Taxability of Corporate Guarantees under GST

– Dayita Kanodia, Executive | finserv@vinodkothari.com

A person who can’t pay gets another person who can’t pay, to guarantee that he can pay.

– Charles Dickens

Background

It is a common practice for companies to issue guarantees for loans taken by their group companies. When transactions happen between related parties, there is always a likelihood of them being not at arm’s length. 

Accordingly, this has led to questions that whether such corporate guarantees given without any consideration shall be liable to GST. A Supreme Court ruling issued earlier this year has clarified that corporate guarantees issued without any consideration shall not be liable to service tax. 

Therefore while the situation in case of levy of service tax has been clarified by the ruling, the same has led to a lot of ambiguities and questions for the levy of GST on such guarantees. This article aims to clarify the same.   

Corporate Guarantees: under Service tax and under GST

As mentioned above, service tax will not be levied upon corporate guarantees issued without any consideration. However, here it is important to understand the reason why the Supreme Court’s view in case of service tax will not be applicable on the GST regime. 

Section 65B(44) of the Finance Act, 1994 defined service to mean ” any activity carried out by a person for another for consideration, and includes a declared service.” Therefore, the service tax regime only considers such activities as service which are rendered for valuable consideration. 

On the other hand the Schedule 1 of the CGST Act, 2017 states that Supply of goods or services or both between related persons or between distinct persons when made in the course or furtherance of business shall be treated as supply even if made without consideration.

Accordingly, the GST regime unlike the service tax regime will apply even if the supply is made without any consideration between related parties. 

View of the tax authorities

The tax authorities have been raising GST demands on corporations which are a party to such corporate guarantees issued without any consideration. Further, in cases where the holding company is located overseas, the demand is being raised on the Indian subsidiary under a reverse charge mechanism. 

The authorities are of the view that corporate guarantees are issued by a parent company to maximize the returns on investment on these subsidiaries and are therefore liable to GST.

However, before we jump to any conclusions as to whether GST shall be applicable in case of corporate guarantees it is important for us to understand the concept of related parties under the GST regime. 

Related party and Corporate guarantees

Related party transactions always follow the presumption of not being at arm’s length and therefore tax provisions prescribe that the transactions should be undertaken at market value and be based on usual commercial terms, as if done with a third party. Transactions with related parties are always subject to scrutiny and are required to demonstrate that the transactions are driven by commercial understanding. The GST regime also prescribes for definition of related persons and applicability of valuation rules, as prescribed in case of transactions with related persons. 

Section 15 of the Central GST Act states that the value of supply of goods or services shall be considered to be the actual price paid or payable for the purpose of taxation, where the transaction is not between related persons and price is the sole consideration for supply. In case the supply of goods or services is between related persons then the value of such supplies shall be determined by the valuation rules prescribed in this regard. 

Who are related persons?

Explanation to Section 15 of the Central GST Act explains that 

1. persons shall be deemed to be “related persons” if 

• such persons are officers or directors of one another’s businesses; 
• such persons are legally recognised partners in business; 
• such persons are employer and employee; any person directly or indirectly owns, controls or holds twenty-five per cent. or more of the outstanding voting stock or shares of both of them; one of them directly or indirectly controls the other; 
• both of them are directly or indirectly controlled by a third person; 
• together they directly or indirectly control a third person; or 
• they are members of the same family; 

2. the term “person” also includes legal persons; 
3. persons who are associated in the business of one another in that one is the sole agent or sole distributor or sole concessionaire, howsoever described, of the other, shall be deemed to be related. Therefore holding and subsidiary, associates, fellow subsidiaries shall be taken to be related persons. 

In view of the above discussion, it seems that GST will be applicable on corporate guarantees issued without any consideration. However, for imposing GST, the value of the guarantees first need to be determined. Therefore, the question which now arises is how would one value such corporate guarantees issued without any consideration ?

