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

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

GST on Corporate Guarantees: Understanding the new regime

–  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  personlocated 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/

Loan Penal Charges: Accounting and GST implications

Abhirup Ghosh, Qasim Saif & Aanchal Kaur Nagpal  | finserv@vinodkothari.com

Background

Levying of penal charges or late payment charges are claimed as ‘just’, owing to the underlying breach of contract under the Contract Act, 1972. A breach or a non-performance by one party entitles the other party to receive compensation for any loss or damage suffered due to such breach. Penalties may not only be compensatory; they also have a deterrent element.

In order to ensure compliant behaviour, lenders  charge penalties to their borrowers for various ‘events of default’; the predominant ones being penalty for delayed payments (in the form of charges or interest) and prepayment penalties. However, such charges stopped being ‘just’ and ‘reasonable’ when lenders started maneuvering such penalties as revenue enhancement tools, rather than as a deterrent measure and compensation for a breach. Such unreasonable penalties coupled with non-disclosures, compounding of penal interest, etc. were highly prejudicial to consumer interest and accordingly, caught the eye of the regulator. 

The RBI introduced guidelines to the lenders to ensure reasonableness and transparency in the disclosure of penal interest vide its Circular on ‘Fair Lending Practice – Penal Charges in Loan Accounts’(RBI Guidelines on penal charges’)  dated August 18, 2023. Our article and FAQs[1] on the same may be read here[2].Our YouTube video discussing the guidelines may be viewed here.

However, charging penal interest also raises several practical questions for lenders, mainly indirect taxation and accounting of penal charges, which will be discussed in detail in this article.

Read more

A Critical Analysis on Corporate Guarantees under Service Tax and GST

Dayita Kanodia, Executive | finserv@vinodkothari.com

“The Supreme Court’s only armour is the cloak of public trust; its sole ammunition, the collective hopes of our society.” – Irving R. Kaufman

Background

The Supreme Court has ruled that service tax will not be levied on corporate guarantees by a parent company to its subsidiaries where there is no consideration involved.

This article discusses the impact of this ruling on companies which issue corporate guarantees without consideration.

Read more

Emission law amendments: Laying the framework for Carbon trading market in India

– Payal Agarwal, Vinod Kothari & Company (payal@vinodkothari.com)

This version: 23rd December, 2022

The Energy Conservation (Amendment) Bill, 2022 (“Bill”) seeks to provide a regulatory framework for carbon markets in India. The Bill was passed in the Lok Sabha on 8th August, 2022, and has been passed in the Rajya Sabha on 12th December, 2022. The President’s asset is all that is required to bring the carbon markets within the statutory framework of India. However, there is still a long way to go before carbon markets are implemented in India, which will require notification of the procedures and rules governing the same. Further, the carbon markets in other countries are still developing in a phased manner, identifying the gaps in the existing system and modifying accordingly. India cannot be an exception to the same. However, the concept of “carbon credits” is not unknown to India since there are several entities in the country which are already generating tons of carbon credits. This article seeks to delve upon the legal aspects of carbon credits markets around the world, the consequences of not exporting the same, and the tax implications upon sale of the generated credits. As we study the existing carbon markets around the world, some learnings from these markets may be taken into consideration for the developing carbon market in India.

Read more

Can companies avail GST benefits on CSR spending?

– By Harsh Juneja | Executive (corplaw@vinodkothari.com)

(Updated as on February 03, 2023 by Lovish Jain | Executive)

Background

Section 135(5) of the Companies Act, 2013 (‘the Act’) requires every eligible company [as per section 135(1)] to spend at least 2% of the average of net profits of immediately preceding 3 financial years towards Corporate Social Responsibilities(‘CSR’) activities. The CSR spending may sometimes include contributions made to NGOs or other beneficiaries, or money paid to implementing agencies. However, quite often, the expense may relate to procurement of goods or services which are applied to one or more CSR activities. This procurement of goods or services comes with the tax cost, viz., GST. So the question is, does this GST paid, while acquiring goods or services, give rise to an input tax credit, such that the same may be claimed as a set off? A related, and more important question is, whether CSR expense for the purpose of sec. 135 (5) be the amount net of the ITC, if the ITC is claimable, or the gross amount paid?

