Revision of criteria of non-company entities on which AS shall be applicable

CS Aisha Begum Ansari and Harsh Juneja (corplaw@vinodkothari.com )

Introduction

For the purpose of applicability of Accounting Standards (“AS”), The Institute of Chartered Accountants of India (“ICAI”) has classified the entities into two segments – company entities and non-company entities. Non-company entities such as sole proprietors, partnership firms, trusts, Hindu Undivided Families, association of persons and co-operative societies are further classified into various levels. Currently, the ICAI has categorized non-company entities into 3 levels.

With increasing number of non-company entities, the ICAI has, now, further classified them into 4 levels. The amendments have been brought to reduce stringency on non-company entities which were earlier required to comply with all AS in pursuance of being level I entities as the norms for the same have been revised.

Since most of the Special Purpose Vehicle(s) (“SPV”s) are in the form of non-company entities, they were required to comply with all accounting standards as most of these were covered under level I category. However, with the proposed changes, the burden of strict adherence to AS will be reduced for SPVs falling under level I category.

This Article is an attempt to cover the proposed revision criteria for application of AS on non-company entities.

Proposed applicability

It is proposed that this scheme be made effective in respect of accounting periods commencing on or after April 1, 2020. However, the same shall be effective once the required changes are incorporated in the AS while publishing the updated Compendium of AS.

Non-company entities[1] on which Ind AS is not applicable. It should be noted that such entities have been classified in 4 levels basis different criteria including turnover and borrowing and classified as large – medium – small and micro entities- last three referred to as MSMEs.

Entities belonging to level II, III, IV have been granted certain exemption. It is to be noted that the applicability of AS has been made milder as one goes down the four level of entities i.e to say, maximum relaxations / exemptions are given to level IV entities.

Disclosures

All non-company entities which are covered under this Proposal, are required to make following disclosures:

  1. That the AS has been complied by the entity;
  2. The level to which the entity belongs and whether it has availed exemptions granted to such level;
  3. Availing of partial exemption – It is to be noted that the entities are allowed to cherry-pick the exemptions they intend to avail. However, such partial availing of exemption should not be misleading. That the entity has cherry-picked the exemptions and not availed all the exemptions granted to such level should be disclosed as to which all exemptions it has availed;

 Transition

The Proposal also talks about disclosure / rules of transition from one level to another, which are as follows:

  1. From transition from a higher level to a lower level – relaxations / exemptions of the lower level may be availed only on staying at such level for two consecutive years.
  2. From transition from a lower level to higher level – while the disclosures pertaining to the higher level becomes applicable, however no change / revision is required to be made in the previous year [where the entity was classified as a lower level, and had availed exemptions / relaxation as such] is required to be made. However, disclosure of such fact is required to be made in the notes to financial statement.
Levels Existing criteria for classification [2019][2] New criteria for classification Applicability
I

[Large]

1.      Equity / Debt Listed / to be listed entity

a)     Entities listed on overseas exchanges also included

2.      Banks (including co-operative banks), FIs, Insurance entities

3.      Entities having [3]turnover in the (excluding other income) > 50 crores

4.      Borrowings (including public deposit) > 10 crores

5.      Holding and subsidiary entities of the above

1.     Listed / to be listed entity

a)     Entities listed on overseas exchanges also included

2.      Banks (including co-operative banks), FIs, Insurance entities

3.      Entities having turnover in the (excluding other income) > 250 crores

4.      Borrowings (including public deposit) > 50 crores

5.      Holding and subsidiary entities of the above

All 29 AS applicable in full.
II [Medium] 1.      Entities having turnover in the (excluding other income) > 40 lakhs ≤ 50 crores

2.      Borrowings (including public deposit) > 1 crores ≤ 5 crores

For turnover / borrowing criteria – only such entities shall be regarded which  are engaged in commercial, industrial or business activities

Holding and subsidiary entities of the above

1.      Entities having turnover in the (excluding other income) > 50 crores ≤ 250 crores

2.      Borrowings (including public deposit) > 10 crores ≤ 50 crores

For turnover / borrowing criteria – only such entities shall be regarded which  are engaged in commercial, industrial or business activities

3.      Holding and subsidiary entities of the above

A.      Accounting Standard(s) not applicable:

AS 3   – Cash Flow Statements

AS 17 – Segment Reporting

AS 20 – Earnings Per Share

 

B.      Accounting Standard(s) applicable with disclosure exemption:

AS 19 – Leases

AS 28 – Impairment of Assets

AS 29 – Provisions, Contingent Liabilities and Contingent Assets

 

C.      Accounting Standard(s) applicable with exemptions:

AS 15 – Employee Benefits

 

D.     Accounting Standard(s) applicable with Note: [following AS, being related to CFS, the same is not applicable to Level II, III, IV entities unless they voluntary decide to consolidate the financial statements]

AS 21 – Consolidated Financial Statements

AS 23 – Accounting for Investments in Associates in Consolidated Financial Statements

AS 25 – Interim Financial Reporting

AS 27 – Financial Reporting of Interests in Joint Ventures (to the extent of requirements relating to Consolidated Financial Statements)

 

III

[Small]

Remaining non corporate entities 1.      Entities having turnover in the (excluding other income) > 10 crores ≤ 50 crores

2.      Borrowings (including public deposit) > 2 crores ≤ 10 crores

For turnover / borrowing criteria – only such entities shall be regarded which are engaged in commercial, industrial or business activities

3.      Holding and subsidiary entities of the above

All exemptions provided to Level II shall be applicable. Further exemptions:

 

A.      In addition to full exemptions as given in Level II, further Accounting Standard(s) not applicable:

 

AS 18 – Related Party Disclosures

AS 24 – Discontinuing Operations

 

B.      In addition to disclosure exemption as given in Level II, further Accounting Standard(s) applicable with disclosure exemption:

 

AS 10 – Property, Plant and Equipment

AS 11 – The Effects of Changes in Foreign Exchange Rates

IV [Micro] There were only III levels Remaining non corporate entities All exemptions provided to Level III shall be applicable. Further exemptions:

 

A.      In addition to full exemptions as given in Level III, further Accounting Standard(s) not applicable:

 

AS 14 – Accounting for Amalgamations

AS 28 – Impairment of Assets

AS 22 is applicable only for current tax related provisions.

 

B.      In addition to disclosure exemption as given in Level III, further Accounting Standard(s) applicable with disclosure exemption:

 

AS 13 – Accounting for Investments

 

Conclusion

As discussed above, the intent to revise the criteria for classification of non-company entities is to provide exemptions/ relaxations from applicability of all AS to certain entities covered under level I as they will now be shifted to descending levels. These proposed amendments will also lessen the difficulties faced by non-company entities falling under the existing levels as they will be provided with partial or full exemptions by getting transferred to descending levels.

 

[1]This Announcement supersedes the earlier Announcement of the ICAI on ‘Harmonisation of various differences between the Accounting Standards issued by the ICAI and the Accounting Standards notified by the Central Government’ issued in February 2008, to the extent it prescribes the criteria for classification of Non-company entities (Non-corporate entities) and applicability of Accounting Standards to non-company entities, and the Announcement ‘Revision in the criteria for classifying Level II non-corporate entities’ issued in January 2013.

