FAQs on Penal Charges in Loan Accounts

– Team Finserv | finserv@vinodkothari.com

Updated as on 4th March 2024

The Circular is applicable from April 01, 2024. Please feel free to drop your queries in the comment box below and we will try our best to reply at the earliest.

RBI on August 18, 2023 came up with the circular Fair Lending practice – Penal charges in Loan accounts (‘Circular’). The Circular restricts entities from charging penal interest on loan accounts, instead they should levy penalty or penal charges..

We have developed a set of FAQs on the press release and updated the same based on this Circular read along with the RBI Notification on Fair Lending Practice – Penal Charges in Loan Accounts: Extension of Timeline for Implementation of Instructions dated December 29, 2023 and FAQs released by RBI where we intend to answer some of the critical questions relating to the penal charges in loan accounts.

Our write-up on the topic can be read here – Penal charges not a cash-cow for lenders

Table of Contents

Applicability

Applicability on the existing loans

Board Approved Policy

Capitalization and Imposition

GST Applicability

Accounting Treatment

Actionables and Disclosure

Applicability

1. Which entities are covered under the Circular?

The Circular covers the following entities –

• All Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks, excluding Payments Banks)
• All Primary (Urban) Co-operative Banks
• All NBFCs
• All HFCs
• All India Financial Institutions

2. What is the scope of coverage of the Circular?

Essentially, it is applicable to all loan or similar facilities, except for the specific exceptions (see below). Since the spirit of the Circular is fair lending, and as fairness in lending is ubiquitous, the Circular should be taken as applying to all forms of lending.

For instance, the Circular is applicable to:

• Working capital facilities
• Other revolving lines of credit, other than credit cards
• Bullet repayment loans
• Demand loans
• Cash Credit and Overdraft (OD) facilities (clarified by the RBI vide its FAQs)

3. Is the Circular applicable to facilities which are not in the nature of loans, such as financial leases, subscription to debt securities, etc?

Structuring of debt securities does not seem to be under the purview of RBI, as debt securities are not loans. Therefore, one may argue that the Circular does not directly apply in such cases.

Financial leases may be de facto loans, but even if the lease is a financial lease, it may have a limited correlation with the value or usage of the asset. Hence, it may be argued that the Circular does not apply to a financial lease. With some hesitation, one may even argue that the Circular does not apply to hire purchase transactions.

4. Is the Circular applicable in case of digital loans too?

Yes, the Circular applies to digital loans as well. Also, the RBI FAQs clarifies that the prescribed instructions on penal charges are also applicable in case of securitisation and co-lending portfolios.

5. The Circular talks about penalties. There are cases where lenders may structure a rebate for performance with the terms of the loan. That is, in addition to or in lieu of penalties, the borrower may get a rebate for appreciable performance. Will such rebate, or withdrawal thereof, also be within the scope of the circular ?

The Circular rests on 3 important premises: transparency, proportionality, and non-capitalisation. Transparency is required for every term of a financial facility, be it a rebate or a penalty. Proportionality essentially implies that the penal terms are not discriminatory in nature, and are proportional to the deviation involved. There is no reason to exclude rebates from this principle. The third principle is that penalties are not added to principal for the purpose of compounding of interest. Rebates may be failing in this regard, because the premise of a rebate is a higher interest by default, supported by an interest rebate if the installments are paid in time. In that case, the higher interest forms a part of the EMIs, and therefore, gets compounded.

The essence of the Circular is that something which is substantively a penalty – that is, a consequence of a breach of the terms of the loans, should not be forming a part of the principal for the purpose of compounding. 

6. Are there any exclusions from the applicability of the Circular ? 

The Circular is not applicable in case of –

• Credit cards
• External commercial borrowings,  trade credits, and structured obligations
• Rupee/ foreign currency export credit and other foreign currency loans (clarified vide RBI FAQs)

Applicability to existing loans:

7. In case of existing loans, from when will the Circular be applicable ?

Pursuant to the RBI circular dated December 29, 2023 and as clarified by RBI in its FAQs (FAQ No.1), the timeline for implementation was extended by three months. Accordingly, the Circular is applicable from April 1, 2024. Further, In case of existing loans as well, the instructions shall come into effect from April 1, 2024 and the switchover to new penal charges regime shall be ensured on the next review / renewal date falling on or after April 1, 2024, but not later than June 30, 2024.

