ROU ready? Quick guide to lease accounting from lessee perspective

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Simrat Singh, Executive | finserv@vinodkothari.com

There is an age-old distinction between financial leases and operating leases; this arose from accounting standards, and has had a sunset, from the perspective of the lessee, because of a change in accounting standards. Globally, IFRS 16, replacing the earlier standards IAS 17, became effective from 1st January, 2019. Note that not every country has still adopted IFRS 16 – USA is a prominent exception.

The equivalent of IFRS 16 in India is Ind AS 116. Under Ind AS 116, there is no distinction between operating leases and finance leases from the perspective of a lessee. Instead, the lessee  recognizes a right-of-use (‘ROU’) asset and a corresponding obligation-to-pay (‘lease liability’) on the lessee’s balance sheet, reflecting their right to use the underlying asset and the obligation to make lease payments.

In this write up, we try to briefly discuss the crucial aspects of lease accounting for an Ind AS compliant lessee.

Recognition and valuation of the ROU asset

The value of the ROU asset is essentially the value of the right which the lessee has to pay to the lessor. If the lessee is entitled to only a portion of the asset’s useful life, the value of the ROU asset is proportionally adjusted. However, its value cannot exceed the actual value of the underlying asset—it may be equal to or lower, depending on the lease terms. Essentially, the present value of the lease rentals is recognised as the ROU asset.

Depreciation of the ROU Asset

The ROU asset is depreciated linearly i.e. on SLM basis. The period for depreciation depends on the lease structure:

  1. If ownership transfers to the lessee or the purchase option is certain to be exercised, the ROU asset is depreciated over its useful life.
  2. If the lease terms do not provide for automatic transfer of ownership, the asset will be depreciated over the lease tenure.

Lease Rentals: Principal & Interest Components

Lease payments are split into two components:

  1. Interest Component – Recognized as a finance cost in the income statement. The rate of interest should be the internal rate of return of the lessor or if the same is not available, then the incremental cost of borrowing of the lessee.
  2. Principal Component – Adjusted against the lease liability, reducing the obligation over the lease tenure.

Net effect over the lease term

At the inception of a lease transaction, the ROU asset and lease liability are equal. Over time, they reduce at different rates:

  1. The ROU asset declines through SLM depreciation (as discussed above).
  2. The lease liability is reduced by the principal portion of each lease payment, eventually being zeroed down.

By the end of the lease tenure, both the ROU asset and lease liability reduce to NIL, reflecting the complete settlement of the lease obligation of the lessee. 

Lets understand the above with the help of an illustration in excel [Link to sheet]

Accounting of lease
Asset cost1000
Tenure4 years
Interest rate (annual basis)10%
Rental₹315.47
NPV₹1,000.00
Yearly rental payments
YearPayment
1₹315.47
2₹315.47
3₹315.47
4₹315.47
Financial statement extract
Balance sheetY0Y1Y2Y3Y4
Assets:
ROU asset₹1,000.00₹750.00₹500.00₹250.00₹0.00
Depreciation-₹250.00-₹250.00-₹250.00-₹250.00
Liabilities:
Lease liability₹1,000.00₹784.53₹547.51₹286.79₹0.00
Write-off (amortization during the year)-₹215.47-₹237.02-₹260.72-₹286.79
Income statementY1Y2Y3Y4
Depreciation expenses₹250.00₹250.00₹250.00₹250.00
Interest expenses₹100.00₹78.45₹54.75₹28.68
Cash flow statementY1Y2Y3Y4
₹315.47₹315.47₹315.47₹315.47

Lets also understand the journal entries for a lease transaction

Journal entries

  1. Creation of asset and corresponding obligation-to-pay 

ROU Asset A/c Dr.

  To Lease liability A/c

  1. Charging depreciation on the ROU Asset

P/L A/c Dr.

 To Depreciation A/c

Depreciation A/c Dr. 

To ROU Asset A/c

  1. Payment of lease rental
  1. Interest component

P/L A/c Dr. 

To interest of lease rental A/c 

(Being interest on lease rental charged to P/L A/c)

Interest of lease rental A/c Dr.

To Cash A/c 

(Being interest of lease rental actually paid in cash)

  1. Principal component

Lease liability A/c Dr.

To Cash A/c

Exception from applicability of Ind AS

Note that there are two exceptions w.r.t applicability of IndAS 116 on a lease transaction, i.e. such a transaction may not follow the above set of rules and may be expensed as an ordinary lease transaction. The two exceptions are:

  1. Short term leases- Leases of tenure up to 12 months. However, if the renewal of the lease is certain then this exception cannot be claimed.
  2. Low value asset – if the underlying asset i.e. the asset which is the subject matter of the lease is of a small value. In such a case, the complexities of IndAS 116 may not apply should the lessee choose not to apply them. 

