The Promise of Predictability: Regulation and Taxation of Future Flow Securitization

Dayita Kanodia | Executive | finserv@vinodkothari.com

The most reliable way to predict the future is to create it

– Abraham Lincoln

Surely, Lincoln did not have either  securitisation  or predictability in mind when he wrote this motivational piece; however, there is an interesting and creative use of securitisation methodology, to raise funding based on cashflows which have some degree of predictability.  In many businesses, once an initial framework has been created, cashflows trickle over time without much performance over time. These situations become ideal to use securitisation, by pledging this stream of cashflows to raise funding upfront. Surely, traditional methods of on-balance-sheet funding fail here, as there is very little assets on the balance sheet.

Future flow securitization represents a financial technique used to raise funds by leveraging anticipated future revenue streams. In this process, future income is pledged from specific assets or revenue-generating activities as collateral for issuing securities. Mostly, the assets or the contracts from which the cashflows will arise are already there.

Unlike traditional asset-backed securities which are backed by existing assets, future flow securitization relies on the projected income generated from future business operations, such as export receivables, subscription fees, royalties, or future revenues from existing resources such as plantations, mines, etc.. These future cash flows are packaged into securities and sold to investors, providing immediate funding to the originator.

The table below gives a comparison of asset backed securitisation and future flow securitisation:

Particulars	Asset-backed securitisation	Future flow securitisation
Legal nature	Existing sale of existing receivables	Sale or agreement to sell receivables in future, such that the sale ripens when receivables arise
Nature of receivables	Contractual receivables for something done or service rendered	Expected receivables from a source or infrastructure already laid out or existing
Intent of the transaction	To sell a right in receivables and to pass on risks/rewards in the receivables to investors, with credit enhancements	To raise funding collateralised by cashflows, along with mechanism of trapping receivables
Nature of amount received by originator	Consideration for sale of receivables	Funding that will be paid, in the first instance, from out of the cashflows
Accounting treatment	Subject to de-recognition conditions, may go off the balance sheet	De-recognition question does not arise as the assets were not on the balance sheet to begin with
Typical ratings	Originator independent ratings, may rise to AA/ AAA	Originator-dependent ratings; usually capped based on originator performance risk
Typical credit enhancements	Subordination	Over-collateralisation

However, the question which will arise now is – are there any regulations in India that govern future flow securitization ?

This article examines the regulatory and taxation  framework surrounding future flow securitization in India, aiming to ascertain the level of regulatory clarity on the subject.

Regulations governing securitization in India

In India there are currently three regulatory frameworks which govern securitization:

1. Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021^[1] (‘SSA Directions’)
2. SEBI (Issue and Listing of Securitised Debt Instruments and Security Receipts) Regulations, 2008^[2] (SDI Framework’)
3. Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002^[3]

Section 115 TCA of the Income Tax Act, which outlines the provisions for taxing income earned by investors from securitization trusts, also acknowledges the regulations mentioned above.

Where does future flow securitization fall within this regulatory framework?

Securitisation volumes in India have topped INR 1.15 trillion in the first nine months of 2023 which represents a 42% year-on-year increase according to rating agency CRISIL^[4]. highlighting its established presence in the financial landscape. However, amidst the existing regulatory framework and oversight bodies, the question which arises is how does future flow securitisation integrate within the current regulatory landscape?

As we know, in future flow securitisation unlike securitisation of loan receivables, the originator can be anyone and not just financial sector entities. For instance, in case of music royalty securitisation, the originator will be the copyright holder.

However, the applicability of the SSA directions is:

• “All Scheduled Commercial Banks (including Small Finance Banks but excluding Regional Rural Banks);
• All All-India Term Financial Institutions (NABARD, NHB, EXIM Bank, and SIDBI);
• All Non-Banking Financial Companies (NBFCs) including Housing Finance Companies (HFCs)”

Accordingly, future flow securitisation cannot be governed by the SSA directions.

However, SEBI’s SDI framework leaves the situation quite open ended. The framework is applicable in case of:

“(a)public offers of securitised debt instruments;

(b)listing of securitised debt instruments issued to public or any person(s),on a recognised stock exchange;

(c)listing of security receipts issued to qualified buyer(s) on a recognized stock exchange in terms of Chapter VIIA, Chapter VIII and Chapter X.”

Further, we can also refer to the definition of originator under both the regulations:

Originator	SSA Directions	SDI Framework
	refers to a lender that transfers from its balance sheet a single asset or a pool of assets to an SPE as a part of a securitisation transaction and would include other entities of the consolidated group to which the lender belongs	means the assignor  of  debt  or  receivables  to  a  special  purpose  distinct entity for the purpose of securitisation

Accordingly, future flow securitization may be governed by the SDI framework. However, for it to fall within this framework, the securities backed by the future receivables issued to the investors will have to be listed.

Key Provisions of the SDI Framework

Since, future flow securitisation will be governed by the SDI framework, it is crucial to discuss some key provisions of the framework:

Registration Requirements: Any issuer intending to issue securitized debt instruments or security receipts must register with SEBI. The registration process involves submitting necessary documents and disclosures, including details of the underlying assets, structure of the transaction, and risk factors.

Due Diligence and Disclosure: Issuers are required to conduct thorough due diligence on the underlying assets and disclose all material information to investors. This includes information on the originator, credit enhancement mechanisms, servicing arrangements, and risks associated with the transaction.