[2] https://resource.cdn.icai.org/56169asb45450.pdf

[3] For turnover / borrowing criteria – only such entities shall be regarded which  are engaged in commercial, industrial or business activities

 

About time to unfreeze NPA classification and reporting

-Siddarth Goel (finserv@vinodkothari.com)

Introduction

The COVID pandemic last year was surely one such rare occurrence that brought unimaginable suffering to all sections of the economy. Various relief measures granted or actions taken by the respective governments, across the globe, may not be adequate compensation against the actual misery suffered by the people. One of the earliest relief that was granted by the Indian government in the financial sector, sensing the urgency and nature of the pandemic, was the moratorium scheme, followed by Emergency Credit Line Guarantee Scheme (ECLGS). Another crucial move was the allowance of restructuring of stressed accounts due to covid related stress. However, every relief provided is not always considered as a blessing and is at times also cursed for its side effects.

Amid the various schemes, one of the controversial matter at the helm of the issue was charging of interest on interest on the accounts which have availed payment deferment under the moratorium scheme. The Supreme Court (SC) in the writ petition No 825/2020 (Gajendra Sharma Vs Union of India & Anr) took up this issue. In this regard, we have also earlier argued that government is in the best position to bear the burden of interest on interest on the accounts granted moratorium under the scheme owing to systemic risk implications.[1] The burden of the same was taken over by the government under its Ex-gratia payment on interest over interest scheme.[2]

However, there were several other issues about the adequacy of actions taken by the government and the RBI, filed through several writ petitions by different stakeholders. One of the most common concern was the reporting of the loan accounts as NPA, in case of non-payment post the moratorium period. The borrowers sought an extended relief in terms of relaxation in reporting the NPA status to the credit bureaus. Looking at the commonality, the SC took the issues collectively under various writ petitions with the petition of Gajendra Sharma Vs Union of India & Anr. While dealing with the writ petitions, the SC granted stay on NPA classification in its order dated September 03, 2020[3]. The said order stated that:

In view of the above, the accounts which were not declared NPA till 31.08.2020 shall not be declared NPA till further orders.”

The intent of granting such a stay was to provide interim relief to the borrowers who have been adversely affected by the pandemic, by not classifying and reporting their accounts as NA and thereby impacting their credit score.

The legal ambiguity

The aforesaid order dated September 03, 2020, has also led to the creation of certain ambiguities amongst banks and NBFCs. One of them being that whether post disposal of WP No. 825/2020 Gajendra Sharma (Supra), the order dated September 03, 2020, should also nullify. While another ambiguity being that whether the stay is only for those accounts that have availed the benefit under moratorium scheme or does it apply to all borrowers.

It is pertinent to note that the SC was dealing with the entire batch of writ petitions while it passed the common order dated September 03, 2020. Hence, the ‘stay on NPA classification’ by the SC was a common order in response to all the writ petitions jointly taken up by the court. Thus, the stay order on NPA classification has to be interpreted broadly and cannot be restricted to only accounts of the petitioners or the accounts that have availed the benefit under the moratorium scheme. As per the order, the SC held that accounts that have not been declared/classified NPA till August 31, 2020, shall not be downgraded further until further orders. This relaxation should not just be restricted to accounts that have availed moratorium benefit and must be applied across the entire borrower segment.

The WP No. 825/2020 Gajendra Sharma (Supra) was disposed of by the SC in its judgment dated November 27, 2020[4], whereby in the petition, the petitioner had prayed for direction like mandamus; to declare moratorium scheme notification dated 27.03.2020 issued by Respondent No.2 (RBI) as ultra vires to the extent it charges interest on the loan amount during the moratorium period and to direct the Respondents (UOI and RBI) to provide relief in repayment of the loan by not charging interest during the moratorium period.

The aforesaid contentions were resolved to the satisfaction of the petitioner vide the Ex-gratia Scheme dated October 23, 2020. However, there has been no express lifting of the stay on NPA classification by the SC in its judgment. Hence, there arose a concern relating to the nullity of the order dated September 03, 2020.

The other writ petitions were listed for hearing on December 02, 2020, by the SC via another order dated November 27, 2020[5]. Since then the case has been heard on dates 02, 03, 08, 09, 14, 16, and 17 of December 2020. The arguments were concluded and the judgment has been reserved by the SC (Order dated Dec 17, 2020[6]).

As per the live media coverage of the hearing by Bar and Bench on the subject matter, at the SC hearing dated December 16, 2020[7], the advocate on behalf of the Indian Bank Association had argued that:

It is undeniable that because of number of times Supreme Court has heard the matter things have progressed. But how far can we go?

I submit this matter must now be closed. Your directions have been followed. People who have no hope of restructuring are benefitting from your ‘ don’t declare NPA’ order.

Therefore, from the foregoing discussion, it could be understood that the final judgment of the SC is still awaited for lifting the stay on NPA classification order dated September 03, 2020.

Interim Dilemma

While the judgment of the SC is awaited, and various issues under the pending writ petitions are yet to be dealt with by the SC in its judgment, it must be reckoned that banking is a sensitive business since it is linked to the wider economic system. The delay in NPA classification of accounts intermittently owing to the SC order would mean less capital provisioning for banks. It may be argued that mere stopping of asset classification downgrade, neither helps a stressed borrower in any manner nor does it helps in presenting the true picture of a bank’s balance sheet. There is a risk of greater future NPA rebound on bank’s balance sheets if the NPA classification is deferred any further. It must be ensured that the cure to be granted by the court while dealing with the respective set of petitions cannot be worse than the disease itself.

The only benefit to the borrower whose account is not classified NPA is the temporary relief from its rating downgrade, while on the contrary, this creates opacity on the actual condition of banking assets. Therefore, it is expected that the SC would do away with the freeze on NPA classification through its pending judgment. Further, it is always open for the government to provide any benefits to the desired sector of the economy either through its upcoming budget or under a separate scheme or arrangement.

THE VERDICT

[Updated on March 24, 2021]

The SC puts the final nail to almost a ten months long legal tussle that started with the plea on waiver of interest on interest charged by the lenders from the borrowers, during the moratorium period under COVID 19 relief package.  From the misfortunes suffered by the people at the hands of the pandemic to economic strangulation of people- the battle with the pandemic is still ongoing and challenging. Nevertheless, the court realised the economic limitation of any Government, even in a welfare state. The apex court of the country acknowledged in the judgment dated March 23, 2020[8], that the economic and fiscal regulatory measures are fields where judges should encroach upon very warily as judges are not experts in these matters. What is best for the economy, and in what manner and to what extent the financial reliefs/packages be formulated, offered and implemented is ultimately to be decided by the Government and RBI on the aid and advice of the experts.

Thus, in concluding part of the judgment while dismissing all the petitions, the court lifted the interim relief granted earlier- not to declare the accounts of respective borrowers as NPA. The last slice of relief in the judgement came for the large borrowers that had loans outstanding/sanctioned as on 29.02.2020 greater than Rs.2 crores. The court did not find any rationale in the two crore limit imposed by the Government for eligibility of borrowers, while granting relief of interest-on-interest (under ex-gratia scheme) to the borrowers.[9] Thus, the court directed that there shall not be any charge of interest on interest/penal interest for the period during moratorium for any borrower, irrespective of the quantum of loan. Since the NPA stay has been uplifted by the SC, NBFCs/banks shall accordingly start classification and reporting of the defaulted loan accounts as NPA, as per the applicable asset classification norms and guidelines.

Henceforth, the CIC reporting of the defaulted loan accounts (NPA) must also be done. Surely, the said directions of the court would be applicable only to the loan accounts that were eligible and have availed moratorium under the COVID 19 package. [10]

The lenders should give credit/adjustment in the next instalment of the loan account or in case the account has been closed, return any amount already recovered, to the concerned borrowers.

Given that the timelines for filing claims under the ex-gratia scheme have expired, it is expected that the Government would be releasing extended/updated operational guidelines in this regard for adjustment/ refund of the interest in interest charged by the lenders from the borrowers.

