Lease Accounting under IFRS 16- A leap towards transparency!

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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:

FAQs on Ind AS 116: The New Lease Accounting Standard

Comparative Analysis of changes in Standards on Leasing over time

Lease accounting: Operating & Financial Lease distinction set to go from financial year 2019-20

IMPLEMENTATION OF IFRS-16 IN VARIOUS COUNTRIES

New lease accounting standard kicks off from 1st April, 2019

Accounting for Leasing Transactions: IndAS 116 and IFRS 9

 

 

 

Employee share based payments: Understanding the taxation aspects

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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?

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-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?

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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

Applicability of GST on penal charges

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By Yutika Lohia (yutika@vinodkothari.com), (finserv@vinodkothari.com)

Introduction

The Goods & Services Tax (GST) has been the biggest tax reform in India founded on the notion of ‘one nation, one market, one tax’. It has and will further affect the entire economy including core industries such as agriculture, manufacturing, finance, service, infrastructure etc. The tax reform has been touted to create a significant positive impact on the economy in the long run. Unfortunately however, GST has not been exception to the fact that any big transition faces short term pains. The GST council has been receiving numerous queries and doubts from the myriad industries and trading associations regarding its applicability and nuances on the supply of various goods and services. One such concern had been on the issue of its applicability on additional/penal interest.

Recently the Council came up with a circular on “Clarification regarding applicability of GST on additional / penal interest” on 28th June, 2019[1] to address the issue.

The word “penal”

Black’s law dictionary defines penalty as ‘punishment imposed by statute as a consequence of the commission of a certain specified offense.” Subsequently as such the word “penal” is something relating to or containing a penalty. To put it in perspective, any default in payment of a loan transaction or in the supply of goods or services is liable for a penalty, which may be fixed or variable and thus may be in the name of additional interest or penalty interest, or overdue interest.

In a financial transaction, when there is a delay in the payment of EMI by the customer/borrower, the lender collects penal /default interest as additional interest for the period of delay, determined in days, months or years as per the agreed terms between the two.

Chargeability of GST

Penal charge is levied when there is delayed payment in a money-to-money transaction or when there is a supply of goods or services.

First let us understand whether the penal interest will be included in the value of supply.

As per section 15(2)(d) of the CGST Act, value of supply includes “interest or late fee or penalty for delayed payment of any consideration for any supply.”

Therefore, any interest or penalty paid for delayed payment in the supply of goods or service or a loan transaction shall be included in the value of supply i.e. the consideration amount.

Further, penal charges will not be covered under Schedule II- Activities to be treated as a supply of goods or services in clause 5(e), where supply of services include “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act”

The expression “to tolerate an act” used in the above clause, should be understood to cover instances where the consideration is being charged by one person in order to allow another person to undertake any particular activity. Therefore it is very clear that at the very inception of the transaction, the intention of one party is to undertake an activity and the other party shall allow the same without any deterrent. To say, the contract is entered to allow the other person to carry out an activity, and not as a penalty or limit the person for carrying out such act in future.

Furthermore, the word “obligation” used in the clause 5(e) of Schedule II where the service recipient requests the service provider to tolerate an act/situation and the service provider obliges to tolerate for a consideration, then such a contractual relationship shall be covered in the above mentioned clause. Therefore it can be said that there is a consensus ad idem between the contracting parties.

Contrary to the above, penal interest/charges are collected only when an event occurs i.e. when there is a default in a payment of a loan transaction or supply of goods/services. The intention of the parties entering into a contract is either to avail the services in way of loan or supply of goods. Penal charges are to be paid if there is a breach in the contract and therefore it does not mean that the parties have entered into a contract for the penal interest.

Therefore penal charges does not fall under the deemed supply list given in Schedule II of the CGST Act.

As penal interest satisfies the definition of “interest” given in the notification, penal interest charged by parties who enter into a contract of giving loans will be covered under serial no. 27 of the notification dated 28th June, 2017.

Ergo, penal charges levied by the lender in a money to money transaction will have no GST implications.

Services by way of extending deposits, loans or advances in so far as the consideration is represented by way of interest or discount is an exempt service and penal charges levied by the vendor on delayed payment in case of supply of goods and services shall be under the purview of GST.

Various clarifications by the GST Council on additional/ penal interest taxability

The GST department’s explanations regarding the applicability of GST of additional / penal interest are listed below:

1.      FAQs on financial sector

The Central Board of Indirect Taxes and Customs (CBIC) came up with a frequently asked questions document (FAQs documents) on financial sector[2] where taxability of additional interest in GST was discussed in serial no 45 of the document.

Any additional interest charged on default in payment of instalment in respect of any supply which is subject to GST, will be included in the value of supply and therefore will be liable to GST.

2.      Notification No. 12/2017-Central Tax (Rate) dated 28th June 2017[3]

The department exempts services by way of extending deposits, loans or advances in so far that the consideration is represented by way of interest or discount (other than interest involved in credit card services).

Also the notification defines the word “interest” which 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.”

Further there was a ruling passed by the Advance Ruling Authority on the applicability of GST on penal interest when there is a delayed in repayment of loan.

3.      The case of Bajaj Finance Limited

In case of Bajaj Finance Limited [4](BFL), an advance ruling was passed on 6th August 2018, where it was concluded that penal charges collected by the BFL shall attract GST.