Special Purpose Distinct Entity (SPDE): The SDI Framework requires the SPDE to be in the form of a trust. It is further prohibited from raising any money otherwise through the issue of securitized debt instruments.

Assignment of debt or receivables: The SDI Framework imposes certain conditions on the debt or receivables proposed to be assigned to the SPDE. One such condition is that the debt or receivable assigned should have reasonable prospects of generating identifiable cash flows for the purpose of servicing the securitised debt instruments. Except this there are various other conditions imposed for assignment of debt or receivable to the SPDE.

Listing Requirements: As discussed above, future flows securitisation will only be governed by the SDI framework if the securities backed by the future receivables are listed.

Securitized debt instruments and security receipts can be listed on stock exchanges, subject to compliance with listing requirements specified by SEBI and the respective stock exchanges. Listing also enhances liquidity and provides investors with an exit route for their investments.

Continuous Disclosure: Issuers are mandated to make timely and accurate disclosures to investors and stock exchanges throughout the life of the securitization transaction. This ensures transparency and enables investors to make informed decisions.

Role of Trustees: Trustees play a crucial role in ensuring compliance with regulatory requirements and protecting the interests of investors. They are responsible for monitoring the performance of the underlying assets and enforcing the terms of the transaction.

It may be noted that the net outstanding amount pertaining to the securitised debt instruments was Rs. 3622 billion as on December 2023.

Taxation of Income from Future Flows Securitisation

As mentioned above, section 115TCA of the income tax act governs the taxation aspect of income arising out of securitization. It acknowledges SEBI’s SDI framework and accordingly, listed securities backed by future receivables will fall into this section of the Income Tax Act.

Section 115TCA(1) provides that,

“Notwithstanding anything contained in this Act, any income accruing or arising to, or received by, a person, being an investor of a securitisation trust, out of investments made in the securitisation trust, shall be chargeable to income-tax in the same manner as if it were the income accruing or arising to, or received by, such person, had the investments by the securitisation trust been made directly by him.”

In simpler terms, this means that the income earned by an investor from their investments in a securitisation trust is treated as if the investor had made those investments directly in the underlying assets, bypassing the trust structure altogether. Consequently, the taxation of such income follows the same rules and procedures that would apply if the investor had indeed made the investments directly.

Key provisions of Section 115TCA

Section 115TCA can be summarised as follows:

Taxability of Income:

As discussed above, according to sub-section (1) of Section 115TCA, any income received by investors from securitisation trusts is chargeable to income tax as if the investments were made directly by the investor.

Nature of Income:

Sub-section (2) stipulates that income paid or credited by the securitisation trust shall be deemed to be of the same nature and in the same proportion in the hands of the investor.

Deemed Crediting of Income:

Sub-section (3) states that if income is not paid or credited to the investor, it shall be deemed to have been credited to the investor’s account on the last day of the previous year.

Reporting Requirements:

Sub-section (4) mandates the furnishing of a statement by the person responsible for crediting or making payment of income, providing details of the income paid or credited during the previous year.

Exclusion from Total Income:

Sub-section (5) elucidates that any income included in the total income of the investor in a previous year shall not be included in the total income of the investor in the year in which the income is actually paid by the securitisation trust.

However, here it is to be noted that, the above discussion applies only to pass through structures and not to pay through securitization.

What if SEBI’s SDI Framework is not applicable ?

As discussed above, future flow securitisation will only be governed by the SDI Framework if the securities issued to the investors are listed. So what will the consequence be if none of the previously mentioned three regulations govern it ?

We have previously discussed that section 115TCA explicitly recognizes only the three aforementioned regulatory frameworks on securitisation in India. Consequently, income generated from securitisation trusts would not fall within the purview of this section if it does not integrate with these specified regulatory frameworks.

In such a case, it will be taxed in the manner laid down under section 115TA, 115TB and 115TC of the income tax act.

Notably, in this case a very high rate of tax may be levied. For ease of reference, section 115TA(1) has been reproduced below:

“Notwithstanding anything contained in any other provisions of the Act, any amount of income distributed by the securitisation trust to its investors shall be chargeable to tax and such securitisation trust shall be liable to pay additional income-tax on such distributed income at the rate of—

  (i) twenty-five per cent on income distributed to any person being an individual or a Hindu undivided family;

 (ii) thirty per cent on income distributed to any other person”

Concluding Remarks

The regulatory framework surrounding future flow securitization in India is essential for ensuring transparency, investor protection, and financial stability. Accordingly, regulatory clarity on the subject is essential. However, since the securitization of future receivables may relate to any industry, it will be difficult to have in place a single regulatory framework governing future flow securitization across industries.

Our articles on the subject – Securitization of future flows

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^[1] https://www.rbi.org.in/scripts/bs_viewmasdirections.aspx?id=12165

^[2] https://www.sebi.gov.in/legal/regulations/aug-2023/sebi-issue-and-listing-of-securitised-debt-instruments-and-security-receipts-regulations-2008-last-amended-on-august-18-2023-_76336.html

^[3] https://www.indiacode.nic.in/bitstream/123456789/2006/1/A2002-54.pdf

^[4] https://www.businessinsider.in/finance/news/securitisation-volume-in-india-jumps-42-past-1-15-lakh-cr-mark-in-9mfy23-crisil/articleshow/97033426.cms