 

 

[1] http://vinodkothari.com/2020/09/moratorium-scheme-conundrum-of-interest-on-interest/

[2] http://vinodkothari.com/2020/10/interest-on-interest-burden-taken-over-by-the-government/#:~:text=Blog%20%2D%20Latest%20News-,Compound%20interest%20burden%20taken%20over%20by%20the%20Central%20Government%3A%20Lenders,pass%20on%20benefit%20to%20borrowers&text=Of%20course%2C%20the%20scheme%2C%20called,2020%20to%2031.8.

[3] https://main.sci.gov.in/supremecourt/2020/11127/11127_2020_34_16_23763_Order_03-Sep-2020.pdf

[4] https://main.sci.gov.in/supremecourt/2020/11127/11127_2020_34_1_24859_Judgement_27-Nov-2020.pdf

[5] https://main.sci.gov.in/supremecourt/2020/11127/11127_2020_34_1_24859_Order_27-Nov-2020.pdf

[6] https://main.sci.gov.in/supremecourt/2020/11162/11162_2020_37_40_25111_Order_17-Dec-2020.pdf

[7] https://www.barandbench.com/news/litigation/rbi-loan-moratorium-hearings-live-from-supreme-court-december-16

[8] https://main.sci.gov.in/supremecourt/2020/11162/11162_2020_35_1501_27212_Judgement_23-Mar-2021.pdf

[9] Compound interest burden taken over by the Central Government: Lenders required to pass on benefit to borrowers – Vinod Kothari Consultants

[10] Moratorium on loans due to Covid-19 disruption – Vinod Kothari Consultants; also see Moratorium 2.0 on term loans and working capital – Vinod Kothari Consultants

 

 

Corporate Restructuring- Corporate Law, Accounting and Tax Perspective

Resolution Division 

(resolution@vinodkothari.com)

Restructuring is the process of redesigning one or more aspects of a company, and is considered as a key driver of corporate existence. Depending upon the ultimate objective, a company may choose to restructure by several modes, viz. mergers, de-mergers, buy-backs and/ or other forms of internal reorganisation, or a combination of two or more such methods.

However, while drafting a restructuring plan, it is important to take into consideration several aspects viz. requirements under the Companies Act, SEBI Regulations, Competition Act, Stamp duty implications, Accounting methods (AS/ Ind-AS), and last but not the least, taxation provisions.

In this presentation, we bring to you a compilation of the various modes of restructuring and the applicable corporate law provisions, accounting standards and taxation provisions.

http://vinodkothari.com/wp-content/uploads/2020/11/Corprorate-Restructuring-Corporate-Law-Accounting-Taxation-Perspective.pdf

GST on consideration paid to a director

Demarcation of salary and fees makes the difference

-Kanakprabha Jethani and Qasim Saif

(finserv@vinodkothari.com)

Introduction

The Goods and Services Tax laws (GST) introduced in 2017, also brought with itself, a concept of Reverse Charge Mechanism (RCM). GST is a tax on supply, however, under the concept of RCM, the liability to pay tax is on the recipient of supply of goods and services instead of the supplier of such goods or services.

Section 9(3) and 9(4) of the Central Goods and Services Tax Act, 2017 (CGST Act) provide two scenarios in which tax shall be chargeable on RCM basis:

  1. Supplies notified by Government u/s 9(3)
  2. Taxable Supplies by unregistered person to registered person

The government, pursuant to section 9(3) notified that any services supplied by a director of a company to the said company shall be taxed on RCM basis.  

While it is clear that as per section 7(2) and schedule III of the CGST Act keep the services provided by an employee to its employer outside the purview of GST. This raised concerns on differential treatment between services of an executive director and an employee of a company.

The recent ruling of Rajasthan Authority of Advance Ruling (AAR) has provided a landmark decision that would be guiding the tax treatment of services provided by the directors. The following write-up intends to provide a basic understanding of RCM and critically analyse the ruling of Rajasthan AAR.

Understanding RCM

RCM can be understood as a method of levying GST under which the liability to pay tax is upon the recipient of services rather than on supplier. Following figure explains taxation on RCM basis:

For further understanding of taxability on RCM basis- read our detailed FAQs here- http://vinodkothari.com/2017/08/faqs-on-gst-on-directors-remuneration/#_ftn3

Levy of GST on Director’s Remuneration

As discussed above, the focal point of issued in GST on director’s remuneration is that GST is not chargeable on services provided by employees but is chargeable of services of directors. Hence, the key question for determination of GST liability will be determining the nature of the employment of a person.

Can director be an employee?

Principally yes. Going by the principles of the Companies Act, 2013 (CA), there is no bar on a director handling operations of a company like any other employee. In fact, the CA has a concept of executive and non-executive directors. Rule 2 (k) of the Companies (Specification of Definitions Details) Rules, 2014 defines executive director as-

“Executive Director” means a whole time director as defined in clause (94) of section 2 of the Act;

Further, whole-time director is defines in the CA as-

“whole-time director” includes a director in the whole-time employment of the company

From the above, it is clear that a director can also be an employee of a company.

Taxability on services of ‘Director + Employee’

The above discussion clarifies that a person can be both employee as well as director of a company. The question in this case will be the whether services provided by such person would be taxable under GST law? Would an executive director be treated as an employee of a company both under CA and CGST Act?

This issue was raised in the matter of Clay Craft India Private Limited[1] (‘Company’), where advance ruling was sought on whether GST would be payable on RCM basis on the salary paid to directors, given that-

  • directors are compensated by way of regular salary and other allowances as per the employment contract;
  • the Company is deducting TDS on salary and also PF norms are being complied;
  • the income of directors is shown as “income from salary” by the directors in their ITRs;
  • the Company deducts EPF contribution from the salary of directors as it does for its other employees;
  • the Company pays GST on commission paid to the directors but not on the salary paid to them.

The AAR, considering the above facts, provided the following observations:

  • GST law does not recognise payment of salary to directors. It only recognises ‘consideration’ paid to directors- which shall mean any payment made or to be made, whether in money or otherwise, in respect of, in response to or for inducement of, the supply of goods or services or both.
  • Consideration paid to directors is specifically recognised through notification[2] issued under section 9(3).

Based on the above observations, the AAR held that any consideration paid to directors shall be taxable on RCM basis.

Analysis of the Ruling

The above discussed ruling failed to consider the existence of relationship of master and servant which is present in the employer-employee relationship.

Also, the AAR did not consider that the definition of whole time director under section 2(94) of the CA. The contention that director cannot be an employee does not hold good at all times.

It is pertinent to note that the outcome of an advance ruling is applicable only on the assessee who was involved in the case. However, the rulings provide guidance on the stand of revenue authorities.

Clarification issued by the CBIC

The CBIC issued a circular on June 10, 2020[3], which clearly demarcated between services provided by an independent director and a whole-time director.

Consideration for services of Independent Director

The circular clarifies that an independent director cannot be an employee of the company as definition of Independent director under section 149(6) of companies Act, 2013 state that a person being employee of Company, or its holding, subsidiary or its associate cannot be an independent director.

Hence, GST will be levied on his remuneration and the company shall be liable to pay the same on reverse charge basis.

Consideration for services of a Whole-time Director

The circular also clarified that the employer-employee relationship of a director in a company may be established on following grounds:

  • Existence of “contract of service”;
  • Remuneration paid to such director being disclosed as salaries in the accounts of company;
  • TDS being deducted under section 192 of Income Tax Act on the consideration paid to such director;

Where the above grounds are satisfied, the services provided by director in such cases shall be exempt under Schedule III of CGST Act, 2017.