Input Tax Credit

Eligibility

Section 16(1) of the Central Goods and Service Tax (‘CGST Act, 2017’) prescribes the eligibility criteria for taking Input Tax Credit. It states that “Every registered person shall, subject to such conditions and restrictions as may be prescribed and in the manner specified in section 49, be entitled to take credit of input tax charged on any supply of goods or services or both to him which are used or intended to be used in the course or furtherance of his business and the said amount shall be credited to the electronic credit ledger of such person.”

Until the Budget 2023 announcement, there was no explicit provision clarifying the position whether input tax credit would be available for acquiring goods or services for carrying out CSR activities. In the Finance Bill, 2023, a proposal has been made for amendment in section 17 of the CGST Act, 2017 to disallow the availability of input tax credit for expenditure made towards CSR activities. Please refer to our article on the same

There have been rulings by Appellate Tribunal and Advance Rulings under GST w.r.t. the same.

Hon’ble CESTAT Mumbai, in the case of M/s Essel Propack Ltd. vs Commissioner of CGST, Bhiwandi, gave a view that the CSR gives a company an economically, socially and environment sustainability in the society in the long run, as a company can not operate without providing benefits to its stakeholders. Therefore, it held that if companies are unable to claim input services in respect of activities relating to business, production and sustainability of the companies themselves would be at stake.

Hon’ble High Court of Karnataka, in its judgement, in the case of M/s Commissioner of Central Excise, Bangalore vs. Millipore India (P) Ltd., also was of view that CSR Expenses are mandatorily incurred by employers towards benefit of the society and “to maintain their factory premises in an eco-friendly manner”. Therefore, the tax paid on such services shall form part of the costs of the final products and thus, the company can claim these taxes paid as input services.

Uttar Pradesh Authority for Advance Ruling (‘AAR’) in the matter of M/s Dwarikesh Sugar Industries Ltd held that a company is mandatorily required to undertake CSR activities and thus, forms a core part of its business process. Hence, the CSR activities are to be treated as incurred in “the course of business”.

Telangana State AAR in the matter of M/s. Bambino Pasta Food Industries Private Limited has clearly held that expenditure made towards CSR, is an expenditure made in the furtherance of the business. Hence the tax paid on purchases made to meet the obligations under CSR will be eligible for ITC. 

Section 135(7) is a penal provision under the Act which deals with penalty on non-compliance of section 135(5)  and (6). It was observed by the AAR that a Company fulfilling eligibility criteria under section 135(1) of the Act is required to mandatorily spend towards CSR and thus, must comply with these provisions to ensure smooth run of business.

Thus, Uttar Pradesh AAR held that the expenses incurred by the Company in order to comply with requirements of CSR under the Act qualify as being incurred in the course of business and are eligible for ITC in terms of the Section 16 of the CGST Act, 2017.

Contrary ruling: Free Supply of Goods

Section 17(5)(h) of the CGST Act excludes “goods lost, stolen, destroyed, written off or disposed of by way of gift or free samples” for the purpose of availing ITC on payment of GST. The term ‘gift’ is not defined anywhere in the CGST Act. However, in layman’s language, gift means a thing given willingly to someone without payment.

In the matter of M/s. Polycab Wires Private Limited, Kerala AAR held that distribution of necessaries to calamity affected people under CSR expenses shall be treated as is if they are given on free basis and without collecting any money. Hence, for these transactions, it was held that ITC shall not be available as per section 17(5)(h).

However, a contrast has been drawn in the Uttar Pradesh AAR Ruling towards goods given as ‘gift’ and given as a part of CSR activities. Gifts are voluntary and occasional in nature whereas CSR expenses are obligatory and regular in nature. AAR held that since CSR expenses are not incurred voluntarily and have to be incurred regularly, they are not to be treated as ‘gift’ and thus, should not be restricted under section 17(5)(h) for claiming ITC.

One may also refer to explanation 2 to Section 37(1) of Income Tax Act, 1961, as also cited by Hon’ble High Court of Delhi in the matter of Pr. Commissioner of Income Tax vs. M/s Steel Authority of India Ltd which provides that, any expenditure incurred by an assessee on the activities relating to CSR referred to in section 135 of the Companies Act, 2013 shall not be deemed to be an expenditure incurred for the purposes of the business or profession.

