date of transition, shall be treated as a part of Tier II capital, subject to a discount of 55%.
  • Any unrealised gains or losses recognised in equity due to (a) own credit risk and (b) cash flow hedge reserve shall be derecognised while determining owned funds.

(B) Treatment of ECL: The Notification allows only Stage 1 ECL, that is, 12 months ECL, to be included as a part of Tier II capital as general provisions and loss reserves. Lifetime ECL shall not be reckoned as a part of Tier II capital.

6.   Securitisation accounting and prudential norms

All securitisation transactions undergo a strict test of de-recognition under Ind AS 109. The conditions for de-recognition are such that most of the structures, prevalent in India, fail to qualify for de-recognition due to credit enhancements. Consequently, the transaction does not go off the books.

The RBI has clarified that the cases of securitisation that does not go off the books, will be allowed capital relief from regulatory point of view. That is, the assets will be assigned 0% risk weight, provided the credit enhancement provided for the transaction is knocked off the Tier I (50%) and Tier II (remaining 50%).

There are structures where the level of credit enhancement required is as high as 20-25%, the question here is – should the entire credit support be knocked off from the capital? The answer to this lies in the RBI’s Securitisation Guidelines from 2006[5], which states that the knocking off of credit support should be capped at the amount of capital that the bank would have been required to hold for the full value of the assets, had they not been securitised, that is 15%.

For securitisation transactions which qualify for complete de-recognition, we are assuming the existing practice shall be followed.

But apart from the above two, there can also be cases, where partial de-recognition can be achieved – fate of such transactions is unclear. However, as per our understanding, to the extent of retained risk, by way of credit enhancement, there should be a knock off from the capital. For anything retained by the originator, risk weighting should be done.

Matters which skipped attention

There are however, certain areas, which we think RBI has missed considering and they are:

  1. Booking of gain in case of de-recognition of assets: As per the RBI Directions on Securitisation, any gain on sale of assets should be spread over a period of time, on the other hand, the Ind AS requires upfront recognition of gain on sale of assets. The gap between the two should been bridged through this Notification.
  2. Consideration of OCI as a part of Regulatory Capital: As per Basel III framework, other comprehensive income forms part of Common Equity Tier I [read our article here], however, this Notification states all unrealised gains should be disregarded. This, therefore, is an area of conflict between the Basel framework and the RBI’s stand on this issue.

 

Read our articles on the topic:

  1. NBFC classification under IFRS financial statements: http://vinodkothari.com/wp-content/uploads/2018/11/Article-template-VKCPL-3.pdf
  2. Ind AS vs Qualifying Criteria for NBFCs-Accounting requirements resulting in regulatory mismatch?: http://vinodkothari.com/2019/07/ind-as-vs-qualifying-criteria-for-nbfcs/
  3. Should OCI be included as a part of Tier I capital for financial institutions?: http://vinodkothari.com/2019/03/should-oci-be-included-as-a-part-of-tier-i-capital-for-financial-institutions/
  4. Servicing Asset and Servicing Liability: A new by-product of securitization under Ind AS 109: http://vinodkothari.com/2019/01/servicing-asset-and-servicing-liability/
  5. Classification and reclassification of financial instruments under Ind AS: http://vinodkothari.com/2019/01/classification-of-financial-asset-liabilities-under-ind-as/

 

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11818&Mode=0#F2

[2] https://rbidocs.rbi.org.in/rdocs/Content/PDFs/FAS93F78EF58DB84295B9E11E21A91500B8.PDF

[3] https://www.bis.org/bcbs/publ/d350.pdf

[4] https://rbidocs.rbi.org.in/rdocs/content/pdfs/NOTI170APP130320.pdf

[5] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=2723

UPDATE: No GST input if supplier doesn’t upload details of output: GST Council amends CGST rules to curb ineligible credit availing

-Rahul Maharshi

(rahul@vinodkothari.com) (finserv@vinodkothari.com)

The GST council in its 37th Meeting held on 20th September, 2019, had proposed to make amendments in the CGST Rules, 2017 (“Rules”) pertaining to matters relating to the extension of due date of filing of GSTR-3B GSTR-1 as well as voluntary requirement of filing of GST Annual return for registered person whose aggregate turnover is less than Rs. 2 crores.