8. Are we saying there is no grandfathering for the Circular?

The provisions are phased in; some loans may expire by the time the applicability for existing loans sets in. To that extent, there is grandfathering.

9. What is the meaning of “renewal” or “review” in case of existing loans? Do loans have a predetermined renewal or review date?

The applicability of the Circular to existing loans is

• June 30, 2024 or
• next review or renewal of the facility falling on or after April 1, 2024, whichever is earlier.

Review or renewal is not common; reviews and renewals are done in case of working capital facilities. In case of demand and call loans also, there is a statutory renewal requirement. Sometimes, loans against shares may also be renewed.

10. For loans that do not have any review date specified, by when should we ensure compliance with the Circular?

The Circular states that in case of existing loans, the compliance with the Circular has to be ensured on the next review / renewal date falling on or after April 1, 2024, but not later than June 30, 2024.

That would technically mean we have time untill June 30, 2024 to apply the Circular to existing loans.

This puts lenders into a very tricky situation, as far as loan management systems are concerned:

• New loans will work as per the new paradigm from 1st April, 2024
• Existing loans may run as per existing contracts, if they are expiring by 30th June, 2024
• Existing loans will be put under new paradigm effective 1st July 2024

Since it may create a challenging situation from LMS perspective, lenders may be encouraged to apply the new paradigm to all new and existing loans from 1st April 2024 itself, such that the need to distinguish between existing and new loans goes away.

11. Are the words “external borrowings, trade credits and structured obligations” used to refer to three different types of facilities, or do they refer to what is covered by RBI’s Master Direction – External Commercial Borrowings, Trade Credits and Structured Obligations (‘ECB Circular’) ?

In our view, giving a plain reading, the expression “ECB, trade credit and structured obligations” refers to the facilities which are coming within the ambit of the RBI’s (‘ECB Circular’). Therefore, trade credits refer to trade credits from overseas vendors, and likewise, structured obligations refer to the following arrangements:

• Guarantee for domestic fund-based and non-fund-based facilities by non-residents, and
• Facility of credit enhancement provided by eligible non-resident entities.

In other words, domestic trade credit couldn’t have been within the scope of the Circular, as it is not a lending facility at all. The granting of a facility on the basis of guarantee is so common domestically that there would have been no case for exclusion.

This has also been clarified by the RBI in its FAQs.

12. Can penal interest or penal charges be levied in such cases of structured obligations under the ECB Circular?

Here, we may refer to the Master Direction on External Commercial Borrowings, Trade Credits and Structured Obligations which states that prepayment charge/ penal interest, if any, for default or breach of covenants, should not be more than 2 percent over and above the contracted rate of interest on the outstanding principal amount and will be outside the all-in-cost ceiling in case of External Commercial Borrowings.

Board Approved Policy

13. What should be the contents of the board approved policy on penalties?

The board approved policy should at minimum state that –

• Events of default which will attract penal charges
• The thresholds or the principles for determination of penal charges
• Indicative list stating the quantum of penal charges for various types of default

Further, as clarified by FAQ No. 6(a) of the RBI FAQs entities may charge different penal charges depending upon the loan amount in accordance with its board approved policy. For this purpose there has to be a suitable structure of penal charges that is reasonable and commensurate with the non-compliance of material terms and conditions of the loan contract in the policy.

14. Should the policy also lay down the factors on which the penalty shall be determined? If yes, what are those factors?        

No, the idea of penalty is not compensatory and therefore the lender cannot relate it to the costs incurred. Therefore, the board approved policy will not lay down the factors but will provide for the principles based on which the penalties will be levied.

