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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RBI to strengthen corporate governance for Core Investment Companies.

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Vinod Kothari

As a part of the Bi-monthly Monetary Policy on 6th June, 2019, the RBI’s review of Development and Regulatory Policies [https://rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=47226] proposed to set up a working group to strengthen the regulatory framework for core investment companies (CICs). The RBI states: “Over the years, corporate group structures have become more complex involving multiple layering and leveraging, which has led to greater inter-connectedness to the financial system through their access to public funds. Further, in light of recent developments, there is a need to strengthen the corporate governance framework of CICs. Accordingly, it has been decided to set up a Working Group to review the regulatory guidelines and supervisory framework applicable to CICs.”

Core investment companies are group holding vehicles, which hold equities of operating or financial companies in a business group. These companies also give financial support in form of loans to group companies. However, CICs are barred from dealing with companies outside the group or engaging in any other business operation.

Currently as per the data as on 30th April, 2019, there are only 58 registered CICs in the country. There may be some unregistered CICs as well, since those not having “public funds” do not require registration.

If a CIC is not holding “public funds” (a broad term that includes bank loans, inter-corporate deposits, NCDs, CP, etc.), the CIC is exempt from registration requirement. Presumably such CICs are also excluded from any regulatory sanctions of the RBI as well. However, it is quite common for CICs to access bank loans or have other forms of debt for funding their investments. Such CICs require registration and come under the regulatory framework of the RBI, if their assets are worth Rs 100 crores or more.

Corporate governance norms applicable to systemically important NBFCs are currently not applicable to CICs.

The RBI has observed that CICs are engaged in layering of leverage. This observation is correct, as very often, banks and other lenders might have lent to CICs. The CICs, with borrowed money, use the same for infusing capital at the operating level below, which, once again, becomes the basis for leveraging. Thus, leveraged funds become basis for leverage, thereby creating multiple layers of leverage.

While agreeing with the contention of the RBI, one would like to mention that currently, the regulatory definition of CICs is so stringent that many of the group holding companies qualify as “investment companies” (now, credit and investment companies) and not CICs. There is a need to reduce the qualifying criteria for definition of CICs to 50% of investments in equities of group companies. This would ensure that a large number of “investment companies” will qualify as CICs, based on predominance of their investments, and would be viewed and regulated as such.

Prominent among the registered CICs are entities like Tata Sons, L&T Finance Holdings, JSW Investments, etc. The extension of corporate governance norms to CICs is unlikely to benefit any, but impact all.

The Reserve Bank has accordingly constituted the Working Group to Review Regulatory and Supervisory Framework for Core Investment Companies on 3rd July, 2019 [https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/PR43DDEE37027375423E989F2C08B3491F4F.PDF]. The Terms of Reference (ToR) of the Working Group are given below:

  • To examine the current regulatory framework for CICs in terms of adequacy, efficacy and effectiveness of every component thereof and suggest changes therein.
  • To assess the appropriateness of and suggest changes to the current approach of the Reserve Bank of India towards registration of CICs including the practice of multiple CICs being allowed within a group.
  • To suggest measures to strengthen corporate governance and disclosure requirements for CICs
  • To assess the adequacy of supervisory returns submitted by CICs and suggest changes therein
  • To suggest appropriate measures to enhance RBI’s off-sight surveillance and on-site supervision over CICs.
  • Any other matter incidental to the above.

As per the press release, the Working Group shall submit its report by October 31, 2019.

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

 

BLOCKCHAIN TECHNOLOGY & ITS APPLICATIONS IN FINANCIAL SECTOR

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Prudential Framework for Resolution of Stressed Assets: New Dispensation for dealing with NPAs

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By Vinod Kothari [vinod@vinodkothari.com]; Abhirup Ghosh [abhirup@vinodkothari.com]

With the 12th Feb., 2018 having been struck down by the Supreme Court, the RBI has come with a new framework, in form of Directions[1], with enhanced applicability covering banks, financial institutions, small finance banks, and systematically important NBFCs. The Directions apply with immediate effect, that is, 7th June, 2019.