However, if the remuneration is declared as any expense other than salary say professional fees, and TDS is deducted under section 192J of IT Act (Fees for professional or technical services) it shall be treated as consideration for providing service and tax on such consideration shall be paid by the company on RCM basis.

Conclusion

A person may provide his/her services to a company as an employee or a director or both. If the consideration paid is recorded as income from salary, the same is not chargeable under GST. If it is not shown as salary income under IT Act, GST on the same will be chargeable on RCM basis. Obviously, where part of consideration is shown as salary income and part is shown as other income, the GST shall be charged on the part other than salary.

The AAR ruling failed to recognise the principles of the CA that differentiate between executive and non-executive directors. However, the clarification issued by CBIC recognises those principles and provides guidance on taxability in both cases.

[1] http://www.gstcouncil.gov.in/sites/default/files/ruling-new/RAJ_AAR_33_2019-20_20.02.2020_CCIPL.pdf

[2] https://www.cbic.gov.in/resources//htdocs-cbec/gst/Notification13-CGST.pdf

[3] https://www.cbic.gov.in/resources/htdocs-cbec/gst/Circular_Refund_140_10_2020.pdf

Important Rulings -Section 56 (2) (viia), 56 (2) (x) and 56 (2) (viib) of Income Tax Act 1961

– Qasim Saif and Mahesh Jethani

finserv@vinodkothari.com

Section 56(2) (viia)

  • When shares of closely held company received without consideration or for inadequate consideration
  • Where shortfall in consideration as compared to Fair Market Value (FMV) exceeded Rs. 50,000
  • Recipient is:

(a) Firm

(b) closely held company

  • Then, FMV of such shares exceeding Rs. 50,000/- after reducing the value of consideration paid, if any, was considered as – Income from other Sources.

Section 56(2) (x)

Section 56(2)(vii)/(viia) is inoperative with effect from 1-4-2017

Clause (x) is inserted in section 56(2) to provide that the specified receipts [same as provided in Sec. 56(2)(vii)] will be taxable as income in the hands of any person, under the head ‘Income from Other Sources’

Sub-Clause (c) of Clause (x) of Section 56-Taxation of any property other than Money and Immovable Property: –

  • If received without consideration, the aggregate fair market value of which exceeds fifty thousand rupees, the whole of the aggregate fair market value of such property shall be considered Income from Other Source
  • If there is inadequate consideration whereby the difference between FMV and consideration exceeds Rs.50,000/- then difference in FMV and consideration will be considered as IFOS

Property means the following capital asset of the assessee –

(i) immovable property being land or building or both;

(ii) share and securities;

(iii) jewellery;

(iv) archaeological collections;

(v) drawings;

(vi) paintings;

(vii) sculptures; or

(viii) any work of art.

(ix) Bullion

Reason for amendments

The Memorandum to the section explains the following-

“The existing definition of property for the purpose of this section includes immovable property, jewellery, shares, paintings, etc. These anti-abuse provisions are currently applicable only in case of individual or HUF and firm or company in certain cases. Therefore, receipt of sum of money or property without consideration or for inadequate consideration does not attract these anti-abuse provisions in cases of other assessee.”

Thus, it appears that through insertion of new provision, the scope of the existing anti-abuse provision is widened to make it applicable to all assessee and also clubbing section 56(2)(vii) & section 56(2) (viia).

 

Important Rulings on Section 56(2) (viia) and 56(2) (x)

 

Taxability of the credit to the general reserve by the amalgamated company

Aamby Valley Ltd vs. ACIT (ITAT Delhi)

Date: 22nd February 2019.

Background:

Section 56(2) (viia) is an anti-abuse provision which applies only to cases of bogus capital building and money laundering. It does not apply to an amalgamation where shares are allotted at alleged undervaluation.

Increase in general reserves due to recording of assets of amalgamating company at FMV not give rise to any real income to the assessee. It is capital in nature

Judgement and conclusion:

This is an important judgement by Tribunal which deals with the taxability of the credit to the general reserve by the amalgamated company of the fair valuation of the assets received under the scheme of amalgamation. The Tribunal held that the transaction does not give rise to real income to the assessee and it thus cannot be treated as a business profit.

Provisions of Section 56 (2) (viia) will not be applicable if fair value of the shares received was not higher than the sacrifice suffered by taxpayer under the composition reorganisation scheme, as there is no incremental benefit to the shareholder.

Reserve directly credited to general reserve and not in P&L cannot be subjected to MAT.

Raising of Tax related Objection by RD when Income Tax Authority did not raise the same.

Casby Cfs Private Limited vs Casby Logistics Private Limited (Bombay High Court)

Date: 19th March 2015

Background:

In the instant case the question of law is that whether the RD could raise tax-related objections to the scheme of amalgamation though the ITA raised no objections? Whether the scheme was liable to be rejected based on the RD’s aforesaid objections?

One of the issue that was pointed out that the scheme was devised to evade capital gain tax by virtue of using the device of beneficial ownership and scheme, transferee is acquiring shares without consideration which will attract section 56 (2) (viia)

Judgement and conclusion:

Since the court was required to ensure that the scheme did not contravene any Act, the RD was not only entitled to, but was duty-bound, to bring to the HC’s notice any provision in the scheme that contravened any law. This included the Income tax law and aimed to ensure that the company did not use the HC sanction as a shield to protect itself from consequences of contravention of the law

That the ITA did not object did not prevent the RD from raising objections or making such observations with regard to the scheme as he/ she deemed fit, including those pertaining to tax laws

The HC has held that the RD is entitled to raise objections pertaining to income tax in a merger scheme, even though no objections were raised by the tax authorities.

Application of Section 56(2)(viia)/56 (2) (x) in case of Buy Back

Vora Financial Services P. Ltd vs. ACIT (ITAT Mumbai)

Date:29th June 2018

Background:

Section is a counter evasion mechanism to prevent laundering of unaccounted income under the garb of gifts. The primary condition for invoking the section is that the asset gifted should become a “capital asset” and property in the hands of recipient. If the assessee-company has purchased shares under a buyback scheme and the said shares are extinguished by writing down the share capital, the shares do not become capital asset of the assessee-company and hence s. 56(2) (viia) cannot be invoked in the hands of the assessee company

Judgement and conclusion:

A combined reading of the provisions of sec. 56(2)(viia) and the memorandum explaining the provisions show that the provisions of sec. 56(2)(viia) would be attracted when “a firm or company (not being a company in which public are substantially interested) “receives a property”, being shares in a company (not being a company in which public are substantially interested)”.

Therefore, it follows the shares should become “property” of recipient company and in that case, it should be shares of any other company and could not be its own shares. Because own shares cannot be become property of the recipient company.

Accordingly, Tribunal was of the view was that the provisions of sec. 56(2) (viia) should be applicable only in cases where the receipt of shares become property in the hands of recipient and the shares shall become property of the recipient only if it is “shares of any other company”. In the instant case, the assessee herein has purchased its own shares under buyback scheme and the same has been extinguished by reducing the capital and hence the tests of “becoming property” and also “shares of any other company” fail in this case.

The tax authorities are not justified in invoking the provisions of sec. 56(2) (viia) for buyback of own shares.

Valuation of Share to be done as per Rule 11UA

Minda SM Technocast Pvt. Ltd vs. ACIT (ITAT Delhi)

Date: 7th March 2018

Background:

Section 56(2)(viia) read with Rule 11UA, The “Fair Market Value” of shares acquired has to be determined by using the values of the underlying assets and not their market values

In the present case, the assessee has acquired shares of TEPL at Rs.5 per shares. The assessee claimed to have valued the shares of TEPL as per the provisions of Rule 11UA of the Rules. AO was of the view that the assets are to be valued at the fair market value which will increase the value of shares to 45.72 and difference Rs. 40.72 being subjected to tax.

