New lease accounting standard kicks off from 1st April, 2019

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Financial Services Division

(finserv@vinodkothari.com)

The Ministry of Corporate Affairs (MCA) has put a small announcement on its website that the new lease accounting standard, IndAS 116 will get implemented from 1st April 2019. The new Standard, globally implemented in several countries from 1st Jan 2019, is called IFRS 16. The Standard eliminates the 6-decade old distinction between financial and operating leases, from lessee accounting perspective, thereby putting all leases on the balance sheet. The phenomenon of off-balance sheet lease transactions was one of the burning analyses after bankruptcy of Enron in 2001, and since then, had been erupting off and on, until the global standard setter decides to push the new standard on the rule book in Jan 2016, effective 1st Jan 2019.

After the introduction of IFRS 16, the ICAI came out with an exposure draft on the new standard in 2017 and kept it open for comments for some days. However, nothing further was heard about it thereafter.

The exposure draft and the final published Ind AS 116 are same except for the below mentioned change which has been incorporated in the final published Ind AS 116:

Para 47 dealing with presentation in books of lessee:
In Exposure Draft Text of published Ind AS 116
Para 47 A lessee shall either present in the balance sheet, or disclose in the notes: Para 47: A lessee shall either present in the balance sheet, or disclose in the notes:
(a) right-of-use assets separately from other assets. (a) right-of-use assets separately from other assets. If a lessee does not  present right-of-use assets separately in the balance sheet, the lessee shall:
(i) include right-of-use assets within the same line item as that  within which the corresponding underlying assets would be  presented if they were owned; and
(ii) disclose which line items in the balance sheet include those  right-of-use assets.
(b) lease liabilities separately from other liabilities. (b) lease liabilities separately from other liabilities. If a lessee does not  present lease liabilities separately in the balance sheet, the lessee  shall disclose which line items in the balance sheet include those liabilities.

(above para is same as para 47 IFRS 16, thereby making IFRS 16 and Ind AS 116 exactly same now, except for the fair value option for investment property- ref para 1 of comparison with IFRS 16 )

Giving the above option makes it clear how the lessee is going to show the asset in books.

For example, if A takes Aircraft-1 on lease and owns Aircraft-2, A can either include both of them in PPE or can show Aircraft-1 in PPE and Aircraft-2 just below PPE under the head ROU.

Correspondingly, a lease liability can be disclosed separately, if not disclosed separately, then disclose which line item in BS includes the lease liability.

Globally, several jurisdictions have implemented the Standard with effect from 1st January, 2019. A list of jurisdictions which have already adopted can be viewed here.

Some of the key takeaways from the implementation of this Standard are:

  • Currently, there are two accounting standards for lease transactions, first, Ind AS 17, which is applicable to the Ind AS compliant companies and second, AS 19, which is applicable to the remaining classes of companies. Ind AS 116 proposes to replace Ind AS 17, therefore, the companies which are not covered by Ind AS shall continue to follow old accounting standard. 
  • The applicability of this standard shall have to be examined separately for the lessor and the lessee, that is, if the lessor is Ind AS compliant and lessee is not Ind AS compliant, then lessor will follow Ind AS 116 whereas lessee will follow AS 19. 
  • The new standard changes treatment of operating leases in the books of the lessees significantly. Earlier, operating leases remained completely off the balance sheet of the lessee, however, vide this standard, lessees will have to recognise a right-to-use asset on their balance sheet and correspondingly a lease liability will be created in the liability side. 
  • Lease of low value assets and short tenure leases (up to 12 months) have been carved out from the requirement of recognition of RTU asset in the books of the lessee.
  • No change in the accounting treatment in case of financial leases. 
  • No change in the lessor’s’ accounting.

While leasing has not been greatly popular in India compared to the world, there has been a substantial pick up in interest over recent years. Therefore, a question comes – will the new standard put a death knell to the feeble leasing industry in India? To the extent the demand for leasing comes from off balance sheet perspective for a lessee, the standard may have some impact. However, there are many economic drivers for lease transactions – such as the ease of usage, tax benefits, better residual realisation, etc. Those factors remain unaffected, and in fact, the focus of lease attractiveness will shift to real economic factors rather than balance sheet cosmetics.

The apparent question that arises here is whether the new standard unsettle the taxation framework for lease transactions in India, especially direct taxes – the answer to this question is negative. The tax treatment of lease transaction does not depend on the treatment of the transaction in books of accounts. Instead, it depends on whether the transaction is case a true lease or is merely a disguised financial transaction. There will be no impact on the indirect taxation framework as well.

