Whether burden shared by captives comes under GST?

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Extended clarification required

-Yutika Lohia

yutika@vinodkothari.com

Introduction

Interest subvention income are earnings received from the third party i.e. person other than the borrower. This scheme work as a compensation to the seller who intends to penetrate the market. They arrange low cost finance for their customers (though not low cost because the part of it is compensated by its captive unit).Therefore the seller (lender) offers subsidized rate to the buyer (borrower) and the discounts are borne by the third party who is either a captive unit of the seller or also by Central or State Government who plans to provide financial aid through subvention.

In the case of Daimler Financial Services India Private Limited[1] (DFSI), the advance authority passed a ruling where it was concluded that interest subvention is like “other miscellaneous services” which was received from Mercedes-Benz India Private Limited (MB India) by DFSI and will be chargeable to GST as a supply.

The case of Daimler Financial Services India Private Limited

In the said case, DFSI is registered as an NBFC and is engaged in the business of leasing and financing. DFSI is a captive finance unit of MB India where the customers get a rebate in the interest component when DFSI acts as a financer and the car is purchased from one of the authorized dealers of MB India. MB India is engaged in the manufacture and sale of car which is usually done through its authorized dealer. The difference interest amount for each transaction is paid upfront by MB India to DFSI who raises an invoice against MB India. Payments made by MB India for the interest subvention was done after deducting TDS under section 194A of the IT Act.

The assessee contended that the interest subvention received is an interest and is an exempt supply. Also, the GST law and the Indian Contract Act 1872 recognize that consideration for a transaction can flow from anybody. The loan agreement with the customers also mentioned the applicable interest rate, the interest subsidy received from the MB India and the net interest payable by the customer.

Several reference of rulings were submitted by the assessee through which it contended that

  • The interest subvention is a subsidy which is made to offset a part of the loss incurred by charging a lower rate of interest.
  • Consideration can flow from a person other than the borrower.
  • If a contract stipulates that for the use of creditor’s money a certain profit shall be payable to the creditor, that profit is interest by whatever name called.

The following points were put up by the department:

The department that DFSI had not borrowed money from MB India. Also interest income can be exempt when there is a direct supply. It was also put that the interest income exempt through notification is not valid for a payment made by third party. The whole structure was set up to promote the business of DFSI.

The department gave reference to section 15 of the CGST Act, where value of supply includes subsidies directly linked to price and the amount of subsidy will be included in the value of supply. Therefore “interest subvention” is an interest subsidy and hence chargeable to GST. Also it was noted that income booked by DFSI is shown under revenue from operations as subsidy income.

The ruling concluded that interest received by DFSI from MB India was to reduce the effective interest rate to the final customer is chargeable to GST as supply under SAC 999792 as other miscellaneous services, agreeing to do an act.

The law behind interest subvention

As per the exempted list of services[2], consideration represented by way of interest or discount on services by way of extending loans or advance is an exempt supply. As it is evident, that services exclude any transaction in money but includes activities relating to use of money i.e. processing fees falls within the meaning of activities relating to use of money and therefore charged to GST.

When there is an interest subsidy, there are two arrays of interest involved- “applicable fixed interest rate gross” and “Net applicable fixed interest rate”. The borrower is under no obligation to pay the lender interest on principal i.e. the applicable fixed interest rate gross. The lender pays at the net applicable fixed interest rate. The difference between the two arrays of interest is the interest subvention borne by the third party. Technically the consideration paid by the borrower is the subsidized rate of interest. The borrower indirectly pays the differential amount of interest through the third party. Therefore referring section 7 of the CGST Act, consideration paid by the borrower is in the course of business whereas consideration paid by the third party is for furtherance of business. The two considerations received are totally different as one is “interest” and the other is “interest subsidy”.

Further, referring to section 15 (2) (e) of the CGST Act, value of supply of includes subsidies directly linked to the price excluding subsidies provided by the Central and State Governments. The interest subvention received are directly linked to price i.e. the interest paid by the borrower to lender and should be considered as value of supply.

Also the definition of “interest” is defined by the council as – “interest” means interest payable in any manner in respect of any moneys borrowed or debt incurred (including a deposit, claim or other similar right or obligation) but does not include any service fee or other charge in respect of the moneys borrowed or debt incurred or in respect of any credit facility which has not been utilised;

The interest paid on money borrowed is under the exempted category of services. Interest subvention disbursed by the captive unit of the lender is not paid on any money borrowed. It is a form of consideration paid so as to promote the business indirectly. They are like any other charges and therefore should not be considered as interest on money borrowed.

Since interest subvention is not interest on money, the same is not an exempt supply and therefore under the purview of GST.

Conclusion

The Advance Ruling Authority (AAR) interpreted the law and considered interest subvention to be taxable under GST. Further clarification is still required on its taxability as  one may note that as per section 103 of the CGST Act, the rulings pronounced by the  Authority is only binding on the applicant.

Therefore, whether interest subvention is taxable under GST or not requires further attention from the department.

 

[1] http://www.gstcouncil.gov.in/sites/default/files/ruling-new/TN-16-AAR-2019-Daimler%20FSIPL.pdf

[2] http://www.cbic.gov.in/resources//htdocs-cbec/gst/Notification9-IGST.pdf;jsessionid=B71F3824BBE3E6EF8C805B56978C9C9F

Applicability of GST on penal charges

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By Yutika Lohia (yutika@vinodkothari.com), (finserv@vinodkothari.com)

Introduction

The Goods & Services Tax (GST) has been the biggest tax reform in India founded on the notion of ‘one nation, one market, one tax’. It has and will further affect the entire economy including core industries such as agriculture, manufacturing, finance, service, infrastructure etc. The tax reform has been touted to create a significant positive impact on the economy in the long run. Unfortunately however, GST has not been exception to the fact that any big transition faces short term pains. The GST council has been receiving numerous queries and doubts from the myriad industries and trading associations regarding its applicability and nuances on the supply of various goods and services. One such concern had been on the issue of its applicability on additional/penal interest.

Recently the Council came up with a circular on “Clarification regarding applicability of GST on additional / penal interest” on 28th June, 2019[1] to address the issue.

The word “penal”

Black’s law dictionary defines penalty as ‘punishment imposed by statute as a consequence of the commission of a certain specified offense.” Subsequently as such the word “penal” is something relating to or containing a penalty. To put it in perspective, any default in payment of a loan transaction or in the supply of goods or services is liable for a penalty, which may be fixed or variable and thus may be in the name of additional interest or penalty interest, or overdue interest.

In a financial transaction, when there is a delay in the payment of EMI by the customer/borrower, the lender collects penal /default interest as additional interest for the period of delay, determined in days, months or years as per the agreed terms between the two.

Chargeability of GST

Penal charge is levied when there is delayed payment in a money-to-money transaction or when there is a supply of goods or services.

First let us understand whether the penal interest will be included in the value of supply.

As per section 15(2)(d) of the CGST Act, value of supply includes “interest or late fee or penalty for delayed payment of any consideration for any supply.”

Therefore, any interest or penalty paid for delayed payment in the supply of goods or service or a loan transaction shall be included in the value of supply i.e. the consideration amount.

Further, penal charges will not be covered under Schedule II- Activities to be treated as a supply of goods or services in clause 5(e), where supply of services include “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act”

The expression “to tolerate an act” used in the above clause, should be understood to cover instances where the consideration is being charged by one person in order to allow another person to undertake any particular activity. Therefore it is very clear that at the very inception of the transaction, the intention of one party is to undertake an activity and the other party shall allow the same without any deterrent. To say, the contract is entered to allow the other person to carry out an activity, and not as a penalty or limit the person for carrying out such act in future.

Furthermore, the word “obligation” used in the clause 5(e) of Schedule II where the service recipient requests the service provider to tolerate an act/situation and the service provider obliges to tolerate for a consideration, then such a contractual relationship shall be covered in the above mentioned clause. Therefore it can be said that there is a consensus ad idem between the contracting parties.

Contrary to the above, penal interest/charges are collected only when an event occurs i.e. when there is a default in a payment of a loan transaction or supply of goods/services. The intention of the parties entering into a contract is either to avail the services in way of loan or supply of goods. Penal charges are to be paid if there is a breach in the contract and therefore it does not mean that the parties have entered into a contract for the penal interest.

Therefore penal charges does not fall under the deemed supply list given in Schedule II of the CGST Act.

As penal interest satisfies the definition of “interest” given in the notification, penal interest charged by parties who enter into a contract of giving loans will be covered under serial no. 27 of the notification dated 28th June, 2017.

Ergo, penal charges levied by the lender in a money to money transaction will have no GST implications.

Services by way of extending deposits, loans or advances in so far as the consideration is represented by way of interest or discount is an exempt service and penal charges levied by the vendor on delayed payment in case of supply of goods and services shall be under the purview of GST.

Various clarifications by the GST Council on additional/ penal interest taxability

The GST department’s explanations regarding the applicability of GST of additional / penal interest are listed below:

1.      FAQs on financial sector

The Central Board of Indirect Taxes and Customs (CBIC) came up with a frequently asked questions document (FAQs documents) on financial sector[2] where taxability of additional interest in GST was discussed in serial no 45 of the document.