Availing Benefit through Beneficiary

A company contributes a sum towards a beneficial organisation such as NGOs, Charitable Trusts and Section 8 Companies (‘implementing agencies’) towards fulfillment of CSR activities. However, these implementing agencies also need to hire services of vendors to complete these activities. These vendors charge GST on the services rendered by them. Since these implementing agencies often do not generate any output, the question raises can these organizations also claim ITC on the services rendered by them?

There is a concept of ‘pure agent’ in GST. Explanation to Rule 33 of CGST Rules, 2017 prescribes that a pure agent means a person who –

The implementing agencies fulfill this eligibility criteria of being a ‘pure agent’. Rule 33 also contains some conditions on the fulfilment of which, expenses incurred by the supplier as a pure agent of the recipient of the supplier of goods or services, are excluded from the value of supply-

In our case, if an implementing agency avails any goods or services from a vendor to fulfil the CSR activities for a company, then the payment of any such amount to the vendor shall be treated as a supply made as a pure agent by the implementing agency on behalf of recipient of supply, i.e., the company. Thus, these expenses incurred by the implementing agencies shall be excluded from the value of supply and therefore, are not liable for payment of GST.

CSR Contribution: Pre-GST or Post-GST?

The Act does not clarify that the amount to be contributed towards CSR activities should be inclusive or exclusive of taxes. However, it seems that since GST is charged on supply of goods and services, irrespective of the intention of social benefit, the amount contributed towards CSR can be both inclusive and exclusive of GST. Having said that, the question still pertains on the inclusivity of the amount of GST paid towards the amount of CSR expenditure for the purpose of section 135(5) of the Companies Act, 2013.

Conclusion

While the rational view would be, expenses incurred on GST for fulfilment of CSR activities should be eligible for claiming input tax credit, however, the Finance Bill, 2023 proposes otherwise. The effective date of the amendment will be 1st April 2023. Hence, once the Budget proposals are passed, any acquisition of goods or services for CSR purposes will be denied the benefit of GST set off. So the next question is whether the CSR expenditure would be inclusive of GST. We deal with the same citing illustrations in our article.

Complete Guide to Sale and Leaseback Transactions

A guide to concepts, taxation, and accounting aspects of sale and leaseback transactions.

 

– Qasim Saif (finserv@vinodkothari.com)

 

Contents

Sale and Leaseback transaction. 2

Advantages to the Lessee. 2

Unlocking value, the hidden value of asset 2

Tax Benefits. 2

Legal issues in SLB: 3

Taxation of SLB transactions. 3

Direct Tax Aspect 3

Goods & Service Tax. 5

The Sale. 5

The Lease. 5

Place of supply. 6

Disposal of Capital Asset 6

Example of GST Calculations on Sale and Leasebacks. 6

Sale of Asset 7

Leasing of asset 7

Accounting of Sale and leasebacks. 7

Criteria for Sale. 8

Transfer of asset does not qualify as sale. 10

Transfer of asset qualifies as sale. 10

Sale at Fair Value. 10

Sale at a discount or premium.. 10

Example of Sale and Leaseback Accounting under Ind AS 109. 11

Calculations. 11

Rental Schedule. 11

Accounting Entries at Inception. 12

 

Sale and Leaseback transaction

A Sale and Leaseback (SLB) is a special case of application of leasing technique. Lease is a preferred mode of using the asset without having to own it. In case of leases, the lessee does not own the asset but acquires the right to use the asset for a specified period of time and pays for the usage.

SLB is a simple financial transaction which allows selling an asset and then taking it back on lease. The transaction thus allows a seller to be able to use the asset and not own it, at the same time releasing the capital blocked by the asset.

SLB allows the lessee to detach itself with legal ownership yet continuing to use the asset as well. In effect there is no movement of asset however on paper there is a change in the title of the asset.

Sale and Leaseback transactions are globally common in the Real estate investment trusts (REITs) and Aviation industry.

Advantages to the Lessee

Unlocking value, the hidden value of asset

As is evident from the mechanics of SLB above, SLB results in taking the asset off the books of the lessee and results in upfront cash which could be used for paying off existing liabilities. Hence this does not impact the existing lines of credit the lessee may be availing.

SLB can help entities raise finance for an amount equal to fair market value of the asset which may be significantly higher than its book value. Though there might be taxation challenges attached to it in Indian context. Nevertheless, SLB may bring about a financial advantage as well wherein a high-cost debt can be substituted with a low-cost lease liability.