The revised framework [FRESA – Framework for Resolution of Stressed Accounts] has much larger room for discretion to lenders, and unlike the 12th Feb., 2018 circular, does not mandate referral of the borrowers en masse to insolvency resolution. While the RBI has reserved the rights, under sec.  35AA of the BR Act, to refer specific borrowers to the IBC, the FRESA gives liberty to the members of the joint lenders forum consisting of banks, financial institutions, small finance banks and systemically important NBFCs, to decide the resolution plan. The resolution plan may involve restructuring, sale of the exposures to other entities, change of management or ownership of the borrower, as also reference to the IBC. Read more →

Large Exposures Framework: New RBI rules to deter banks’ concentric lending

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-Kanakprabha Jethani |Executive
Vinod Kothari Consultants

Background

The RBI has made some crucial amendments to the Large Exposures Framework (LEF) by notification dated June 03, 2019. These changes are intended to align with global practices, such as look through approach for identifying exposures, determination of the group of “connected” counterparties, to name a few.

The LEF, announced by the RBI vide its notification dated December 01, 2016[1] and amended through notification dated June 03, 2019[2], is applicable with effect from April 1, 2019. However, the provisions relating to Introduction of economic interdependence criteria in definition of connected counterparties and non-centrally cleared derivatives exposures shall become applicable from April 1, 2020. This framework is likely to widen the scope of the definition of group of connected counterparties on one hand, and narrowing down the same by expanding the scope of exempted counterparties. Further, look-through approach demarcates between direct or indirect exposure of banks in various counterparties.

More about the LEF

A bank may have exposure to various large borrowers, and of group of entities that are related to each other. This exposure in large borrowers, whether singularly or by way of different related entities, results in concentration of bank’s exposure in the same group, thus increasing the credit risk of the bank. There have been examples of large banking failures throughout the world. In the words of the Basel Committee on Banking Supervision-

“Throughout history there have been instances of banks failing due to concentrated exposures to individual counterparties (eg Johnson Matthey Bankers in the United Kingdom in 1984, the Korean banking crisis in the late 1990s). Large exposures regulation has been developed as a tool for limiting the maximum loss a bank could face in the event of a sudden counterparty failure to a level that does not endanger the bank’s solvency.”

To deal with the risk arising out of such concentration, there has to be in place limits on concentration in a single borrower or a borrower group. Accordingly, after considering various frameworks being included in local laws and banking regulations and recommendations of committees such as Basel Committee on Banking Supervision, ‘Supervisory framework for measuring and controlling large exposures’[3] was issued by the said committee. The same was adopted by the RBI in respect of banks in India.

The Large Exposure Framework (LEF) shall be applied by banks at group level (considering assets and liabilities of borrower and its subsidiaries, joint ventures and associates) as well as at solo level (considering the capital strength and risk profile of borrower only).

Reporting of large exposure: As per the LEF, large exposure shall mean exposure of 10% or more of the eligible capital base of the bank in a single counterparty or a group of counterparties. The same shall be reported to Department of Banking Supervision, Central Office, Reserve Bank of India.

Limit on large exposure: the maximum exposure of a bank in a single counterparty shall not be more than 20% of its eligible capital base at any time. This limit shall be raised to 25% of bank’s eligible capital base in case of a group of counterparties.

Eligible capital base, in this reference shall mean the aggregate of Tier 1 capital as defined in Basel III – Capital Regulation[4] as per the latest balance sheet of the company, infusion of capital under Tier I after the published balance sheet date and profits accrued during the year which are not in deviation of more than 25% from the average profit of four quarters.

Applicability

The LEF shall be applicable on all scheduled commercial banks in India, with respect to their counterparties only.

The LEF has become applicable with effect from April 1, 2019. The revised guidelines on LEF shall also become applicable from the same date with retrospective effect except for the provisions of economic interdependence and non-centrally cleared derivative exposures.

What sort of borrowers are affected?

The revised guidelines have an impact on the borrowers who used to take advantage of different entities and hide behind the corporate veil to avail funding. The introduction of economic interdependence as a criteria for determining connected counterparties ensures that no same persons, whether promoters or management avail facilities through other entity.

Further, borrowers who operate as special purposes vehicles, securitisation structures or other structures having investments in underlying assets would also be affected as the banks will now look-through the structure to identify the counterparty corresponding the underlying asset.

However, the LEF does not address issues relating to lending to any specific sector or such other exposures.

What happens to affected borrowers?

The borrowers taking advantage of corporate veil will no more be able to avail funds in the covers of veil. The entities having same or related parties in their management shall not be able to avail funds exceeding the exposure limit. This would result in shrinkage of the availability of borrowed funds that would have otherwise been available to the entities. Also, entities operating as aforementioned structures, are likely to face contraction of borrowed fund availability.