Any additional interest charged on default in payment of instalment in respect of any supply which is subject to GST, will be included in the value of supply and therefore will be liable to GST.

2.      Notification No. 12/2017-Central Tax (Rate) dated 28th June 2017[3]

The department exempts services by way of extending deposits, loans or advances in so far that the consideration is represented by way of interest or discount (other than interest involved in credit card services).

Also the notification defines the word “interest” which means “interest payable in any manner in respect of any moneys borrowed or debt incurred (including a deposit, claim or other similar right or obligation) but does not include any service fee or other charge in respect of the moneys borrowed or debt incurred or in respect of any credit facility which has not been utilised.”

Further there was a ruling passed by the Advance Ruling Authority on the applicability of GST on penal interest when there is a delayed in repayment of loan.

3.      The case of Bajaj Finance Limited

In case of Bajaj Finance Limited [4](BFL), an advance ruling was passed on 6th August 2018, where it was concluded that penal charges collected by the BFL shall attract GST.

Here it was said that in case of default of payment of EMI by the customer, the applicant tolerated such an act of default or a situation and the defaulting party i.e. the customer was required to compensate the applicant by way of payment of extra amounts in addition to principal and interest. Also, the additional interest is not in the nature of interest but penal charges.

Therefore, the charges levied for any default in repayment of loan will be covered under clause 5(e) of Schedule II of the CGST Act. Also, the same is not an exempt service and will be liable to tax under GST.

4.      Circular no 102/21/2019-GST dated 28th June 2019

Given the numerous queries, the department finally released clarification on the matter. Penal interest charged on delayed payment for supply of goods and services will be included in the value of supply and will stand liable for GST. Whereas penal interest charged on the delayed payment of loan repayment will be exempt under GST.

The clarification given under the notification is discussed at length below.

The various clarifications by the GST Council on additional/ penal interest taxability is represented below in a tabular form:

 

 

FAQs on financial sector

 

  

Notification No. 12/2017-Central Tax (Rate) dated 28th June 2017

  

Case of Bajaj Finance Limited

  

Circular no 102/21/2019-GST dated 28th June 2019

 
Additional interest in case of default payment of instalment in respect of supply, which is subject to GST will be included in the value of supply and therefore liable to GST Consideration by way of interest or discount on deposits loans and advances are considered as exempt service. Charges levied for any default in repayment of loan will be liable to tax under GST.

 Penal interest charged on delayed payment for supply of goods and services will be included in the value of supply and will stand liable for GST. Whereas penal interest charged on the delayed payment of loan repayment will be exempt under GST

 

Implication of GST on penal charges

Accordingly, there are different GST implications, which are discussed by way of examples. Financing to a borrower may be done in the following ways:

  • Situation 1: ABC Co (lender/shopkeeper) sells a car to Mr A (borrower) where the selling price of the car is ₹6,00,000. However ABC Co gives Mr A an option to pay the selling price of the car in 24 months (24 instalments) i.e. ₹ 26,250 (Repayment of principal ₹ 25000 + Interest @5% i.e. ₹ 1250). The instalment shall be paid every 10th of the month, and any delay on such payment shall be liable for a penal interest of ₹ 500 per day for delay in payment.

Here the transaction between ABC Co and Mr A is that of supply of taxable goods and not a money to money transaction. The shopkeeper has broken down the payment into tranches referred to as the EMI facility. The said EMI includes interest component as well which is subjected to GST. Also a penal interest is charged on the delayed payment. Accordingly, the interest and penal charges paid on the delayed payments shall be included in the value of supply and as a consequence, it will be under the ambit of GST.

Also this situation will not be covered under clause 5(e) of the Schedule II of the CGST Act. The expression to tolerate an act cannot be said to include a situation wherein penal charges are imposed on the erring party for delayed or non-payment.

Since the above is not covered under serial no 27 of the notification[5], the same is not exempt and taxable under GST.

  • Situation 2: ABC Co sells a car to Mr. A where the selling price of the car is ₹6,00,000. Mr A has an option to avail a car loan at an interest of 12% per annum for purchasing the car from XYZ Co. The term of the loan from XYZ Co allows A, a period of 24 months to repay the loan and an additional /penal interest @1% per annum for every day of delay in payment.

Here the transaction between XYZ co and Mr. A is that of money to money transaction. The penal interest charged will be covered under serial no 27 of notification no 12/2017 Central Tax (Rate) dated the 28.06.2017 “services by way of (a) extending deposits, loans or advances in so far as the consideration is represented by way of interest or discount (other than interest involved in credit card services)”is exempted.

Accordingly, in this case, the “penal interest” charged thereon on transaction between XYZ Co and Mr. A would not be subject to GST. The value of supply by ABC Co to Mr. A would be ₹ 6,00,000 for the purpose of GST. Whereas there will be no GST charged on the interest and additional/ penal interest charged by the XYZ Co (lender) as the same is considered as an exempt supply.

Therefore, the vendor has the following option to sell the car to the customer:

  • Provide a deferred payment facility by the vendor himself on account of purchase of the car, or
  • Provide a loan facility to purchase the asset through the vendor’s captive lending unit, or
  • Provide a loan facility to purchase the asset through any bank/NBFC

In all the three cases mentioned above, GST taxability will be different. In case the deferred payment facility is provided by the vendor and there is a delay in payment of EMI by the borrower, GST shall be charged on the additional interest due to such delay in payment. However, in case a loan facility has been provided by the vendor’s captive lending unit or by an independent bank or an NBFC, the additional interest charged on the delayed repayment will not be taxable under GST.

Conclusion

The circular by the government came up as a clarification in regard to GST implications on penal charges. This clarification brings ease to various NBFCs who were levying penal charges as per the agreement on the delayed payment of loan instalment. Also, the circular overrides the advance ruling in the case of Bajaj Finance Limited.

To summarise the above discussed concept:

  • Penal charges in case of delayed payment of instalment of supply of goods and services shall be included in the value of supply as per section 15(2) (d) of the CGST Act. The same shall be liable to tax under GST
  • Penal charges in case of delayed payment of instalment of a money to money transaction will be included in the value of supply as per section 15(2) (d) of the CGST Act. The same shall be exempt through serial no 27 of the notification No. 12/2017-Central Tax (Rate) dated 28th June 2017. Therefore penal charges in this case shall not be taxable under GST.

 

[1] http://www.cbic.gov.in/resources//htdocs-cbec/gst/circular-cgst-102.pdf;jsessionid=4085899A448EFF7FCF1762E53BC68D3F

[2][2] http://gstcouncil.gov.in/sites/default/files/faq/27122018-UPDATED_FAQs-ON-BANKING-INSURANCE-STOCK-BROKERS.pdf

[3] http://www.cbic.gov.in/resources//htdocs-cbec/gst/Notification12-CGST.pdf;jsessionid=3D2C63EDD8A1183AEB262F41985CB224

[4] https://mahagst.gov.in/sites/default/files/ddq/GST%20ARA%20ORDER-22.%20BAJAJ%20FINANCE%20LTD.pdf

[5] [5] http://www.cbic.gov.in/resources//htdocs-cbec/gst/Notification12-CGST.pdf;jsessionid=3D2C63EDD8A1183AEB262F41985CB224

Car Leasing In India: ‘Breaking the Stereotypical Definition Of Luxury’

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Julie Mehta (julie@vinodkothari.com)

Introduction

Who thought hiring was even an option to enjoy the luxury of having to use a car. But with the world undergoing a paradigm shift, it untapped its energies into providing and establishing better services for its customers, leasing has paved its way into existence. Most of the industries have adopted this concept and structured their services accordingly in order to provide the best they can to their customers, but that requires huge understanding of their needs. A commoner would always be awed by the immensely developing technology and the environment around them but limited resources makes them take a step back from the thought of availing such services. The market had its solution as hiring and renting came into picture. This has ensured dreams do come true.

Car has always been a luxury at least in most parts of India because of the fact that India still in its developing stage and there still remains a big gap between the rich and the poor and the middle income families fall nowhere. Indians have been developed with the mind state that not everyone can afford everything and thus one should limit their demands keeping in mind their pocket potential. The concept of hiring and renting is not only limited to houses and properties but with the advent of MNC’s and startup companies, they have widened the scope of bringing in the concept of hiring even furniture, vehicles, electronic equipment’s, etc.

Earlier, the concept of car leasing was only limited to corporate senior executives that was earlier known as ‘corporate leasing’ and was common for the luxury car brands. But slowly it has trickled down and become accessible to commoners and middle income families. Companies like Mahindra & Mahindra made some of its models available for leasing. Following this concept, several other car brands like Hyundai, TATA group and luxury brands like BMW, Mercedes etc. have also opened their doors to providing the lease facilities.

Car leasing and rental is one of the most lucrative and fast growing segment of the automobile sector in India even though it currently represents only 4-5% of the market in terms of absolute number of vehicles, but its future prospects are strong enough.