Our other relevant resources on this topic:

  1. PPT on lease accounting
  2. Note on the discussion paper on lease accounting
  3. Background and international accounting changes on lease accounting
  4. IAS 19 on lease accounting
  5. Lease Accounting under IFRS 16- A leap towards transparency!
  6. Accounting for Leasing Transactions: IndAS 116 and IFRS 9
  7. Video – accounting for lease transactions

Union Budget 2025: Key Highlights and Reforms focusing on Financial Sector Entities

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Can CICs invest in AIFs? A Regulatory Paradox

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-Anshika Agarwal (finserv@vinodkothari.com)

Core Investment Companies (CIC) and Alternative Investment Funds (AIF) are two very common modes to channelise investments in the Indian market. Both are regulated by different regulators; while CICs are regulated by the RBI, AIFs are regulated by the SEBI. Under their respective regulatory frameworks, both are technically permitted to invest in one another. However, this permissibility introduces an intriguing paradox, especially for a CIC, which is allowed to invest in group companies. It points out that this approach effectively creates two investment pools—one directly under the CICs and another through the AIFs. This dual-pool structure complicates what could otherwise be a straightforward process, introducing unnecessary layers of complexity, thus deviating from the primary purpose of CICs to hold and manage investments efficiently within group companies. 

The following article examines the implications of Paragraph 26(a)1 of the Master Direction – Core Investment Companies (Reserve Bank) Directions, 2016 (“CIC Master Directions”), but before delving into the specifics, it may be worthwhile to discuss in brief the concepts of AIF and CIC. 

What are AIFs (Alternative Investment Funds)?

AIFs have gained prominence as a pivotal part of the financial ecosystem, providing investors with access to diverse and innovative investment opportunities. The key features of an AIF are as follows:

  1. An AIF is a privately pooled investment vehicle, therefore, it cannot raise money from public at large through a public issue of units;
  2. The investors could be Indian or foreign – there is no bar on the nature of the investor who can invest.
  3. The investments made by the fund should be in accordance with the investment policy.
  4. There are three categories of AIFs, depending on the kind of investments they make, and each category is regulated differently:
    1. Category 1 which invests in start up or early stage ventures or social ventures or SMEs or infrastructure or other sectors or areas which the government or regulators consider as socially or economically desirable and shall include venture capital funds, SME Funds, social venture funds, infrastructure funds and such other Alternative Investment Funds as may be specified.
    2. Category 2 which does not fall in Category I and III and which does not undertake leverage or borrowing other than to meet day to day operational requirements and as permitted in these regulations. It includes private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other regulator shall be included.
    3. Category 3 which employs diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives.

What are Core Investment Companies (CICs)?

CICs are a specialized subset of Non-Banking Financial Companies (NBFCs) established with the primary purpose of holding and managing investments in group companies. CICs do not engage in traditional financial intermediation but play a vital role in maintaining financial stability within the ‘group companies’. CICs are governed under the CIC Master Directions to ensure that their activities align with regulatory standards. 

Below given graph explains the regulatory permissibility of the kind of investments a CIC can make:

In addition with the aforesaid, it may further be noted that CICs are permitted to carry out the following financial activities only:

  1. investment in-
    1. bank deposits,
    2. money market instruments, including money market mutual funds that make investments in debt/money market instruments with a maturity of up to 1 year.
    3. government securities, and
    4. bonds or debentures issued by group companies,
  2. granting of loans to group companies and
  3. issuing guarantees on behalf of group companies. 

It may be noted that the RBI’s FAQs on Core Investment Companies, particularly Question 92 has clarified about the 10% of Net Asset – 

“What items are included in the 10% of Net assets which CIC/CIC’s-ND-SI can hold outside the group?

Ans: These would include real estate or other fixed assets which are required for effective functioning of a company, but should not include other financial investments/loans in non group companies.”

Who are included in Group Companies?

The term “group companies” is defined under Para 3(1)(v) of the CIC Master Directions. It refers to an arrangement involving two or more entities that are related to each other through any of the following relationships:

Subsidiary – Parent (as defined under AS 21),
Joint Venture (as defined under AS 27),
Associate (as defined under AS 23),
Promoter-Promotee (as per the SEBI [Acquisition of Shares and Takeover] Regulations, 1997 for listed companies),
Related Party (as defined under AS 18),
Entities sharing a Common Brand Name, or
Entities with an investment in equity shares of 20% or more

The Issue with Paragraph 26(a): The paradox

Para 26A of the CIC Master Directions deals with Investments in AIFs. The language of the provisions suggest that CICs are permitted to invest in AIFs. However, this provision introduces a significant legal contradiction that undermines the regulatory framework governing CICs. According to the Doctrine of Colorable Legislation, a legal principle ensuring legislative consistency, what cannot be achieved directly cannot be permitted indirectly. By allowing CICs to invest in AIFs, Para 26(a) effectively circumvents the explicit restriction on investments outside group companies. This indirect allowance is inconsistent with the foundational objectives of the CIC Master Directions and creates substantial legal and operational confusion.

Can there be an AIF which in turn invests in the group only? 

Under the SEBI (Alternative Investment Funds) Regulations, 2012, the primary objective of an Alternative Investment Fund (AIF) is to pool funds from investors and allocate them across diverse investment opportunities. However, structuring an AIF to invest predominantly or exclusively in entities within the same group raises concerns regarding compliance with SEBI’s regulatory framework, particularly its diversification. SEBI imposes strict investment concentration limits, as outlined in one of its Circular3. 