Capitalization and imposition

15. Is overdue interest also a penal charge?

In general, overdue interest is not a penalty. However, if the rate for the overdue period is higher than the contracted rate of interest, then the additional interest will be treated as a penalty.

Lets say, the arrangement between the lender and the borrower is such that, the normal rate of interest is 12% and in case of default, the interest for the overdue period will be 36%. In such a case this additional 24% is the penal interest.

Therefore, while the lender is allowed to collect the 12% interest for the overdue period as well, this additional 24% is nothing but a penalty imposed and will have to comply with the Circular.

This has also been affirmed by the RBI vide its FAQs.

16. What is meant by capitalisation of penal interest ?

Capitalization of penal interest refers to the amount of penal interest being added to the principal, and then interest is charged on such aggregated amounts. Such capitalisation of penal charges is not allowed.

Further, as clarified by RBI in its FAQs, in case of failure of the borrower to pay the earlier imposed penal charges, additional penal charges cannot be imposed on the outstanding amount of penal charges.

17. Can such penal charges be imposed as a percentage?

Yes, nothing in the Circular prevents entities from levying penal charges as a percentage provided there is no capitalisation of such charges. However, in our view, the penalty should be dependent on the nature of non-compliance. For example, cheque bounce charges should not be in the form of percentage rather a fixed amount.

In essence, penal charges may be:

• Based on an amount or ad valorem
• Based on time
• Based on amount and time – this is the most common example of penal charges on delayed payments
• Based on an event – say NACH bounce charge

18. The Circular states that “The penal charges in case of loans sanctioned to ‘individual borrowers, for purposes other than business’, shall not be higher than the penal charges applicable to non-individual borrowers for similar non-compliance of material terms and conditions.”

Here, what does ‘similar non-compliance’ mean?

Here, the intent of the Circular is to ensure that loans given to individual borrowers for other than business purposes do not carry a higher penal charge for the non compliance of material terms stated therein as compared to the loans given to non-individual borrowers for non-compliance of similar material terms. The RBI FAQs have also specified that the structure of penal charges within a particular loan / product category shall have to be uniform irrespective of the constitution of the borrower- be it individual or corporate.

Therefore, if let’s say, a corporate borrower is being charged Rs. 500 as cheque bounce charges. Then, in case of bouncing of cheques by individual borrowers against loans taken for non-business purposes, the penal charge should not be more than 500.

Further, the RBI vide its FAQs has clarified the meaning of “material terms and conditions” stating that the material terms and conditions may be defined, if not already done, as per the credit policy of the bank and they may vary from one category of loan to another, and also, from lender to lender based on their own assessment.

19. In case of failure to create security interest, can step – up interest be charged?

Usually in case of secured loans backed by immovable property, the borrowers are given a certain period of time to create security interest. The time may be needed to get cession of security interest by existing charge holders, creation or modification of the mortgage, filing/registration, etc. If the security interest is not created within the time period, there is usually a step-up interest rate. Let’s say, the arrangement between the lender and the borrower is such that, the normal rate of interest is 12% and in case of delay in creation of security interest, the rate of interest will be 14%. In such a case, it may be questioned as to whether this additional 2% is in the nature of penal interest or not.

One potential argument would be that this should ideally be treated as penal charges for the purposes of this circular, as the increase in the interest rate is a result of failure to create security interest within a prescribed period, which is a breach of certain material terms of the contract.

Another argument could be that the step up interest has been pre-agreed and is in the nature of interest towards the loan considering the credit risk associated with an uncollateralized or under collateralized loan. In case the security interest is not created, the credit risk shall be higher and hence leading to an increase in the rate of interest as well. This should not be considered as a penalty.

There may be similar stipulations in case of breach of financial covenants – for example, failure to maintain security cover, DE ratio, or other financial covenants. In our view, the nature of the step-up rate is compensatory and not penal.

20. The Circular states that “the quantum of penal charges shall be reasonable and commensurate with the non-compliance of material terms and conditions of loan contract without being discriminatory within a particular loan / product category.”