Here it was said that in case of default of payment of EMI by the customer, the applicant tolerated such an act of default or a situation and the defaulting party i.e. the customer was required to compensate the applicant by way of payment of extra amounts in addition to principal and interest. Also, the additional interest is not in the nature of interest but penal charges.

Therefore, the charges levied for any default in repayment of loan will be covered under clause 5(e) of Schedule II of the CGST Act. Also, the same is not an exempt service and will be liable to tax under GST.

4.      Circular no 102/21/2019-GST dated 28th June 2019

Given the numerous queries, the department finally released clarification on the matter. Penal interest charged on delayed payment for supply of goods and services will be included in the value of supply and will stand liable for GST. Whereas penal interest charged on the delayed payment of loan repayment will be exempt under GST.

The clarification given under the notification is discussed at length below.

The various clarifications by the GST Council on additional/ penal interest taxability is represented below in a tabular form:

 

 

FAQs on financial sector

 

  

Notification No. 12/2017-Central Tax (Rate) dated 28th June 2017

  

Case of Bajaj Finance Limited

  

Circular no 102/21/2019-GST dated 28th June 2019

 
Additional interest in case of default payment of instalment in respect of supply, which is subject to GST will be included in the value of supply and therefore liable to GST Consideration by way of interest or discount on deposits loans and advances are considered as exempt service. Charges levied for any default in repayment of loan will be liable to tax under GST.

 Penal interest charged on delayed payment for supply of goods and services will be included in the value of supply and will stand liable for GST. Whereas penal interest charged on the delayed payment of loan repayment will be exempt under GST

 

Implication of GST on penal charges

Accordingly, there are different GST implications, which are discussed by way of examples. Financing to a borrower may be done in the following ways:

  • 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 instalments) i.e. ₹ 26,250 (Repayment of principal ₹ 25000 + Interest @5% i.e. ₹ 1250). The instalment 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.

Here 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 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 notification[5], the same is not exempt and taxable under GST.

  • 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 money to money transaction. The penal interest charged will be covered under serial no 27 of notification no 12/2017 Central Tax (Rate) dated the 28.06.2017 “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.

Therefore, the vendor has the following option to sell the car to the customer:

  • Provide a deferred payment facility by the vendor himself on account of purchase of the car, or
  • Provide a loan facility to purchase the asset through the vendor’s captive lending unit, or
  • Provide a loan facility to purchase the asset through any bank/NBFC

In all the three cases mentioned above, GST taxability will be different. In case the deferred payment facility is provided by the vendor and there is a delay in payment of EMI by the borrower, GST shall be charged on the additional interest due to such delay in payment. However, in case a loan facility has been provided by the vendor’s captive lending unit or by an independent bank or an NBFC, the additional interest charged on the delayed repayment will not be taxable under GST.

Conclusion

The circular by the government came up as a clarification in regard to GST implications on penal charges. This clarification brings ease to various NBFCs who were levying penal charges as per the agreement on the delayed payment of loan instalment. Also, the circular overrides the advance ruling in the case of Bajaj Finance Limited.

To summarise the above discussed concept:

  • Penal charges in case of delayed payment of instalment of supply of goods and services shall be included in the value of supply as per section 15(2) (d) of the CGST Act. The same shall be liable to tax under GST
  • Penal charges in case of delayed payment of instalment of a money to money transaction will be included in the value of supply as per section 15(2) (d) of the CGST Act. The same shall be exempt through serial no 27 of the notification No. 12/2017-Central Tax (Rate) dated 28th June 2017. Therefore penal charges in this case shall not be taxable under GST.

 

[1] http://www.cbic.gov.in/resources//htdocs-cbec/gst/circular-cgst-102.pdf;jsessionid=4085899A448EFF7FCF1762E53BC68D3F

[2][2] http://gstcouncil.gov.in/sites/default/files/faq/27122018-UPDATED_FAQs-ON-BANKING-INSURANCE-STOCK-BROKERS.pdf

[3] http://www.cbic.gov.in/resources//htdocs-cbec/gst/Notification12-CGST.pdf;jsessionid=3D2C63EDD8A1183AEB262F41985CB224

[4] https://mahagst.gov.in/sites/default/files/ddq/GST%20ARA%20ORDER-22.%20BAJAJ%20FINANCE%20LTD.pdf

[5] [5] http://www.cbic.gov.in/resources//htdocs-cbec/gst/Notification12-CGST.pdf;jsessionid=3D2C63EDD8A1183AEB262F41985CB224

Car Leasing In India: ‘Breaking the Stereotypical Definition Of Luxury’

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Julie Mehta (julie@vinodkothari.com)

Introduction

Who thought hiring was even an option to enjoy the luxury of having to use a car. But with the world undergoing a paradigm shift, it untapped its energies into providing and establishing better services for its customers, leasing has paved its way into existence. Most of the industries have adopted this concept and structured their services accordingly in order to provide the best they can to their customers, but that requires huge understanding of their needs. A commoner would always be awed by the immensely developing technology and the environment around them but limited resources makes them take a step back from the thought of availing such services. The market had its solution as hiring and renting came into picture. This has ensured dreams do come true.

Car has always been a luxury at least in most parts of India because of the fact that India still in its developing stage and there still remains a big gap between the rich and the poor and the middle income families fall nowhere. Indians have been developed with the mind state that not everyone can afford everything and thus one should limit their demands keeping in mind their pocket potential. The concept of hiring and renting is not only limited to houses and properties but with the advent of MNC’s and startup companies, they have widened the scope of bringing in the concept of hiring even furniture, vehicles, electronic equipment’s, etc.