For Category I and II AIFs, no more than 25% of their investable funds can be allocated to a single investee company, while Category III AIFs are restricted to 10%. These regulations inherently prevent AIFs from focusing solely on group entities unless the investment structure strictly adheres to these limits. For CICs intending to invest in AIFs, these restrictions pose significant limitations if the goal is to channel funds primarily into group companies. 

Can AIFs be a Group Entity in a CIC’s Group Structure?

Technically, the answer is affirmative—AIFs can be part of a group entity within a group if it satisfies any of the conditions mentioned in the definition. However, if CICs invest in AIFs within the same group structure, it fails to resolve the underlying issue. AIFs often invest outside the group companies, exposing CICs indirectly to entities external to the group. This contradicts the core purpose of CICs, which is to focus investments within their own group companies. Such a structure not only undermines the original intent of CICs but also raises compliance concerns. The RBI adopts a pass-through approach in these cases and is likely to view such practices as non-compliant. 

Conclusion

The regulatory paradox of allowing CICs to invest in AIFs under Para 26(a) of the CICs Master Direction raises important questions about the practicality and purpose of this provision. At its core, CICs are meant to simplify and streamline the management of investments within their group companies. However, the inclusion of AIFs creates an unnecessary layer of complexity, dividing investments into dual investment pools and making it harder to track, manage, and maintain transparency.

This arrangement doesn’t just complicate operations, it also moves CICs away from their original purpose. By routing investments through AIFs, CICs are exposed to entities outside their group, which can lead to compliance risks, regulatory confusion, and inefficiencies. Even from a taxation perspective, the setup offers no real benefits, adding financial burdens without meaningful gains. Paragraph 26(a) of the CICs Master Direction has been taken from the SBR Master Direction, which is applicable to NBFCs. However, including it in the CICs Master Direction, which provided regulation specifically for CICs NBFC does not appear to serve any purpose. Even if it were to be amended, its relevance of stating the same for CICs NBFC would still remain questionable.

  1.  Reserve Bank of India, Master Direction – Core Investment Companies (Reserve Bank) Directions, 2016. Available at:https://www.lawrbit.com/wp-content/uploads/2021/05/Master-Direction-Core-Investment-Companies-Reserve-Bank-Directions-2016.pdf (Accessed: 19 January 2025). ↩︎
  2. FAQs on Core Investment Companies, available at: https://www.rbi.org.in/commonman/english/scripts/FAQs.aspx?Id=836 (Accessed: 19 January 2025). ↩︎
  3.  SEBI (Alternative Investment Funds) Regulations, 2012 available at: https://www.sebi.gov.in/legal/regulations/apr-2017/sebi-alternative-investment-funds-regulations-2012-last-amended-on-march-6-2017-_34694.html ↩︎

Co-Lending and GST: Does the relationship between co-lenders constitute a supply that may be subject to GST?

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Team Finserv (finserv@vinodkothari.com)

Introduction 

Banks and Non Banking Financial Companies (‘NBFCs’) have been receiving notices from statutory authorities stating the occurrence of evasion of goods and services tax (‘GST’) in respect of co-lending arrangements. At present, the GST laws do not address the implications of GST on co-lending transactions. In response to the investigations carried out Central Board of Indirect Taxes and Customs (‘CBIC’) on various banks and financial institutions, industry participants had requested for clarification on the matter in 2023 on whether GST is applicable on colending transactions.  However, the issue still remains unaddressed.

While multiple theories go around in the market on the subject, this article aims to discuss the theories and examine them in light of applicable laws. 

The issue

It is common knowledge that, for GST to be applicable, there needs to be a supply of goods or services. Therefore, the primary question to be answered here is whether the originating or servicing co-lender (‘OC’) provides any services to the arrangement? Can it be argued that the OC who is retaining a higher proportion of interest as compared to its proportion of funding of the principal amount of loan is actually providing services to the arrangement, and therefore, should be paying GST on the services to the other lenders?

The analysis

It is crucial to understand the nature of the relationship between the lenders involved. A co-lending arrangement is essentially a collaborative partnership between two lenders. To the extent two lenders agree to originate and partake in lending jointly, it is a limited purpose partnership or a joint venture. To the extent the two co-lenders extend a lending facility, the relation between the two of them together on one side, and the borrower on the other, amounts to a loan agreement. However, as there are two lenders together on the lender side, the borrower makes promises to two of them together, and therefore, the rights of any one of them is governed by the law relating to “joint promisees”. Given this framework, co-lending arrangements cannot simply be viewed as service agreements between the parties involved. Instead, they represent a distinct legal relationship characterized by shared responsibilities, rights, and risks associated with the lending process.

Does it qualify as a Supply?

The interest rates expected by the two co-lenders may vary due to the differing roles they play in the co-lending arrangement. It may be agreed that the funding co-lender receives a specific percentage of the interest charged to the borrower, while any excess interest earned beyond this hurdle rate shall be retained by the OC. Since the OC is performing services in the co-lending arrangement, would this excess spread be considered as consideration for supply of service under GST laws?

As discussed earlier, co-lending is inherently a partnership between two entities where each party’s contributions, functions, and responsibilities can vary. This results in a differential sharing of both risks and rewards, which means that the income earned from the loan may not necessarily be distributed in the same ratio as the principal loan amount.