Indefinite deferral of IFRS for banks: needed reprieve or deferring the pain?

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Vinod Kothari (vinod@vinodkothari.com); Abhirup Ghosh (abhirup@vinodkothari.com)

On 22 March, 2019, just days before the onset of the new financial year, when banks were supposed to be moving into IFRS, the RBI issued a notification[1], giving Indian banks indefinite time for moving into IFRS. Most global banks have moved into IFRS; a survey of implementation for financial institutions shows that there are few countries, especially which are less developed, where banks are still adopting traditional GAAPs. However, whether the Notification of the RBI is giving the banks a break that they badly needed, or is just giving them today’s gain for tomorrow’s pain, remains to be analysed.

The RBI notifications lays it on the legislative changes which, as it says, are required to implement IFRS. It refers to the First Bi-monthly Monetary Policy 2018-19[2], wherein there was reference to legislative changes, and preparedness. There is no mention in the present  notification for preparedness – it merely points to the required legislative changes. The legislative change in the BR Act would have mostly been to the format of financial statements – which is something that may be brought by way of notification. That is how it has been done in case of the Companies Act.

This article analyses the major ways in which IFRS would have affected Indian banks, and what does the notification mean to the banking sector.

Major changes that IFRS would have affected bank accounting:

  • Expected Credit Loss – Currently, financial institutions in India follow an incurred credit loss model for providing for financial assets originated by them. Under the ECL model, financial assets will have to be classified into three different stages depending on credit risk in the asset and they are:
    • Stage 1: Where the credit risk in the asset has not changed significantly as compared to the credit risk at the time of origination of the asset.
    • Stage 2: Where the credit risk in the asset has increased significantly as compared to the credit risk at the time of origination of the asset.
    • Stage 3: Where the asset is credit impaired.

While for stage 1 financial assets, ECL has to be provided for based on 12 months’ expected losses, for the remaining stages, ECL has to be provided for based on lifetime expected losses.

The ECL methodology prescribed is very subjective in nature, this implies that the model will vary based on the management estimates of each entity; this is in sharp contrast to the existing provisioning methodology where regulators prescribed for uniform provisioning requirements.

Also, since the provisioning requirements are pegged with the credit risk in the asset, this could give rise to a situation where the one single borrower can be classified into different stages in books of two different financial institutions. In fact, this could also lead to a situation where two different accounts of one single borrower can be classified into two different stages in the books of one financial entity.

  • De-recognition rules – Like ECL provisioning requirements, another change that will hurt banks dearly is the criteria for derecognition of financial assets.

Currently, a significant amount of NPAs are currently been sold to ARCs. Normally, transactions are executed in a 15:85 structure, where 15% of sale consideration is discharged in cash and the remaining 85% is discharged by issuing SRs. Since, the originators continue to hold 85% of the SRs issued against the receivables even after the sell-off, there is a chance that the trusts floated by the ARCs can be deemed to be under the control of the originator. This will lead to the NPAs coming back on the balance sheet of banks by way of consolidation.

  • Fair value accounting – Fair value accounting of financial assets is yet another change in the accounting treatment of financial assets in the books of the banks. Earlier, the unquoted investments were valued at carrying value, however, as per the new standards, all financial assets will have to be fair valued at the time of transitioning and an on-going basis.

It is expected that the new requirements will lead to capital erosion for most of the banks and for some the hit can be one-half or more, considering the current quality of assets the banks are holding. This deferment allows the banks to clean up their balance sheet before transitioning which will lead to less of an impact on the capital, as it is expected that the majority of the impact will be caused due to ECL provisioning.

World over most of the jurisdictions have already implemented IFRS in the banking sector. In fact, a study[3] shows that major banks in Europe have been able to escape the transitory effects with small impact on their capital. The table below shows the impact of first time adoption of IFRS on some of the leading banking corporations in Europe:

Impact of this deferment on NBFCs

While RBI has been deferring its plan to implement IFRS in the banking sector for quite some time, this deferral was not considered for NBFCs at all, despite the same being admittedly less regulated than banks. The first phase of implementation among NBFCs was already done with effect from 1st April, 2018.