Factors like increasing popularity of app-cab providers like Ola, Uber, Zoom car cab booking facilities, rapid urbanization, relocation of rural population into cities, adds on to the potential of car leasing in India.

[1]The growth of the market in India is to ensure manifold growth in its CAGR by 15-20% in the coming ten years and further on making hiring of cars simpler eventually with current worth of Rs. 1500 crores. Most car making companies are making 40% of its business from leasing cars. This has largely helped change the mentality of customers and imbibed the fact that ‘why buy when you can lease it’.

 

Yellow number plates or white number plates?

People remain apprehensive about the color of the number plate they use in the car. While a yellow number plates denotes commercial use, white number represents personal use. People taking cars on lease will of course want white number plates on their cars.

The current legal framework for registration of motor vehicles allow cars taken on lease for personal use to bear white number plates.

In case of a car taken on lease, the lessee is the person having possession of the vehicle and hence, the ‘owner’ as per the Motor Vehicles Act, 1988. Further, since it is the lessee who is actually using the car and the same has not been given on hire or used for any other commercial purpose, the car shall have a white number plate.

 

Global Status of Car Leasing

Globally, car leasing and hiring has been prevalent and growing for many years now. The analysts have forecasted that in the coming years, the global leasing market is to grow at a CAGR of 13-15%. This is gaining momentum due to the development of new mobility concepts by car leasing companies. For example, telematics was introduced in leased vehicles to monitor their usage on the job, another technological development was the installation of navigation in the leased vehicles making it more convenient for the lessor. People want change and with such facilities where there is an added benefit of not burning the pockets of customers, the lease scheme always works to hire cars on lease and cancel the contract anytime to shift on to better and advanced models of cars.[2]

The new trends dominating the global markets are the introduction of electric vehicle leasing and environment friendly cars that lead to sustainable development in the car manufacturing industries as well in the overall environmental situation. Such facilities encourage people to be more socially responsible and to do their bit towards the betterment of the society and also getting the leasing benefit out of it. Governments across the world are offering subsidies and tax benefits to encourage and boost the penetration of electric vehicles in their fleet. They have also introduced the concept of leasing old cars which helps reduce wastage as well as optimum usage. It is offered at a highly considerate premium and is attractive for low income customers. The global leasing market is fast moving with efficient strategies that ensures further growth too.

 

[3]Why has Leasing gained popularity in recent times?

GST introduction has come out to be a source of relief in time of distress for the Indian markets and consumers due to the stiff tax system of the country resulting in poor market functioning. With the introduction of ‘Goods and Services Tax’ on July 1, 2017, times have changed for the consumers, dealers as well as manufactures and has helped bring stability and balance in the economy by considering every person and their transaction at par, with the motive to bridge the gap between rich and poor in the long run. Evaluating their benefits below taking into consideration automobile industry:

  • To the consumers: The new tax regime has resulted in significant reduction in the tax rates imposed on the end consumers in comparison to the previous tax system.
  • To the dealers: The benefit of claiming the tax paid earlier benefits the dealers with the introduction of GST provides an added advantage to the dealers.
  • To the manufacturers: In recent times, car manufacturing companies have marked a fall in their sales which has led to dwindling profits. With the increasing exposure to car leasing, manufacturers have found their resort to stabilise their performance. This option induces customers to opt for leasing, thereby ensuring good business to the car manufacturers.
 CAR TYPE GST RATES COMPENSATION CESS TOTAL
Small Cars 28% 1% or 3% (depending on capacity) 29% or 31%
Mid-segment Cars 28% 15% 43%
Large Cars 28% 17% 45%
Sports Utility Vehicles (SUV’s) 28% 22% 50%
Electric Cars 12% N.A. 12%

Numerical Comparison

To understand the calculation of Loan EMIs and Lease rentals, we structure an example with the concept of residual model to distinguish the calculations of both the alternatives.

Any loan transaction requires an initial down payment to the seller after which installments follow on monthly/quarterly/annually basis. The down payment creates an extra outflow on part of the buyer on loan along with additional installments. While no down payment is required in case of a lease that makes its overall outflow on the lower side in comparison to a loan.

Plus, in case of a lease transaction, the lessor takes an exposure on the residual value of the asset, this brings down the lease rentals per month.

In the example below, with the assumption of different rates of residual value, we understand that with the every increase in the percentage of residual value, the lease rentals of the operating lease borne by lessee comes down. This implies lower the term of the lease contract, lesser value of the asset is used, and thus lesser are thee lease rentals.

Details of the Vehicle  
Unit Cost 1000000.00
GST rate 28%
Compensation Cess 17%
Rate of GST 45%
GST 450000.00
Total 1450000.90
When Residual Value is considered to be 20%
Operating lease arrangement    
Basic price 1000000.00  
Add GST on purchase (ITC eligible) 450000.00  
Funding Amount 1450000.00  
Processing fees 3.80% 55100.00
Expected Residual Value 20% 200000.00
Tenure 48  
IRR 18%  
Lease Rentals (RV not factored) ₹ 42,593.75  
Lease Rentals (before passing GST benefit) ₹ 39,718.75  
Input tax credit percentage 100%  
Less: GST benefit ₹ 9,375.00  
Lease Rentals (after passing GST benefit) ₹ 30,343.75  
Add: GST on rentals ₹ 13,654.69  
Total inflow ₹ 43,998.44  
 
Loan arrangement    
Loan amount 1450000.90  
Processing fees 3.80% 55100.0342
Expected Residual Value 0% 0
Tenure 48  
IRR 18%  
EMI ₹ 42,593.78  

 

When Residual Value is considered to be 25%
Loan arrangement    
Loan amount 1450000.90  
Processing fees 3.80% 55100.0342
Expected Residual Value 0% 0
Tenure 48  
IRR 18%  
EMI ₹ 42,593.78  

 

Operating lease arrangement    
Basic price 1000000.00  
Add GST on purchase (ITC eligible) 450000.00  
Funding Amount 1450000.00  
Processing fees 3.80% 55100.00
Expected Residual Value 25% 250000.00
Tenure 48  
IRR 18%  
Lease Rentals (RV not factored) ₹ 42,593.75  
Lease Rentals (before passing GST benefit) ₹ 39,000.00  
Input tax credit percentage 100%  
Less: GST benefit ₹ 9,375.00  
Lease Rentals (after passing GST benefit) ₹ 29,625.00  
Add: GST on rentals ₹ 13,331.25  
Total inflow ₹ 42,956.25  
When the Residual Value is considered to be 30%
Loan arrangement    
Loan amount 1450000.90  
Processing fees 3.80% 55100.0342
Expected Residual Value 0% 0
Tenure 48  
IRR 18%  
EMI ₹ 42,593.78  

 

Operating lease arrangement    
Basic price 1000000.00  
Add GST on purchase (ITC eligible) 450000.00  
Funding Amount 1450000.00  
Processing fees 3.80% 55100.00
Expected Residual Value 30% 300000.00
Tenure 48  
IRR 18%  
Lease Rentals (RV not factored) ₹ 42,593.75  
Lease Rentals (before passing GST benefit) ₹ 38,281.25  
Input tax credit percentage 100%  
Less: GST benefit ₹ 9,375.00  
Lease Rentals (after passing GST benefit) ₹ 28,906.25  
Add: GST on rentals ₹ 13,007.81  
Total inflow ₹ 41,914.06  

 

Conclusion

The major differentiating factors between a lease and a loan is that the former gives the right to use the asset without any upfront down payment, however, in case of the latter, there is an upfront down payment. Leasing works better when the lessor takes exposure on a handsome amount of residual value. Otherwise, it will turn out to be costlier than loan.

In the coming years, the car leasing market in India will be prospering as most car brands have now started to expand their services to even leasing now, which wasn’t prevalent until the last 4-5 years. With this competitive spirit, many more well developed brands would undertake this strategy to enhance customer base. The statistics of no: of cars being sold is going through a falling spree currently and is expected to fall further. But the leasing market will be flourishing on the other hand. It provides the ‘Best of Both Worlds’ to the customers as well as benefits the owner who still retain the ownership of the cars and gain benefit out of it.

 

[1] http://www.businessworld.in/article/-India-s-Car-Leasing-Market-Is-Worth-Rs-1-5K-Cr-Poised-For-15-20-CAGR-/27-05-2017-119041/

[2] www.statista.com

[3]http://www.cbic.gov.in/resources//htdocs-cbec/gst/notification05-compensation-cess-rate.pdf;jsessionid=B47A84DD8CE463AF356CD17117E2316B

[4]https://www.statista.com/outlook/270/119/car-rentals/india#market-arpu

 

 

Union Budget 2019-20: Impact on Corporate and Financial sector

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Project Rupee Raftaar: An Analysis

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-Kanakprabha Jethani | Executive

Vinod Kothari Consultants Pvt. Ltd.

kanak@vinodkothari.com, finserv@vinodkothari.com

BACKGROUND

The Working Group on Developing Avenues for Aircraft Financing and Leasing Activities in India, constituted by Ministry of Civil Aviation submitted its report[1] on measures for developing this industry in the country. The Working Group was formed to examine the regulatory framework relating to financing and leasing of aircrafts. The idea was derived from the Cape Town convention and it has also been proposed to enact a bill in order to fully implement the convention. This project is based on the theme “Flying for All”. The Indian civil aviation market has been exhibiting tremendous growth for past years. There is an overwhelming increase in demand for passenger transportation for which airlines in India have placed orders for more than 1000 aircrafts. Moreover, Indian airlines have been relying on other countries for financing acquisition of aircrafts on export credit, loan or lease basis. This hair-triggers the need for India to have in place its own systems for financing of such acquisitions.