The sharing of interest in co-lending arrangements is typically determined by each co-lender’s involvement in managing the loan’s overall risk—covering both pre and post-disbursement activities. Consequently, the excess interest earned by one co-lender over another is not reflective of a supply of a service provided by one entity to the other. Instead, this excess interest is merely a differential income that retains its original characteristic as interest income.

In a co-lending arrangement,  the co-lenders split their mutual roles i.e the co-lender performs various services pursuant to the co-lending arrangement, the same cannot be constituted as a separate supply provided to the other co-lender. For example if the borrower interface is being done by OC, it would be wrong to regard the OC as an agent for the Funding Co-lender. Both of them are acting for their mutual arrangement, sharing their responsibilities as agreed. Neither is providing any service to  the other. The co-lenders are effectively splitting the functionalities to the best of their capacity and expertise under their co-lending arrangement, which does not tantamount to any additional services being provided by one co-lender to the other. 

This view can be further strengthened by the ITAT ruling of May 7, 2024 which confirmed that the excess interest allowed to be retained with the NBFC was not a consideration for rendering professional/ technical services by the transferor NBFC to the transferee bank and neither would it fall within the ambit of commission or brokerage. 

ITAT examined some major points for characterisation of the excess interest spread retained by the NBFC analyzing mainly:

Excess interest retained not in the nature of professional/technical fees

The ruling examined whether the retained interest could be classified as fees for professional or technical services under Section 194J. The ITAT noted that while the NBFC had a service agreement with the bank, wherein it was responsible for managing and collecting payments, the agreed-upon service fee of Rs. 1 lakh was clearly defined and separate from the excess interest. The court dismissed the revenue department’s argument that the service fee of Rs 1 lakh was inadequate and the excess interest be considered as fee for rendering the services by the transferor NBFC, stating that the NBFC’s role was not as an agent acting on behalf of the bank.

Excess interest retained not in the nature of commission or brokerage 

The ITAT ruling clarified that the excess interest retained by the NBFC does not qualify as commission or brokerage under Section 194H of the Income Tax Act. The tribunal determined that the loans originated by the NBFC were not on behalf of the bank, but rather as independent transactions governed by a separate service agreement. This agreement stipulated distinct service fees for the NBFC’s management of the loans, emphasizing that the NBFC was not acting as an agent for the bank.

By making this distinction, the ITAT characterized the excess spread as a financial outcome of the contractual arrangement rather than a commission for services rendered. Consequently, the tribunal concluded that there was no obligation to deduct TDS on the excess interest retained by the NBFC, reinforcing the understanding that such retained interest is not subject to typical taxation associated with agent-like relationships. You may refer to our article on the ruling here. 

Conclusion

Therefore, taking into consideration the structure of the co-lending arrangement it can be concluded that the differential or higher interest rate retained by the OC shall not be treated as consideration for performing the agreed-upon role between the co-lenders. The recent ITAT ruling provides crucial clarity regarding the treatment of excess spreads in co-lending arrangements, affirming that such retained interest does not constitute a supply of services or a fees for professional services, commission, or brokerage. By highlighting the distinct nature of the contractual relationship between co-lenders, the ruling reinforces the idea that excess interest is a product of shared risk and reward rather than compensation for services rendered. Consequently, applying GST to a transaction that does not constitute a service would be inappropriate and misaligned with the tax framework.

Workshop on Co-lending and Loan Partnering – For registration click here: https://forms.gle/bq18tHgQb618jAcb9

Our other resources on this topic:

  1. White-paper-on-Co-lending
  2. The Law of Co-lending
  3. Shashtrarth 10: Cool with Co-lending – Analysing Scenario after RBI FAQs on PSL
  4. FAQs on Co-lending
  5. Vikas Path: The Securitised Path to Financial Inclusion

Scope of partial business exit as a mode of scaling down a company

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Mahak Agarwal | corplaw@vinodkothari.com

After the recent Finance Act of 2024 shifts the incidence of tax in case of buyback from the company to the shareholders, a pertinent question that arises is what could be the next best mode for a company which is looking to partially exit from business and scale itself down.

Here is a quick 5 min video analyzing the above: https://lnkd.in/gK6878qg

Also watch our video on the tax regime on buyback proposed by the Finance Bill, 2024 (now enacted as the Finance Act) here: https://lnkd.in/gu7NrbeM

Read our FAQs on Buyback here: https://lnkd.in/gTZx838x

Bye bye to Share Buybacks

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– Finance Bill 2024 puts buybacks to a biting tax proposal w.e.f. 1st October, 2024

-Team Corplaw | corplaw@vinodkothari.com

Among the tax law changes proposed by Finance Bill, 2024, the one on share buybacks, explained as one intended to remove tax inequity, is perhaps the most unexplainable.  The proposed change, by introduction of a new sub-clause (f) to section 2 (22) [deemed dividend], and simultaneous amendments to sec. 46A and sec. 115QA, not only shifts the tax burden from companies to shareholders, but surprisingly, brings to tax the entire amount paid on buyback, irrespective of the excess realised by the shareholder. It  leaves the cost of shares to be claimed as capital loss and set off against potential capital gains, of course only if such gains arise  within the prescribed timelines for carry forward and set off.