This early implementation of IFRS among NBFCs and deferral for banks leads to another issue especially for the NBFCs which are associates/ subsidiaries of banking companies and are having to follow Ind AS. While these NBFCs will have to prepare their own financials as per Ind AS, however, they will have to maintain separate financials as per IGAAP for the purpose of consolidation by banks.

What does this deferment mean for banks which have global listing?

As already stated, IFRS have been implemented in most of the jurisdictions worldwide, this would create issues for banks which are listed on global stock exchanges. This could lead to these banks maintaining two separate accounts – first, as per IGAAP for regulatory reporting requirements in India and second, as per IFRS for regulatory reporting requirements in the foreign jurisdictions.

—

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11506&Mode=0

[2] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=43574

[3] https://www.spglobal.com/marketintelligence/en/news-insights/research/european-banks-capital-survives-new-ifrs-9-accounting-impact-but-concerns-remain

Compound financial instruments- A paradigm shift in accounting concepts

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By Rahul Maharshi (rahul@vinodkothari.com, ifrs@vinodkothari.com) 

Introduction

Financial instruments accounting has been one of the highlighting issues in implementation of Ind AS in India. Several new concepts have been introduced and compound financial instrument (CFI) is one of them.

Explained in para 28 of Ind AS 32, a CFI is a financial instrument which is a non-derivative financial instrument that, from the issuer’s perspective, contains both liability and equity component. Therefore, when characteristics of both, liability and equity are fused into one instrument, it gives rise to a CFI.

It is usually observed, as a way of raising funds, many companies go for issuing debt instruments with a conversion feature in it. A bond which is convertible into fixed number of shares of the issuer would generally be preferred over a plain vanilla bond, since there lies a convertibility feature which would be an incentive for the investor over and above the interest income on such a bond. Additionally, if the issuer company is one which is positively growing, the investor would reap out fair amount of benefits with the help of a convertibility option.

Therefore, this makes CFI an interesting topic to discuss. In this article, we intend to discuss the manner of treatment, recognition, classification and various other intricacies associated with CFIs.

Compound financial instrument from investors perspective

The accounting treatment with respect with CFI prescribed in Ind AS 32 deals with the issuer’s books of accounts only, there is no special treatment required in the books of the investor. A CFI is nothing but a financial asset in the books of an investor.

A CFI is required to be accounted for in the books of an investor as a financial asset till redemption, however, at the time of redemption, if the instrument is converted into equity, the same will require reclassification for subsequent measurement of the financial asset as a whole by the investor.

Compound financial instrument vs. Hybrid financial instrument

Yet another new concept in the Ind AS is that of hybrid financial instrument. Differentiating the same with CFI; a hybrid financial instrument, or a hybrid contract is one which has an embedded derivative sitting on a host contract. From an investor’s point of view, a host contract can be of any kind, such as a financial asset or a non-financial asset.

If the host contract is a non-financial asset, the embedded derivative will be required to be separated from the host contract subject to the requirements given in para 4.3.3 of Ind AS 109. After separation, the host contract shall be required to be accounted for in accordance with the appropriate Ind AS(s).

For example, a lease agreement with variable lease payments adjusted to the change in a benchmark interest rate such as LIBOR would result in a hybrid instrument with the host contract being the lease agreement i.e. a non-financial asset and an embedded derivative being the variability feature of the lease payments being leveraged. The lease agreement should be accounted for as per Ind AS 17- Leases and the derivative feature may be required to be accounted for as per Ind AS 109 subject to para 4.3.3.

A host contract being a financial instrument (viz. being a financial asset) is required to be accounted for by the investor as explained in the earlier section.

However, for the purpose of this article, emphasis is required to be given on the treatment of a CFI being a host contract with an embedded derivative (such as a call option) from an issuer’s point of view. Ind AS 32 provides that the value of the derivative embedded on CFI is required to be included in the liability component of the CFI.

It is to be noted that the equity conversion option in a CFI, on a standalone basis, is not a derivative. The derivative that is required to be included in the liability component are those which qualify to be a derivative as defined under Ind AS 109.

The concept of CFI and a Hybrid contract is diagrammatically explained below:

The above diagram can be seen as an example of deriving concepts from application of two Ind AS(s) viz. Ind AS 109 and Ind AS 32. By interpretation, it exhibits the notion that a CFI is in fact, a type of a hybrid contract, but a hybrid contract is not a type of a CFI. Nevertheless, this notion can be questioned on the ground that both the instruments are required to be looked at from different perspectives.