One of the major amendment proposed was to restrict the claiming of input tax credit by the recipient, in case of mismatch in details uploaded by the supplier, to the extent of 20% over and above the value of uploaded details by the supplier.

The above proposed amendment has been brought into force through notification 49/2019- Central Tax   [1] whereby the input credit availed by a registered person, the details of which have not been uploaded by the suppliers vide GSTR-1, the same should not exceed 20% of the eligible credit that has been uploaded by the suppliers.

As per the insertion in the CGST rules, 2017, viz. sub-rule (4) of rule 36:

“(4) Input tax credit to be availed by a registered person in respect of invoices or debit notes, the details of which have not been uploaded by the suppliers under sub-section (1) of section 37, shall not exceed 20 per cent. of the eligible credit available in respect of invoices or debit notes the details of which have been uploaded by the suppliers under sub-section (1) of section 37.”

For example, as per the books of the recipient, there is an input tax credit of Rs. 5,000 for a particular month from a particular supplier against 5 tax invoices having the GST component of Rs. 1,000 each.  Post the amendment, the following scenarios shall arise:

Case-1: In case the supplier has uploaded all 5 invoices:

In case the supplier has duly uploaded the details of all the 5 invoices through filing the GSTR-1 for the particular month, the auto-populated GSTR-2A will have the details of all such invoices and accordingly the recipient will be eligible to claim the input tax credit of all 5 invoices

Case-2: In case the supplier has uploaded 3 invoices:

In case the supplier has uploaded less than 5 invoices, i.e. 3 invoices having GST component of Rs. 3,000, the recipient will be eligible to claim input tax credit at a maximum of Rs. 3,600 (viz. 3,000+20% of 3,000= 3,600).

Case-3: In case the supplier has not uploaded any invoice:

In case the supplier has not uploaded any invoice in the GSTR-1 of the respective month, the recipient will not be eligible to claim the input tax credit in that particular month. However, the recipient may claim the input as soon as the supplier uploads the details in the GSTR-1 and corresponding details reflect in the auto-populated GSTR-2A.

As a result of the said amendment, the recipient will be required to monitor the duly uploading of the invoices by the supplier in a more stringent manner, since omission of the same will result in reduction in claiming of input tax credit by the recipient.

Also, an important point of concern will be the change in accounting of the input tax credit in the books of the recipient. The excess claim over 20% of the eligible input tax credit will require allocation against the invoices of which the input tax credit would pertain to.

Continuing the above example viz. Case 2, where the supplier has uploaded 3 invoices, how will the recipient allocate the said portion of 20% viz. Rs. 600 if the recipient claims input tax credit at the excess of 20%. The recipient has to allocate the said amount against portion of particular invoices.

The above move may be seen as a way to monitor the claiming of inputs by the recipients as well as a check on the supplier for uploading the returns on a regular basis. However, there are pertinent issues which require further clarification from the department.

 

[1] http://www.cbic.gov.in/resources//htdocs-cbec/gst/notfctn-49-central-tax-english-2019.pdf;jsessionid=15BA096E92769114F368D806E28B8FF5

Lease Accounting under IFRS 16- A leap towards transparency!

Megha Mittal

mittal@vinodkothari.com

Our mission is to develop IFRS Standards that bring transparency, accountability and efficiency to financial markets around the world”, the International Accounting Standards Board (IASB) is indeed on a way towards fulfilling its mission. The International Financial Reporting Standards (IFRS) have been worldwide acknowledged and appreciated as a benchmark of transparency, trust and growth. In another specimen of its attempt to increase transparency in financial markets around the world, the IASB, back in 2016, introduced the IFRS 16, to be applicable w.e.f. annual reporting period beginning on or after 01.01.2019.

Introduced with the objective of introducing a single lessee accounting model, the IFRS-16, aims at ensuring faithful representation of lease transactions and pioneers the concept of “Right-to-Use” Assets.

In this article, we intend to delve deeper into what IFRS-16 brings to the table, its objective and most importantly its impact.

