Taxation in Securitisation: A judicial overview

-Anirudh Grover, Executive | finserv@vinodkothari.com

Introduction

Securitization transactions in India post the pandemic has seen significant improvement with volumes growing by 70% to Rs. 73000 crores in FY 2023 compared to Rs. 43000 crores in FY 2022.^[1] This growth was also highlighted in one of our recent write up wherein it can be seen from the data laid down that despite the global slowdown in the world economy on account of the pandemic, the volume of securitization transactions in India gained a lot of popularity. Given the impetus of this fundraising mode, it is important to have a vibrant securitization market. This can be only achieved if the governing framework with respect to taxation does not impose an additional taxation burden on the parties. Through this article, the writer will be reviewing the stance of various courts by highlighting the principles with respect to the taxation of the parties involved in a securitization framework i.e. Originator, Special Purpose Vehicle(‘SPV’), and the Investors. For a better understanding of the framework of securitization, the readers can also refer to our Article on Securitization: A Primer.

The Originator

Whenever there is a transfer of an asset there will be some type of income for the transferor which can either be gain or loss. This gain or loss can either come under the head of business income or income arising out of capital gain. In a securitization transaction, the originator of the property (i.e. asset being securitized) will be transferring the property to a third entity(bankruptcy remote entity) against a consideration. From an accounting perspective the computation of the consideration in the form of gain on sale is based on the valuation of the residual interest in the transaction, that is, the value of the excess spread, and treating such value as a part of the sale consideration. This is an accounting estimation of the future profit, which, being associated with the sale transaction, is upfronted. But for tax purposes treating such profit as a part of the taxable profit will deviate from the basic principle that income tax can only be paid on income which is earned or for which reasonable certainty of collection can be established and not that which is simply estimated.  However, in this regard an issue that arises is the aspect of spreading such gain over a period of time and thereby deferring the tax liability. This issue was taken cognizance by the  Income Tax Appellate Tribunal in the case Axis Bank Limited vs Addl. Commissioner of Income Tax Range-1^[2] wherein it was opined that even though it is a settled position of law that what is relevant for income tax purposes is the aspect of real income^[3] still the receivables being booked in the form of gains by the originator will not be subject to tax upfront as the RBI Directive provides that gain on securitization is recognized over the period of the underlying securities issued by the SPV.  Another interesting rationale with respect to the recognition of securitization income was deliberated upon by the Madras High Court in the case of The Commissioner of Income Tax vs Shriram Investments Limited^[4] wherein the conclusion of non-subjecting receivables to tax was premised on the reasoning that since the same receivables if not securitized would have been subject to tax over a period of time, therefore the conduct of the assessee to book its income of securitized receivables over a spread would be revenue neutral.

However the Hon’ble Bombay High Court in this regard held otherwise in the case of L&T Finance Ltd vs Deputy Commissioner of Income Tax^[5]. It rejected the analogy propounded by the assessee of spreading of expenditure or the matching concept by opining that since these gains are realized they will have to be taxed in accordance with the prescribed rate at the time of transfer only.  Furthermore, the ITAT Hyderabad in the case of Asmitha Microfin Ltd. vs ACIT^[6] imposed a tax on gains arising out of a securitization transaction. But it is relevant to understand that in this case, the gains, in the form of the discounted value of future interest, were already realized at the time of the transaction as a part of the sale consideration.

Notably, it can be perceived from the L&T Finance and the Asmitha Microfin case that the approach of the courts has been to recognize the claims of the Revenue and thereby subject the receivables of securitization to tax only in scenarios where the gain/income is realized. However, the principles laid down in the Shriram Investments Limited case is also a counter-argument that the parties to the securitization arrangement can rely on.