Earlier, the concept of car leasing was only limited to corporate senior executives that was earlier known as ‘corporate leasing’ and was common for the luxury car brands. But slowly it has trickled down and become accessible to commoners and middle income families. Companies like Mahindra & Mahindra made some of its models available for leasing. Following this concept, several other car brands like Hyundai, TATA group and luxury brands like BMW, Mercedes etc. have also opened their doors to providing the lease facilities.

Car leasing and rental is one of the most lucrative and fast growing segment of the automobile sector in India even though it currently represents only 4-5% of the market in terms of absolute number of vehicles, but its future prospects are strong enough.

Factors like increasing popularity of app-cab providers like Ola, Uber, Zoom car cab booking facilities, rapid urbanization, relocation of rural population into cities, adds on to the potential of car leasing in India.

[1]The growth of the market in India is to ensure manifold growth in its CAGR by 15-20% in the coming ten years and further on making hiring of cars simpler eventually with current worth of Rs. 1500 crores. Most car making companies are making 40% of its business from leasing cars. This has largely helped change the mentality of customers and imbibed the fact that ‘why buy when you can lease it’.

 

Yellow number plates or white number plates?

People remain apprehensive about the color of the number plate they use in the car. While a yellow number plates denotes commercial use, white number represents personal use. People taking cars on lease will of course want white number plates on their cars.

The current legal framework for registration of motor vehicles allow cars taken on lease for personal use to bear white number plates.

In case of a car taken on lease, the lessee is the person having possession of the vehicle and hence, the ‘owner’ as per the Motor Vehicles Act, 1988. Further, since it is the lessee who is actually using the car and the same has not been given on hire or used for any other commercial purpose, the car shall have a white number plate.

 

Global Status of Car Leasing

Globally, car leasing and hiring has been prevalent and growing for many years now. The analysts have forecasted that in the coming years, the global leasing market is to grow at a CAGR of 13-15%. This is gaining momentum due to the development of new mobility concepts by car leasing companies. For example, telematics was introduced in leased vehicles to monitor their usage on the job, another technological development was the installation of navigation in the leased vehicles making it more convenient for the lessor. People want change and with such facilities where there is an added benefit of not burning the pockets of customers, the lease scheme always works to hire cars on lease and cancel the contract anytime to shift on to better and advanced models of cars.[2]

The new trends dominating the global markets are the introduction of electric vehicle leasing and environment friendly cars that lead to sustainable development in the car manufacturing industries as well in the overall environmental situation. Such facilities encourage people to be more socially responsible and to do their bit towards the betterment of the society and also getting the leasing benefit out of it. Governments across the world are offering subsidies and tax benefits to encourage and boost the penetration of electric vehicles in their fleet. They have also introduced the concept of leasing old cars which helps reduce wastage as well as optimum usage. It is offered at a highly considerate premium and is attractive for low income customers. The global leasing market is fast moving with efficient strategies that ensures further growth too.

 

[3]Why has Leasing gained popularity in recent times?

GST introduction has come out to be a source of relief in time of distress for the Indian markets and consumers due to the stiff tax system of the country resulting in poor market functioning. With the introduction of ‘Goods and Services Tax’ on July 1, 2017, times have changed for the consumers, dealers as well as manufactures and has helped bring stability and balance in the economy by considering every person and their transaction at par, with the motive to bridge the gap between rich and poor in the long run. Evaluating their benefits below taking into consideration automobile industry:

  • To the consumers: The new tax regime has resulted in significant reduction in the tax rates imposed on the end consumers in comparison to the previous tax system.
  • To the dealers: The benefit of claiming the tax paid earlier benefits the dealers with the introduction of GST provides an added advantage to the dealers.
  • To the manufacturers: In recent times, car manufacturing companies have marked a fall in their sales which has led to dwindling profits. With the increasing exposure to car leasing, manufacturers have found their resort to stabilise their performance. This option induces customers to opt for leasing, thereby ensuring good business to the car manufacturers.
 CAR TYPE GST RATES COMPENSATION CESS TOTAL
Small Cars 28% 1% or 3% (depending on capacity) 29% or 31%
Mid-segment Cars 28% 15% 43%
Large Cars 28% 17% 45%
Sports Utility Vehicles (SUV’s) 28% 22% 50%
Electric Cars 12% N.A. 12%

Numerical Comparison

To understand the calculation of Loan EMIs and Lease rentals, we structure an example with the concept of residual model to distinguish the calculations of both the alternatives.

Any loan transaction requires an initial down payment to the seller after which installments follow on monthly/quarterly/annually basis. The down payment creates an extra outflow on part of the buyer on loan along with additional installments. While no down payment is required in case of a lease that makes its overall outflow on the lower side in comparison to a loan.

Plus, in case of a lease transaction, the lessor takes an exposure on the residual value of the asset, this brings down the lease rentals per month.

In the example below, with the assumption of different rates of residual value, we understand that with the every increase in the percentage of residual value, the lease rentals of the operating lease borne by lessee comes down. This implies lower the term of the lease contract, lesser value of the asset is used, and thus lesser are thee lease rentals.