Understanding the Concept

In the present financial set-up of our economy and business environment, “Lease” is an indispensable element. With the advantages it carries and the flexibility it has provided to financing, the concept of lease has penetrated to every strata of being. However, from an accounting perspective, the nexus of “lease” with “assets” makes it essential to understand the procedure of incorporating the lease transactions in the books of both the lessor (legal owner of the asset) and the lessee (user of the asset); and, IFRS-16 is the answer.

While it does not modify the accounting treatment in the books of the lessors from that laid down in IAS 17, IFRS-16 introduces a single lessee accounting model and requires a lessee to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value. A lessee is required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments.

To understand better, let us now take an illustration:

Illustration 1:

A is the legal owner of a car. B, a small businessman, intends to take the car on lease for a period of 3 years. Here, A becomes the Lessor, and B, steps into the shoes of a Lessee. Now that B has the right to use the car, he must identify this car as a right-to-use asset, more colloquially knows as RTU Asset.

Hence, the Lessee records the car along with other non-financial assets like property, plant and building, and the lease liabilities along with other liabilities. It is pertinent to note that the RTU asset must however, be recorded at its present value, arrived at by discounting at its Internal Rate of Return (IRR). As a result, the lessee also recognises depreciation of the RTU Asset and interest on the lease liability in its Statement of Profit and Loss.

Rationale behind IFRS-16:

By what can be called the “5 Rule Check”, IAS 17, distinguishes leases into two broad classesviz. Operational and Financial Leases. While the leased assets wererecorded in the books of the lessor, in case of both operational and financial leases; as per IAS 17, an operational lease in the books of a lessee was treated as an “off-balance sheet” item. Regards the objective with which the new standard was introduced, IASB Chairman, Mr. Hans Hoogervorst, said that “These new accounting requirements bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligation. The new standard will provide much-needed transparency on companies’ lease assets and liabilities, meaning that off balance sheet lease financing is no longer lurking in the shadows. It will also improve comparability between companies that lease and those that borrow to buy.

Hence, it is clearly a step towards IASB’s vision of transparency, accountability and efficiency.

Impact:

Put simply, IFRS 16 eliminates the distinction between operational and financial lease in the books of a lessee. We shall now analyse its impact in the real field and compare the outcome with the expectations.

Overall Impact:

On the surface, the accounting treatment will have a knock-off effect on financial elements; for instance, Earnings before Interest, Tax, Depreciation & Amortization (EBITDA) and Profit After Tax (PAT).

Let us understand this effect with the help of an illustration:

Illustration 2:

A Ltd., an aviation company, has taken on lease, aircrafts worth Rs. 1000 crore, having residual value (RV) 20%, for 36 months, @ 12% p.a., having revenue of Rs. 15,000 crore

On the basis of the above information, we get the following:

  • Lease Rental p.a. : Rs. 342.86 crores
  • Right to Use Asset (RTU) : Rs. 860.22 crores
  • Depreciation on RTU Asset (on SLM Basis) : Rs. 286.74 crores
  • Annual Interest @ 12% p.a. : Rs. 89.59 crores

Now let us compare the impact of the accounting treatment under IAS 17 vs. IFRS 16:

Note: Unlike IFRS-16, under IAS 17, the entire operating lease transaction remains to be an off-balance sheet transaction. Under IFRS 16, the RTU less depreciation is recorded under the assets side vis-à-vis. Lease payables under the liabilities head.

Hence, as evident from the above illustration, sum towards rentals (fixed cost) under IAS 17, have now been substituted with Interest obligation under IFRS 16, and as such the EBIDTA is higher in the initial years. Further, recording the asset at RTU value also gives way for depreciation, and hence, as a result of depreciation along with interest, the PBT reduces in the initial years. From a bird’s eye view, both the assets and liabilities of the lessees adopting IFRS 16 will increase.

Re-negotiation of Loan Covenants:

Further, now that the lease assets are to be recorded, it will typically result in companies appearing to be more debt leveraged; however, since leases are most likely on the operating transaction side vis-à-vis loan transactions, this is not the true picture. This pseudo-presence of huge liabilities is also likely to take a toll on the lessee’s credit rating. Hence, formal communication with the lenders will become a matter of concern, and a sound two-way communication and transparency with the lenders will be the key to managing the transition from IAS 17 to IFRS 16, smooth and efficient.

