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

/0 Comments/in , , , , /by

Team Finserv (finserv@vinodkothari.com)

Introduction 

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

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

The issue

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

The analysis

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

Does it qualify as a Supply?

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

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

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

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

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

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

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

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

Excess interest retained not in the nature of commission or brokerage 

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

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

Conclusion

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

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

Our other resources on this topic:

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

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

/0 Comments/in , , /by

Mahak Agarwal | corplaw@vinodkothari.com

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

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

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

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

GST on Corporate Guarantees: Understanding the new regime

/0 Comments/in , , , /by

–  Payal Agarwal, Associate | corplaw@vinodkothari.com


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


Effective date of the amendment


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


Understanding the terminology


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


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


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


Value of supply of corporate guarantee for related persons


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


  • As per the deemed value of the supply

  • As per invoice value of the supply

  • As per determination by the tax officer

The below chart summarises the same:


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


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


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


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


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



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

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

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

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


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


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


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


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


Persons eligible for full ITC

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


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


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


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


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


Applicability of deemed value on FLDG arrangements


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


Conclusion


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


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


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


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


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


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


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

Interest Imbalance: Will the disproportionate interest Split in Loan Transfers be liable to withholding tax?

/0 Comments/in , , , , /by

ITAT Ruling Clarifies Taxation on Disproportionate Interest share in Loan Transfers

– Dayita Kanodia | Finserv@vinodkothari.com

Direct Assignment of a loan or transfer of loan exposures refers to the process where financial institutions, such as banks, purchase a pool of loans or assets from other entities, typically NBFCs, without the involvement of a third-party intermediary. In this arrangement, the buying institution directly acquires the ownership of the loans or assets and the associated rights, including the right to receive future payments from the borrowers. This method allows the selling NBFC to offload its loans, thereby freeing up capital, while the purchasing institution gains the opportunity to enhance its loan portfolio and earn interest income from the acquired loans. This Direct Assignment is essentially what is popularly known as the transfer of loan exposure.

The RBI issued the transfer of loan exposures directions in 2021 regulating all transactions among regulated entities involving transfer of loan exposures.

Interest sharing and servicing after the transfer

Pursuant to a transfer of loan, it is not necessary that the future interest income arising from the loans would be shared in the same proportion as that of the transfer. For instance, if an NBFC assigns 90% of the loan portfolio to a bank, there is no mandate that all interest income received in the future would be shared in the same proportion of 90:10. Generally, the borrower is not made aware of the transfer and therefore it is important that the NBFC continues to service the loan. In such cases it is only fair that the NBFC gets a higher proportion of interest. Accordingly, it is quite common in direct assignment transactions to have a disproportionate interest share. 

The question which now arises is whether this excess interest income retained by the NBFC would be taxable under the provisions of the income tax act. 

ITAT Ruling and taxation on disproportionate interest share in loan transfers

A recent ITAT ruling of May 7, 2024 clarifies the taxation treatment for disproportionate interest share in case of loan transfers. In this case, NBFC assigned 90% of the loan portfolio to a bank via the direct assignment route. However, the bank was not receiving the entire interest on the 90% loan assigned but was only entitled to a fixed percentage of share while the NBFC retained the excess interest. Accordingly, the revenue department was of the view that the assessee was responsible to deduct TDS on the excess interest allowed to be retained by the NBFC under section 194A of the Income Tax Act. 

The revenue department further raised the question on deduction of TDS under SEction 194J and 194H of the Income Tax Act. 

Interest Retained not a result of money borrowed or debt incurred by the transferee

For the deciding the fate of the NBFC under section 194A of the Income Tax Act, the following was observed by the ITAT:

  1. For TDS to be deducted under section 194A of the Income Tax Act, the crucial aspect to be satisfied was whether the part interest allowed to be retained by the originating NBFC by the bank is payment in the nature of interest to the NBFC for any money borrowed or debt incurred by the bank.
  1. It was acknowledged that the 90% of the loan portfolio was assigned to the bank and consequently any default among the assigned loans would result in loss to the bank. 
  1. Any amount collected from the borrowers was initially getting deposited in an escrow account and was subsequently distributed between the NBFC and the bank in accordance with the agreement entered into by the entities. 
  1. It could not be shown that the interest allowed to be retained with the NBFC was a result of any money borrowed or debt incurred by the bank from the NBFC. 
  2. Accordingly, the assessee was under no obligation to deduct TDS on the excess interest retained by the NBFC under section 194A. 

Interest retained not in the nature of fees for any professional / technical services rendered by the transferor

The next issue which was adjudicated in the case was whether the interest allowed to be retained with the NBFC was a consideration for rendering professional / technical services by the transferor NBFC to the transferee bank. 

As per section 194J of the Act, any person, not being an individual or HUF, who is responsible for paying to a resident any sum, inter alia, by way of fees for professional services or fees for technical services shall at the time of credit of such sum to the account of payee deduct tax at source.