The distinctions between a hybrid contract and a CFI can be tabulated as below:

Basis of distinction Hybrid contract/ Hybrid financial instrument Compound financial instrument
Governing Ind AS for accounting Ind AS 109 Financial Instruments Ind AS 32 Financial Instruments- Presentation
Nature Derivative Derivative /Non- derivative
Split accounting Based on conditions given in para 4.3.3 of Ind AS 109 Mandatory in all cases
Resultant instruments after splitting Financial assets, non-financial assets, financial liability, non-financial liability  and/or equity Equity and financial liability

Split Accounting in case of a CFI

The incidence or event of testing a financial instrument to be a CFI or not is not only to be done at the issuance or on a periodic basis, rather whenever the terms of the contract of a financial instrument reveal a dual character i.e. of equity as well as liability, the same should be classified and accounted for.

The steps involved in accounting for a CFI from the perspective of an issuer is diagrammatically represented below:

Step 1: Identification of the components of the CFI:

Identifying the components of CFI into equity and liability from the issuer’s perspective is done by checking the terms and conditions provided in the contract of the financial instrument.

For example, an issuer issues 7% Optionally Convertible Debentures, convertible into a fixed number of shares. This would mean that the obligation towards debenture holder can be discharged either by payment of cash or by issuing a fixed number of the equity shares of the issuer. The liability component here being the issuer’s obligation to pay 7% interest and the potential redemption of the debenture in cash at maturity. The equity component here being the holder’s call option for the issuer’s shares.

Step 2:  Determination of fair value of CFI as a whole

The fair value of the CFI as a whole would normally be the transaction price as provided in para B5.1.2A of Ind AS 109. In case the transaction has not taken place under market conditions, then the principles of Ind AS 113 would be applied to derive at the fair value of the financial instrument as a whole.

Step 3: Determination of the fair value of the liability component:

Fair value of the liability component is the present value of the contractually determined stream of future cash flows discounted at the rate of interest applied at that time by the market to instruments of comparable credit status and providing substantially the same cash flows, on the same terms but without the convertibility option.

The act of discounting the cash flows of the instrument as a whole with the discounting rate being the rate of interest prevailing in the market on a debenture without the conversion option is done to derive the value of the liability component.

Now if the instrument as a whole has an embedded derivative, like a call option on the equity shares, the liability component is inclusive of the value of the derivative embedded in the CFI.

Step 4: Determine value of the equity component:

The equity component of a CFI is nothing but the residual amount left after subtracting the liability component as computed in step 3 from the fair value of the CFI as a whole (step 2).

This is fairly evident from the definition of equity as provided in para 11 of Ind AS as below:

“An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.”

Also, once the value of the equity component of a CFI is determined, being the residual amount, it is not re-measured or reclassified till final settlement. In cases of conversion, there can merely be a change within equity. Any kind of cost associated with the issue of the CFI shall be proportionately allocated to the liability and equity components.

Since the liability component of a CFI satisfies the definition of a financial liability as per Ind AS 32, the same is required to be subsequently accounted for in accordance with the principles of subsequent measurement of financial liabilities as provided in para 4.2 of Ind AS 109 viz. at Fair value through profit or loss (FVTPL) or at amortised cost method.

Examples

Example 1: 9% Preference shares with partial conversion and partial redemption

Company M has issued 10,000 9% Preference shares having face value Rs. 100 each with mandatory dividends and mandatory conversion of 50% preference shares into equity and balance 50% redemption at the end of 3 years from the date of issue. Market rate for Preference shares with similar credit status and other features except the conversion feature is 12%p.a.

The preference share has two components – (1) Contractual obligation for payment of mandatory dividend and mandatory redemption of 50% Preference shares. (2) Mandatory conversion of 50% Preference shares into equity.

The first component is a financial liability because the same consist of contractual obligation to pay cash and the entity does not have an unconditional right to avoid delivering cash.

The second component is equity since there is mandatory conversion into equity shares, which, in substance, signifies that the amount for the equity is already prepended even before receiving the shares in reality.

The values of equity and liability components are calculated as follows:

Present value of Principal payable at the end of the 3 years (Rs. 5,00,000 discounted at 12% for 3 years)= Rs.3,55,890.

Present value of contractual obligation to pay dividends in arrears for 3 years (Rs. 90,000 discounted at 12% for 3 years) = Rs. 2,16,165

Total financial liability= Rs.5, 72, 055.