One of the motivations of the project is to ensure that the dependence of Indian aviation industry on import leases is reduced. Currently more than 90% of the aircrafts operating in the country are on import lease basis, and there is a huge monthly outflow of foreign exchange by way of lease rentals, which is not reported as ECB, since it is an operating expense.

GLOBAL PERSPECTIVE TO AIRCRAFT FINANCING AND LEASING

The key players in global aircraft financing and leasing market are Ireland and the US. Countries like China, Singapore, Hong Kong and Japan are emerging competitors in the market. The structures of aircraft financing, however, differ largely in all of these countries. The overall trends in the global arena can be evaluated on following bases:

Regional Outlook: through a research conducted for the Aviation Industry Leaders Report[2], it was concluded that North America is viewed as the most optimistic market player. Europe shows mixed signals due to market being strong and simultaneous slowing down of economy and other political issues. The Middle Eastern countries show a slow pace of growth and their models exhibit signs of stress. African airline market still has a lot of unrealised potential.

Financing Trends: sale and lease back transactions have become the most frequently used medium of aircraft finance over the world. Other forms of financing such as commercial bank debt, pre-delivering payment financing etc. have picked up pace. Also, traditional forms of financing such as export credit continue to be in operation but with reducing levels. Overall, the capital market remains very active and innovative in the aircraft finance sector.

Technology: new technology in aircrafts is being introduced frequently. However, implementation and commercialisation of the same continues to be a challenge. The Aviation Working Group’s Global Aircraft Trading System (GATS) proposed digitisation of transfer of lease deed ownership system which shall be expected to be activated by end of the year 2019.

CURRENT SCENARIO OF AIRCRAFT FINANCING IN INDIA

In terms of growth and advancement, India is far behind other Asian economies such as China, Singapore and Hong Kong. However, the Indian Aviation market has shown exponential rise in the past few years with an annual growth rate of 18.86% in 2017-18 and overall growth of 16.08% in passenger traffic. From 74 operational airports in 2013, it has reached a height of 101 operational airports in 2016. Expectations of having 190-200 operational airports by the end of 2040 are pointed out through various studies.

Currently, India has large aircraft order books, virtually all of which are leased through leasing companies located offshore. Under the regional connectivity scheme Ude Desh ka Aam Nagrik (UDAN), the government has decide to lease out operations, maintenance, and development of certain airports under Public private Partnership (PPP) model.

Overall, India has immense potential for growth in aviation sector but little means to aid the growth. It is in need of systems that aid the growth in a cost-effective and sustainable manner.

AIRCRAFT FINANCING STRUCTURE

Why is it needed?

In the view of increasing demand and non-availability of own sources of aircraft financing, it is essential for India to set up its own structures for the same. Moreover, civil aviation sector is an important sector for development of the economy. In the civil aviation industry, aircraft financing is the most profitable segment and there are no entities in the country exploring this line of business. All the benefits from this gap are being enjoyed by foreign entities.

What will be the structure?

For this structure, GIFT-CITY in Gujarat has been identified as preferred destination for initiation of operations in this industry as it offers a tax regime competitive to that of leasing companies all over the world.

Barriers in the structure

The aforementioned structure will face following barriers:

  • GAAR prevents Indian financers from taking advantage of other jurisdictions.
  • Aircraft financing is not a specifically permitted activity for banks.
  • Units operating in GIFT-CITY not permitted to undertake aircraft financing.
  • Framework for setting-up of NBFCs in GIFT-CITY and provisions as to treatment of income from operating lease is not provided.
  • Taxes and duties:
  • GST of 5% on import of aircraft
  • GST on lease rentals
  • Interest amount which forms part of lease rentals in case of financial lease is not eligible for any tax benefit.
  • No exemptions from withholding taxes
  • Stamp duty on instruments and documents executed.

The working group has proposed corresponding changes and amendments to be made to overcome these barriers. The response of relevant authorities is awaited.

Tax implications of the structure

Particulars

Tax rates
IFSC-GIFT CITY (proposed structure) INDIA (not following the structure)
INCOME TAX
Corporate Tax Rate: 34.94

o   Year 1 to 5

 0.00

o   Year 6 to 10

 17.47

o   Year 11 onwards

 34.94
Minimum Alternate Tax 10.48 21.55
Capital gains on sale of aircraft 0.00 34.94
Withholding tax

o   Operating lease rentals

 0.00 2.00

o   Interest payment (USD debt)

 0.00 5.46

o   Interest payment (INR debt)

 0.00 0.00

o   Other payments

 0.00 10.00
Dividend Distribution Tax nil 20.56
GOODS AND SERVICES TAX
Purchase of aircraft 0.00 0.00
Operating lease rentals 0.00 5.00
Underfinance lease(interest portion) 0.00 5.00
Other services nil 18.00
Stamp duty on lease related documents 0.00 3.00

ANALYSIS OF TAX IMPLICATIONS UNDER VARIOUS MODELS OF FINANCING

Following table shows an analysis of indirect tax implications from the point of view of lessee and compares the proposed structure with the existing practice of financing as well as situation if financing is done outside the proposed structure but in India.

This table is based on following assumptions:

  • Value of aircraft- Rs.3500 crores
  • Residual value- Rs.500 crores
  • Rate of interest- 7.5%
  • Lease tenure- 25 years
  • Processing fee- 2%

On the aforesaid assumptions, lease rental per annum would amount to Rs.306.63 crores

Amount (in Rs. crores)

Tax expenditure Ireland IFSC-GIFT CITY Rest of India
GST on lease rentals 15.3315 0.00 15.3315
Stamp duty 0.00 0.00 105
GST on other services 0.00 nil 12.6
Overall indirect tax expenditure 15.3315 0.00 27.9315

OVERCOMING THE BARRIERS

Recommendations have been made by the Working Group to various regulatory authorities in order to overcome various barriers that are a hindrance to establishment of India’s own structure of aircraft financing and leasing. Following table shows some of the major recommendations:

Authority Recommendations
RBI Confirm that the term “equipment” includes aircrafts or notify aircraft financing and leasing as permitted activity for banks or subsidiaries of banks.
Amend IBU circular to include equipment leasing and investment in capital of leasing entities in scope of activities of banks
Confirm that equipment leasing entities shall be eligible to register as NBFC in IFSC
Issue specific directions in regard to investment in or by foreign entities engaged in aircraft financing and leasing activities.
Tax authorities Capital gains on sale of leased aircrafts should be fully exempted.
GST on leasing aircraft should be made zero-rated.
Nil withholding tax should be specified for airline companies.
Transfer/novation of aircraft financing / leasing contracts to units in an IFSC should not be under the purview of GAAR, for both the lessee and lessor
SEBI Amend SEBI (AIF) Regulations to create a separate category of AIFs for investment in aircraft financing/leasing activities or permit greater concentration of investment in aircraft financing/leasing entities.
Clarify whether 25% investment cap by AIFs applies on investment in equipment and grant additional relaxations to AIFs investing in aircraft financing activities.
Create separate category of mutual funds of investment in entities engaged in aircraft financing and leasing activities.
Clarify which institution can invest in entities registered in IFSC.
IRDAI Amend IRDAI regulations permitting companies set up in IFSC to invest in entities engaged in aircraft financing and leasing activities.
Clarify whether investment of funds of policyholders’ in entities registered in IFSC be considered as funds invested in India only.
Others Clarify under aircraft rules that aircrafts of lessors cannot be detained against any statutory or other outstanding dues.
Entities like pension funds, insurance companies, employee provident fund organisations be allowed to invest directly or indirectly in aircraft financing and leasing activities.
SARFAESI Act not be applicable to aircrafts.
Gujarat Stamp Act to exempt aircraft financing and leasing from its purview.
Permit airlines to set up branch in IFSC.

CONCLUSION

It is absolutely evident that aircraft industry is on upsurge and will continue to be rising globally in the coming years. To meet the rising demand and expand the country’s hold in the aviation market the proposed structure provides a well-established groundwork through the proposed structure. All recommendations, if accepted and implemented in a proper manner, will enable India to pioneer a very profitable and growth-oriented aviation market.