Buyback of shares is the only way a company seeks to scale down its capital. The proposed amendment makes it impossible for companies to reduce their capital base by returning capital not needed, as the only other way is through reduction of share capital, which is subject to shareholders’, creditors’, and NCLT approval. It is surprising that this amendment by the very same Budget which proposes to introduce the novel concept of “variable capital companies”.

Read more →

GST on Corporate Guarantees: Understanding the new regime

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–  Payal Agarwal, Associate | corplaw@vinodkothari.com


The debate around levy of GST on corporate guarantee extended without or with inadequate consideration has been settled with the insertion of sub-rule (2) to Rule 28 of the Determination of Value of Supply Rules (“Valuation Rules”), effective from 26th October, 2023. Sub-rule (2) of Rule 28 specifies a deemed value for provisions of corporate guarantee to a related person subject to certain conditions. Now, vide another notification dated 10th July, 2024, amendments have been made to the said sub-rule, to ease out the provisions with respect to value of corporate guarantee given to a related person.


Effective date of the amendment


Sub-rule (2) of Rule 28 has been notified and made applicable w.e.f. 26th October, 2023. The amendments made under sub-rule (2), vide the July 2024 notification, has also been made applicable retrospectively, i.e., w.e.f. 26th October, 2023. Hence, sub-rule (2) of rule 28 applies to a corporate guarantee issued or renewed on or after 26th October, 2023.


Understanding the terminology


In usual financial parlance, the guarantor provides a guarantee to a lender (or other person to whom certain obligations or performance is owed), in favour of a borrower (or obligant, owing performance obligations). The guarantor is the giver of the guarantee, the lender is the receiver of the guarantee and the person for whom the guarantee is given is the beneficiary of the guarantee.


However, in GST parlance, it is important to understand that the language is from the viewpoint of “supply of services”. Hence, the guarantor is the supplier of the service, the borrower or beneficiary is the recipient of the service, and the lender is actually not a party to the supply, but has a relevance as the rules relate to who the guarantee is given.


Hence, importantly, the receiver of the supply in GST parlance is not the lender, but the borrower.


Value of supply of corporate guarantee for related persons


With the amendments coming into force, there are three ways the value of supply of service, i.e., issue of corporate guarantee, is to be determined, based on the nature of the recipient and the lender:


  • As per the deemed value of the supply

  • As per invoice value of the supply

  • As per determination by the tax officer

The below chart summarises the same:


(a)   Value of corporate guarantee as per deemed value under rule 28(2)


Rule 28 prescribes the value for supply of goods and services between distinct persons or related persons. In view of the common practice among related persons to provide corporate guarantee at nil consideration, sub-rule (2) was inserted under rule 28 to explicitly provide for a deemed value of consideration in case of supply of corporate guarantee. The same has been further amended vide the July amendment.


Sub-rule (2), as amended, reads as below:


“Notwithstanding anything contained in sub-rule (1), the value of supply of services by a supplier to a recipient  who  is  a  related  person,  located in India, by  way  of  providing  corporate  guarantee  to  any  banking  company  or financial institution on behalf of the said recipient, shall be deemed to be one per cent of the amount of such guarantee offered per annum, or the actual consideration, whichever is higher.”


The deemed value provided under the said rule is 1% p.a. of the amount of guarantee offered, where no consideration is charged, or the actual consideration is lower than the aforesaid threshold. However, the said deemed value is applicable only where the following conditions are met:



  • Recipient of the service (i.e., the borrower) is a related person of the supplier (i.e., the guarantor),

  • Recipient of the service is located in India (since GST is not levied on export of services),

  • Recipient of the service is not eligible for full ITC, and

  • Corporate guarantee has been provided to a banking company or financial institution[1]


(b)  Value of corporate guarantee as per declared value in the invoice


A new proviso has also been inserted to sub-rule (2) of rule 28 vide the July amendment to ease out the GST implications on corporate guarantees. Pursuant to the said amendment, the deemed value of corporate guarantee will not apply, and the declared value in the invoice is taken as the value of the corporate guarantee, where the recipient of the service, i.e., the borrower is eligible for full ITC.


A similar proviso exists under sub-rule (1) of rule 28 as well. However, sub-rule (2) begins with a non-obstante clause, and thus, sub-rule (1) becomes non-existent for corporate guarantees between related persons to the banks/ financial institutions.


Hence, prior to the present amendment, for corporate guarantee between related persons, the relief with respect to invoice value was not available, and hence, GST was leviable on the basis of the deemed value. However, the amendments being applicable retrospectively, for recipients eligible for full ITC, benefit of invoice value will be available for corporate guarantees issued or renewed on or after 26th October, 2023.


Persons eligible for full ITC

Section 16 of the CGST Act specifies the eligibility and conditions for availing ITC. Where a person is eligible for a claim of full ITC, the value of supply of corporate guarantee will be based on the invoice value instead of the deemed value.