In this regard, how will the thresholds for charging penal charges be determined ?

The threshold could either be stated in terms of amount or time, that is to say the defaulted amount or the number of days for which the default continues. For instance, the delay in payment would attract penal charges in case the same continues beyond the grace period of 3 days or such time limit specified by the lender. 

The same may also be charged in the form of amount of default or gravity of the default/ breach. This may lead to different rates/ amounts of penal charges dependent on the type of breach or non compliance.

Further, as clarified by the RBI FAQs, it is important to note that penal charges shall be reasonable and levied by the lenders only on the amount under default in a non-discriminatory manner as per their Board approved policy.

20A. Will charges such as seizing expenses, legal expenses, collection charges, and cheque or NACH bounce charges be categorized as penal charges ?

• Seizing Expenses and legal expenses:

Penal Charges are imposed in case of material non-compliance with the terms and conditions of the loan contract. Further, penal charges act as a deterrent for the borrower from committing any non-compliance with the terms and conditions. On the other hand, seizing charges or legal expenses in case of enforcement of security interest, are not in the nature of penalty but are actual expenses incurred by the lender on account of the borrowers. Therefore, in our view, the RBI Circular will not be applicable since the RBI Circular only contains provisions for the imposition of charges in the nature of penalty.

Considering that these expenses are incurred by the lender on behalf of the borrowers and the agreement provides the right to the lender to recover these from the borrower, this can be added to the outstanding POS. The amount charged and added should however be limited to the actual expense incurred by the lender. It is suggested that vide loan agreement or a separate notice, the customer may be notified to surrender the asset and failure to do so would result in the lender from getting it done and recovering the actual charges from the borrower.

• Cheque bounce charges and collection expenses:

For operational convenience, these expenses may not be charged on actuals but a flat amount may be imposed irrespective of the loan or EMI amount, for a particular category of loan product. Considering the fact that these are not in the nature of pure reimbursement and have a deterrent value and hence, in our view these would be considered as penal charges. Hence, there cannot be any capitalisation of such charges.

20B. In case the loan contract clearly provides for the borrower to maintain adequate insurance on the security kept as collateral and the lender incurred an expenditure on behalf of the borrower to maintain the same; will such expenditure be classified as penal charge?

The insurance charges are incurred by the lender on behalf of the borrower due to the failure of the borrower from taking/maintaining adequate insurance on their vehicles. If the terms of agreement clearly recognise this as a responsibility of the borrower the same can be added to the outstanding POS to the extent they are on the actual expenditure incurred. The same shall not be in the nature of penal charges.

GST Applicability 

The RBI in its FAQs while addressing the question on the applicability of GST on penal charges has stated as follows-

“Since instructions related to GST are issued by Central Board of Indirect Taxes & Customs (CBIC), instructions and clarifications, if any, issued by CBIC in this regard may be followed.”

While any clarification from CBIC in this regard is still awaited, we have tried to answer the questions relating to the applicability of GST on penal charges.

21. Will the erstwhile circular of the GST Department on penal interest being exempted from GST still be applicable?

Notification by the GST council dated 28th June, 2019^[1] stated that penal interest shall be exempt through serial no 27 of the notification No. 12/2017-Central Tax (Rate)^[2]. However, this Circular  does not seem to apply now. This is because of the regulatory change, the penalty is no more penal interest or additional interest but is over and above interest. Further, even if the penalty is based on the time during which default continues, the RBI clearly mentions that penalties are not to be treated as interest.

Therefore, penal charges may not fall under the exemption granted by the above mentioned notification.

22. Will GST be charged on penal charges in the nature of cheque bounce charges?

There is a circular form the GST department dated August 3, 2022^[3], which states that

“The fine or penalty that the supplier or a banker imposes, for dishonour of a cheque, is a penalty imposed not for tolerating the act or situation but a fine, or penalty imposed for not tolerating, penalizing and thereby deterring and discouraging such an act or situation. Therefore, cheque dishonor fine or penalty is not a consideration for any service and not taxable.” (Para 7.3)

Accordingly, cheque bounce charges or NACH bounce charges shall not attract GST.