Judgement and conclusion:

“Fair Market Value” of a property, other than an immovable property, means the value determined in accordance with the method as may be prescribed”

On the plain reading of Rule 11UA, it is revealed that while valuing the shares the book value of the assets and liabilities declared by the TEPL should be taken into consideration. There is no whisper under the provision of 11UA of the Rules to refer the Fair Market Value of the land as taken by the Assessing Officer as applicable to the year under consideration. Therefore, ITAT was of the view that the share price calculated by the assessee of TEPL for Rs. 5 per shares has been determined in accordance with the provision of Rule 11UA.

Applicability of section in case of “Gift” by one company to another.

Gagan Infraenergy Ltd vs. DCIT (ITAT Delhi)

Date: 15th May 2018

Background:

Huge volume of shares in a company were transferred by assessee to another company without any consideration and without any proper documentation being executed as per law, giving it name of “Gift”.

Question raised: Will the said transaction be covered by section 56(2)(viia) or is exempt from tax u/s 47(iii) of the Income Tax Act, 1961 (the Act)

Judgement and conclusion:

After considering all the facts and circumstances of the case, it is held that the AO has correctly observed that gift by a corporation to another corporation is a strange transaction as there cannot be a gift between artificial entities/persons. The submissions filed by the Appellant are considered and not found to be tenable.

The assessee has to establish to the hilt, the factum, genuineness and validity of the transaction, the right to enter into such transaction especially when, revenue challenges its genuineness. There is no agreement/document that has been executed between group companies forming part of family realignment. To postulate that a company can give away its assets free to another even orally, can only be aiding dubious attempts at avoidance of tax payable under the Act unless it is supported by documentary evidence

It has been vehemently contested by authorities. CIT (DR) contented that transaction has been effectuated for avoiding payment of tax and to get out of the ambit of section 56 (2) (viia) of the Act. Hence benefit of exemption under section 47 (iii) can not be granted.

 

Application of Section in case of Bonus Issue

Commissioner of Income-Tax vs Dalmia Investment Co. Ltd (Supreme Court)

Date:13th March 1964

Background

There has been a constant flip flop by the CBDT on the issue that whether the provisions of the given section would apply on fresh issue of shares. As the ambiguity prevails the highly celebrated case can be referred for determining applicability of section on Bonus Issue.

Judgement and Conclusion

The apex court in the given case while adjudicating the issue of taxability on transfer of shares held that the Bonus shares were acquired “Without Payment of price and not without consideration” hence it can be implied that Section 56(2) (viia) would not apply in case of bonus issue.

Whether it is valid in law to assess the difference between the value of the shares allotted to the taxpayer and the consideration paid by it, as the taxpayer’s income?

Sudhir Menon HUF vs. ACIT (ITAT Mumbai)

Date: 12th March 2014

Background:

Section 56(2)(vii) (c) (ii) provides that where an individual or a HUF receives any property for a consideration which is less than the FMV of the property, the difference shall be assessed as income of the recipient. The section does not apply to the issue of bonus shares because there is a mere capitalization of profit by the issuing-company and there is neither any increase nor decrease in the wealth of the shareholder as his percentage holding remains constant. Similar view can be taken while considering rights issue as well.

Judgement and conclusion:

Since Right Shares are allotted on the basis of original holding, it cannot be said that same have been allotted at a price less than the fair market value without consideration. Therefore, provisions of Section 56(2)(x) of the Act are not applicable. Moreover, in view of specific provisions of Section 55(2)(aa)(iii) cost of acquisition of these shares will be taken to be the actual price paid by the shareholder and same is not to be adjusted by the amount of deemed income in terms of section 49(4) of the Act, applicability of provisions of section 56(2)(x) is not intended. However it shall be noted that in case the right is assigned to a person the given section would apply.

Valuation of share can be done only on basis of FMV and Not Market Value:

DCIT Mumbai vs Ozoneland Agro Pvt Ltd (ITAT Mumbai)

Date: 2nd May 2018

Background

A.O. observed that two persons transferred their shares to the assessee at Rs.75.49 per share whereas, on the same day all the other shareholders transferred their shareholdings to the assessee at Re.1 per share. He observed that when the market rate is Rs.75.49/share, the assessee has purchased the shares at less than the market price i.e., Re.1 per share and therefore, the transactions attract provisions of section 56(2) (viia) of the I.T. Act.

The assessee however argued that under section 56(2)(viia) FMV as calculated under Rule 11U is to be considered and not market price. And FMV of the shares were negative and hence the section has no applicability in the given case.

Judgement and Conclusion

The Tribunal on due consideration ruled that the action of AO was outside the ambit of law and only FMV under Rule 11U can be considered and not Market price. Hence dismissing appeal by the AO.

Application of Section on acquisition of shares before 1st July 2010.

M/S Nathoo Ram Nityanand Timber vs Department of Income Tax (ITAT Lucknow)

Date: 30th August 2016

Background

In the given case the assessee had acquired shares prior to notification of section 56(2) (viia), that is before 1st July 2010 however the said case came into consideration after the notification of said section the Assessing officer, reassessed the income of assessee giving impact of section 56 (2)(viia). Which was challenged by the assessee

Judgement and Conclusion

The ITAT upheld the argument forwarded by the assessee and ruled that in case transaction had been undertaken before the notification that is to say before 1st July 2020 that income would not be readjusted based on provisions of section 56(2)(viia).

Section 56 (2) (viib)

Where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:

Explanation. – For the purposes of this clause,—

(a)  the fair market value of the shares shall be the value—

(i)  as may be determined in accordance with such method as may be prescribed; or

(ii)  as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature,

whichever is higher

Important Ruling on Section 56(2) (viib)

 

Discretion of Assessee to choose method of Valuation

Cinestaan Entertainment P. Ltd vs. ITO (ITAT Delhi)

Date: June 27, 2019 

Background:

The assessee has the option under Rule 11UA (2) to determine the FMV by either the ‘DCF Method’ or the ‘NAV Method’. The AO has no jurisdiction to tinker with the valuation and to substitute his own value or to reject the valuation. He also cannot question the commercial wisdom of the assessee and its investors.

Judgement and Conclusion:

It is a well settled position of law with regard to the valuation, that valuation is not an exact science and can never be done with arithmetic precision.

Also, an important angle to view such cases, is that, here the shares have not been subscribed by any sister concern or closely related person, but by an outside investors like, Anand Mahindra, Rakesh Jhunjhunwala, and Radhakishan Damani who are one of the top investors and businessman of the country and if they have seen certain potential and accepted this valuation, then how AO or Ld. CIT(A) can question their wisdom.

Read our related write ups on the subject –

Companies under IBC-quarantine, get GST-rebirth

-Vinod Kothari 

[vinod@vinodkothari.com]

Resolution is not a re-birth of an entity – it is simply like nursing a sick entity back to health. It is almost akin to putting the company under a quarantine – immune from onslaught of creditor actions, while the debtor and/or the creditors prepare a revival plan. The objective is that the entity revives – in which case, it is out of the isolation, and is back as a healthy entity once again.

This process is not unknown in insolvency laws world-over. However, in India, revival under insolvency framework has taken a completely unique trajectory. First was section 29A, cutting the company from its promoter-lineage for all time to come. The next was section 32A – redeeming the company from the past burden of civil as well as criminal wrongs, thereby giving it a new avatar, with a new management.