Most of the assets considered for SLB have been used by the lessee for a substantial period of time and the value of the physical assets may be insignificant. Hence SLB is sometimes referred to as junk financing.

Tax Benefits

SLB may sometimes lead to tax benefits as well (we shall see this in detail in the sections below). This has been one of the major drivers of SLB transactions in India and has its own downsides as well. One of the major pitfalls to SLB is the danger of excess leveraging; the lessee may tend to overvalue the asset. Considering that SLB is a mode of asset-backed lending but the asset has may not have much value and the lessee may exercise discretion on the application of funds poses threat of misuse of the product.

Legal issues in SLB:

The legal validity of SLB was discussed by the U.S Supreme Court in the landmark ruling of Frank Lyon and Company[1]. In Frank Lyon’s case the bank took the building on SLB. Under the lease terms the bank was liable to pay rentals periodically and had the option to purchase the building at various times at a consideration based on its outstanding balance. The bank took possession of the building in the year it was completed and the lessor claimed deductions on depreciation, interest on construction loan, expenses related to sale and lease back and accrued the rent from the bank.

The Commissioner of Internal Revenue denied the claims of the petitioner on the grounds that the petitioner was not the owner of the building and the sale and leaseback was a mere financing transaction. The Hon’ble Court held that –

Where, as here, there is a genuine multiple-party transaction with economic substance that is compelled or encouraged by business or regulatory realities, that is imbued with tax-independent considerations, and that is not shaped solely by tax-avoidance features to which meaningless labels are attached, the Government should honor the allocation of rights and duties effectuated by the parties; so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes.

The fundamental principle is that the Court should be concerned with the real substance of the transaction rather than the form of the same. If there are reasons to believe that the form of the transaction and its real substance are not aligned, the Court must not be simply concerned by the form of the transaction nor by the nomenclature that the parties have given to it.

In India too, the legality of SLB transactions have been questioned in several cases; sometimes the transactions have come out clean while in some cases, SLBs were considered an accounting gimmick.

The legality of SLB transactions and analysis of various judicial pronouncements on the same, have been discussed in detail in our write up “Understanding Sale and leaseback

Taxation of SLB transactions

Tax aspects specifically direct tax acts as a major motivation behind such transactions, SLB provides a creative playground for finance professionals to structure transactions in a manner that can lead to substantial benefit to the entity, and taxation acts as a major tool at their disposal.

Direct Tax Aspect

Though tax benefits have been a motivator for SLB transaction, the same has also been the reason for near wipe-out of SLB from Indian markets.

During the 1996-98 period one of the most infamous cases was the sale and leaseback of electric meters by state electricity boards (SEBs). For SEBs it made perfect sense as it amounted to cheap borrowing by the cash starved SEBs who had practically no other source of borrowing.

For leasing companies and others looking for a tax break, it was a perfect deal as there was 100% write off in case of assets costing Rs 5000 or less. Thus, an electric meter will qualify for 100% deduction. Several SEBs had undertaken such transactions in those days. Obvious enough the sole motive was tax deduction no one would care about the value, quality, existence etc of the meters. In some cases, the asset was bought on 30th March to be used only for a day, assets revalued heavily at the time of sale to leasing companies etc. Lease of non-existing assets such as electric meters, computers, glass bottles, tools, etc, lure of depreciation allowances caused the tax authorities to come down hard on sale and leaseback transactions calling them tax evading transactions. The whole fiasco of such sham transactions resulted in leasing going off the market completely. The burns of the past continue to linger even after a decade and half since SLB transactions were completely written off.

The most significant consideration in lease transactions is the depreciation claim. For tax purposes, depreciation is calculated on the block of the assets and not on the written down value of each asset separately.

Section 2(11) of the Income Tax Act, 1961 (IT Act) defines block of assets to mean

“”block of assets” means a group of assets falling within a class of assets comprising—

(a) tangible assets, being buildings, machinery, plant or furniture;

(b) intangible assets, being know-how, patents, copyrights, trade-marks, licences, franchises or any other business or commercial rights of similar nature, in respect of which the same percentage of depreciation is prescribed.”

The sale proceeds of the assets sold are deducted from the written down value of the block. In case of SLB transaction, assets are sold at higher than written down value, and the gain made on such a sale results in reduction in depreciable value of the block of assets. The reduction in depreciation will be allowed over a number of years. Similar would be the case in case the asset was sold at less than written down value, sale consideration would be reduced from the block of the assets.