 

[1] https://www.globalaviationsummit.in/documents/PROJECTRUPEERAFTAAR.pdf

[2] https://assets.kpmg/content/dam/kpmg/ie/pdf/2019/01/ie-aviation-industry-leaders-report-2019.pdf

 

E-form AGILE- Consolidation of various registrations along with company incorporation

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By Dibisha Mishra (dibisha@vinodkothari.com) (corplaw@vinodkothari.com)

Introduction

There has been a series of changes brought in by the Ministry of Corporate Affairs (“MCA”) in recent years to bring in better transparency, easier compliance and weed out hurdles in the way of Ease of doing Business. In furtherance of the same, MCA vide notification dated 29th March, 2019, notified Companies (Incorporation) Third Amendment Rules, 2019 (hereinafter referred to as “Amended Rules”)[i] which has upgraded the existing SPICe form with a view to bring in a single window system for making application under GST, Employees Provident Fund Organization (‘EFPO’) and Employees State Insurance Corporation (‘ESIC’).

These additional services are being catered via e-form INC-35 named as ‘AGILE’ which shall be  linked with SPICe (e-form INC-32) during filing with MCA. It is to be noted that though linking of the form is mandatory, option of availing the aforementioned services is left to the applicant. The company can very well choose the services which it wishes to avail.

The main features along with the technicalities of the incorporation process prior to the Amended Rules have been covered in our earlier article[ii]. This write up covers the highlights of AGILE along with a brief discussion on some practical aspects. Read more →

Slump sale, a supply of goods or service under GST?

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By Yutika Lohia (finserv@vinodkothari.com)

Introduction

India is en-route to turn itself into a 21st century super-economy fuelled by the unprecedented growth of its business enterprises. Business may grow in two ways – either in an organic way or inorganic. The former refers to the internal forces of the enterprises which are re-organised to bring in development and growth into the business, whereas, in case of inorganic growth, the company goes into corporate restructuring to re-align its external facade to fuel the planned development and growth. In today’s fast moving corporate environment, corporate restructuring happens to be the most ideal tool to win an advantage in this pursuit.

Business restructuring is a comprehensive process, be it financial or technological or market or organisational. Business can be re-arranged by way of mergers, demergers, disinvestments, takeovers, strategic alliance or slump sale.

This article focusses on implications of GST on slump sale.

Concept of Slump Sale

The concept of slump sale comes from the Income Tax Act, 1961. The IT Act, in section 2(42C) defines “slump sale” as – “slump sale” means the transfer of one or more undertakings as a result of the sale for a lump sum consideration without values being assigned to the individual assets and liabilities in such sales.”  Further as per explanation 1 to section 2(19AA), “undertaking” shall include any part of an undertaking or a business activity taken as whole, but does not include individual assets or liabilities or any combination thereof not constituting a business activity.

Therefore, slump sale contains the following conditions:

  • Sale of one or more undertaking,
  • No individual value should be assigned to assets and liabilities, and the same to be sold for a lump sum consideration, and
  • All assets and liabilities of the undertaking must be transferred.

Transfer of all assets and liabilities

One of the major precondition of a slump sale transaction is that all assets and liabilities of the business undertaking must be transferred to the buyer.

As per Section 50B of IT Act, the cost of acquisition of such sale shall be the net worth (book value of assets and liabilities) of the undertaking.

Explanation 1 provides the method of computing the net worth of an undertaking or a division sold on slump sale basis. As per Explanation 1 “For the purposes of this section, “net worth” shall be the aggregate value of total assets of the undertaking or division as reduced by the value of liabilities of such undertaking or division as appearing in its books of account.”  This definition is no different from the meaning of the expression ‘net worth’, as is commonly understood in the accounting parlance.

There are various judicial pronouncements where there is difference of opinion that it is not essential to transfer all assets and liabilities for a transaction to qualify for a slump sale. That is to say, that even if some assets are retained by the transferor and the undertaking after such transfer carries out its business activities without any obstruction, it shall still qualify to be a slump sale. The same has been substantiated by Bombay High Court[1] in its ruling.

Since all assets and liabilities are to be transferred in a slump sale, it is important for one to understand the concept of going concern which is discussed at length below.

Going Concern Concept

The terminology “going concern” is not precisely mentioned in the definition of slump sale. Transfer as a going concern means transfer of a business or a unit which is capable of being carried on by a purchaser as an independent business. To constitute a slump sale, it is not necessary that the business is ongoing at the time of its transfer.

Going Concern is a fundamental accounting assumption and Accounting Standard 1, Disclosure of Accounting Policies defines it as follows:

“The enterprise is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the scale of the operations.”

To constitute a slump sale all the assets and liabilities of the undertaking are to be transferred. Therefore it can be said that companies whose operations are shut and is into liquidation may also opt for slump sale provided the conditions mentioned above are met. The intention of such condition is to ensure that the business will continue in the new hands with regularity and a nature of permanency.\

Further it is not necessary that the entity should be a profit making company. The only valid point to be considered for a transfer to constitute as a “going concern” to mean if it constitutes a business activity capable of being run independently for a foreseeable future. Such views were taken In the Matter of M/S. Indo Rama Textiles Ltd[2]

The term “going concern” has no place in the GST Act. However one can refer to the pronouncement of the Advance Authority Ruling in case of Rajashri Foods Pvt Ltd for the same as mentioned below:\

A going concern is a concept of accounting and applies to the business of the company as a whole. Transfer of a going concern means transfer of a running business which is capable of being carried on by the purchaser as an independent business. Such transfer of business as a whole will comprise comprehensive transfer of immovable property, goods and transfer of unexecuted orders, employees, goodwill etc.

The transfer of business assets implies where the part of assets are transferred and not the whole business, i.e. the liabilities remain in the books of the transferor, whereas in transfer of business all assets and liabilities are transferred together. The concept of transfer of going concern comes handy when the business as a whole is transferred, however case laws and analysis do suggest the likelihood of transfer of assets as a going concern.

Slump sale: supply of good or supply of service under GST Act?

To understand the applicability of GST on a slump sale transaction, it is imperative to throw light on the word “supply” under the GST Act. It is explicitly discussed that for GST to be levied, there must be a case of “supply”. Therefore, we shall now refer the scope of supply as mentioned in Section 7 of the (Central Goods and Services Tax Act 2017 (CGST Act) which is as follows:

“(1) For the purposes of this Act, the expression “supply” includes––

  • 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;”

XX

Supply includes activities such as sale, transfer, barter etc for a consideration in the course or furtherance of business. From this we can infer that the activities shall take place in the course or furtherance of business. Coming to slump sale, the transaction is neither during the course of business nor in persistence of business. However since the word “includes” has been used in the definition in Section 7 (1) of the CGST Act, the scope of supply goes beyond the course or furtherance of business. Therefore the transfer as a going concern shall also be treated as “supply” under GST.

As slump sale is considered to be a supply under GST, we should now understand if the same constitutes to be goods or services.

The term goods has been defined under section 2(52) of the CGST Act as:

“(52)“goods” means every kind of movable property other than money and securities but includes actionable claim, growing crops, grass and things attached to or forming part of the land which are agreed to be severed before supply or under a contract of supply;”

Further definition of “Service” as per section 2(102) of the CGST Act defines the term service as:

“(102)“services” means anything other than goods, money and securities but includes activities relating to the use of money or its conversion by cash or by any other mode, from one form, currency or denomination, to another form, currency or denomination for which a separate consideration is charged.”

Clause 4(c) of Schedule II of CGST Act states that

“(c) where any person ceases to be a taxable person, any goods forming part of the assets of any business carried on by him shall be deemed to be supplied by him in the course or furtherance of his business immediately before he ceases to be a taxable person, unless—

            (i) the business is transferred as a going concern to another person; or

             (ii) the business is carried on by a personal representative who is deemed to be a taxable person.”

Schedule II of the CGST Act talks about activities to be treated as a supply of good or supply of service wherein Clause 4, transfer of business assets has been considered as supply of goods. In Clause 4(c ) transfer of business as a going concern does not constitute as supply of goods.

As per the definition of services, anything other than goods is called a service. Business transferred as a going concern is excluded from the list of supply of goods. Since the schedule specifically excludes this activity, it becomes very obvious that transfer of business as a going concern is considered to be a supply of service.

Ministry of Finance vide its notification[3] no 12/2017- Central Tax (Rate) dated 28th June 2017, came out with a list of supply of services and further brought clarity on “service by way of transfer of a going concern, as a whole or an independent part thereof” in serial no 2 of the said notification to constitute under supply of service. Further, activity of transfer of a going concern shall have “nil” rate of tax on such supply.

Since the notification talks about the activity of transfer of a going concern as a supply of service and the same is exempt from the purview of GST. Similarly Schedule II of the CSGT Act excludes transfer of business as a going concern as supply of goods, the same shall be considered as a supply of service and GST shall be levied.

It shall be inferred that transfer of a going concern as a whole or a part there or transfer of business as a going concern is tax-exempt under GST and transfer of business assets will have GST implications.

The above can be further justified by referring to the judgement passed by the Tax Authority of Advance Ruling in Karnataka in the case of Rajashri Foods Pvt Ltd[4] where it was decided that subject to the condition that the unit being transferred is a going concern, it will be considered as a supply of service and the same shall be exempt from the payment of GST to the extent leviable under sub section (1) of Section (9) of the CGST Act, 2017.