Industry-wise Impact:

With the first quarter of F.Y. 2019-20 embarking the first quarter of implementation of IFRS 16, the author makes a humble attempt to study the impact, on the basis of financial results declared by several industry-majors.

BPM Industry-

According to a study by Cushman & Wakefield in June 2019, the Indian markets show a strong presence in office space leasing. It has also been observed that the IT-BPM sector, has a higher share in office lease activities, as compared to its contemporaries. Hence, it is evident that the “leasing” is an essential element in the BPM industry.

As the Mumbai-based BPM giant, WNS Global announced its first quarter results; we observe that while the operating profit increased as a result of IFRS 16, the profit for the quarter has decreased. This increase in the operating margins comes to picture as fixed costs reduce with interests of lease payments replace the rentals; the counter result of which is the increase in finance costs due to which the ultimate profit dips.

It is said that the three objectives of any business is Survival, Profit and then Growth. However, as may be seen from above, application of IFRS 16 has led to fall in the profit. It is apprehended that the fall in profit may hold back companies, in the BPM sector from continuing office-space leasing.

Aviation Industry-

Ever imagined that the airplanes we fly in, are most likely not even present on the company’s balance sheet? This non-appearance in the balance sheets was the outcome of accounting standards laid down under IAS 17. However, with IFRS 16 in the picture, the new financial year will be different from previous fiscals, especially for the aviation industry, as they now have to record all lease transactions in their books.

Adopting IAS 116, the Indian counterpart of IFRS 16, the airline industries now have to capitalise operating leases as RTU assets. While recording lease transactions and its by-products like interest, depreciation, the impact will majorly depend on factors like

  • Proportion of operating lease in the overall asset pool;
  • Duration of leases.

With leasing forming an indispensable element of airline companies, even though accounting should not be the key driver in commercial negotiations, market behaviour might change towards shorter lease tenures to minimize lease liabilities.

Owing to the fall in profits in the initial years, it is expected that there might be fall in operating leases, and sale & lease-back arrangements, which will prompt the airlines to purchase more aircrafts. Mr. Wui Jin Woon, Head of Aviation, Asia Pacific, Natixis CIB, also said that “Airline with sufficient access to liquidity may be more incline to purchase now that there is no difference from an accounting perspective between operating and finance leases.

However, adopting IAS 116, the Indian counterpart of IFRS 16, the airline industry major, IndiGo stated that while there might be changes in the future reported profits, which may necessitate a change in current P/E based valuation methodology, it will not impact IndiGo’s cash profits, cash flows and growth strategy.

Hence, while there is broad consensus on how the standard will affect various financial metrics, there is considerably less agreement on how it might influence operating decisions and market sentiments.

Communication Industry:

Most Communications companies enter into lease agreements both as lessors and lessees, as such, leases in the industry are prevalent. The new standard is likely therefore to have a material impact for Communications companies.

Arrangements which may contain leases could include – customer contracts for using identified network or infrastructure equipment, equipment provided to customers through which the operator delivers communication services such as set top boxes and modems, and data centre services etc.

As a consequence of IFRS 16, the potential business impact could include renegotiation of network development and network sharing agreements. Further, companies already having large asset bases, may be prey to the impairment risk with the addition of further assets in the balance sheet.

Automobile Industry

(a) Corporate Car Leasing

Corporate Car Leasing is a very innovative employee benefit scheme that has cropped up off late. Under this scheme, big corporates provide its employees, car taken on operational lease, which the end of tenure is sold to the employee at a nominal value.Hence, while the car is essentially for the benefit of the employees, the company is the actual lessee. As this set up was in the nature of an operating lease, the lessee, as per IAS 17, was not required to record the car in its balance sheet.

However, will the roll in of IFRS 16, the corporates will be required to record these cars at their RTU as assets and a corresponding lease liability in their books; as a result of which, the balance sheet of the corporate shall increase manifold.