Now, the initiation of a CIRP proceeding will be akin to a new birth to the company, at least for GST purposes. Therefore, irrespective of whether the revival process succeeds or not, at least for GST purposes, the entity becomes clean-slate entity. This is the result of the new GST rule announced on 21st March, 2020. However, the new rules do not seem to have envisaged several eventualities, and we opine the intent of giving an immunity from past liabilities might have better been carried out by appropriate administrative instructions, rather than the new registration process.

Read more

Bridging the gap between Ind AS 109 and the regulatory framework for NBFCs

-Abhirup Ghosh

(abhirup@vinodkothari.com)

The Reserve Bank of India, on 13th March, 2020, issued a notification[1] providing guidance on implementation of Indian Accounting Standards by non-banking financial companies. This guidance comes after almost 2 years from the date of commencement of first phase of implementation of Ind AS for NBFCs.

The intention behind this Notification is to ensure consistency in certain areas like – asset classification, provisioning, regulatory capital treatment etc. The idea of the Notification is not to provide detailed guidelines on Ind AS implementation. For areas which the Notification has not dealt with, notified accounting standards, application guidance, educational material and other clarifications issued by the ICAI should be referred to.

The Notification is addressed to all non-banking financial companies and asset reconstruction companies. Since, housing finance companies are now governed by RBI and primarily a class of NBFCs, this Notification should also apply to them. But for the purpose of this write-up we wish to restrict our scope to NBFCs, which includes HFCs, only.

The Notification becomes applicable for preparation of financial statements from the financial year 2019-20 onwards, therefore, it seems the actions to be taken under the Notification will have to be undertaken before 31st March, 2020, so far as possible.

In this article we wish to discuss the outcome the Notification along with our comments on each issue. This article consists of the following segments:

  1. Things to be done by the Board of Directors (BOD)
  2. Expected Credit Losses (ECL) and prudential norms
  3. Dealing with defaults and significant increase in credit risk
  4. Things to be done by the Audit Committee of the Board (ACB)
  5. Computation of regulatory capital
  6. Securitisation accounting and prudential norms
  7. Matters which skipped attention

1.   Things to be done by the BOD

The Notification starts with a sweeping statement that the responsibility of preparing and ensuring fair presentation of the financial statements lies with the BOD of the company. In addition to this sweeping statement, the Notification also demands the BOD to lay down some crucial policies which will be essential for the implementation of Ind AS among NBFCs and they are: a) Policy for determining business model of the company; and b) Policy on Expected Credit Losses.

(A) Board approved policy on business models: The Company should have a Board approved policy, which should articulate and document the business models and portfolios of the Company. This is an extremely policy as the entire classification of financial assets, depends on the business model of the NBFC. Some key areas which, we think, the Policy should entail are:

There are primarily three business models that Ind AS recognises for subsequent measurement of financial assets:

(a) hold financial assets in order to collect contractual cash flows;

(b) hold financial assets in order to collect contractual cash flows and also to sell financial assets; and

(c) hold financial assets for the purpose of selling them.

The assessment of the business model should not be done at instrument-by-instrument level, but can be done at a higher level of aggregation. But at the same time, the aggregation should be not be done at an entity-level because there could be multiple business models in a company.

Further, with respect the first model, the Ind AS states that the business model of the company can still be to hold the financial assets in order to collect contractual cash flows even if some of the assets are sold are expected to be sold in future. For instance, the business model of the company shall remain unaffected due to the following transactions of sale:

(a) Sale of financial assets due to increase in credit risk, irrespective of the frequency or value of such sale;

(b) Sale of cash flows are made close to the maturity and where the proceeds from the sale approximate the collection of the remaining contractual cash flows; and

(c) Sale of financial assets due to other reasons, namely, to avoid credit concentration, if such sales are insignificant in value (individually or in aggregate) or infrequent.

For the third situation, what constitutes to insignificant or infrequent has not been discussed in the Ind AS. However, reference can be drawn from the Report of the Working Group of RBI on implementation of Ind AS by banks[2], which proposes that there could be a rebuttable presumption that where there are more than 5% of sale, by value, within a specified time period, of the total amortised cost of financial assets held in a particular business model, such a business model may be considered inconsistent with the objective to hold financial assets in order to collect contractual cash flow.

However, we are not inclined to take the same as prescriptive. Business model of an entity is still a question hinging on several relevant factors, primarily the profit recognition, internal reporting of profits, pursuit of securitization/direct assignment strategy, etc. Of course, the volume may be a persuasive factor.

The Notification also requires that the companies should also have a policy on sale of assets held under amortised cost method, and such policy should be disclosed in the financial statements.

(B) Board approved policy on ECL methodology: the Notification requires the companies to lay down Board approved sound methodologies for computation of Expected Credit Losses. For this purpose, the RBI has advised the companies to use the Guidance on Credit Risk and Accounting for Expected Credit Losses issued by Basel Committee on Banking Supervision (BCBS)[3] for reference.

The methodologies laid down should commensurate with the size, complexity and risks specific to the NBFC. The parameters and assumptions for risk assessment should be well documented along with sensitivity of various parameters and assumptions on the ECL output.

Therefore, as per our understanding, the policy on ECL should contain the following –

(a) The assumptions and parameters for risk assessment – which should basically talk about the probabilities of defaults in different situations. Here it is important to note that the assumptions could vary for the different products that the reporting entity offers to its customers. For instance, if a company offers LAP and auto loans at the same time, it cannot apply same set of assumptions for both these products.

Further, the policy should also lay down indicators of significant increase in credit risk, impairment etc. This would allow the reporting entity in determining classifying its assets into Stage 1, Stage 2 and Stage 3.

(b) Backtesting of assumptions – the second aspect of this policy should deal with backtesting of the assumptions. The policy should provide for mechanism of backtesting of assumption on historical data so as to examine the accuracy of the assumptions.

(c) Sensitivity analysis – Another important aspect of this policy is sensitivity analysis. The policy should provide for mechanism of sensitivity analysis, which would predict the outcome based on variations in the assumptions. This will help in identifying how dependant the output is on a particular input.

Further, the Notification states that any change in the ECL model must be well documented along with justifications, and should be approved by the Board. Here it is important to note that there could two types of variations – first, variation in inputs, and second, variation in the model. As per our understanding, only the latter should be placed before the BOD for its approval.

Further, any change in the assumptions or parameters or the ECL model for the purpose of profit smothering shall seriously be frowned upon by the RBI, as it has clearly expressed its opinion against such practices.

2.   Expected Credit Losses (ECL) and prudential norms

The RBI has clarified that whatever be the ECL output, the same should be subject to a regulatory floor which in this case would be the provisions required to be created as the IRAC norms. Let us understand the situation better:

The companies will have to compute two types of provisions or loss estimations going forward – first, the ECL as per Ind AS 109 and its internal ECL model and second, provisions as per the RBI regulations, which has to be computed in parallel, and at asset level.

The difference between the two will have to be dealt with in the following manner:

(A) Impairment Reserve: Where the ECL computed as per the ECL methodology is lower than the provisions computed as per the IRAC norms, then the difference between the two should be transferred to a separate “Impairment Reserve”. This transfer will not be a charge against profit, instead, the Notification states that the difference should be appropriated against the profit or loss after taxes.

Interestingly, no withdrawals against this Impairment Reserve is allowed without RBI’s approval. Ideally, any loss on a financial asset should be first adjusted from the provision created for that particular account.

Further, the continuity of this Impairment Reserve shall be reviewed by the RBI going forward.