Itemisation of assets for levy of GST

In a slump sale, assets proposed to be transferred consist of both movable and immovable property i.e. land, building, stock, plant and machinery etc. Since these assets and liabilities are sold together for a lump sum consideration it does not tantamount to a “mixed supply” under GST.

Let us first understand the concept of mixed supply under GST

Section 2(74) of the CGST Act defines mixed supply as under:

“(74) “mixed supply” means two or more individual supplies of goods or services, or any combination thereof, made in conjunction with each other by a taxable person for a single price where such supply does not constitute a composite supply.”                     

To constitute a mixed supply, there has to be two or more supplies of goods or services and they have be in conjunction with each other. Therefore if the item in the bundle are neither goods nor services, it will not be considered a mixed supply under GST.

Let us understand the same with the help of an example. Suppose the assets being transferred to the buyer are plant & machinery, land and stock for a single price. Here there are more than one good transferred in the transaction. The bundle is not exclusively that of goods or services or both. The same will not qualify to be a mixed supply as land being transferred is excluded from the purview of GST (As per Schedule III of the GST Act which enumerates items which are neither supply of good nor supply of services).

Referring to the above example we may say that all legs of the definition should be satisfied for it to become a mixed supply. Merely because multiple items are sold for a single price should not, by the very fact render them as “mixed supply”. In so far as movable assets being concerned, it would be treated as supply of goods and is likely to attract GST.

Conclusion

Slump sale may be of an on-going business/unit or transfer of a stalled business/unit where the intent of the transferee is to run the entity. It can be said that that when there is a transfer of business and not of that of assets, in order to insulate from GST, it would require evaluation whether transfer is as a going concern or not.

The transaction of transfer of business as a whole of one of the units in the nature of going concern amounts to supply of service. The notification holds good, but subject to the condition that the unit is a going concern and therefore the same shall be free from the GST purview.

To summarise the above discussed concept

  • Transfer of business assets: Supply of goods
  • Transfer of business: Supply of Service
  • Transfer of business/ or a part thereof as a going concern : Supply of service and exempt via notification

Revival of companies will definitely be more cost effective than setting up a new structure altogether. Also this will give a push to the investors to take over such companies and create more job opportunities in India.

 

[1] https://indiankanoon.org/doc/1182478/

[2] https://indiankanoon.org/doc/135651533/

[3]http://www.cbic.gov.in/resources//htdocscbec/gst/Notification12CGST.pdf;jsessionid=D5B61ED295EAEE2B9E0361CAE1525D0F

[4] http://gst.kar.nic.in/Documents/General/06_RAJASHREE_LIMITED.pdf

PENAL INTEREST WITHIN THE SCOPE OF GST OR NOT?

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By Beni Agarwal (beni@vinodkothari.com)

Introduction

A recent advance ruling has thrown the financial industry off its balance. The pre-ruling opinion amongst the industry members has been refuted and yet another item has been brought within the ambit of GST, that is, penal interest or overdue interest. Before the aforesaid advance ruling, which we have discussed at length later on, there were various views circulating in the market. Some said penal interest should be charged to GST, while others said that it is nothing but interest for using the amount for the extended period of time.

However, all these speculations have been put to rest, first, by a set of frequently asked questions on GST on financial services, and second, by the aforesaid advance ruling. In this write-up we intend to discuss the outcome of the advance ruling and comment on how justified the decision is.

Background

After the imposition of GST since 1st July, 2017, various supplies have been brought within the ambit of GST. There are some supplies which have been exempted from GST levy vide notification no 12/2017- Central tax (Rate) dated 28.06.2017, by way of powers vested with the Central Government through section 11 of CGST Act 2017. One such supply that is exempted is services by way of extending deposits, loans or advances, in so far as the consideration is exempt by way of interest or discount. Based on the exemption and its interpretation that such penal interest is nothing but additional interest, the view was that penal interest too shall not be subject to GST. However, the FAQs on Banking Sector[1], issued by GST Council, clarified that additional interest charged on delay or default in payment of installment by the customer shall be included in the taxable value of supply. The recent advance ruling in the case of Bajaj Finance Limited, [2]would give additional weightage to the FAQs.

Earlier Stance

In case of a loan transaction, it was argued that the overdue interest was merely a stepped-up interest, for the period for which the contractual terms of the loan had been in breach. Overdue interest is, admittedly, nothing but interest, albeit at a higher rate. It could not be argued that a delayed payment for a loan led to any service. Typically, interest is based on the tenure for which the loan is due/overdue. If there is an element which is charged disregarding the tenure, that is, on absolute basis, it may, then, not qualify to be interest, and hence, become chargeable to GST.

Advance Ruling by the Adjudicating Authority

In case of Bajaj Finance Limited, an advance ruling has been passed on 6/08/2018 on imposition of GST on penal interest.

In the said case, BFL gave loan to customers for a specific period repayable in EMIS including principal and interest amount. Failure to pay within the due date attracts penalty charges based on a certain percentage. In the process, BFL agreed to tolerate the act of delayed payment in lieu of penalty.

The following questions were asked and answered:

Q1.  Whether the penal interest is to be treated as interest for the purpose of exemption under Sr 27 of Notification no 12/2017- Central tax ( Rate) dated 28.06.2017, Sr no 27 of Maharashtra State Notification No 12/2017- State Tax ( Rate) dated 29.06.2017, and Sr no 28 of Notification No 9/2017 Integrated Tax (Rate) dated 28.06.2017?

Answered in the negative.

Q2. If the answer to the above is negative, whether the activity of collecting penal interest by BFL would amount to a taxable supply under the GST?

                Answered in the affirmative. The said activity squarely falls under clause 5(e) of the Schedule II of GST Act, 2018 and therefore such amounts received, would attract tax liabilities under GST.

Hence, basis the above mentioned advance ruling, interest on penal charges shall be liable to GST.

Treatment of Penal Interest under Service Tax Regime

Interest on loans were outside the scope of Service Tax in the pre GST period. Lending as a service was first time brought within the ambit of Service Tax on 10.09.2004 , by an amendment in the definition of banking and other financial services’ under section 65(12) of Finance Act, 1994. At the same time, with effect from 10.09.2004, by virtue of clause (viii) of

Explanation 1 under section 67 of Finance Act, 1994 , the following was added:

“SECTION 67. Valuation of Taxable Services for charging service tax: For the purposes of this chapter, the value of taxable services shall be the gross amount charged by the service provider for such service rendered by him.

Explanation 1. For the removal of doubts, it is hereby declared that the value of taxable service, as the case maybe includes …

But does not include ...

(viii) interest on loans.”

Thus, from 10.9.2004, interest on loan was out of the purview of Service Tax under section 67.

However, from 19.04.2006, the valuation provisions contained in Finance Act was shifted to Service Tax ( Determination of Value) Rules , 2006, which provided the following:

“6. Cases in which commission, costs, etc will be included or excluded-

  • Subject to the provisions of Section 67, the value of taxable services shall include-
  • Subject to the provisions contained in sub rule(1), the value of any taxable services, as the case may be, does not include–

(iv) interest on loan”

Hence from 19.04.2006, interest on loans was excluded from value of taxable services by way of Service Tax (Determination of Value) Rules, 2006.

Further, from 1.07.2012 to 30.06.2017, interest on loan was exempted under Negative List clause(n) of Section 66D of Finance Act, 1994. The same read as under:

“SECTION 66D. Negative List of Services: The negative list shall comprise of the following services, namely-

(n) services by way of-

(i) extending deposits, loans or advance in so far as the consideration is represented by way of interest or discount”

Thus, throughout the period before GST, interest on loan was excluded from levy of tax by way of provisions as stated above.

Rationale behind the current Ruling

Imposition of GST on penalty by the name of penal charges, penal interest or penalty is backed by the following arguments:-

  • Schedule II, entry 5 of CGST Act, includes services in the scope of supply as “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act “. Thus, it is contended that there is a service of tolerating an act because there is toleration of the act of default or situation of default of the loanee or borrower by the Lender in exchange for default charges named as penal interest. The nomenclature does not alter the substance of the transaction. Penal charges are charges on over-due amount. Thus, penal charges falls within the scope of supply under the CGST Act, Section 7.
  • EMI calculation is done based on the amount of loan and the total tenure of loan. Interest is calculated keeping in mind the total life of the loan over which the principal shall be outstanding as reduced by the installments paid. Delay or default in payment of EMI is not factored in. The contention that it is separately charged and hence it is in the nature of interest, is invalid. This is because, the percentage of charge is on a per month basis of default. It does not encompass the entire life of the loan. It arises only when there is a default or delay and it is calculated for that period of delay. This is obviously not factored in as there is no encouraging effect of the erring activity on the part of the borrower. Hence, it is not an additional interest. Moreover, these are in the form of compensation charged for tolerating the act of default or delay and not in the nature of interest capturing the time value of money.
  • Default charges are defined within a specified range, say 2 % to 5 % and varies from customer to customer. Moreover, a specified percentage is generally set beyond which the charges will not go. This is not the characteristic of interest.