Here, it is important to note that the proviso refers to “full ITC”, and hence, eligibility for availing ITC u/s 16 is not enough, the recipient should be eligible for “full ITC”. The meaning of eligibility for full ITC is controversial, with some advance rulings on the subject[2]. In view of the aforesaid, it appears that the benefit of the proviso may not be available for a banking company or financial institution availing the option of 50% ITC as per sub-section (4) of section 17 of the CGST Act, as well as other persons providing exempt supplies. In essence, if the borrower (note, borrower is the recipient of the service) is a bank or financial institution or an entity providing exempt supplies, for whose borrowings a guarantor, being a related person, has given a guarantee, the deemed value will be applicable.


(c)   Value of corporate guarantee determined by tax officers under rule 28(1)


Rule 28(2) being a specific provision for value of corporate guarantee between related persons, valuation as per sub-rule (1) will apply only in cases where sub-rule (2) is not applicable. Sub-rule (1) is a general provision, applicable to supply for any goods or services between distinct or related persons. Under the said sub-rule, the value of corporate guarantee will be based on the determination by the tax officer (refer our article on the same here).


Hence, the same will be applicable only in cases where value of supply as per (a) and (b) above does not apply.


Applicability of deemed value on FLDG arrangements


First Loss Default Guarantee or FLDGs[3] are arrangements that do not involve the borrower, the guarantee is usually given by the supplier (i.e., the DLG provider) to the lender. As such, unlike guarantee which is a tripartite contract between the guarantor, borrower and the lender, FLDG is more like an indemnity, involving only two parties – the indemnifier (i.e., the guarantor) and the indemnified (i.e., the lender). The borrower being out of the picture, the applicability of deemed value of corporate guarantee, if at all, would arise if the guarantor and the lender are related persons. However, going by the nature of FLDG – being an indemnity rather than a guarantee – sub-rule (2) of rule 28 does not seem to be applicable. However, if the transaction is between related persons, the recipient of the service being an NBFC, it is important to ensure that the terms of the service are based on arms’ length consideration.


Conclusion


With the recent amendments in the GST regime applicable on corporate guarantees to related persons, the deemed value of supply for levying GST on corporate guarantee does not apply, if consideration is being charged by the guarantor and the recipient is eligible to claim full ITC. Market valuation principles do not apply, and hence, one may further want to circumvent the provisions by charging guarantee commission at negligible value, thereby, avoiding a higher GST charge. However, that does not preclude the RPT consideration under corporate laws, that require at least companies to ensure that any related party transaction is undertaken at arm’s length terms including pricing, and hence, the guarantee commission charged from a related party should also be based on the same principle.


[1] The meaning of financial institution is to be taken from section 45-I(c) of RBI Act, 1934.


[2] See a few advance rulings on the subject by West Bengal AAR, Tamil Nadu AAR. 


Also see a few articles on the subject: https://www.livelaw.in/law-firms/law-firm-articles-/input-tax-credit-central-goods-services-tax-rules-cgst-act-itc-tlc-legal-243111


https://taxguru.in/goods-and-service-tax/meaning-full-input-tax-credit-2nd-proviso-rule-28.html


[3]Structured Default Guarantees – https://vinodkothari.com/2022/09/structured-default-guarantees/


See our FAQs on default loss guarantee here – https://vinodkothari.com/2023/06/faqs-on-default-loss-guarantee-in-digital-lending/

Capital Treatment, Loan Loss Provisioning and Accounting for Default Loss Guarantees

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Vinod Kothari (finserv@vinodkothari.com)

The FinTech sector is booming and is a market disruptor as well as facilitator, based on the report published by Inc42, the estimated market opportunity in India fintech is around $2.1 Tn+ and currently there are 23 FinTech “unicorns” with combined valuation of $74 Bn+ and 34 FinTech “soonicorns” with combined valuation of $12.7Bn+.

The unprecedented growth of the fintech sector has transformed guarantees specifically First Loss Default Guarantees (FLDG) into a commonly employed tool for emerging players like fintechs. They leverage these guarantees to take exposures on loan transactions using low-cost funding from established entities such as large NBFCs and Banks. Fintechs issue guarantees that enable them to garner trust from prominent lenders, facilitating the origination of new loans through their digital platforms. 

One of the crucial concerns in DLG arrangements is navigating the complexities surrounding capital treatment and NPA accounting covering both lenders and guarantors. In this article, we delve into an in-depth exploration of these crucial issues.

Capital Treatment 

We organise this section into the following parts:

  • Capital treatment for the lender availing the guarantee
  • Capital treatment for the guarantor 
  • Expected credit loss treatment for the lender availing the guarantee
  • Expected credit loss treatment for the guarantor
  • Provisioning requirement for the lender availing the guarantee
  • Provisioning requirement for the guarantor

Capital Treatment for Lenders: 

Capital requirement is linked with the credit risk on the exposure: hence, before getting into the regulatory prescription, let us examine what is impact on the credit risk of the lender. For capital rules, a guarantee is regarded as a case of credit risk mitigation, provided the guarantee satisfies several conditions (e.g., it should be explicit, enforceable, guarantor’s financial resources adequate, etc). The lender, on the basis of the guarantee, shifts the risk of the first (or subsequent, as may be the nature of the guarantee) layer of the losses to the guarantor. Thus, there is a substitution of risk from the borrowers in the pool to the guarantor. The remaining exposure remains unprotected – hence, to that extent, there is no credit risk transfer. Therefore, if the risk weight of the guarantor is lesser than the risk weight of the underlying pool, there was a case to expect a reduction in the capital requirements.