Details of the Vehicle  
Unit Cost 1000000.00
GST rate 28%
Compensation Cess 17%
Rate of GST 45%
GST 450000.00
Total 1450000.90
When Residual Value is considered to be 20%
Operating lease arrangement    
Basic price 1000000.00  
Add GST on purchase (ITC eligible) 450000.00  
Funding Amount 1450000.00  
Processing fees 3.80% 55100.00
Expected Residual Value 20% 200000.00
Tenure 48  
IRR 18%  
Lease Rentals (RV not factored) ₹ 42,593.75  
Lease Rentals (before passing GST benefit) ₹ 39,718.75  
Input tax credit percentage 100%  
Less: GST benefit ₹ 9,375.00  
Lease Rentals (after passing GST benefit) ₹ 30,343.75  
Add: GST on rentals ₹ 13,654.69  
Total inflow ₹ 43,998.44  
 
Loan arrangement    
Loan amount 1450000.90  
Processing fees 3.80% 55100.0342
Expected Residual Value 0% 0
Tenure 48  
IRR 18%  
EMI ₹ 42,593.78  

 

When Residual Value is considered to be 25%
Loan arrangement    
Loan amount 1450000.90  
Processing fees 3.80% 55100.0342
Expected Residual Value 0% 0
Tenure 48  
IRR 18%  
EMI ₹ 42,593.78  

 

Operating lease arrangement    
Basic price 1000000.00  
Add GST on purchase (ITC eligible) 450000.00  
Funding Amount 1450000.00  
Processing fees 3.80% 55100.00
Expected Residual Value 25% 250000.00
Tenure 48  
IRR 18%  
Lease Rentals (RV not factored) ₹ 42,593.75  
Lease Rentals (before passing GST benefit) ₹ 39,000.00  
Input tax credit percentage 100%  
Less: GST benefit ₹ 9,375.00  
Lease Rentals (after passing GST benefit) ₹ 29,625.00  
Add: GST on rentals ₹ 13,331.25  
Total inflow ₹ 42,956.25  
When the Residual Value is considered to be 30%
Loan arrangement    
Loan amount 1450000.90  
Processing fees 3.80% 55100.0342
Expected Residual Value 0% 0
Tenure 48  
IRR 18%  
EMI ₹ 42,593.78  

 

Operating lease arrangement    
Basic price 1000000.00  
Add GST on purchase (ITC eligible) 450000.00  
Funding Amount 1450000.00  
Processing fees 3.80% 55100.00
Expected Residual Value 30% 300000.00
Tenure 48  
IRR 18%  
Lease Rentals (RV not factored) ₹ 42,593.75  
Lease Rentals (before passing GST benefit) ₹ 38,281.25  
Input tax credit percentage 100%  
Less: GST benefit ₹ 9,375.00  
Lease Rentals (after passing GST benefit) ₹ 28,906.25  
Add: GST on rentals ₹ 13,007.81  
Total inflow ₹ 41,914.06  

 

Conclusion

The major differentiating factors between a lease and a loan is that the former gives the right to use the asset without any upfront down payment, however, in case of the latter, there is an upfront down payment. Leasing works better when the lessor takes exposure on a handsome amount of residual value. Otherwise, it will turn out to be costlier than loan.

In the coming years, the car leasing market in India will be prospering as most car brands have now started to expand their services to even leasing now, which wasn’t prevalent until the last 4-5 years. With this competitive spirit, many more well developed brands would undertake this strategy to enhance customer base. The statistics of no: of cars being sold is going through a falling spree currently and is expected to fall further. But the leasing market will be flourishing on the other hand. It provides the ‘Best of Both Worlds’ to the customers as well as benefits the owner who still retain the ownership of the cars and gain benefit out of it.

 

[1] http://www.businessworld.in/article/-India-s-Car-Leasing-Market-Is-Worth-Rs-1-5K-Cr-Poised-For-15-20-CAGR-/27-05-2017-119041/

[2] www.statista.com

[3]http://www.cbic.gov.in/resources//htdocs-cbec/gst/notification05-compensation-cess-rate.pdf;jsessionid=B47A84DD8CE463AF356CD17117E2316B

[4]https://www.statista.com/outlook/270/119/car-rentals/india#market-arpu

 

 

Union Budget 2019-20: Impact on Corporate and Financial sector

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ICSI Auditing standards -A guidance to the Members in Practice

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By Kanakprabha Jethani | Executive

Kanak@vinodkothari.com

Background

ICSI has recently issued four Auditing Standards[1] (‘Standards’) for the members in practice namely:

  • CSAS-1 – Auditing Standard on Audit Engagement
  • CSAS-2 – Auditing Standard on Audit Process and Documentation
  • CSAS-3 – Auditing Standard on Forming of Opinion
  • CSAS-4 – Auditing Standard on Secretarial Audit

in order to enable them to carry out the audit engagements more effectively. The first three Standards will be applicable to all kind of audit engagements and the fourth one will specifically be applicable for the Secretarial Audit under Section 204 of the Companies Act, 2013. In terms of ICSI’s own language, the Standards shall be mandatorily effective from the audit engagements accepted on or after 1st April, 2020.