(b) Fleet Management

In the Fleet Management market, leasing, especially operating lease has proven to be a smart move to optimise its costs and maintain adequate ratios, as until now, it was not required to be recognized in the balance sheet of the lessee.

Murray Price, managing director of EQSTRA Fleet Management said, “These include the impact on the company’s financial report, key ratios, disclosures, the cost of implementation, the ability to access desired information, the impact of covenants and debt renegotiations and leasing strategies.

This magnification of balance sheet, by virtue of change in accounting policies is anticipated to be detrimental to this industry. It is expected that this will hold back corporates from entering into such arrangements.

Change in the Lessors’ Approach:

Like every action has a reaction, even though IFRS 16 does not essentially alter or modify accounting methodologies adopted by the lessors,  the lessors may be impacted in their business models due to change in lessees’ behaviour. From the foregoing, a common thread that can be observed is that lessees having better liquidity, will now tend to incline towards purchasing the assets rather than leasing, as such, lessors may be required to revaluate the current portfolio of leases and prospective targets to identify lessees that may seek to alter their strategies as a result of IFRS-16.

Global Scenario:

Moving ahead from the industry wise acceptance, we shall now see how the new standard has been welcomed at the global level.While India has come up with IAS 116, drawn on the same lines and principles as IFRS 16, the United stated shall continue to follow ASC 842, dealing with the same subject.

Further, barring variances in implementation due to local regulatory requirements, IFRS 16 has been relatively consistently adopted in most of the Asia-Pacific markets. In Hong Kong, for example, most companies have a December financial year-end and submit financial statements to in around August in the following year. IFRS 16 impacts may become more apparent when listed companies release interim results in July 2019.

In Australia, most year-ends are in June, so some companies will not technically need to grapple with IFRS 16 until the second half of 2019.Similar patterns are evident in Singapore, Malaysia, India and the Philippines, where common accounting periods and reporting practices mean many companies won’t have to address IFRS 16 until later in the year.

The equivalent standards in Thailand and Indonesia are not effective until January 2020. In China, the Ministry of Finance only released the local version of the standard in December 2018, giving non-listed companies up to 2021 to adopt.

Conclusion:

Given the gravitas and indispensable presence of leases and the fact that it resides on such a large scale ground, to judge with certainty, the impact of IFRS 16 certainly requires more time. The dust around the same has not settled yet, hence one can say the picture is not yet vivid; however, it surely sets up the pace for what might unveil in days to come.

 

Link to our other publication on the above subject are provided below:

 

 

 

Employee share based payments: Understanding the taxation aspects

By Rahul Maharshi (rahul@vinodkothari.com), (finserv@vinodkothari.com)

Introduction

Employee share based payments (ESBPs) are an effective way of incentivising employees. ESBPs work as a two way growth strategy for both company as well as the employees. On one hand, it helps the employees to participate in the growth of the entity and in turn reap out the benefits from it, on the other hand it helps the entity to boost the growth rate and align the vision of the employees with that of the company. The ESBPs work as a catalyst for the employee growth as well as the growth of the company.

The theme of this article revolves around the taxation aspects of different types of ESBPs, but before we proceed further, let us have a quick understanding about the different types of ESBPs. Read more

Ind AS vs Qualifying Criteria for NBFCs-Accounting requirements resulting in regulatory mismatch?

-Financial Services Division and IFRS Division,  (finserv@vinodkothari.com  ifrs@vinodkothari.com)

The transition of accounting policies for the non-banking financial companies (NBFCs) is on the verge of being completed. As was laid down in the implementation guide issued by the Ministry of Corporate Affairs, the Indian Accounting Standard (Ind AS) was to be implemented in the following manner:

Non-Banking Financial Companies (NBFCs)
Phase I

 

 From 1st April, 2018 (with comparatives for the periods ending on 31st  March, 2018)
·         NBFCs having net worth of rupees five hundred crore or more (whether listed or unlisted)
·         holding, subsidiary, joint venture and associates companies of above NBFC other than those already covered under corporate roadmap shall also apply from said date
Phase II From 1st April, 2019 (with comparatives for the periods ending on 31st March, 2019)
·         NBFCs whose equity and/or debt securities are listed or in the process of listing on any stock exchange in India or outside India and having net worth less than rupees five hundred crore

 

·         NBFCs that are unlisted companies, having net worth of rupees two-hundred and fifty crore  or more but less than rupees five hundred crore
·         holding, subsidiary, joint venture and associate companies of above other than those already covered under the corporate roadmap
· Unlisted NBFCs having net worth below two-hundred and fifty crore shall not apply Ind AS.