The SPV

The transferee in the case of a securitization arrangement is a special-purpose vehicle that is incorporated either in the form of a trust or a company. When SPV is organized as a trust it generally possesses a pass-through quality by virtue of which no tax is levied in the hands of the SPV. However, this position may not be the same if the trust so incorporated is a revocable trust. In this regard, the case of the ITO- 21(3)(2) vs Scheme A1 of Arcil CPS XI Trust^[7] can be referred to wherein it was categorically stated that merely because the trust deed specifies that revocation of the contributions is conditional upon the consent of the contributors holding 75% of the units will not lead to a conclusion that the trust so incorporated is an irrevocable trust and the benefit of pass-through will not be applicable. This premise was fortified by referring to the case  Behramji Sorabji Lalkaka Vs. CIT^[8] wherein it was observed by the Hon’ble High Court that the words “revocable transfer” are well understood in law and a transfer does not cease to be revocable because the settlor cannot exercise the power of revocation without the consent of the named individuals or any of them. As observed by the Hon’ble High Court, a transfer is nonetheless revocable even if it can be revoked only with the consent of any named person or persons.This position was also upheld in the case of the ITO-23(1)(2) Vs Indian Corporate Loan Securities Trust 2008 Series 14 & Ors^[9] the ITAT Bombay held that income arising from only a revocable securitization trust would be taxable in the hands of the investor.

The Investor

The taxation framework with respect to the investor is sufficiently clear as it is understood from Sections 61 and 63 of the Income Tax Act, 1961 wherein it has been provided that since SPV acts as a representative assessee for the investor all the income of the trust will be taxed in the hands of the investors/beneficiaries. Notably, any tax withheld at source by the SPV will be eligible for set off against the tax liability of the investors.

Concluding Remarks

Tax neutrality is one of the foremost tax objectives in securitization arrangements. This means that the parties shall ensure that there are no additional tax liabilities arising out of the arrangement for the parties. Further, the requirement of tax certainty also stems from the fact that rating agencies will also demand assurances with respect to no unexpected tax charges for the issuer (the SPV). Thus, the tax certainty shall be kept in mind by the parties of a securitization arrangement. The above pronouncements can portray some sort of certainty to the parties undertaking such securitization as it lays down certain principles that may be considered as established given the fact that it is also upheld in the courts of law.

See our resources on similar topics here-

1. Our dedicated page on securitisation – https://vinodkothari.com/sechome/
2. Our articles on securitisation – https://vinodkothari.com/category/securitisation/
3. Securitisation: Indian market grows amidst global volume contraction
4. Security Token Offerings & their Application to Structured Finance
5. Resurgence of synthetic securitizations: Capital-relief driven transactions scale new peaks
6. Has the cover fallen off Covered Bonds?
7. Legal Issues in Securitization
8. FAQs on Securitisation of Standard Assets
9. After 15 years: New Securitisation regulatory framework takes effect
10. Securitization Glossary
11. Global Securitisation Markets in 2021: A Robust Year for Structured Finance
12. Evolution of securitization – Genesis of MBS

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^[1] Press Relase October 11, 2022 OpenMedia (icra.in)

^[2] Axis Bank Limited vs Addl. Commissioner of Income Tax Range- 1 ITA Nos. 577, 691, 1015 and 1129/AHD/2011 and 250/AHD/2012

^[3] CIT vs Bokaro Steel Limited [1999] 102 Taxman 94 (SC)2

^[4] The Commissioner of Income Tax vs Shriram Investments Limited Tax Case Appeal No. 328 of 2011

^[5] L&T Finance Ltd vs Deputy Commissioner of Income Tax IT Appeal Nos. 256 and 267 of 2016

^[6] Asmitha Microfin Ltd. vs ACIT I.T.A. No. 137/HYD/2013

^[7] ITO- 21(3)(2) vs Scheme A1 of Arcil CPS XI Trust ITA No. 2293/Mum/2018

^[8]  Behramji Sorabji Lalkaka Vs. CIT: (1948) 16 ITR 301) (Bom)

^[9] ITO-23(1)(2) Vs Indian Corporate Loan Securities Trust 2008 Series 14 & Ors ITA No.4789/Mum/2017