Once the asset is sold and taken off the books of the lessee, the lessee is able to account for an immediate accounting profit without having to pay tax on it instantly. As under the block concept of depreciation, when the lessee sells the capital assets, the sale proceeds including the profits on sale are allowed to be deducted from the block of assets and hence there is no immediate tax on the accounting profits.

Also, typically the asset is recorded on historical costs which may be lower than the intrinsic value of the asset. SLB sometimes allows the entities to unlock the appreciation in value. However, it is not always necessary that the asset would have appreciated value. In some cases, the asset may have become junk completely.

To avoid the same revenue has introduced following provisions in the IT act, in order to restrict undue benefits being passed by use of sham SLB transactions:

Section 43 (1) provides for treatment of sale and lease back transactions for tax purposes, the relevant extracts are reproduced below –

“Explanation 3.—Where, before the date of acquisition by the assessee, the assets were at any time used by any other person for the purposes of his business or profession and the Assessing Officer is satisfied that the main purpose of the transfer of such assets, directly or indirectly to the assessee, was the reduction of a liability to income-tax (by claiming depreciation with reference to an enhanced cost), the actual cost to the assessee shall be such an amount as the Assessing Officer may, with the previous approval of the Joint Commissioner, determine having regard to all the circumstances of the case.”

“Explanation 4A.—Where before the date of acquisition by the assessee (hereinafter referred to as the first mentioned person), the assets were at any time used by any other person (hereinafter referred to as the second mentioned person) for the purposes of his business or profession and depreciation allowance has been claimed in respect of such assets in the case of the second mentioned person and such person acquires on lease, hire or otherwise assets from the first mentioned person, then, notwithstanding anything contained in Explanation 3, the actual cost of the transferred assets, in the case of first mentioned person, shall be the same as the written down value of the said assets at the time of transfer thereof by the second mentioned person.

Explanation 3 and 4A of Section 43 (1) restricts the consideration at which the lessor purchases the assets to written down value of the asset as appearing in the books of the lessee before it was sold and taken back on lease. The explanation explicitly states that the sale value for such sale and lease back transactions will be ignored and depreciation will be allowed on the first seller’s depreciated value. Take, for instance, A purchased machinery for Rs. 10 crores from B, though the WDV in the books of B is Rs. 2 crores. A can claim depreciation on Rs. 2 crores and not on Rs. 10 crores.

The said provisions removes any motivation for the lessor to carryout transactions at inflated values. Hence preventing junk financing to enter into SLB transactions.

Goods & Service Tax

Pre-GST indirect taxation regime acted as a major road block in the development of leasing industry as a whole, the legal differentiation as well as non-availability of credit among central and state taxes made leasing transactions costly.

Introduction of GST is playing a key role in development of leasing industry, from a stage where it had nearly become extinct. We have further discussed GST implications on leasing.

The Sale

The first leg of the transaction would involve sale of Assets by lessee to lessor.

In terms of section 7(1)(a) “all forms of supply of goods or services or both such as sale, transfer, barter, exchange, licence, rental, lease or disposal made or agreed to be made for a consideration by a person in the course or furtherance of business;”

The taxability under GST arises on the event of supply accordingly the sale of capital assets for a consideration would fall under the ambit of supply and accordingly GST shall be levied.

The Lease

The second part of transaction would lease back that is when the asset is leased back from buyer -lessor to seller lessee. The leaseback would be subject to GST like any other lease transaction.

The term lease has not been defined anywhere in GST Act or Rules. To classify a lease transaction as either supply of goods or supply of service, we have to refer Schedule II of the CGST Act, 2017 where in clear guidelines for classification of a transaction as either “supply of goods” or “supply of services” has been enumerated, based on certain parameters: –

  • Any transfer of the title in goods is a supply of goods;
  • Any transfer of right in goods or of undivided share in goods without the transfer of title thereof, is a supply of services;
  • Any transfer of title in goods under an agreement which stipulates that property in goods shall pass at a future date upon payment of full consideration as agreed, is a supply of goods.
  • Any lease, tenancy, easement, licence to occupy land is a supply of services;
  • Any lease or letting out of the building including a commercial, industrial or residential complex for business or commerce, either wholly or partly, is a supply of services.