· Voluntary adoption of Ind AS is not allowed (allowed only when required as per roadmap)

· Applicable for both Consolidated and Individual Financial Statements

As may be noted, the NBFCs have been classified into three major categories – a) Large NBFCs (those with net worth of ₹ 500 crores or more), b) Mid-sized NBFCs (those with net worth of ₹ 250 crores – ₹ 500 crores) and c) Small NBFCs (unlisted NBFCs with net worth of less than ₹ 250 crores).

The implementation of Ind AS for Large NBFCs has already been completed, and those for Mid-sized NBFCs is in process; the Small NBFCs are anyways not required implementation.

The NBFCs are facing several implementation challenges, more so because the regulatory framework for NBFCs have not undergone any change, despite the same being closely related to accounting framework. Several compliance requirements under the prudential norms are correlated with the financial statements of the NBFCs, however, several principles in Ind AS are contradictory in nature.

One such issue of contradiction relates to determination of qualifying assets for the purpose of NBFC classification. RBI classifies NBFCs into different classes depending on the nature of the business they carry on like Infrastructure Finance Companies, Factoring Companies, Micro Finance Companies and so on. In addition to the principal business criteria which is applicable to all NBFCs, RBI has also laid down special conditions specific to the business carried on by the different classes of NBFCs. For instance, the additional qualifying criteria for NBFC-IFCs are:

(a) a minimum of 75 per cent of its total assets deployed in “infrastructure loans”;

(b) Net owned funds of Rs.300 crore or above;

(c) minimum credit rating ‘A’ or equivalent of CRISIL, FITCH, CARE, ICRA, Brickwork Rating India Pvt. Ltd. (Brickwork) or equivalent rating by any other credit rating agency accredited by RBI;

(d) CRAR of 15 percent (with a minimum Tier I capital of 10 percent)

Similarly, there are conditions laid down for other classes of NBFCs as well. The theme of this article revolves the impact of the Ind AS implementation of the conditions such as these, especially the ones dealing with sectoral deployment of assets or qualifying assets. But before we examine the specific impact of Ind AS on the compliance, let us first understand the implications of the requirement.

Relevance of sectoral deployment of funds/ qualifying assets for NBFCs

The requirement, such as the one discussed above, that is, of having 75% of the total assets deployed in infrastructure loans by the company happens to be a qualifying criteria. IFCs are registered with the understanding that they will operate predominantly to cater the requirements of the infrastructure sector and therefore, their assets should also be deployed in the infrastructure sector. However, once the thresholds are satisfied, the remaining part of the assets can be deployed elsewhere, as per the discretion of the NBFC.

The above requirement, in its simplest form, means to have intentional and substantial amount of the total assets of the NBFC in question to be deployed in the infrastructure area, both, at the time of registration, as well as a regulatory requirement, which has to be met over time. Breaching the same would result in non-fulfilment of the RBI regulations.

Impact of Ind AS on the qualifying criteria

The above requirement might seem simple, however, with the implementation of Ind AS on NBFC, there can be important issues which might result in the breach of the above requirement.

With the overall slogan of “Substance over Form”, and promoting “Fair Value Accounting” and an aim to make the financial statements more transparent and just, Ind AS have been implemented. However, the same fair value accounting can result in a mismatch of regulatory requirement, to such an extent that the repercussion may have a serious impact on the existence of being an NBFC.

As already stated above, once an NBFC satisfies the qualifying criteria, it can deploy the remaining assets anywhere as per its discretion. Let us assume a case, where the remaining assets are deployed in equity instruments of other companies. All this while, under the Indian GAAP, investments in equity shares were recorded in the books of accounts as per their book value, but with the advent of Ind AS, most of these investments are now required to be recorded on fair values. This logic not only applies in case of equity instruments, but in other classes of financial instruments, other than those eligible for classification as per amortised cost method.