The regulatory prescription is as follows: DLG Guidelines states that for the purpose of capital computation, i.e., computation of exposure and application of Credit Risk Mitigation benefits on individual loan assets in the portfolio shall continue to be governed by the extant norms. The “extant norms” for this purpose would be the norms on credit risk mitigation. These norms are applicable in case of banks [see part 7 of the Basel III  Master circular ] However, in case of NBFCs, there is no equivalent.

However, FLDG is expected to be backed by either a cash deposit, or a bank guarantee. If it is backed by cash deposit, cash is to be assigned 0 risk weight. Similarly, if it is backed by a bank guarantee, the risk shifts to the bank, and therefore, a 20% risk weight as applicable to banks may be assigned by the NBFC. Note that the above risk weights are only for the part backed by the guarantee. That is, if there is a 5% FLDG, the 5% of the loan pool will be risk weighted as above, and the remaining 95% will attract the risk weight applicable to the borrower pool.

Capital Treatment for the guarantor 

When we talk about capital treatment, the same would depend on the capital rules applicable to the guarantor entity. If the guarantor entity is an RBI regulated lender, it will be covered by the capital rules. If the guarantor not a regulated lender, it is unlikely to have any capital rules.

We discussed above the nature of a structured default loss guarantee. A structured DLG (first loss, second loss, or subsequent loss) integrates the risk of a pool of loans and then strips the same into multiple tranches. Therefore, it becomes a case of structured risk transfer.

The generic rule in case of any structured risk transfer is that the acquirer of the first loss tranche acquires the risk of the entire pool. Therefore, a first loss default guarantor is required to keep capital on the pool size (and not the size of the guarantee). However, the size of the guarantee is the loss limit of the guarantor – therefore, the capital requirement, computed by applying the risk weight to the pool size, will be limited to the size of the guarantee. We discuss this further below. 

First Loss

If the guarantee is first loss in nature, then, as the principle goes, the RE will have to maintain capital on the entire pool, since, it is exposed to all the risks associated with all loan accounts individually, subject to a ceiling on the the amount of guarantee it has provided. 

For instance, if the guarantor provides a 5% FLDG for a pool of loans aggregating to Rs. 100 crores, and the regulatory capital requirement of the guarantor is 15%, then the capital required to be maintained against such pool is:

Lower of

  • 15% of Rs. 100 crores * 100% (Assuming 100% is the applicable risk weight of such loans)
  • 5% of Rs. 100 crores

= Rs. 5 crores.

As per the RBI FAQs, RE providing DLG shall deduct “the full amount of the DLG which is outstanding” from its capital. The above is in line with the RBI FAQs on the subject.

This prescription should be taken as applicable in case of first loss guarantees.

Further, the apparent question that arises here is in what proportion should the capital be reduced from Tier I and Tier II. In absence of any specifications in this regard in the regulations or the FAQs, it is only logical to deduct the capital from the Tier I and Tier II in their respective ratios. That is, if the Tier I is 10% and Tier II is 5%, then the capital reduction should also happen in the ratio of 2:1.

Second Loss

If the guarantee is second loss in nature, then, the losses will start piling up on the guarantor only once the first loss support is exhausted. Unlike the other case, here, the guarantor is not exposed to all the risks associated with all loan accounts individually. Therefore, the capital will have to be maintained on the amount of guarantee provided instead of the entire pool. 

Using the same example, as used in the earlier case, the capital requirement for the RE will be:

Rs. 100 crores * 5% * 15% = Rs. 0.75 crores.

Of course, this is applicable only where the first loss guarantee is sufficient to absorb losses upto a level sufficient to absorb a certain multiple of “expected losses”. Usually, the multiple should be sufficient so as to render the second loss facility to achieve an investment grade rating.

Expected credit loss for the recipient of the guarantee

Expected credit losses are for the potential for the loan or pool of loans to result in credit losses. If the lender has the benefit of first loss guarantee, the situation is that to the extent of the FLDG, the lender has exposure on the guarantor, and for the remaining pool size, the lender has exposure on the borrowers.

As regards a potential credit loss on the guaranteed amount, the RBI rules require the guarantee to be either fully backed by cash, or backed by a bank guarantee. Hence, the question of any credit loss on the same does not arise.

Hence, the lender will be exposed to losses only on so much of the expected credit losses as exceed the FLDG cover. For instance, if the FLDG is 5%, and the ECL estimated by the lender is 6.8%, the lender may create ECL provision only for 1.8%.

Note that ECL for any pool is a dynamic number – while estimations of the default probabilities and the exposure change over time, there are also changes due to unwinding of the discounting factor applied in computing present value of the ECL. Therefore, ECL estimation is bound to change every reporting period. For that matter, FLDG will remain fixed as 5% of the originated pool, but this number will also be dynamic as the loan pool matures – partly due to amortisation of the pool, and partly due to utilisation of the guarantee. Therefore, on an ongoing basis, the lender may compare the ECL with the percentage of FLDG still available, and create ECL for the differential amount.