Critical Analysis of the Ruling

The ruling has caused a jolt to the financial industry. There are several contentions that seem impractical and not carefully thought of. First of all, to state that penal charge is a compensation to tolerate an act is not completely justified. Penal interest is deterrent in nature as the lender is deterring or discouraging the borrower from delaying the payment by imposing a penalty. It is in the nature of additional interest on overdue amount. Interest charged is exempt from GST ambit which implies that it is not considered as supply to tolerate an act. If that is the case, then how can additional interest be considered as something to tolerate an act of delay or over-due. Its nature is similar to interest and interest is considered as a rate for incorporating time value of money and not classified as an act to tolerate the period in which the lender was devoid of that money.

Further, it is a top up on the rate of interest that is charged on the loan amount. Interest rate is the amount of money charged by the lender for usage of money which is calculated keeping in mind the time value of money. Penal interest is an add-on to the normal interest rate. If interest is considered as time value of money, then how can additional interest be considered any different? Penal interest is the interest rate charged on the over-due amount which is just a notch up on the existing rate.

To contend that the penal interest charged deviates from the nature of interest, because it is varying in nature, is a little funny. This implies that specifying a range of top up like 2% to 4% as against a fixed 10 % is grave enough to challenge the nature of interest. To state that the rate of penalty charged is varying from customer to customer and hence drifts away from the nature of interest is quite strange. The selection of rate of interest and charging them on customer basis should not be a point to declare that penal interest digresses from basic interest. There are a set of factors that determine the rate of interest to be charged from different customers.

Also, it is very important to note that charging GST in a sector that is already under the brunt of Non-Performing Assets (NPAs) is quite damaging to the banking and financial sector. We are talking of a sector where default or NPAs is a norm. The sector is already burdened with NPA and the problem is aggravated further by imposition of GST. Penal charges are collected by banks and it is their liability to pay to the Government. Whether or not they can shift the burden to the customers is a matter left on the banks. We are speaking about the customers who have made the delay or default and hence they are not the ones with best payment ability or willingness. Indeed it is very much possible that the ultimate burden may not be shifted to the customers and stay with the banks only. This burden of GST in addition to NPAs is definitely not a welcome change for banks and banking sector.

Argument for the earlier view taken

By way of notification no 12/2017- Central tax ( Rate) dated 28.06.2017, under serial no 27, services by way of extending deposits, loans or advances, in so far as the consideration is exempt by way of interest or discount( other than interest in connection with credit card services) have been excluded from the levy of GST.

Further clause (zk) of para 2 of the said notification defines interest as “interest payable in any manner in respect of monies borrowed or debt incurred (including a deposit, claim or other similar right or obligation) but does not include any service fee or other charge in respect of the monies borrowed or debt incurred or in respect of any credit facility which has not been utilized.”

Penal Interest are meant to include overdue charges on non-payment of installment on the due date. This was meant for compensating the lender for the time value lost for the extended use of loan proceeds. EMI amount factors in the interest portion for the tenure of the loan, but these additional charges are over and above the interest factored in.

Section 7 (1)(d) of CGST Act refers to Schedule II to include services that shall be considered supply. Entry 5 of Schedule II, includes the following as supply “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act “.

It was argued that the expression to tolerate an act cannot be said to include situation wherein penal charges are imposed on the erring party for delayed or non-payment. This is because, this is not the intention at the very inception, to undertake the activity of default or delay with no hindrance from the other party. The clause of penalty is created with a deterrent effect so that the activity is not repeated by the erring party.

Furthermore, the international laws like Australian Law does not impose GST on penal interest.

Potential impact of the Ruling on the Financial Industry

Penal Interest shall be subject to GST as per the recent AAR ruling, as it is not ruled to be in the nature of additional interest, but it is classified as supply under GST. The AAR ruling has adopted a position which is contrary to the historical approach adopted by financial services industry.

– Increase the working capital burden of Financial Institutions: The output GST liability shall block the working capital thereby increasing the working capital requirements. 18% GST on penal interest amount shall be required to be paid to the government by the banks. The output GST shall be recorded in the books as a liability payable.  This liability did not arise till now and hence there was no additional burden on the working capital of financial institutions. But with the new ruling, financial institutions will face a working capital crunch.

– Pinch on the customers’ pocket: The amount of interest on loans or deposits or advances did not attract service tax during pre GST era and does not attract tax during the current GST tax regime as well. However, the penal interest is not in the nature of interest and hence shall be chargeable to GST. The banks may transfer the GST payable on penal charges to customers. This will pinch the pocket of the customers.

– Increased litigation: The ruling has gone against the long standing opinion in the financial industry and it is not going to be accepted without any further appeals. This may give rise to potential dispute and may register appeals in higher platforms. Also as these rulings serve as precedents for other cases, it will give rise to several related litigations in the process.

Conclusion

Putting an end to the industry-wide confusion , AAR has ruled, based on the provision in Schedule II, entry 5 of CGST Act 2017, that penal charges shall be considered a supply under GST and hence be a part of value of taxable supplies. According to the ruling, imposition of penal charges indicate a clear understanding between the parties that in case of delay in payment of the agreed upon amount, a penal charge shall be imposed which will be payable by the person in default as consideration for act of tolerance done by the lender. The consideration is clearly in monetary terms. Penalty by whatever name called, be it penal charges or penal interest or additional interest shall be subject to GST as a taxable supply. The ruling does not appear to be practical as it defies the very basic concept of time value of money.

Moreover, it might turn out to be an impediment for the banks and other financial institutions in the NPA-laden finance industry, due to the added disadvantage of GST on penalty. Given the current situation in the country, in most of the cases, it is the banks or the lenders who will have to take the hit. In case of distressed loans, where recovery of principal itself is questionable, expecting the borrower to cough up another 18% on the penal interest is highly irrational.

In all likelihood, this might call for further appeals in the higher forums, as the decision most likely, shall not go down well amongst the industry players.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

[1] https://mahagst.gov.in/sites/default/files/ddq/GST%20ARA%20ORDER-22.%20BAJAJ%20FINANCE%20LTD.pdf

[2] http://gstcouncil.gov.in/sites/default/files/faq/FAQs_on_Financial_Services_Sector.pdf

GST on assignment of receivables: Wrong path to the right destination

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Team Vinod Kothari Consultants P. Ltd

 

There has been a lot of uncertainty on the issue of exigibility of direct assignments and securitisation transactions to goods and services tax (GST). While on one hand, there have been opinions that assignments of secured debts may be taxable being covered by the circuitous definition of “actionable claims”, there are other views holding such assignments of debts (secured or unsecured) to be non-taxable since an obligation to pay money is nothing but money, and hence, not  “goods” under the GST law[1]. The uncertainty was costing the market heavily[2].

In order to put diverging views to rest, the GST Council came out with a set of Frequently Asked Questions on Financial Services Sector[3], trying to clarify the position of some arguable issues pertaining to transactions undertaken in the financial sector. These FAQs include three separate (and interestingly, mutually unclear) questions on – (a) assignment or sale of secured or secured debts [Q.40], (b) whether assignment of secured debts constitutes a transaction in money [Q.41], and (c) securitisation transactions undertaken by banks [Q.65].

The end-result arising out of these questions is that there will be no GST on securitisation transactions. However, the GST Council has relied on some very intriguing arguments to come to this conclusion – seemingly lost between the meaning of “derivatives”, “securities”, and “actionable claims”. If one does not care about why we reached here, the conclusion is most welcome. However, the FAQs also reflect the serious lack of understanding of financial instruments with the Council, which may potentially create issues in the long run.

In this note[4] we intend to discuss the outcome of the FAQs, but before that let us first understand what the situation of the issue was before this clarification.

Situation before the clarification

  1. GST is chargeable on supply of goods or services or both. Goods have been defined in section 2(52) of the CGST Act in the following manner:

“(52) “goods” means every kind of movable property other than money and securities but includes actionable claim, growing crops, grass and things attached to or forming part of the land which are agreed to be severed before supply or under a contract of supply;”

Services have been defined in section 2(102) of the CGST Act oin in the following manner:

““services” means anything other than goods, money and securities but includes activities relating to the use of money or its conversion by cash or by any other mode, from one form, currency or denomination, to another form, currency or denomination for which a separate consideration is charged;”

Money, is therefore, excludible from the scope of “goods” as well as “services”.

Section 7 details the scope of the expression “supply”. According to the section, “supply” includes “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.” However, activities as specified in Schedule III of the said Act shall not be considered as “supply”.

It may be noted here that “Actionable claims, other than lottery, betting and gambling” are enlisted in entry 6 of Schedule III of the said Act; therefore are not exigible to GST.

  1. There is no doubt that a “receivable” is a movable property. “Receivable” denotes something which one is entitled to receive. Receivable is therefore, a mirror image for “debt”. If a sum of money is receivable for A, the same sum of money must be a debt for B. A debt is an obligation to pay, a receivable is the corresponding right to receive.

Coming to the definition of “money”, it has been defined under section 2(75) as follows –

““money” means the Indian legal tender or any foreign currency, cheque, promissory note, bill of exchange, letter of credit, draft, pay order, traveller cheque, money order, postal or electronic remittance or any other instrument recognised by the Reserve Bank of India when used as a consideration to settle an obligation or exchange with Indian legal tender of another denomination but shall not include any currency that is held for its numismatic value.”