The problem arises when the fair value of the financial instruments, other than the NBFC category specific loans like infrastructure loans, exceed the permitted level of diversification (in case of IFC – 25% of the total assets). Such a situation leads to a question whether this will breach the qualifying criteria for the NBFC. A numeric illustration to understand the situation better has been provided below:

Say, an NBFC-IFC, having a total asset size of Rs. 1,000 crores would be required to have 75% of the total assets deployed in infrastructure loans i.e. Rs. 750 crores. The remaining Rs. 250 crores is free for discretionary deployments. Let us assume that the entire Rs. 250 crores have been deployed in other financial assets.

Now, say, after fair valuation of such other financial assets, the value of such assets increases to ₹ 500 crores, this will lead to the following:

Under Indian GAAP Under Ind AS
Amount

(in ₹ crores)

As per a % of total assets Amount

(in ₹ crores)

As per a % of total assets
Infrastructure Loans 750 75% 750 60%
Other financial assets 250 25% 500 40%
Total assets 1000 100% 1250 100%

 

Therefore, if one goes by the face of the balance sheet of the NBFC, there is a clear breach as per the Ind AS accounting, as the qualifying asset comes down to 60% as against the required level of 75%. However, is it justified to take such a view?

The above interpretation is counter-intuitive.

It may be noted that the stress is on “deployment” of its assets by an IFC. Merely because the value of the equity has appreciated due to fair valuation, it cannot be argued that the IFC has breached its maximum discretionary investment limits. The deployment was only limited to 25% or so to say that even though the fair value of the exposure has gone up but the real exposure of the NBFC is only to the extent of 25%. Under Ind AS, the fair value of an exposure may vary but the real exposure will remain unchanged.

Taking any other interpretation will be counter-intuitive. If the equity in question appreciates in value, and if the fair value is captured as the value of the asset in the balance sheet, the IFC will be required to increase its exposure on infrastructure loans. But the IFC in question may be already fully invested, and may not have any funding capability to extend any further infrastructure loans. Under circumstances, one cannot argue that the IFC must be forced to disinvest its equities to bring down its investment in equities, particularly as the same had nothing to do with “deployment” of funds.

This is further fortified by Para 10. Accounting of Investments, Chapter V- Prudential Regulations of the Master Direction – Non-Banking Financial Company – Systemically Important Non-Deposit taking Company and Deposit taking Company (Reserve Bank) Directions, 2016 about valuation of equities:

“Quoted current investments for each category shall be valued at cost or market value whichever is lower”.

Hence, the RBI Regulations have been framed keeping in view the historical cost accounting. There is no question of taking into consideration any increase in fair value of investments.

Conclusion

Therefore, it is safe to say that while determining the compliance with qualifying criteria, one must consider real exposures and not fair value of exposures as the same is neither in spirit of the regulations nor seems logical. This will however be tested over time as we are sure the regulator will have its own say in this, however, until anything contrary is issued in this regard, the above notion seems logical.

Whether burden shared by captives comes under GST?

Extended clarification required

-Yutika Lohia

yutika@vinodkothari.com

Introduction

Interest subvention income are earnings received from the third party i.e. person other than the borrower. This scheme work as a compensation to the seller who intends to penetrate the market. They arrange low cost finance for their customers (though not low cost because the part of it is compensated by its captive unit).Therefore the seller (lender) offers subsidized rate to the buyer (borrower) and the discounts are borne by the third party who is either a captive unit of the seller or also by Central or State Government who plans to provide financial aid through subvention.

In the case of Daimler Financial Services India Private Limited[1] (DFSI), the advance authority passed a ruling where it was concluded that interest subvention is like “other miscellaneous services” which was received from Mercedes-Benz India Private Limited (MB India) by DFSI and will be chargeable to GST as a supply.