Therefore, equity component= fair value of CFI, say Rs. 10,00,000 less financial liability component i.e. Rs. 5,72,055=Rs. 4,27,945.

Subsequent year’s profit and loss account is charged with interest amortisation at 12% on the financial liability component and dividend expense of Rs. 90,000 each.

Example 2: 6% optionally convertible debentures (OCDs)

X ltd (issuer) has issued 6% p.a. debentures to Y Ltd. (holder) for a consideration of Rs. 30 lakhs. The holder has an option to convert these debentures to a fixed number of equity instrument of the issuer anytime up to a period of 3 years. If the option is not exercised by the holder, the debentures are redeemed at the end of 3 years. The prevailing market rate for similar debentures without the conversion feature is 9% p.a.

The instrument has two components – (1) Contractual obligation that is conditional on holder exercising his right to redeem, and (2) conversion option with the holder.

The first component is a financial liability because the entity does not have an unconditional right to avoid delivering cash. The other component, conversion option with the holder, is an equity feature.

The values of liability and equity component are calculated as follows:

Present value of principal payable at the end of 3 years (Rs. 30 Lakhs discounted at 9% for 3 years)= Rs. 23,16,550.

Present value of interest payable in arrears for 3 years (Rs. 1,80,000 discounted at 9% for each of 3 years) = Rs. 4,55,632

Total financial liability= Rs. 27,72,182.

Therefore, equity component= fair value of CFI, say Rs. 30 Lakhs less financial liability component i.e. Rs. 27, 72,182=Rs. 2, 27,818.

In subsequent years the profit is charged with interest of 9% on the debt instrument.

Example 3: Accounting for Compound financial instrument on date of transition

On 1st April, 2015, X Ltd. issued 50,000, 7% convertible debentures of face value of Rs. 100 per debenture at par. The debentures are redeemable on 31st March 2020 or these may be converted into ordinary shares at the option of the holder. The interest rate for equivalent debentures without the conversion rights would have been 10%. The date of transition to Ind AS is 1st April, 2017.

As per previous Indian GAAP, the given instrument has been accounted for as a non-current liability and corresponding interest expense of Rs. 3,50,000 each for 2 years should have been charged directly to profit and loss account.

On the date of transition to Ind AS, i.e. 1st April, 2017, the Company has to account for the instrument as a compound financial instrument as per para 28 of Ind AS 32. Subsequently, the value of debt component and equity component has to be calculated (viz. split accounting).

Therefore, for the remaining 3 years, there will be an interest expense at Rs. 3,50,000 each and at the end of 3rd year the instrument either gets redeemed or gets converted into ordinary shares of the Company.

On 1st April, 2017

Value of Debt:

Present value of interest payable for 17-18, 18-19 & 19-20 = (Rs. 3,50,000 discounted at 10% for each of the 3 years)= Rs. 8,70,398

Present value of Principal at the end of 3rd year i.e. as on 31st March, 2020 = (Rs. 50,00,000 discounted at 10% for 3 years) = Rs. 37,56,574

Value of Debt component= Rs. 37,56,574 + 8, 70,398 =Rs.46,26,972

Value of equity component= Rs. 50,00,000-46,26,972=3,73,028

Therefore, on the date of transition i.e. 1/4/2017 amount of Rs. 50,00,000 being the Fair value of CFI will be split into debt & equity as given above.

For the coming 3 years, the following treatment shall be done by the X Ltd.

Particulars 2017-18 2018-19 2019-20
Opening debt component 46,26,972 47,33,669 48,57,015
(+)Interest amortisation @ 10% 4,62,697 4,73,365 4,85,702
(-)Interest expense at 3.5 lakhs p.a 3,50,000 3,50,000 3,50,000
Closing balance of debt component   47,33,669 48,63,635 50,00,000

Conclusion

The move towards substance over form and fair value accounting is fairly reflected with the introduction of the concept of CFI. There has been a fundamental shift in the understanding when a contract is put to test in light of Ind AS governing financial instruments. The instruments which were erstwhile treated to be debt are currently being treated as equity. This is primarily dependant on the notion that equity capital is the amount of money not repaid, accordingly an instrument convertible into equity capital should also be treated as equity. Therefore, a CCD is shown as a CFI.

However, in the midst of split accounting of a CFI, there are certain issues which are of concern to entities in doing the same. The major challenge to stakeholders lies in treatment of the equity component of the CFI from Income tax perspective, since there arises a MAT implication.