Global framework

The global framework on large exposures called the Supervisory framework for measuring and controlling large exposures became applicable from 1st Jan 2019. The key features of the global framework are as follows:

  • Norms for determining scope of counterparties and exemptions thereto.
  • Specification of limits of large exposures and reporting requirements.
  • The sum of exposure to a single borrower or a group of connected borrowers shall not exceed 25% of bank’s available capital base.
  • If a G-SIB (Global systemically Important Banks) shall not exceed exposure limit of 15% of its available capital base in another G-SIB.
  • Principles for measurement of value of exposures.
  • Techniques for mitigation of credit risk.
  • Treatment of sovereign exposures, interbank exposures, exposures on covered bonds collective investment schemes, securitisation vehicles or other structures having underlying assets and in central counterparties been specified.

“Connected” borrowers

A bank shall lend within concentration limits prescribed in the LEF. For this purpose, the aggregate of concentration in all the connected counterparties shall be considered. Basically, connected counterparties are those parties which have such a relationship among themselves, either by way of control or interdependence, that failure of one of them would result in failure of the other too. The LEF provides the following criteria for determining the “connected” relationship between counterparties.

  • Control- where one of the counterparties has direct or indirect control over the other, ‘Control maybe determined considering the following:
    • holding 50% or more of total voting rights
    • having significant influence in appointment of managers, supervisors etc.
    • significant influence on senior management
    • where both the counterparties are controlled by a third party
    • Qualitative guidance on determining control as provided in accounting standards.
    • Common owners, shareholders, management etc.
  • Economic interdependence- where if one of the counterparties is facing problems in funding or repayment, the other party would also be likely to face similar difficulties. Following criteria has to be considered for determining economic interdependence between entities:
    • Where 50% or more of gross receipts or expenditures is derived from the counterparty
    • Where one counterparty has guaranteed exposure of the other either fully or partly
    • Significant part of one counterparty’s output is purchased by the other
    • When the counterparties share the source of funds to repay their loans
    • When the counterparties rely on same source of funding

Look through approach

In case of investing vehicles such as collective investment vehicles, securitisation SPVs and other cases such as mutual funds, venture capital funds, alternative investment funds, investment in security receipts, real estate investment trusts, infrastructure investment trusts etc., the recognition of exposures will be done on a see-through or look-through approach. The meaning of look-through approach is the underlying exposures will be recognised in constituents of the pool or the fund, rather than the fund.

When banks invest in structures which themselves have exposures to underlying assets, the bank shall determine if it is able to look-through the structure. If the bank is able to look-through and the exposure of bank in each of the underlying asset of the structure is equal to or above 0.25% of its eligible capital base, the bank must identify specific counterparties corresponding to the underlying asset. The exposure of bank in each of such underlying assets shall be added to the bank’s overall exposure in the corresponding counterparty.

Further, if the exposure in each of the underlying assets is less than 0.25% of bank’s eligible capital base, the exposure maybe assigned to the structure itself.

However, if a bank is unable to identify underlying counterparties in a structure:

  • bank’s exposure in that structure is 0.25% or more of its eligible capital base, the bank shall assign such exposure in the name of “unknown client”.
  • bank’s exposure in that structure is less than 0.25% of its eligible capital base, the exposure shall be assigned to the structure itself.

However, if the exposure of bank in the structure is less than 0.25% of the eligible capital base of the bank, the total exposure maybe assigned to the structure itself, as a distinct counterparty, rather than looking through the structure and assigning it to corresponding counterparties.

Overall impact of the LEF

The primary objective of LEF is to limit the concentration of bank in a single group of borrowers. By specifying criteria for large exposures, determination of “connected” relationship, reporting to RBI, ways to mitigate risk etc. the LEF intends to reduce credit risk of banks caused due to concentration in a single borrower or a group of borrowers.

The application of provisions of LEF will reduce the concentration risk of banks which in turn would result in reduction of credit risk of the bank. It would also result in increased monitoring by the RBI on the lending practices of banks. It is likely to reduce the instances of default in repayments, which have become a routine practice nowadays.

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=10757&Mode=0

[2] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=11573&Mode=0

[3] https://www.bis.org/publ/bcbs283.pdf

[4] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=9859&Mode=0