Objective of the Standards

Seemingly, ICSI is seeking to promote best auditing practices, uniformity and consistency in conduct of the audits by the members in practice. These are expected to strengthen the audit process and corporate governance practices. Since, varied audit practices are being carried over by different auditors, monitoring of audit process becomes cumbersome and troublesome at the same time. These Standards are expected to harmonise the audit practices among the auditors all over the country. The objective is to streamline and enable members to effectively undertake secretarial audit and ensure compliance. It is also expected that these Standards will enhance the quality of compliance.

Applicability of Standards

These Standards shall be effective and recommendatory to be accepted by the auditors on or after 1st July 2019. However, the same shall be mandatorily applicable to the audit assignments obtained on or after 1st April 2020.

Whether these Standards are statutorily required?

In order to be statutorily applicable and binding, legal backing to the provision is required. For example, for the Secretarial Standard-1 and secretarial Standard-2 have a backing of legal provision i.e. Section 118 of the Companies Act 2013. Section 118(10) provides that every company shall observe secretarial standards with respect to general and Board meetings specified by the Institute of Company Secretaries of India. In compliance of aforesaid section, companies follow these two secretarial standards. The same is not the case for other secretarial standards issued by ICSI such as, Secretarial Standard -3 relating to Dividend or Secretarial Standard-4 relating to maintenance of registers and records and hence purely voluntary.

Likewise, the Auditing standards issued by ICSI also do not carry a legal backing as of now though the same is being brought in by ICSI with an intent to make it mandatory.

What are the various audits a PCS can undertake?

A Practising Company Secretary is authorised to undertake various audits as prescribed under the Companies Act 2013, SEBI regulations and other applicable laws, some of which are as under:

  • Secretarial Audit as per provisions of Section 204 of the Companies Act 2013;
  • Half-yearly certificate certifying that all share certificates were issued by Share transfer Agent/ Registrar and transfer Agent within 30 days of lodgement of transfer as provided under regulation 40(9) of SEBI(Listing Obligations and Disclosure Requirements) Regulations;
  • Annual Secretarial Compliance Report as per SEBI Listing Regulations;
  • Half-yearly certification of maintenance of 100% asset cover for non-convertible debt securities as per regulation 56(d) of SEBI(Listing Obligations and Disclosure Requirements) Regulations;
  • Certificate regarding compliance of conditions of corporate governance as per SEBI Listing Regulations;
  • Share Reconciliation Certificate as per SEBI (Depositories and Participants) Regulations, 2018 etc.

These Standards shall be applicable to all these audits along with any other audit required to be done by PCS. Thus, for the purposes of these Standards, ‘Auditor’ shall mean a Practising Company Secretary undertaking any of such audits.

The list of TO DO’s for auditors

CSAS-1 – AUDITING STANDARD ON AUDIT ENGAGEMENT

This deals with roles and responsibilities of Auditor undertaking audit engagement. They also elaborates procedures and principles for entering into agreement with appointing authority.

Eligibility to take audit engagement

  • Auditor shall not hold, singly or along with partners, spouse, parent, sibling, and child of such person or of the spouse, any of whom is either dependent financially on such person, more than 2% in the paid up share capital or shares of nominal value of Rs. 50,000, whichever is lower or more than 2% voting power in the Auditee, as the case may be.
  • Auditor shall not be indebted to the Auditee for an amount of five lakh rupees or more except if such indebtedness is arising out of ordinary course of business.
  • If an Auditor was in employment of the Auditee, its holding or subsidiary company and 2 (two) years must have lapsed from the date of cessation of employment.

Things to do pursuant to CSAS-1:

  • Ensure that appointment is made as per provisions of Companies Act 2013 and rules made thereunder.
  • Submit eligibility certificate to appointing authority.
  • Obtain audit engagement letter and copy of resolution passed by appointing authority and provide acceptance thereto.
  • Ensure audit engagement letter includes:
  1. The objective and scope of the audit; if the same has been established by law, reference to relevant provisions must be stated.
  2. The responsibilities of the Auditor and the Auditee;
  3. Written representations provided and/or to be provided by the Management to the Auditor, including particulars of the Predecessor or Previous Auditor;
  4. The period within which the audit report shall be submitted by the Auditor, along with milestones, if any;
  5. The commercial terms regarding audit fees and reimbursement of out of pocket expenses in connection with the audit;
  6. Limitations of audit, if any.
  • Intimate previous auditor about such engagement, in writing.
  • Ensure that such engagement is within the limits prescribed by ICSI from time to time.
  • Maintain confidentiality of information obtained during the course of audit unless there is a legal obligation to disclose such information. Also, ensure that employees, staff and other team members also be bound by duty of confidentiality.
  • Do not agree to change in terms of engagement unless there is reasonable justification for doing so.
  • If terms of appointment are changed resulting in lower level of assurance, it shall be accepted only after considering the appropriateness of the same.
  • Any changes in terms of engagement must be agreed by way of supplementary or revised engagement letter.

 

CSAS-2 AUDITING STANDARD ON AUDIT PROCESS AND DOCUMENTATION

This Standard deals with the roles and responsibilities of Auditor with respect to maintenance of proper audit records that provides-

  • sufficient and appropriate record to form the basis for the Auditor’s Report; and
  • evidence that the audit was planned and performed in accordance with the applicable Auditing Standards and statutory requirements.