For this purpose the ITAT observed the following:

  1. The NBFC and the Bank entered into a tripartite service agreement pursuant to which the originating NBFC was appointed as servicer for the loans. The NBFC was therefore responsible for managing, collecting and receiving payment of the receivable and depositing the same in the ‘Collection and Payout Account’ to enable the distribution of the payout therefrom and providing certain other services.
  1. As per the service agreement, a one time service fee of Rs.1 Lakh was agreed to be payable by the bank to the NBFC as consideration for the services rendered.
  1. The ITAT brushed aside the contention of the revenue department that service fee of Rs 1L was inadequate and the excess interest allowed to be retained by the NBFC should in fact be considered as fee for rendering the services by the transferor NBFC. 
  1. There was a separate tripartite Deed of Assignment of receivables entered into by the parties according to which the bank paid the entire principal amount equivalent to 90% of the entire pool to the NBFC upfront. However, it was observed that the transfer being an independent commercial transaction cannot be on a cost to cost basis without there being any markup.
  1. Accordingly, the bank opted to pay the consideration for the loans assigned partially by way of an upfront payment equivalent to the principal amount of the loan assigned to it and partly by agreeing to earn a lower rate of interest on its portion of assigned loans and allowing the NBFC to retain the part interest received from the borrower.
  1. Therefore the liability under section 194J of the Income Tax Act was only for the service fee of Rs.1 L and cannot be extended to the excess interest share retained by the NBFC.
  1. Accordingly, the assessee was under no obligation to deduct TDS on the excess interest share retained by the NBFC under section 194J of the Income Tax Act. 

Interest retained not in the nature of commission / brokerage

The last issue in this case to be decided before the ITAT was whether the retained interest would fall in the category of commission or brokerage and was liable to TDS under section 194H of the Income Tax Act. 

As per section 194H of the Act, any person, not being an individual or HUF, who is responsible for paying to a resident, any income by way of commission or brokerage, shall at the time of credit of such income to the account of the payee deduct tax.

For determining the tax treatment under this section, the ITAT observed the following:

  1. It could not be said that the loans originated by the NBFC were on behalf of the bank.
  1. For the services rendered by the NBFC, it was observed that the same was pursuant to a separate service agreement which provides for payment of separate service fees in lieu of such services.
  1. Accordingly, it cannot be contended that the transferor NBFC was acting as an agent of the transferee bank.
  1. Accordingly, the liability to deduct TDS on the excess interest retained by the NBFC under section 194H of the Income Tax Act does not arise. 

Concluding Remarks 

In conclusion, the recent ITAT ruling has provided significant clarity on the taxation treatment of disproportionate interest shares in loan transfers, particularly in the context of Direct Assignment transactions. 

In this case, the ITAT emphasized that the interest retained by the NBFC was not a result of any money borrowed or debt incurred by the bank. Additionally, it was clarified that the interest retained did not constitute fees for professional or technical services rendered by the transferor NBFC, nor did it fall within the ambit of commission or brokerage.

As the financial landscape continues to evolve, such judicial pronouncements play a crucial role in fostering transparency, compliance, and fairness in taxation.

The iSAFE option to start up funding: Legality and taxation

/0 Comments/in , , /by

Mahak Agarwal | corplaw@vinodkothari.com

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

Origin

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

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

Read more →

Securing the Beat: Tuning into Music Royalty Securitization

/0 Comments/in , , , /by

Dayita Kanodia | finserv@vinodkothari.com

“Music can change the world”

–Ludwig van Beethoven

This quote by Beethoven remains relevant today, not only within the music industry but also in the realm of finance. In the continually evolving landscape of finance, innovative strategies emerge to monetize various assets. One such groundbreaking concept gaining traction in recent years is music royalty securitization. This financial mechanism offers investors a unique opportunity to access the lucrative world of music royalties while providing artists and rights holders with upfront capital.

The roots of this innovative financing technique can be traced back to the 1990s when musician David Bowie made history by becoming the first artist to securitize his future earnings through what became known as ‘Bowie Bonds’. This move not only garnered attention but also paved the way for other artists to follow suit. Bowie Bonds marked a significant shift in how music royalties are bought, sold, and traded.

As per the S&P Global Ratings[1], the issuance of securities backed by music royalties totaled nearly $3 billion over the two-year span 2021-22. The graph below shows a recent surge in issuance of securities backed by music royalties.

Data showing the growth of Music Royalty Securitization

This article discusses music royalty securitization, its mechanics, benefits, challenges along with implications for the music industry.

Understanding Music Royalties:

Before exploring music royalty securitization, it’s essential to understand the concept of music royalties. In the music industry, artists and rights holders earn royalties whenever their music is played, streamed, downloaded, or licensed for use. These royalties are generated through various channels, including digital platforms, radio, TV broadcasts, live performances, and synchronization licenses for commercials, movies, and TV shows. However, it’s important to note that artists only earn royalties when their music is utilized, whether through sales, streaming, broadcasting, or live performances.

As a result, the cash flows from these royalties being uncertain are received over time and continue to be received for an extended period. Consequently, artists experience a delay in receiving substantial amounts from these royalties, sometimes waiting for several years before seeing significant income.