On the date of transition to Ind AS, there arises a tax implication on the already issued instruments which require reclassification as a CFI in the current Ind AS regime. The equity component of the CFI is required to be included in the “transition amount” defined in sub-section 2(C) of section 115JB of the Income Tax Act, 1961.

This results in taxing the one-fifth amount of the equity component for 5 years. The same has been further clarified by the CBDT circular dated 25th July, 2017[1] stating that the equity component of a CFI is to be included in the transition amount and further be taxed for MAT purposes over a period of five years. The same is seen as a burden on companies transitioning from erstwhile Indian GAAP to Ind AS because the equity component is not excluded from the purview of book profits as computed for MAT purposes.

Nevertheless, we feel the concept is relatively new to the Indian context and the same shall be developed over a period of time.

[1] https://www.incometaxindia.gov.in/Communications/Circular/Circular_24_%202017.pdf

Notional income tax on issue of shares by closely held applicable not applicable under Sec.56(2) (vii a), clarifies CBDT

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-Million dollar question: Can the same be extended to Sec. 56(2)(x) ?

By Yutika Lohia (yutika@vinodkothari.com)

The abolition of Gift Tax Act in the year 1998 paved way for one of the most dynamic sections of the Income Tax Act, 1961, – Section 56(2). Under this section all kinds of incomes and gains which were from sources other than the sources mentioned in the Act at that time was brought under the purview of Income Tax. Now, incomes and gains arising out of such transactions which were structured to pass on assets to some other party without any consideration or with inadequate consideration was subject to be taxed under this section.

While the Section 56(2) gave the authorities a tool to keep check on the transactions structured to merely launder unaccounted income, it also brought in many questions with itself. The CBDT has since been releasing clarification to address the questions as well as making changes to the section to cover all lose ends of laundering unaccounted incomes.

Recently Central Board of Direct Taxes (CBDT) in its circular dated 31st December, 2018 came up with a clarification to address the question –

Does the terms “receives” with regards to section 56 (2)(viia) include receiving shares of companies (where public are not substantially interested) by way of issues of shares by way of fresh issue/ bonus issue/ issue of rights shares/ transaction of similar nature?

Before we get to the clarification lets first analyse the sections – 56(2)(vii), 56(2)(viia) , 56(2)(viib) & 56(2)(x)

Analysis of Section 56(2)(vii) Section 56(2)(viia) Section 56(2)(viib) & Section 56(2)(x)

Section 56(2)(vii) Section 56(2)(viia) Section 56(2)(viib) Section

56(2)(x)
Applicable to Individual/ HUF Firm/ Company (closely held) Company (closely held) Person as per section 2(31) of the IT Act, 1961
Applicable on 1. Money

2. Immovable Property

3.Property other Immovable Property

 Shares of closely held company 1.Issue of Shares 1. Money

2. Immovable Property

3.Property other Immovable Property
Applicable date From  1st October, 2009 to 31st March, 2017 From 1st June, 2010 to 31st March, 2017 From 1st April, 2013 From 1st April, 2017

 

Section 56(2)(viia) of the IT Act, 1961 was inserted by Finance Act, 2010. Referring to the memorandum of Finance Act, 2010[1] clause (viia) was incorporated in section 56 to prevent the practice of transferring unlisted shares at a price which was different from the fair market value (i.e no or inadequate consideration) of the shares and also include within its ambit transactions undertaken in shares of the company (not being a company in which public are substantially interested) either for inadequate consideration or without consideration where recipient is a firm or a company (not being a company in which public are substantially interested).

In a layman’s term the act of receiving means to receive something which was already in existence and the act of creation of the that particular thing.

Similarly receipt of shares of shares by way of fresh issue/ bonus issue/ issue of rights shares/ transaction of similar nature is an act of creation of the securities and not transfer of the same. The CBDT in its circular dated 31st December, 2018has clarified the same. section 56(2)(viia) is applicable to transactions involving subsequent transfer of the shares form the initial receiver to some third party, and not time of issuance of such shares.

It is palpable that the shares would be treated as goods only when it comes into existence and issuance of shares is the act of bringing the shares into existence. The word “receives” with respect to section 56(2)(viia) would not include issuance of shares within its ambit.