Place of supply

Undoubtedly, the SLBs do not involve movement of goods, the seller lessee continuous to be in possession of leased asset even after the sale. Hence, In the case of such sale, there is no physical movement of the asset from the premises of the lessee to the premises of the lessor. The ownership gets transferred in the premise of the lessee.

In terms of Section 10(1)(c) of the IGST Act, the place of supply of goods where the supply does not involve movement of the said goods whether by the supplier or the recipient shall be the location of such goods at the time of delivery to the recipient. Accordingly, the place of supply in this case will be same as the location of the supplier. Accordingly, the sale of the asset will be considered as an intra-state supply as per Section 8 of the IGST Act and will be subjected to CGST + SGST.

Disposal of Capital Asset

Applications of GST on disposal of capital assets is one of the major deterring factors of in SLBs. Section 18(6) of the CGST Act,2017 state that:

In case of supply of capital goods or plant and machinery, on which input tax credit has been taken, the registered person shall pay an amount equal to the input tax credit taken on the said capital goods or plant and machinery reduced by such percentage points as may be prescribed or the tax on the transaction value of such capital goods or plant and machinery determined under section 15, whichever is higher:”

Entry no. (6) Of Rule 44 of CGST Rules, 2017: Manner of Reversal of ITC under Special Circumstances which reads as under: –

“The amount of input tax credit for the purposes of sub-section (6) of section 18 relating to capital goods shall be determined in the same manner as specified in clause (b) of sub-rule (1) and the amount shall be determined separately for input tax credit of central tax, State tax, Union territory tax and integrated tax:”         

“……………..Clause (b) of sub rule 1 of same rules states that :

(b) for capital goods held in stock, the input tax credit involved in the remaining useful life in months shall be computed on pro-rata basis, taking the useful life as five years………….”

Generally, the lessor procures the capital Assets at WDV due to Income tax Act implication. In that case WDV as per Income tax act would be the transaction value.

Example of GST Calculations on Sale and Leasebacks

Let’s consider a numerical example: an Entity A enters into SLB arrangement with an Entity B. A sells its machinery to B for Rs. 5,00,000/- as on 31st May 2021. The entity had purchased the asset for Rs. 6,00,000/- as on 31st March 2019.

B then leases back the asset to A for a yearly rental of Rs, 1,00,000/- for 3 years term with a purchase option at the end of 4th year at Rs. 2,50,000. (Assumed to be exercised)

(GST @ 18%)

Sale of Asset
Disposal of assets

On disposal asset, GST will be charged on the selling price of the asset. However, the amount to be deposited to the government with respect to this sale transaction shall be higher of the following:

  1. GST on the sale consideration;
  2. ITC reversed on transfer of capital asset or plant and machinery based on the prescribed formula

Portion of ITC availed on the asset, attributable to the period during which the transferor used the asset:

6,00,000 * 18% * (5% * 8) = 43200

Remaining ITC = (6,00,000 * 18%) – 43200 = 64800

GST on the selling price = 500000 * 18% = 90000

Therefore, GST to be paid to the government is 90000, that is higher of the two amounts discussed above.

Leasing of asset

As mentioned above GST shall be chargeable to lease rental, at the rate similar to that charged on acquisition of leased asset. Accordingly, Entity B shall charge GST on rentals for an amount of Rs. 18,000/- (Rs. 1,00,000/- * 18%).

Further GST shall also be charged on sale of asset at the end of lease tenure for an amount of Rs. 45,000/-(2,50,000*18%).

Accounting of Sale and leasebacks

IAS 17 covered the accounting for a sale and leaseback transaction in considerable detail but only from the perspective of the seller-lessee.

As Ind AS 116/IFRS 16 has withdrawn the concepts of operating leases and finance leases from lessee accounting, the accounting requirement that the seller-lessee must apply to a sale and leaseback is more straight forward.

The graphic below shows how SLB transactions should be accounted for:

Criteria for Sale

IFRS 16/Ind AS 116 state that

“ An entity shall apply the requirements for determining when a performance obligation is satisfied in Ind AS 115 to determine whether the transfer of an asset is accounted for as a sale of that asset.”