Things to do pursuant to CSAS-2

  • Formulate an audit plan as per terms of audit engagement.
  • Ensure adherence to audit plan.
  • Conduct risk assessment of auditee considering business, environmental and organisational structure and compliance requirements.
  • Evaluate high-risk areas relating to internal control systems, transparency, prudence, probity, changes in compliance team etc.
  • Obtain sufficient information of the auditee for conduct of audit.
  • Make use of systematic and comprehensive checklists.
  • Obtain necessary evidence and evaluate the same so as to support the opinion. This shall be adequately documented in audit working papers.
  • Obtain third-party confirmations wherever required.
  • Document discussions with management of the auditee in significant matters.
  • Collate the documentation for records within 45 days of date of signing of auditor’s report.
  • Maintain documentation in physical or electronic form for a period of 8 years from date of signing of auditor’s report.

Features of audit plan

  • The audit shall be planned in a manner which ensures that qualitative audit is carried out in an efficient, effective and timely manner.
  • Audit planning shall ensure that appropriate attention is accorded to crucial areas of audit and significant issues are identified in a timely manner.
  • Audit plan should be based on professional scepticism, so that it is possible to exercise professional judgment in an objective manner.

CSAS-3 – Auditing Standard on Forming of Opinion

This Standard provides details about the manner of evaluation of conclusions derived out of audit evidence which leads to formation of Auditor’s opinion.

Things to do pursuant to CSAS-3

  • Consider materiality while forming opinion.
  • Consider all relevant audit evidence before issuing audit report.
  • Apply professional judgement and scepticism to ensure evidence is factually correct.
  • Prepare audit report within the agreed time-frame.
  • Verify accuracy of facts and responses from concerned persons.
  • Adhere to generally accepted principles and practices in relation to audit process.
  • Indicate if any third-party report or opinion is being relied on.
  • Indicate if third-party report is provided by the auditee and also consider important findings of third party.
  • Carry out a supplemental test to check veracity of third-party report.
  • Express unmodified opinion if satisfied that applicable laws have been duly complied with and relevant records are free from misstatement.
  • Express modified opinion in bold or italic letters. Modified opinion is to be issued if:
    • non-compliance of applicable laws is found,
    • relevant records aren’t free from misstatement,
    • sufficient and appropriate audit evidence to ensure the above is not available.

 

 

  • Ask auditee to remove any such limitation on scope of audit which is likely to make the Auditor give modified opinion or disclaimer.
  • Give unmodified opinion, if in case of absence of sufficient and appropriate evidence, Auditor can conclude that effects of unavailability of such evidence will be non-material. However, if the effects are likely to be material, the auditor shall express disclaimer of opinion.

Format of audit report

  • The report shall be addressed to appointing authority unless the terms of engagement provide otherwise.
  • Report must be detailed. Specific formats, if any, must be followed.
  • Provide annexures for detailing of certain aspects, wherever necessary.
  • Include a section named Auditor’s responsibility in the audit report.
  • This section shall state that the audit was conducted in accordance with applicable Standards.
  • The report shall state that due to the inherent limitations of an audit, there is an unavoidable risk that some material misstatements or material non-compliances may not be detected, even though the audit is properly planned and performed.
  • Signature block shall mention name of auditor/firm, certificate of practice number/registration number and membership number of the auditor.
  • Mention clearly the date and place of signing audit report.

CSAS-4 – Auditing Standard on Secretarial Audit

This Standard lays down the manner of evaluation of statutory compliances and corporate conduct in the process of doing secretarial audit u/s 204 of the Companies Act, 2013. It gives a broad structure to the audit process.

Things to do pursuant to CSAS-4

  • Take note of laws applicable to the auditee. This includes specific laws as well as general laws.
  • Review Memorandum of Association, Articles of Association, statutory books, disclosure by the auditee etc.
  • Identify events and corporate actions that took place in the audit period by reviewing website of the auditee, disclosures made to stock exchanges, statutory records of the auditee etc.
  • Verify event based as well as calendar compliances of the auditee.
  • Verify composition of Board of directors is in compliance with applicable rules and regulations i.e. optimum combination and strength is maintained and directors are not disqualified.
  • Ensure formation of required committees and proper composition of such committees.
  • Ensure decisions by board of directors are taken in compliance with the law i.e. in properly constituted meeting or by circulation.
  • Ensure that systems of compliance are adequate and effective.
  • Analyse instances of receipt of show cause notices, prosecutions initiated, fee or penalty levied etc.
  • Collect further evidence and conduct in-depth checking if a fraud is suspected.
  • If there is a sufficient reason to believe that a fraud has been committed, the same shall be reported to Audit Committee/Board/Central Government as per the process laid down under the Companies Act, 2013. Also, the same shall be included in Secretarial Audit Report.
  • Verify the comments received on reporting fraud.
  • Include fraud detected by other auditor in the audit report.
  • Report all the events that affect auditee’s going concern or alters the charter or capital structure or management or business operation or control, etc.

Conclusion

These Standards provide a broad structure to the audit process and direction as to proceeding the audit. Having a direction to proceed will make the audit more systematic. To establish these structures and systems would initially require plenty of clerical nature work. However, this is a one-time labour to be put in for structuring all the future audits.

These Standards are issued with a motive to enhance the level and quality of compliance and at the same time harmonise the audit practices being followed by various auditors. Unity of procedures ensures clarity to the auditee which enables them to ensure systematic compliance. Application of these Standards is believed to be beneficial for the Auditors as well as the companies and regulators in the long run.