The definition above enlists all such instruments which have a “value-in-exchange”, so as to represent money. A debt also represents a sum of money and the form in which it can be paid can be any of these forms as enlisted above.

So, in effect, a receivable is also a sum of “money”. As such, receivables shall not be considered as “goods” or “services” for the purpose of GST law.

  1. As mentioned earlier, “actionable claims” have been included in the definition of “goods” under the CGST Act, however, any transfer (i.e. supply) of actionable claim is explicitly excluded from being treated as a supply of either goods or services for the purpose of levy of GST.

Section 2(1) of the CGST Act defines “actionable claim” so as to assign it the same meaning as in section 3 of the Transfer of Property Act, 1882, which in turn, defines “actionable claim” as –

“actionable claim” means a claim to any debt, other than a debt secured by mortgage of immovable property or by hypothecation or pledge of movable property, or to any beneficial interest in movable property not in the possession, either actual or constructive, of the claimant, which the civil courts recognise as affording grounds for relief, whether such debt or beneficial interest be existent, accruing, conditional or contingent;”

It may be noted that the inclusion of “actionable claim” is still subject to the exclusion of “money” from the definition of “goods”. The definition of actionable claim travels beyond “claim to a debt” and covers “claim to any beneficial interest in movable property”. Therefore, an actionable claim is definitely more than a “receivable”. Hence, if the actionable claim represents property that is money, it can be held that such form of the actionable claim shall be excluded from the ambit of “goods”.

There were views in the industry which, on the basis of the definition above, distinguish between — (a) a debt secured by mortgage of immovable property, and a debt secured by hypothecation/pledge of movable property on one hand (which are excluded from the definition of actionable claim); and (b) an unsecured debt on the other hand. However, others opined that a debt, whether secured or unsecured, is after all a “debt”, i.e. a property in money; and thus can never be classified as “goods”. Therefore, the entire exercise of making a distinction between secured and unsecured debt may not be relevant at all.

In case it is argued that a receivable which is secured (i.e. a secured debt) shall come within the definition of “goods”, it must be noted that a security granted against a debt is merely a back-up, a collateral against default in repayment of debt.

  1. In one of the background materials on GST published by the Institute of Chartered Accountants of India[5], it has been emphasised that a transaction where a person merely slips into the shoes of another person, the same cannot be termed as supply. As such, unrestricted expansion of the expression “supply” should not be encouraged:

“. . . supply is not a boundless word of uncertain meaning. The inclusive part of the opening words in this clause may be understood to include everything that supply is generally understood to be PLUS the ones that are enlisted. It must be admitted that the general understanding of the world supply is but an amalgam of these 8 forms of supply. Any attempt at expanding this list of 8 forms of supply must be attempted with great caution. Attempting to find other forms of supply has not yielded results however, transactions that do not want to supply have been discovered. Transactions of assignment where one person steps into the shoes of another appears to slip away from the scope of supply as well as transactions where goods are destroyed without a transfer of any kind taking place.”

Also, as already stated, where the object is neither goods nor services, there is no question of being a supply thereof.

  1. Therefore, there was one school of thought which treated as assignment of secured receivables as a supply under the GST regime and another school of thought promoted a view which was contrary to the other one. To clarify the position, representations were made by some of the leading bankers and the Indian Securitisation Foundation.

Situation after the clarification

  1. The GST Council has discussed the issue of assignment and securitisation of receivables through different question, extracts have been reproduced below:

 

  1. Whether assignment or sale of secured or unsecured debts is liable to GST?

Section 2(52) of the CGST Act, 2017 defines ‘goods’ to mean every kind of movable property other than money and securities but includes actionable claim. Schedule III of the CGST Act, 2017 lists activities or transactions which shall be treated neither as a supply of goods nor a supply of services and actionable claims other than lottery, betting and gambling are included in the said Schedule. Thus, only actionable claims in respect of lottery, betting and gambling would be taxable under GST. Further, where sale, transfer or assignment of debts falls within the purview of actionable claims, the same would not be subject to GST.

Further, any charges collected in the course of transfer or assignment of a debt would be chargeable to GST, being in the nature of consideration for supply of services.

  1. Would sale, purchase, acquisition or assignment of a secured debt constitute a transaction in money?

Sale, purchase, acquisition or assignment of a secured debt does not constitute a transaction in money; it is in the nature of a derivative and hence a security.

  1. What is the leviability of GST on securitization transactions undertaken by banks?

Securitized assets are in the nature of securities and hence not liable to GST. However, if some service charges or service fees or documentation fees or broking charges or such like fees or charges are charged, the same would be a consideration for provision of services related to securitization and chargeable to GST.

 

  1. The fallacy starts with two sequential and separate questions: one dealing with securitisation and the other on assignment transactions. There was absolutely no need for incorporating separate questions for the two, since all securitisation transactions involve an assignment of debt.

 

  1. Next, the department in Question 40 has clarified that the assignment of actionable claims, other than lottery, betting and gambling forms a part of the list of exclusion under Schedule III of the CGST Act, therefore, are not subject to GST. This was apparent from the reading of law, therefore, there is nothing new in this.

 

However, the second part of the answer needs further discussion. The second part of the answer states that – any charges collected in the course of transfer or assignment of a debt would be chargeable to GST, being in the nature of consideration for supply of services.

There are multiple charges or fees associated in an assignment or securitisation transaction – such as  servicing fees or excess spread. While it is very clear that the GST will be chargeable on servicing fees charged by the servicer, there is still a confusion on whether GST will be charged on the excess spread or not. Typically, transactions are devised to give residuary sweep to the originator after servicing the PTCs. Therefore, there could be a challenge that sweep right is also a component of servicing fees or consideration for acting as a servicing agent. The meaning of consideration[6] under the CGST Act is consideration in any form and the nomenclature supports the intent of the transaction.

Since, the originator gets the excess spread, question may arise, if excess spread is in the nature of interest.  This indicates the need for proper structuring of transactions, to ensure that either the sweep right is structured as a security, or the same is structured as a right to interest. One commonly followed international structure is credit-enhancing IO strip. The IO strip has not been tried in Indian transactions, and recommendably this structure may alleviate concerns about GST being applied on the excess spread.

  1. Till now, whatever has been discussed was more or less settled before the clarification, question 41 settles the dispute on the contentious question of whether GST will be charged on assigned of secured debt. The answer to question 41 has compared sale, purchase, acquisition or assignment of secured debt with a derivative. The answer has rejected the view, held by the authors, that any right to a payment in money is money itself. The GST Council holds the view that the receivables are in the nature of derivatives, the transaction qualifies to be a security and therefore, exempt from the purview of supply of goods or supply of services.

While the intent of the GST Council is coming out very clear, but this view is lacking supporting logic. Neither the question discusses why assignments of secured receivables are not transactions in money, nor does it state why it is being treated as derivative.

Our humble submission in this regard is that assignment of secured receivables may not be treated as derivatives. The meaning of the term “derivatives” have been drawn from section 2(ac) of the Securities Contracts (Regulation) Act, 1956, which includes the following –

(A) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

(B) a contract which derives its value from the prices, or index of prices, of underlying securities.

In the present case, assignment of receivables do not represent any security nor does it derive its value from anything else. The receivables themselves have an inherent value, which get assigned, the fact that it is backed a collateral security does not make any difference as the value of the receivables also factor the value of the underlying.

Even though the logic is not coming out clear, the intent of the Council is coming out clearly and the efforts made by the Council to clear out the ambiguities is really commendable.

 

[1] Refer: GST on Securitisation Transactions, by Nidhi Bothra, and Sikha Bansal, at  http://vinodkothari.com/blog/gst-on-securitisation-transactions-2/; pg. last visited on 06.06.2018

[2] At the recently concluded Seventh Securitisation Summit on 25th May, 2018, one leading originator confirmed that his company had kept transactions on hold in view of the GST uncertainty. It was widely believed that the dip in volumes in FY 2017-18 was primarily due to GST uncertainty.

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

[4] Portions of this note have been adopted from the article – GST on Securitisation Transactions, by Nidhi Bothra and Sikha Bansal.

[5] http://idtc-icai.s3.amazonaws.com/download/pdf18/Volume-I(BGM-idtc).pdf; pg. last visited on 19.05.2018

[6] (31) “consideration” in relation to the supply of goods or services or both includes––

(a) any payment made or to be made, whether in money or otherwise, in respect of, in response to, or for the inducement of, the supply of goods or services or both, whether by the recipient or by any other person but shall not include any subsidy given by the Central Government or a State Government;

(b) the monetary value of any act or forbearance, in respect of, in response to, or for the inducement of, the supply of goods or services or both, whether by the recipient or by any other person but shall not include any subsidy given by the Central Government or a State Government:

Provided that a deposit given in respect of the supply of goods or services or both shall not be considered as payment made for such supply unless the supplier applies such deposit as consideration for the said supply;