Accordingly, when a seller-lessee has undertaken a sale and lease back transaction with a buyer-lessor, both the seller-lessee and the buyer-lessor must first determine whether the transfer qualifies as a sale. This determination is based on the requirements for satisfying a performance obligation in IFRS 15/Ind AS 115 – “Revenue from Contracts with Customers”.

The accounting treatment will vary depending on whether or not the transfer qualifies as a sale.

The para 38 of Ind AS 115/IFRS 15- Performance obligations satisfied at a point in time, provides ample guidance on determining whether the performance obligation is satisfied.

The para states that:

“If a performance obligation is not satisfied over time in accordance with paragraphs 35– 37, an entity satisfies the performance obligation at a point in time. To determine the point in time at which a customer obtains control of a promised asset and the entity satisfies a performance obligation, the entity shall consider the requirements for control in paragraphs 31–34. In addition, an entity shall consider indicators of the transfer of control, which include, but are not limited to, the following:

(a) The entity has a present right to payment for the asset—if a customer is presently obliged to pay for an asset, then that may indicate that the customer has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset in exchange.

(b) The customer has legal title to the asset—legal title may indicate which party to a contract has the ability to direct the use of, and obtain substantially all of the remaining benefits from, an asset or to restrict the access of other entities to those benefits. Therefore, the transfer of legal title of an asset may indicate that the customer has obtained control of the asset. If an entity retains legal title solely as protection against the customer’s failure to pay, those rights of the entity would not preclude the customer from obtaining control of an asset.

(c) The entity has transferred physical possession of the asset—the customer’s physical possession of an asset may indicate that the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset or to restrict the access of other entities to those benefits. However, physical possession may not coincide with control of an asset. For example, in some repurchase agreements and in some consignment arrangements, a customer or consignee may have physical possession of an asset that the entity controls. Conversely, in some bill-and-hold arrangements, the entity may have physical possession of an asset that the customer controls. Paragraphs B64–B76, B77–B78 and B79–B82 provide guidance on accounting for repurchase agreements, consignment arrangements and bill-and-hold arrangements, respectively.

(d) The customer has the significant risks and rewards of ownership of the asset—the transfer of the significant risks and rewards of ownership of an asset to the customer may indicate that the customer has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. However, when evaluating the risks and rewards of ownership of a promised asset, an entity shall exclude any risks that give rise to a separate performance obligation in addition to the performance obligation to transfer the asset. For example, an entity may have transferred control of an asset to a customer but not yet satisfied an additional performance obligation to provide maintenance services related to the transferred asset.

(e) The customer has accepted the asset—the customer’s acceptance of an asset may indicate that it has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. To evaluate the effect of a contractual customer acceptance clause on when control of an asset is transferred, an entity shall consider the guidance in paragraphs B83–B86.”

It shall be noted that no single criteria can be taken as a determining factor for concluding that sale has taken place. Each criterion should be individually assessed every case. Needless to say, substance of the transaction should be adjudge based on principles set.

The criteria set out in the para 38 specified above can be summarised as follows:

  • There is a present right to payment has been established.
  • The legal tittle of the asset is transferred. It shall be noted that this shall not conclusively determine sale, rather a to be considered in consonance with another criterion.
  • Physical possession of the asset has been transferred. Now this is a matter of discussion, as under SLB, the possession never leaves the seller. However, in our view even in case of symbolic transfer of possession the criterion can be said to be satisfied subject to the condition that buyer-lessor has an ability to direct the use of asset. Hence, an entity should ensure that the buyer-lessor is not bound by sale agreement or otherwise to leaseback the asset.
  • Significant risk and reward attached to ownership are transferred to the buyer
  • The buyer has accepted the asset

Transfer of asset does not qualify as sale

If the transfer does not qualify as a sale the parties account for it as a financing transaction. This means that:

  • The seller-lessee continues to recognise the asset on its balance sheet as there is no sale. The seller-lessee accounts for proceeds from the sale and leaseback as a financial liability in accordance with Ind AS 109/IFRS 9. This arrangement is similar to a loan secured over the underlying asset – in other words a financing transaction
  • The buyer-lessor has not purchased the underlying asset and therefore does not recognise the transferred asset on its balance sheet. Instead, the buyer-lessor accounts for the amounts paid to the seller-lessee as a financial asset in accordance with Ind AS 109/IFRS 9. From the perspective of the buyer-lessor also, this arrangement is a financing transaction.