Expected credit loss for the guarantor

If the guarantor is covered by ECL requirements, the guarantor needs to estimate the losses likely to be caused to the guarantor. As against the guarantee, the payoff of the guarantor may be (a) fixed guarantee fees (b) right to get a variable fee, usually linked with the excess spreads from the pool. 

Note that ECL computation is required not only for loans, but also for financial guarantees. Therefore, the guarantor will need to compute the expected credit losses from the underlying loans using exactly the same basis as if the loans were on the books of the guarantor. Of course, the maximum ECL will be the limit of the guarantee.

Provisioning for the recipient of the guarantee

In this regard, the RBI has clearly specified that no benefit will be given for provisioning requirements – that is, the regulatory provisioning will continue irrespective of the guarantee.

Provisioning for the guarantor

As regards the guarantor, while a financial guarantee is regarded as a direct credit substitute, however, there are no explicit provisioning requirements. To the extent the guarantee has already been utilised, it will be taken as a loss (even though recovery may happen subsequently, but it will be contingent). 

Accounting

Given that the recoveries are against an outstanding asset, receipts from DLG invocation should not be treated as income. The recoveries made from the accounts, for which the lender has already invoked DLG, in our view,should be recorded as a liability. This is because any recoveries from borrowers after receiving DLG payout would be liable to be remitted back to the DLG provider, and the lender will only hold it in trust. Hence creating a back to back obligation on the RE. It is important to note that, in general, a lender may not relinquish their legal right to recover a loan, even after the loan has been written off. Consequently, the obligation to pass on the recoveries from the borrower may also persist indefinitely. 

To support this perspective, we suggest that the lender establish a timeline in agreement with the DLG provider. This timeline should specify the duration during which any recoveries from loans, for which DLG payouts were made, will be passed on to the DLG provider. After the specified period, the lender will no longer be obligated to transfer such recoveries. Consequently, upon completion of the agreed period, the RE can write off the liability associated with the credit protection payouts received.

Treatment of an NPA account in case the guarantee is invoked.

Through the DLG Guidelines RBI has stated that the NPA classification would be the responsibility of the RE and would be as per the extant asset classification and provisioning norms irrespective of any DLG cover available at the portfolio level [para 7 of the DLG Guidelines]. The amount invoked by the DLG cannot be set off against the underlying individual loans and thus, asset classification and provisioning would not be affected by any DLG cover. However, any future recovery by the RE from the loans on which the DLG cover was invoked and realised can be shared with the DLG provider in terms of their contractual arrangements.

Since the guarantee invoked cannot be set off against the loan, how would the guarantee amount be shown in the books of the RE?

Accounting-wise, if the amount has been recovered, it is set off from the outstanding pool However, there is a departure here between accounting treatment and the NPA/capital requirements, as the RBI expects the NPA recognition to be continued in the books of the lender. 

Similarly, capital requirements will also remain unaffected. However,  it will be wrong to show the amount recovered from the guarantor as a liability as it is not a liability – though there may be an understanding that any recovery from the loans will be paid back to the guarantor. It is also wrong to treat the amount received from the guarantor as income, as the payment consists of both interest and principal.

Invocation of DLG will not affect NPA classification of borrower

It shall be noted that despite the FLDG being invoked against the borrowers outstanding amount, the capital requirements and asset classification remain unaffected. Further, reporting to CIC and NESL pertains to the borrowers performance, and therefore, the invocation of FLDG shall not influence these reporting. Repayment as well as defaults of the borrower should continue to be reported without any impact from FLDG invocation. Therefore, the borrowes account will continue to be classified as NPA and reported accordingly to the CIC and other relevant reporting entities.

Related Articles – 

FAQs on Default Loss Guarantee in Digital Lending

Lend, Recover, Replenish: A guide to revolving lines of credit

The iSAFE option to start up funding: Legality and taxation

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Mahak Agarwal | corplaw@vinodkothari.com

Navigating the world of fundraising for startups is no easy feat. This becomes all the more challenging for a pre-revenue start-up which cannot have a valuation. Amongst the several fundraising options available to a start-up, one of the budding and lesser-known sources happens to be iSAFE.

Origin

iSAFE, short for, India Simple Agreement for Future Equity, was first introduced in India by 100X.VC, an early-stage investment firm. This move was inspired by US’s ‘Simple Agreement for Future Equity (‘SAFE’)’, an alternative to convertible debt and the brainchild of an American start-up incubator. SAFE is a financing contract between a startup and an investor that grants the investor the right to acquire equity in the firm subject to specific activating events, such as a future equity fundraising.[1]

So far as the success of SAFE in India is concerned, being neither debt (since they do not accrue interest), nor equity (since they do not carry any dividend or shareholders’ rights) or any other instrument, it could not carve its place in India and was cornered as a mere contingent contract with low reliability and security. On the contrary, iSAFE happened to be the game changer in the Indian context, being a significantly modified version of SAFE.

Read more →

Amendment in Rule 11UA

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– Nitu Poddar and Ankit Singh Mehar | corplaw@vinodkothari.com

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