23. Will GST be charged on penal charges in the nature of penalty on delayed payments?

Para 7.1.6 of the circular dated August 3, 2022 states that

“amounts paid for acceptance of late payment, early termination of lease or for pre-payment of loan or the amounts forfeited on cancellation of service by the customer as contemplated by the contract as part of commercial terms agreed to by the parties, constitute consideration for the supply of a facility, namely, of acceptance of late payment, early termination of a lease agreement, of prepayment of loan and of making arrangements for the intended supply by the tour operator respectively. Therefore, such payments, even though they may be referred to as fine or penalty, are actually payments that amount to consideration for supply, and are subject to GST, in cases where such supply is taxable. Since these supplies are ancillary to the principal supply for which the contract is signed, they shall be eligible to be assessed as the principal supply, as discussed in detail in the later paragraphs. Naturally, such payments will not be taxable if the principal supply is exempt. Based on the aforesaid it seems that since the consideration for loan as a supply of service is interest, which is exempted from GST; hence, the ancillary supplies, such as prepayment charges or delayed payment charges should also be exempt. However, applicability of GST on penal charges is something that will require clarification from the authorities. In our view in the absence of any such clarification, in the light of the 2022 circular, penal charges should not be charged to GST.

Accounting Treatment

24. How will the penal charges be accounted for by a lender preparing financials as per IGAAP?

The recognition of income by a financial sector entity is carried out in accordance with the provisions of the RBI Directions and AS 9. As a general principle, an entity must recognise income arising from standard assets on an accrual basis, and that from NPA on a receipt basis. While this may hold good for incomes which flow in the natural course from a loan transaction – like interest – can this principle also be extended to other charges like penal charges etc.?

While for NPAs, they have to be recognised necessarily on cash basis, however, even for performing loans, the market practice is to recognize it on cash basis considering uncertainties surrounding the same.

While there is no specific guidance in place, the market practice is to recognise it on cash basis, considering the uncertainties relating to collection of the same.

The RBI FAQs have also discussed this saying that in respect of NPA accounts, penal charges shall be reversed to the extent it remains uncollected for the specific purpose of non-recognition of income. However, the same shall be part of the total liability of the borrower to the lender, unless it is waived as per the bank’s Board approved policy.

25. How will the penal charges be accounted for by a lender preparing financials as per Ind AS?

For entities covered by Ind AS, they have been advised by the RBI to comply with the applicable Ind AS. Financial instruments are usually accounted for as per Ind AS 109. The standard provides for accrual-based accounting for all financial assets, whether they are performing or credit impaired. Para B5.4.3 states that fees that are not an integral part of the effective interest rate of a financial instrument and are accounted for in accordance with Ind AS115. Penalties shall not form part of EIR, hence, shall be accounted for in accordance with Ind AS 115.

As per para 9(e) of the standard, which states that revenue will be recognised only when it is probable that the entity will be able to collect the consideration or not. Further, para 13 of the standard states that: if a customer’s ability to pay the consideration deteriorates significantly, an entity would reassess whether it is probable that the entity will collect the consideration to which the entity will be entitled in exchange for the remaining goods or services that will be transferred to the customer.

Applying the same logic in case of penalties charged by the lenders: penalties are charged when the borrower does not perform its obligations under the contract in the manner it is expected to, such a situation makes a strong case to prove a deterioration in the customer’s ability to pay. Therefore, the certainty of the receipt of consideration cannot be established in such a case, and accordingly, penalties must be recognised only when they are actually realised.