Transfer of asset qualifies as sale

Where the transfer qualifies as sale, there can be further two situations:

  1. Sale at Fair value
  2. Sale at discount or premium.
Sale at Fair Value

If the transfer qualifies as a sale and is on fair value basis the seller-lessee effectively splits the previous carrying amount of the underlying asset into:

  • a right-of-use asset arising from the leaseback, and
  • the rights in the underlying asset retained by the buyer-lessor at the end of the leaseback.

The seller-lessee recognises a portion of the total gain or loss on the sale. The amount recognised is calculated by splitting the total gain or loss into:

  • an unrecognised amount relating to the rights retained by the seller-lessee, and
  • a recognised amount relating to the buyer-lessor’s rights in the underlying asset at the end of the leaseback.

The leaseback itself is then accounted for under the lessee accounting model.

The buyer-lessor accounts for the purchase in accordance with the applicable standards (eg IAS 16 ‘Property, Plant and Equipment’ if the asset is property, plant or equipment or IAS 40 ‘Investment Property’ if the property is investment property). The lease is then accounted for as either a finance lease or an operating lease using IFRS 16’s lessor accounting requirements.

Sale at a discount or premium

The accounting methodology shall remain the same, However, Adjustments would be required to provide for the discounted or premium price.

These adjustments would be as follows:

  1. a prepayment would be recorded in order to provide for adjustment in regard to sale at a discount
  2. Any amount paid in excess of fair value would be recorded as an additional financing facility and accounted for under Ind AS 109.

Example of Sale and Leaseback Accounting under Ind AS 109

A sample spreadsheet calculations for the below example can be accessed here

Calculations

 

ParticularAmountRemarks
Sale considerations₹ 10,00,000.00
Carrying Amount₹ 5,00,000.00
Term15year
Rentals/year₹ 80,000.00year
Fair Value of Building₹ 9,00,000.00
Incremental borrowing rate10%
PV of rentals₹ 6,08,486.36
Additional Financing₹ 1,00,000.00Sale Consideration
– Fair Value
Payments towards Lease Rentals₹ 5,08,486.36PV of Rentals
– Additional Financing
Ratio of PV of rentals and
Payment towards lease Rentals
16%
Yearly payments towards Add. Financing₹ 13,147.38Rental X Ratio
Yearly payments towards Lease Rental₹ 66,852.62Rental – Payment toward Add. Fin.
ROU of Asset₹ 2,82,492.42Carrying Amount X
[Payments towards Lease Rentals/Fair Value of Building]
Total Gain on sale₹ 4,00,000.00Fair Value – Carrying Amount
Gain recognised Upfront₹ 1,74,006.06Total Gain X [(Fair Value of Building-Payments towards Lease Rentals)
/Fair Value of Building]

 

Rental Schedule

 

NPVNPV
₹ 5,08,486.36₹ 1,00,000.00
YearLease RentalsAdditional Financing
0
1 ₹ 66,852.62 ₹ 13,147.38
2 ₹ 66,852.62 ₹ 13,147.38
3 ₹ 66,852.62 ₹ 13,147.38
4 ₹ 66,852.62 ₹ 13,147.38
5 ₹ 66,852.62 ₹ 13,147.38
6 ₹ 66,852.62 ₹ 13,147.38
7 ₹ 66,852.62 ₹ 13,147.38
8 ₹ 66,852.62 ₹ 13,147.38
9 ₹ 66,852.62 ₹ 13,147.38
10 ₹ 66,852.62 ₹ 13,147.38
11 ₹ 66,852.62 ₹ 13,147.38
12 ₹ 66,852.62 ₹ 13,147.38
13 ₹ 66,852.62 ₹ 13,147.38
14 ₹ 66,852.62 ₹ 13,147.38
15 ₹ 66,852.62 ₹ 13,147.38

 

Accounting Entries at Inception

 

Buyer-Lessor
Building ₹            9,00,000.00
Financial Asset ₹            1,00,000.00
       Bank ₹         10,00,000.00
*Lease accounted as per Finance or operating lease accounting
Seller-Lessee
Bank ₹          10,00,000.00
ROU ₹            2,82,492.42
          Building ₹            5,00,000.00
          Financial Liability ₹            6,08,486.36
         Gains on Asset Transfer ₹            1,74,006.06

 

[1] 435 U.S. 561 (1978)

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

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

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