[1] https://www.icsi.edu/media/webmodules/ICSI_Auditing_Standards.pdf

Project Rupee Raftaar: An Analysis

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-Kanakprabha Jethani | Executive

Vinod Kothari Consultants Pvt. Ltd.

kanak@vinodkothari.com, finserv@vinodkothari.com

BACKGROUND

The Working Group on Developing Avenues for Aircraft Financing and Leasing Activities in India, constituted by Ministry of Civil Aviation submitted its report[1] on measures for developing this industry in the country. The Working Group was formed to examine the regulatory framework relating to financing and leasing of aircrafts. The idea was derived from the Cape Town convention and it has also been proposed to enact a bill in order to fully implement the convention. This project is based on the theme “Flying for All”. The Indian civil aviation market has been exhibiting tremendous growth for past years. There is an overwhelming increase in demand for passenger transportation for which airlines in India have placed orders for more than 1000 aircrafts. Moreover, Indian airlines have been relying on other countries for financing acquisition of aircrafts on export credit, loan or lease basis. This hair-triggers the need for India to have in place its own systems for financing of such acquisitions.

One of the motivations of the project is to ensure that the dependence of Indian aviation industry on import leases is reduced. Currently more than 90% of the aircrafts operating in the country are on import lease basis, and there is a huge monthly outflow of foreign exchange by way of lease rentals, which is not reported as ECB, since it is an operating expense.

GLOBAL PERSPECTIVE TO AIRCRAFT FINANCING AND LEASING

The key players in global aircraft financing and leasing market are Ireland and the US. Countries like China, Singapore, Hong Kong and Japan are emerging competitors in the market. The structures of aircraft financing, however, differ largely in all of these countries. The overall trends in the global arena can be evaluated on following bases:

Regional Outlook: through a research conducted for the Aviation Industry Leaders Report[2], it was concluded that North America is viewed as the most optimistic market player. Europe shows mixed signals due to market being strong and simultaneous slowing down of economy and other political issues. The Middle Eastern countries show a slow pace of growth and their models exhibit signs of stress. African airline market still has a lot of unrealised potential.

Financing Trends: sale and lease back transactions have become the most frequently used medium of aircraft finance over the world. Other forms of financing such as commercial bank debt, pre-delivering payment financing etc. have picked up pace. Also, traditional forms of financing such as export credit continue to be in operation but with reducing levels. Overall, the capital market remains very active and innovative in the aircraft finance sector.

Technology: new technology in aircrafts is being introduced frequently. However, implementation and commercialisation of the same continues to be a challenge. The Aviation Working Group’s Global Aircraft Trading System (GATS) proposed digitisation of transfer of lease deed ownership system which shall be expected to be activated by end of the year 2019.

CURRENT SCENARIO OF AIRCRAFT FINANCING IN INDIA

In terms of growth and advancement, India is far behind other Asian economies such as China, Singapore and Hong Kong. However, the Indian Aviation market has shown exponential rise in the past few years with an annual growth rate of 18.86% in 2017-18 and overall growth of 16.08% in passenger traffic. From 74 operational airports in 2013, it has reached a height of 101 operational airports in 2016. Expectations of having 190-200 operational airports by the end of 2040 are pointed out through various studies.

Currently, India has large aircraft order books, virtually all of which are leased through leasing companies located offshore. Under the regional connectivity scheme Ude Desh ka Aam Nagrik (UDAN), the government has decide to lease out operations, maintenance, and development of certain airports under Public private Partnership (PPP) model.

Overall, India has immense potential for growth in aviation sector but little means to aid the growth. It is in need of systems that aid the growth in a cost-effective and sustainable manner.

AIRCRAFT FINANCING STRUCTURE

Why is it needed?

In the view of increasing demand and non-availability of own sources of aircraft financing, it is essential for India to set up its own structures for the same. Moreover, civil aviation sector is an important sector for development of the economy. In the civil aviation industry, aircraft financing is the most profitable segment and there are no entities in the country exploring this line of business. All the benefits from this gap are being enjoyed by foreign entities.

What will be the structure?

For this structure, GIFT-CITY in Gujarat has been identified as preferred destination for initiation of operations in this industry as it offers a tax regime competitive to that of leasing companies all over the world.

Barriers in the structure

The aforementioned structure will face following barriers:

  • GAAR prevents Indian financers from taking advantage of other jurisdictions.
  • Aircraft financing is not a specifically permitted activity for banks.
  • Units operating in GIFT-CITY not permitted to undertake aircraft financing.
  • Framework for setting-up of NBFCs in GIFT-CITY and provisions as to treatment of income from operating lease is not provided.
  • Taxes and duties:
  • GST of 5% on import of aircraft
  • GST on lease rentals
  • Interest amount which forms part of lease rentals in case of financial lease is not eligible for any tax benefit.
  • No exemptions from withholding taxes
  • Stamp duty on instruments and documents executed.

The working group has proposed corresponding changes and amendments to be made to overcome these barriers. The response of relevant authorities is awaited.