The case of Daimler Financial Services India Private Limited

In the said case, DFSI is registered as an NBFC and is engaged in the business of leasing and financing. DFSI is a captive finance unit of MB India where the customers get a rebate in the interest component when DFSI acts as a financer and the car is purchased from one of the authorized dealers of MB India. MB India is engaged in the manufacture and sale of car which is usually done through its authorized dealer. The difference interest amount for each transaction is paid upfront by MB India to DFSI who raises an invoice against MB India. Payments made by MB India for the interest subvention was done after deducting TDS under section 194A of the IT Act.

The assessee contended that the interest subvention received is an interest and is an exempt supply. Also, the GST law and the Indian Contract Act 1872 recognize that consideration for a transaction can flow from anybody. The loan agreement with the customers also mentioned the applicable interest rate, the interest subsidy received from the MB India and the net interest payable by the customer.

Several reference of rulings were submitted by the assessee through which it contended that

  • The interest subvention is a subsidy which is made to offset a part of the loss incurred by charging a lower rate of interest.
  • Consideration can flow from a person other than the borrower.
  • If a contract stipulates that for the use of creditor’s money a certain profit shall be payable to the creditor, that profit is interest by whatever name called.

The following points were put up by the department:

The department that DFSI had not borrowed money from MB India. Also interest income can be exempt when there is a direct supply. It was also put that the interest income exempt through notification is not valid for a payment made by third party. The whole structure was set up to promote the business of DFSI.

The department gave reference to section 15 of the CGST Act, where value of supply includes subsidies directly linked to price and the amount of subsidy will be included in the value of supply. Therefore “interest subvention” is an interest subsidy and hence chargeable to GST. Also it was noted that income booked by DFSI is shown under revenue from operations as subsidy income.

The ruling concluded that interest received by DFSI from MB India was to reduce the effective interest rate to the final customer is chargeable to GST as supply under SAC 999792 as other miscellaneous services, agreeing to do an act.

The law behind interest subvention

As per the exempted list of services[2], consideration represented by way of interest or discount on services by way of extending loans or advance is an exempt supply. As it is evident, that services exclude any transaction in money but includes activities relating to use of money i.e. processing fees falls within the meaning of activities relating to use of money and therefore charged to GST.

When there is an interest subsidy, there are two arrays of interest involved- “applicable fixed interest rate gross” and “Net applicable fixed interest rate”. The borrower is under no obligation to pay the lender interest on principal i.e. the applicable fixed interest rate gross. The lender pays at the net applicable fixed interest rate. The difference between the two arrays of interest is the interest subvention borne by the third party. Technically the consideration paid by the borrower is the subsidized rate of interest. The borrower indirectly pays the differential amount of interest through the third party. Therefore referring section 7 of the CGST Act, consideration paid by the borrower is in the course of business whereas consideration paid by the third party is for furtherance of business. The two considerations received are totally different as one is “interest” and the other is “interest subsidy”.

Further, referring to section 15 (2) (e) of the CGST Act, value of supply of includes subsidies directly linked to the price excluding subsidies provided by the Central and State Governments. The interest subvention received are directly linked to price i.e. the interest paid by the borrower to lender and should be considered as value of supply.

Also the definition of “interest” is defined by the council as – “interest” means 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;

The interest paid on money borrowed is under the exempted category of services. Interest subvention disbursed by the captive unit of the lender is not paid on any money borrowed. It is a form of consideration paid so as to promote the business indirectly. They are like any other charges and therefore should not be considered as interest on money borrowed.

Since interest subvention is not interest on money, the same is not an exempt supply and therefore under the purview of GST.

Conclusion

The Advance Ruling Authority (AAR) interpreted the law and considered interest subvention to be taxable under GST. Further clarification is still required on its taxability as  one may note that as per section 103 of the CGST Act, the rulings pronounced by the  Authority is only binding on the applicant.

Therefore, whether interest subvention is taxable under GST or not requires further attention from the department.

 

[1] http://www.gstcouncil.gov.in/sites/default/files/ruling-new/TN-16-AAR-2019-Daimler%20FSIPL.pdf

[2] http://www.cbic.gov.in/resources//htdocs-cbec/gst/Notification9-IGST.pdf;jsessionid=B71F3824BBE3E6EF8C805B56978C9C9F