Actionables and disclosure requirements:

26. What are the actionables for REs due to this Circular ?

The REs are required to –

• Formulate and adopt a board approved policy
• Amend the existing policies (such as FPC or interest rate policy) to ensure compliance with the Circular, for instance, changing the reference from ‘penal interest’ to ‘penal charges’
• Ensure the implementation of the Circular by the effective date (as discussed above)
• Ensure necessary disclosures to the customers (as discussed below)

27. What are the various disclosure requirements ?

REs should disclose the following –

1. In case of new loans –
   1. Quantum and reason for penal charges shall be clearly disclosed in the
      • loan agreement and
      • most important terms & conditions / Key Fact Statement (KFS) as applicable
        • Website under interest rates and service charges
2. In case of existing loans –
   1. Intimate the borrower of this regulatory change by way of sending intimations or by disclosing it on the website.
3. Intimate all borrower abouts of the applicable penal charges at the time of sending reminders for non-compliance of material terms and conditions.

Moreover, in terms of the FAQ No. 9, such disclosure has to be specifically made in the MITC/KFS to be sent to the borrowers and only a website disclosure will not suffice.

28. The Digital Lending Guidelines (DL Guidelines) state that the rate of such penal charges are to be disclosed upfront on an annualised basis to the borrower in the KFS. Does the Circular require the disclosure of penal charges on an annualised basis too ?

No, the Circular, unlike the DL Guidelines, does not mandate the disclosure of penal charges on an annualised basis. 

29. Given that the Circular is only applicable from April 01, 2024, can lenders compound penal charges during the interim period (i.e from August 18, 2023 to April 01, 2024 even for existing loans?.

The Circular was issued on August 18, 2023, but is applicable from April 01, 2024 for new loans and for existing loans based on the date of renewal or review but not later than June 30, 2024. Given that the lenders are already aware about the intent of the regulator with regard to the treatment of penal charges, in our view, it is recommended that they should take steps to ensure that penal interest is not compounded during the interim period as well, even if the Circular is applicable only from April 01, 2024. Further, in case of existing borrowers as well, penal charge and not interest should be levied in the event of any default during the interim period.

29A. If the penal interest has already accrued but is not paid by the borrower, will it be foregone post the effective date?

First of all, whether before or after the effective date, the Circular is not saying penalties cannot be charged and have to be foregone. All it says is that penalty will be charged as penalty and not as penal interest.

Till 31st March, 2023, if there is an existing contract for charging penal or additional interest, the same may continue.

Now, there are 2 consequences of charging something a penal interest:

• Compounding – that is, interest will start accruing on the penal interest as well; and
• Accrual for accounting purposes.

Usually, irrespective of contractual compounding, penal interest is not accrued, even if the loan remains a performing loan. This is on the ground that the reasonable certainty as to collection of the penal interest is missing. Therefore, lenders accrue only the regular interest and not the penal interest.

In case the loan has become an NPA, there is no question of accrual of either the regular interest or the penal interest (refer to discussion above under the heading Accounting).

Now, for the penal interest that has already been added, based on a contractual provision, to the ODPOS as on 31st March, 2023, has already become a contractual debt. We do not see any reason to make a retroactive application of the Circular to remove the accumulated penal interest from the outstanding dues. If that is to be done, it will amount to retroactive application of the Circular. For a lot of corporate loans that have been outstanding for a long time, it will create tremendous difficulties.

The principle of prospective application of a rule is – whatever has been done till the date of the applicability, as per practices which were regular till then, there is no undoing the same.

Therefore:

• What penal interest has been added to the SOA as per contractual provisions till 31st March will remain unaffected
• On and from 1st April. or such earlier date as the lender voluntarily implements the Circular, penal interest will be replaced by penalties, which will not accrue any interest.
• Therefore, regular interest may be charged on the  amount that has been added to the ODPOS till 31st March 2023.

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^[1] New Doc 2019-06-28 18.29.15 (gstcouncil.gov.in)

^[2] showfile (indiacode.nic.in)

^[3] cir-178-08-2022-cgst.pdf (gstcouncil.gov.in)

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Our write-up on the topic can be read here – Penal charges not a cash-cow for lenders

Our Youtube Video on the topic can be accessed here – Shastrarth – Regulations for Floating Rate Reset & Penal Charges