Tax implications of the structure

Particulars

Tax rates
IFSC-GIFT CITY (proposed structure) INDIA (not following the structure)
INCOME TAX
Corporate Tax Rate: 34.94

o   Year 1 to 5

 0.00

o   Year 6 to 10

 17.47

o   Year 11 onwards

 34.94
Minimum Alternate Tax 10.48 21.55
Capital gains on sale of aircraft 0.00 34.94
Withholding tax

o   Operating lease rentals

 0.00 2.00

o   Interest payment (USD debt)

 0.00 5.46

o   Interest payment (INR debt)

 0.00 0.00

o   Other payments

 0.00 10.00
Dividend Distribution Tax nil 20.56
GOODS AND SERVICES TAX
Purchase of aircraft 0.00 0.00
Operating lease rentals 0.00 5.00
Underfinance lease(interest portion) 0.00 5.00
Other services nil 18.00
Stamp duty on lease related documents 0.00 3.00

ANALYSIS OF TAX IMPLICATIONS UNDER VARIOUS MODELS OF FINANCING

Following table shows an analysis of indirect tax implications from the point of view of lessee and compares the proposed structure with the existing practice of financing as well as situation if financing is done outside the proposed structure but in India.

This table is based on following assumptions:

  • Value of aircraft- Rs.3500 crores
  • Residual value- Rs.500 crores
  • Rate of interest- 7.5%
  • Lease tenure- 25 years
  • Processing fee- 2%

On the aforesaid assumptions, lease rental per annum would amount to Rs.306.63 crores

Amount (in Rs. crores)

Tax expenditure Ireland IFSC-GIFT CITY Rest of India
GST on lease rentals 15.3315 0.00 15.3315
Stamp duty 0.00 0.00 105
GST on other services 0.00 nil 12.6
Overall indirect tax expenditure 15.3315 0.00 27.9315

OVERCOMING THE BARRIERS

Recommendations have been made by the Working Group to various regulatory authorities in order to overcome various barriers that are a hindrance to establishment of India’s own structure of aircraft financing and leasing. Following table shows some of the major recommendations:

Authority Recommendations
RBI Confirm that the term “equipment” includes aircrafts or notify aircraft financing and leasing as permitted activity for banks or subsidiaries of banks.
Amend IBU circular to include equipment leasing and investment in capital of leasing entities in scope of activities of banks
Confirm that equipment leasing entities shall be eligible to register as NBFC in IFSC
Issue specific directions in regard to investment in or by foreign entities engaged in aircraft financing and leasing activities.
Tax authorities Capital gains on sale of leased aircrafts should be fully exempted.
GST on leasing aircraft should be made zero-rated.
Nil withholding tax should be specified for airline companies.
Transfer/novation of aircraft financing / leasing contracts to units in an IFSC should not be under the purview of GAAR, for both the lessee and lessor
SEBI Amend SEBI (AIF) Regulations to create a separate category of AIFs for investment in aircraft financing/leasing activities or permit greater concentration of investment in aircraft financing/leasing entities.
Clarify whether 25% investment cap by AIFs applies on investment in equipment and grant additional relaxations to AIFs investing in aircraft financing activities.
Create separate category of mutual funds of investment in entities engaged in aircraft financing and leasing activities.
Clarify which institution can invest in entities registered in IFSC.
IRDAI Amend IRDAI regulations permitting companies set up in IFSC to invest in entities engaged in aircraft financing and leasing activities.
Clarify whether investment of funds of policyholders’ in entities registered in IFSC be considered as funds invested in India only.
Others Clarify under aircraft rules that aircrafts of lessors cannot be detained against any statutory or other outstanding dues.
Entities like pension funds, insurance companies, employee provident fund organisations be allowed to invest directly or indirectly in aircraft financing and leasing activities.
SARFAESI Act not be applicable to aircrafts.
Gujarat Stamp Act to exempt aircraft financing and leasing from its purview.
Permit airlines to set up branch in IFSC.

CONCLUSION

It is absolutely evident that aircraft industry is on upsurge and will continue to be rising globally in the coming years. To meet the rising demand and expand the country’s hold in the aviation market the proposed structure provides a well-established groundwork through the proposed structure. All recommendations, if accepted and implemented in a proper manner, will enable India to pioneer a very profitable and growth-oriented aviation market.

 

[1] https://www.globalaviationsummit.in/documents/PROJECTRUPEERAFTAAR.pdf

[2] https://assets.kpmg/content/dam/kpmg/ie/pdf/2019/01/ie-aviation-industry-leaders-report-2019.pdf

 

E-form AGILE- Consolidation of various registrations along with company incorporation

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By Dibisha Mishra (dibisha@vinodkothari.com) (corplaw@vinodkothari.com)

Introduction

There has been a series of changes brought in by the Ministry of Corporate Affairs (“MCA”) in recent years to bring in better transparency, easier compliance and weed out hurdles in the way of Ease of doing Business. In furtherance of the same, MCA vide notification dated 29th March, 2019, notified Companies (Incorporation) Third Amendment Rules, 2019 (hereinafter referred to as “Amended Rules”)[i] which has upgraded the existing SPICe form with a view to bring in a single window system for making application under GST, Employees Provident Fund Organization (‘EFPO’) and Employees State Insurance Corporation (‘ESIC’).

These additional services are being catered via e-form INC-35 named as ‘AGILE’ which shall be  linked with SPICe (e-form INC-32) during filing with MCA. It is to be noted that though linking of the form is mandatory, option of availing the aforementioned services is left to the applicant. The company can very well choose the services which it wishes to avail.

The main features along with the technicalities of the incorporation process prior to the Amended Rules have been covered in our earlier article[ii]. This write up covers the highlights of AGILE along with a brief discussion on some practical aspects. Read more →