The intent of insertion of clause (viia) to section 56 was to apply anti-abuse provision i.e transfer of shares for no or inadequate consideration, it is hereby clarified by the CBDT circular that section 56(2)(viia) of the Act shall apply in cases where a company (not being a company in which public are substantially interested)  or a firm receives the shares  of the company (not being a company in which public are substantially interested) through transfer for no or inadequate consideration. Hence section 56(2)(viia) of the Act shall not be applicable on fresh issue of shares by the specified company.

Taxation of fresh issue of shares comes under the purview of section 56(2)(viib).

The Subhodh Menon case in context to Section 56

Recently the Income Tax Appellate Tribunal (ITAT) in the case of The Assistant Commissioner of Income Tax Vs. Shri Subhodh Menon[2], order dated 7th December, 2018 held that a shareholder cannot be taxed under section 56(2)(vii)(c) of the IT Act, 1961 so long as the shares are allotted to the holder on a proportionate basis (right shares), even if such shares are allotted at a value lower than the fair market value.

Drawing from the above case law, right shares issued at a value below the fair market value to individual/ HUF where allotment is disproportionate will not be taxable under section 56(2)(vii)(c) of the IT Act, 1961. Shares issued higher than proportion offered (based on shareholding) shall attract tax provisions.

Conclusion

The Union Budget 2017[3] introduced the section 56(2)(x) of the IT Act, 1961 widening the scope of Income from other sources and also clubbing section 56(2)(vii) & section 56(2)(viia).  Income Tax shall not be chargeable at normal rate for fresh issue of shares for closely held companies.

Since the offence that section 56(2)(viia) was trying to curb is the same as section 56(2)(x), the question still lies, whether the term “receives” clarified in the CBDT circular shall have the same analogy for Section 56(2)(x)? Simply put, whether section 56(2)(x) of the Act will also be limited to transfer of existing shares and not cover fresh issue of shares?

[1] https://www.indiabudget.gov.in/ub2010-11/mem/mem1.pdf

[2] http://itatonline.org/archives/wp-content/uploads/Subodh-Menon-shares.pdf

[3] https://www.indiabudget.gov.in/budget2017-2018/ub2017-18/memo/memo.pdf

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;”

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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

Servicing Asset and Servicing Liability: A new by-product of securitization under Ind AS 109

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(finserv@vinodkothari.com)

Securitisation has gained popularity in India in the recent times, however, one more concept that has grown parallel to it is, direct assignment. In fact, at times, direct assignments have overpowered securitisation in the Indian market[1]. Financial institutions have been using these extensively to address their liquidity issues. However, if there is anything that affected the financial institutions dearly, then it is the change in the accounting treatment under the Indian Accounting Standards (Ind AS).

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Classification and reclassification of financial instruments under Ind AS

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By Team IFRS & Valuation Services (ifrs@vinodkothari.com) (finserv@vinodkothari.com)

Background

As India moves into Indian Accounting Standards (Ind AS), one standard which the accountants will be wary about is the Ind AS 109: Financial Instruments. This standard is an adaption of the International Financial Reporting Standard 9.  Ind AS 109 specifically provides for the manner in which the financial assets and financial liabilities are to be dealt with the books of the accounts. This standard itself is incomplete, as to draw a meaningful conclusion to any matter relating to financial asset or financial liability, one will also have to refer to the Ind AS 32. Read more →

Accounting for Direct Assignment under Indian Accounting Standards (Ind AS)

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By Team IFRS & Valuation Services (ifrs@vinodkothari.com) (finserv@vinodkothari.com)

Introduction

Direct assignment (DA) is a very popular way of achieving liquidity needs of an entity. With the motives of achieving off- balance sheet treatment accompanied by low cost of raising funds, financial sector entities enter into securitisation and direct assignment transactions involving sale of their loan portfolios. DA in the context of Indian securitisation practices involves sale of loan portfolios without the involvement of a special purpose vehicle, unlike securitisation, where setting up of an SPV is an imperative.

The term DA is unique to India, that is, only in Indian context we use the term DA for assignment of loan or lease portfolios to another entity like bank. Whereas, on a global level, a similar arrangements are known by various other names like loan sale, whole-loan sales or loan portfolio sale.

In India, the regulatory framework governing Das and securitisation transactions are laid down by the Reserve Bank of India (RBI). The guidelines for governing securitisation structures, often referred to as pass-through certificates route (PTCs) were issued for the first time in 2006, where the focus of the Guidelines was restricted to securitisation transactions only and direct assignments were nowhere in the picture. The RBI Guidelines were revised in 2012 to include provisions relating to direct assignment transactions.

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