Valuation of consideration less corporate guarantees for levy of GST?

Rule 2 of the Determination of Value of Supply Rules, provides for determining the value of supply of goods and/ or services between distinct or related persons, other than through agent The rule prescribes that the value of the supply between related persons shall be: 

• the open market value of such supply; 
• where open market value of such supply is not available, it shall be the value of supply of like kind and quality; and 
• where the value cannot be determined by the mechanisms stated in (a) and (b) above, it shall be determined by application of Rule 4 or Rule 5 of the aforesaid rules. 

Guarantees provided by holding to a subsidiary or transactions alike between related persons will be considered to be a supply of service for the purpose of GST and usually, there is no guarantee commission charged. So in case of guarantees provided by related persons, the valuation rules shall apply. Also there is no market for guarantee commissions or service of like nature. 

Proviso to Rule 2 states that – 

“Provided that where goods are intended for further supply as such by the recipient, the value shall, at the option of the supplier, be an amount equivalent to ninety percent of the price charged for the supply of goods of like kind and quality by the recipient to his customer not being a related person.

Provided further that where the recipient is eligible for full input tax credit, the value declared in the invoice shall be deemed to be the open market value of goods or services.“

The provisos creates a carve out, 

a) where there is regular supply of such goods or 

b) where the recipient is eligible for full input tax credit, the value of the supply shall be  based on the invoice value for the purpose of taxability. 

In case of guarantee the relevant proviso is where the recipient is a full input tax credit eligible entity. In case it is not, then one will have to look at Rule 4 and Rule 5 to conclude on the value of supply. 

Rule 4 and Rule 5 

Rule 4 states that – 

“Where the value of a supply of goods or services or both is not determinable by any of the preceding rules, the value shall be one hundred and ten percent of the cost of production or manufacture or cost of acquisition of such goods or cost of provision of such services.”

In case of guarantees there cannot be a computation of costs. Therefore the rule is not relevant. 

Rule 5 is the residual method of valuation and states that – 

“Where the value of supply of goods or services or both cannot be determined under rules 1 to 4, the same shall be determined using reasonable means consistent with the principles and general provisions of section 15 and these rules.”

Rule 5 exposes the determination of value of supply to the discretion of the tax officer. 

The officer can apply any methodology to arrive at the value of guarantee for the purpose of tax. 

The definition of related persons and the rationale for valuation is in lines with the World Trade Organisation Customs Valuation Agreement. 

Valuation of Corporate guarantees 

We have already discussed how consideration-less guarantees can be valued as per the GST regime. 

While there are several sophisticated ways of pricing guarantees however, two very common ways of pricing a corporate guarantee have been provided below: 

1. Value of Guarantee = Value of Uncovered Transaction – Value of Covered Transaction

Here, the basic objective is to price the transaction based on the difference in the value of the loan with and without the guarantee.

Say, a lending institution was asking for interest @10% for a loan being obtained by the guarantee. Now because of the presence of a guarantor, the rate of interest comes down to 8%. Here in this case the value of the guarantee should be based on 2% of the loan amount. 

2. Expected losses approach:

The second approach is based on expected losses from the exposure. The guarantee commission should adequately cover the expected losses.

Here,

Expected loss = Loss given default * probability; and Loss given default = amount for which guarantee is given * (1-recovery rate)

[Note: In a guarantee, generally a part of the amount is recovered from the principal debtor through a counter guarantee or a security. Therefore the guarantee fee should be calculated after taking into account the same.]

Conclusion

In light of the above discussion it seems that GST will be applicable on corporate guarantees issued without any consideration as under the GST regime, there is no question of treating the value of the service as zero. It therefore increases the cost of providing guarantee, dissuading companies from giving guarantees.

However, it would require a clarification by the tax authorities themselves or perhaps another court ruling to decide on the applicability of GST in case of such consideration less corporate guarantees. 

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Earlier version of the article can be accessed here