A large number of NBFCs have already presented their first financial statements as per Ind AS for the year ended 31st March, 2019. There were two types of practices which were followed with respect to provisioning and loss estimations. First, where the NBFCs charged only the ECL output against its profits and disregarded the regulatory provisioning requirements. Second, where the NBFCs computed provisions as per regulatory requirements as well as ECL and charged the higher amount between the two against the profits.

The questions that arise here are:

(a) For the first situation, should the NBFCs appropriate a higher amount in the current year, so as to compensate for the amount not transferred in the previous year?

(b) For the second situation, should the NBFCs reverse the difference amount, if any, already charged against profit during the current year and appropriate the same against profit or loss?

The answer for both the questions is negative. The provisions of the Notification shall have to be implemented for the preparation of financial statements from the financial year 2019-20 onwards, hence, we don’t see the need for adjustments for what has already been done in the previous year’s financial statements.

(B) Disclosure: The difference between the two will have to be disclosed in the annual financial statements of the company, format of which has been provided in the Notification[4]. Going by the format, the loss allowances created on Stage 1, Stage 2 and Stage 3 cases will have to be shown separately, similarly, the provisions computed on those shall also have to be shown separately.

While Stage 1 and Stage 2 cases have been classified as standard assets in the format, Stage 3 cases cover sub-standard, doubtful and loss assets.

Loss estimations on loan commitments, guarantees etc. which are covered under Ind AS but does not require provisioning under the RBI Directions should also be presented.

3.     Dealing with defaults and significant increase in credit risk

Estimation of expected losses in financial assets as per Ind AS depends primarily on credit risk assessment and identifying situations for impairment. Considering the importance of issue, the RBI has voiced its opinion on identification of “defaults” and “significant increase in credit risk”.

(A)Defaults: The next issue which has been dealt with in the Notification is the meaning of defaults. Currently, there seems to be a departure between the Ind AS and the regulatory definition of “defaults”. While the former allows the company to declare an account as default based on its internal credit risk assessments, the latter requires that all cases with delay of more than 90 days should be treated as default. The RBI expects the accounting classification to be guided by the regulatory definition of “defaults”.

 If a company decides not to impair an account even after a 90 days delay, then the same should be approved by the Audit Committee.

This view is also in line with the definition of “default” proposed by the BASEL framework for IRB framework, which is:

“A default is considered to have occurred with regard to a particular obligor when one or more of the following events has taken place.

 (a) It is determined that the obligor is unlikely to pay its debt obligations (principal, interest, or fees) in full;

 (b) A credit loss event associated with any obligation of the obligor, such as a charge-off, specific provision, or distressed restructuring involving the forgiveness or postponement of principal, interest, or fees;

 (c) The obligor is past due more than 90 days on any credit obligation; or

 (d) The obligor has filed for bankruptcy or similar protection from creditors.”

Further, the number of cases of defaults and the total amount outstanding and overdue should be disclosed in the notes to the financial statements. As per the current regulatory framework, NBFCs have to present the details of sub-standard, doubtful and loss assets in its financial statements. Hence, this disclosure requirement is not new, only the sub-classification of NPAs have now been taken off.

(B) Dealing with significant increase in credit risk: Assessment of credit risk plays an important role in ECL computation under Ind AS 109. Just to recapitulate, credit risk assessments can be lead to three possible situations – first, where there is no significant increase in credit risk, second, where there is significant increase in credit risk, but no default, and third, where there is a default. These three outcomes are known as Stage 1, Stage 2 and Stage 3 cases respectively.

 In case an account is under Stage 1, the loss estimation has to be done based on probabilities of default during next 12 months after the reporting date. However, if an account is under Stage 2 or Stage 3, the loss estimation has to be done based on lifetime probabilities of default.

Technically, both Stage 1 and Stage 2 cases would fall under the definition of standard assets for the purpose of RBI Directions, however, from accounting purposes, these two stages would attract different loss estimation techniques. Hence, the RBI has also voiced its opinion on the methodology of credit risk assessment for Stage 2 cases.

The Notification acknowledges the presence of a rebuttable presumption of significant increase in credit risk of an account, should there be a delay of 30 days or more. However, this presumption is rebuttable if the reporting entity has reasonable and supportable information that demonstrates that the credit risk has not increased significantly since initial recognition, despite a delay of more than 30 days. In a reporting entity opts to rebut the presumption and assume there is no increase in credit risk, then the reasons for such should be properly documented and the same should be placed before the Audit Committee.

However, the Notification also states that under no circumstances the Stage 2 classification be deferred beyond 60 days overdue.

4.   Things to be done by the ACB

The Notification lays down responsibilities for the ACB and they are:

(A) Approval of any subsequent modification in the ECL model: In order to be doubly sure about that any subsequent change made to the ECL model is not frivolous, the same has to be placed before the Audit Committee for their approval. If approved, the rationale and basis of such approval should be properly documented by the company.

(B) Reviewing cases of delays and defaults: As may have been noted above, the following matters will have to be routed through the ACB:

(a) Where the reporting entity decides not to impair an account, even if there is delay in payment of more than 90 days.

(b) Where as per the risk assessment of the reporting entity, with respect to an account involving a delay of more than 30 days, it rebuts that there is no significant increase in credit risk.

In both the cases, if the ACB approves the assumptions made by the management, the approval along with the rationale and justification should be properly documented.

5.   Computation of Regulatory Capital

The Notification provides a bunch of clarifications with respect to calculation of “owned funds”, “net owned funds”, and “regulatory capital”, each of which has been discussed here onwards:

(A) Impact of unrealised gains or losses arising on fair valuation of financial instruments: The concept of fair valuation of financial instruments is one of the highlights of IFRS or Ind AS. Ind AS 109 requires fair valuation of all financial instruments. The obvious question that arises is how these gains or losses on fair valuation will be treated for the purpose of capital computation. RBI’s answer to this question is pretty straight and simple – none of these of gains will be considered for the purpose of regulatory capital computation, however, the losses, if any, should be considered. This view seems to be inspired from the principle of conservatism.

 Here it is important to note that the Notification talks about all unrealised gains arising out of fair valuation of financial assets. Unrealised gain could arise in two situations – first, when the assets are measured on fair value through other comprehensive income (FVOCI), and second, when the assets are measured on fair value through profit or loss (FVTPL).

In case of assets which are fair valued through profit or loss, the gains or losses once booked are taken to the statement of profit or loss. Once taken to the statement of profit or loss, these gains or losses lose their individuality. Further, these gains or losses are not shown separately in the Balance Sheet and are blended with accumulated profits or losses of the company. Monitoring the unrealised gains from individual assets would mean maintenance of parallel accounts, which could have several administrative implications.

Further, when these assets are finally sold and gain is realised, only the difference between the fair value and value of disposal is booked in the profit and loss account. It is to be noted here that the gain on sale of assets shown in the profit and loss account in the year of sale is not exactly the actual gain realised from the financial asset because a part of it has been already booked during previous financial years as unrealised gains. If we were to interpret that by “unrealised gains” RBI meant unrealised gains arising due to FVTPL as well, the apparent question that would arise here is – whether the part which was earlier disregarded for the purpose of regulatory capital will now be treated as a part of capital?

Needless to say, extending the scope of “unrealised gains” to mean unrealised gains from FVTPL can create several ambiguities. However, the Notification, as it stands, does not contain answers for these.

In addition to the above, the Notification states the following in this regard:

  • Even unrealised gains arising on transition to Ind AS will have to be disregarded.
  • For the purpose of computation of Tier I capital, for investments in NBFCs and group companies, the entities must reduce the lower of cost of acquisition or their fair value, since, unrealised gains are anyway deducted from owned funds.
  • For any other category of investments, unrealised gains may be reduced from the value of asset for the purpose of risk-weighting.
  • Netting off of gains and losses from one category of assets is allowed, however, netting off is not allowed among different classes of assets.
  • Fair value gains on revaluation of property, plant and equipment arising from fair valuation on the date of transition, shall be treated as a part of Tier II capital, subject to a discount of 55%.
  • Any unrealised gains or losses recognised in equity due to (a) own credit risk and (b) cash flow hedge reserve shall be derecognised while determining owned funds.

(B) Treatment of ECL: The Notification allows only Stage 1 ECL, that is, 12 months ECL, to be included as a part of Tier II capital as general provisions and loss reserves. Lifetime ECL shall not be reckoned as a part of Tier II capital.

6.   Securitisation accounting and prudential norms

All securitisation transactions undergo a strict test of de-recognition under Ind AS 109. The conditions for de-recognition are such that most of the structures, prevalent in India, fail to qualify for de-recognition due to credit enhancements. Consequently, the transaction does not go off the books.

The RBI has clarified that the cases of securitisation that does not go off the books, will be allowed capital relief from regulatory point of view. That is, the assets will be assigned 0% risk weight, provided the credit enhancement provided for the transaction is knocked off the Tier I (50%) and Tier II (remaining 50%).

There are structures where the level of credit enhancement required is as high as 20-25%, the question here is – should the entire credit support be knocked off from the capital? The answer to this lies in the RBI’s Securitisation Guidelines from 2006[5], which states that the knocking off of credit support should be capped at the amount of capital that the bank would have been required to hold for the full value of the assets, had they not been securitised, that is 15%.

For securitisation transactions which qualify for complete de-recognition, we are assuming the existing practice shall be followed.

But apart from the above two, there can also be cases, where partial de-recognition can be achieved – fate of such transactions is unclear. However, as per our understanding, to the extent of retained risk, by way of credit enhancement, there should be a knock off from the capital. For anything retained by the originator, risk weighting should be done.

Matters which skipped attention

There are however, certain areas, which we think RBI has missed considering and they are:

  1. Booking of gain in case of de-recognition of assets: As per the RBI Directions on Securitisation, any gain on sale of assets should be spread over a period of time, on the other hand, the Ind AS requires upfront recognition of gain on sale of assets. The gap between the two should been bridged through this Notification.
  2. Consideration of OCI as a part of Regulatory Capital: As per Basel III framework, other comprehensive income forms part of Common Equity Tier I [read our article here], however, this Notification states all unrealised gains should be disregarded. This, therefore, is an area of conflict between the Basel framework and the RBI’s stand on this issue.

 

Read our articles on the topic:

  1. NBFC classification under IFRS financial statements: http://vinodkothari.com/wp-content/uploads/2018/11/Article-template-VKCPL-3.pdf
  2. Ind AS vs Qualifying Criteria for NBFCs-Accounting requirements resulting in regulatory mismatch?: http://vinodkothari.com/2019/07/ind-as-vs-qualifying-criteria-for-nbfcs/
  3. Should OCI be included as a part of Tier I capital for financial institutions?: http://vinodkothari.com/2019/03/should-oci-be-included-as-a-part-of-tier-i-capital-for-financial-institutions/
  4. Servicing Asset and Servicing Liability: A new by-product of securitization under Ind AS 109: http://vinodkothari.com/2019/01/servicing-asset-and-servicing-liability/
  5. Classification and reclassification of financial instruments under Ind AS: http://vinodkothari.com/2019/01/classification-of-financial-asset-liabilities-under-ind-as/

 

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11818&Mode=0#F2

[2] https://rbidocs.rbi.org.in/rdocs/Content/PDFs/FAS93F78EF58DB84295B9E11E21A91500B8.PDF

[3] https://www.bis.org/bcbs/publ/d350.pdf

[4] https://rbidocs.rbi.org.in/rdocs/content/pdfs/NOTI170APP130320.pdf

[5] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=2723

UPDATE: No GST input if supplier doesn’t upload details of output: GST Council amends CGST rules to curb ineligible credit availing

-Rahul Maharshi

(rahul@vinodkothari.com) (finserv@vinodkothari.com)

The GST council in its 37th Meeting held on 20th September, 2019, had proposed to make amendments in the CGST Rules, 2017 (“Rules”) pertaining to matters relating to the extension of due date of filing of GSTR-3B GSTR-1 as well as voluntary requirement of filing of GST Annual return for registered person whose aggregate turnover is less than Rs. 2 crores.

One of the major amendment proposed was to restrict the claiming of input tax credit by the recipient, in case of mismatch in details uploaded by the supplier, to the extent of 20% over and above the value of uploaded details by the supplier.

The above proposed amendment has been brought into force through notification 49/2019- Central Tax   [1] whereby the input credit availed by a registered person, the details of which have not been uploaded by the suppliers vide GSTR-1, the same should not exceed 20% of the eligible credit that has been uploaded by the suppliers.

As per the insertion in the CGST rules, 2017, viz. sub-rule (4) of rule 36:

“(4) Input tax credit to be availed by a registered person in respect of invoices or debit notes, the details of which have not been uploaded by the suppliers under sub-section (1) of section 37, shall not exceed 20 per cent. of the eligible credit available in respect of invoices or debit notes the details of which have been uploaded by the suppliers under sub-section (1) of section 37.”

For example, as per the books of the recipient, there is an input tax credit of Rs. 5,000 for a particular month from a particular supplier against 5 tax invoices having the GST component of Rs. 1,000 each.  Post the amendment, the following scenarios shall arise:

Case-1: In case the supplier has uploaded all 5 invoices:

In case the supplier has duly uploaded the details of all the 5 invoices through filing the GSTR-1 for the particular month, the auto-populated GSTR-2A will have the details of all such invoices and accordingly the recipient will be eligible to claim the input tax credit of all 5 invoices

Case-2: In case the supplier has uploaded 3 invoices:

In case the supplier has uploaded less than 5 invoices, i.e. 3 invoices having GST component of Rs. 3,000, the recipient will be eligible to claim input tax credit at a maximum of Rs. 3,600 (viz. 3,000+20% of 3,000= 3,600).

Case-3: In case the supplier has not uploaded any invoice:

In case the supplier has not uploaded any invoice in the GSTR-1 of the respective month, the recipient will not be eligible to claim the input tax credit in that particular month. However, the recipient may claim the input as soon as the supplier uploads the details in the GSTR-1 and corresponding details reflect in the auto-populated GSTR-2A.

As a result of the said amendment, the recipient will be required to monitor the duly uploading of the invoices by the supplier in a more stringent manner, since omission of the same will result in reduction in claiming of input tax credit by the recipient.

Also, an important point of concern will be the change in accounting of the input tax credit in the books of the recipient. The excess claim over 20% of the eligible input tax credit will require allocation against the invoices of which the input tax credit would pertain to.

Continuing the above example viz. Case 2, where the supplier has uploaded 3 invoices, how will the recipient allocate the said portion of 20% viz. Rs. 600 if the recipient claims input tax credit at the excess of 20%. The recipient has to allocate the said amount against portion of particular invoices.

The above move may be seen as a way to monitor the claiming of inputs by the recipients as well as a check on the supplier for uploading the returns on a regular basis. However, there are pertinent issues which require further clarification from the department.

 

[1] http://www.cbic.gov.in/resources//htdocs-cbec/gst/notfctn-49-central-tax-english-2019.pdf;jsessionid=15BA096E92769114F368D806E28B8FF5