The Birth of Music Royalty Securitization:

Securitization involves pooling and repackaging financial assets into securities, which are then sold to investors. The idea is to transform illiquid assets, such as mortgage loans or in our case, music royalties, into tradable securities. Music royalty securitization follows a similar principle, where the future income generated from music royalties is bundled together and sold to investors in the form of bonds or other financial instruments.

Future Flows Securitization:

Music royalty securitization is a constituent of future flows securitization and therefore before discussing the constituent, it is important to discuss the broader concept of future flows securitization.

Future flows securitization involves the securitization of future cash flows derived from specific revenue-generating assets or income streams. These assets can encompass a wide range of future revenue sources, including export receivables, toll revenues, franchise fees, and other contractual payments, even future sales. By bundling these future cash flows into tradable securities, issuers can raise capital upfront, effectively monetizing their future income. Future flows securitization differs from the traditional asset backed securitization by their very nature as while the latter relates to assets that exist, the former relates to assets that are expected to exist. There is a source, a business or infrastructure which already exists and which will have to be worked upon to generate the income. Thus, in future flows securitization the income has not been originated at the time of securitization. The same can be summed up as: In future flow securitization, the asset being transferred by the originator is not an existing claim against existing obligors, but a future claim against future obligors.

Mechanics of Music Royalty Securitization:

Music royalty securitization involves packaging the future income streams generated by music royalties into tradable financial instruments. The process begins with the identification of income-generating assets, which are then bundled into a special purpose vehicle (SPV). The SPV issues securities backed by these assets, which are sold to investors. The revenue generated from the underlying music royalties serves as collateral for the securities, providing investors with a stream of income over a specified period.

The process of music royalty securitization typically involves several key steps:

Asset Identification: Rights holders, such as artists, record labels, or music publishers, identify their future royalty streams eligible for securitization.

Valuation: A valuation is conducted to estimate the present value of the anticipated royalty income streams. Factors such as historical performance, market trends, and artist popularity are taken into account.

Selling the future flows: The future flows from royalties are then sold off to the Special Purpose Vehicle (SPV) to make them bankruptcy remote. The sale entitles the trust to all the revenues that are generated by the assets throughout the term of the transaction, thus protecting against credit risk and sovereign risk as discussed later in this article.

Structuring the Securities: These future cash flows are then structured into securities. This may involve creating different tranches with varying levels of risk and return.

Issuance: The securities are then issued and sold to investors through public offerings or private placements. The proceeds from the sale provide upfront capital to the rights holders.

Revenue Collection and Distribution: The entity responsible for managing the securitized royalties collects the revenue from various sources which is then distributed to the investors according to the terms of the securities.

Importance of Over-collateralization:

Over-collateralization is an important element in music royalty securitization. In music royalty securitization and in all future flows transactions in general, the extent of over-collateralization as compared to asset backed transactions is much higher. The same is to protect the investors against performance risk, that is the risk of not generating sufficient royalty incomes. Over-collateralization becomes even more important since subordination structures generally do not work for future flow securitizations. This is because the rating here will generally be capped at the entity rating of the originator.

Why go for securitization ?

Now the question may arise as to why an artist or a right holder of a royalty has to go for securitization of his music royalties in order to secure funding. Why cant he simply opt for a traditional source of funding ? The answer to this question is two folds: 

Firstly, the originator in the present case generally has no collateral to leverage and hardly there will be a lender willing to advance a loan based on assets that are yet to exist. 

Secondly even if they are able to obtain funding it will be at a very high cost due to high risk the lender perceives with the lending. 

Music royalty securitization, could be his chance to borrow at a lower cost. The cost of borrowing is related to the risks associated with the transaction, that is, the risk the lender takes on the borrower. Now, this risk includes performance risk, that is the risk that the work of the originator does not generate enough cash flows. While this risk holds good in case of securitization as well, it however takes away two major risks – credit risk and sovereign risk. 

Credit risk, as divested from the performance risk would basically mean that the originator has sufficient cash flows but does not pay it to the lender. This risk can be removed in case of a securitization by giving the SPV a legal right over the cash flow. 

Sovereign risk on the other hand emanates only in case of cross-border lending. This risk arises when an external lender gives a loan to a borrower whose sovereign later on in the event of an exchange crises either imposes a moratorium on payments to external lenders or may redirect foreign exchange earnings. This problem is again solved by giving the SPV a legal right over the cash flows from the royalties arising in countries other than the originator’s, therefore trapping cash flow before it comes under the control of the sovereign. 

The lack of these two types of risks might reduce the cost of borrowing for the originator; thus making music royalty securitization a lucrative option.   

Accounting Treatment:

As discussed, there is no existing asset in a music royalty transaction. In terms Ind AS 39, an entity may derecognize an asset only when either the contractual rights to the cash flows from the financial asset have expired or if it transfers the financial asset. However, here asset means an existing asset and a future right to receive does not qualify as an asset in terms of the definition under Ind AS 32.

Accordingly, the funding obtained through the securitization of music royalties should be shown as a liability in books as the same cannot qualify as an off-balance sheet funding.               

Regulatory Framework in India:

It is crucial to discuss the applicable regulatory framework on securitization currently prevalent in India and whether music royalty securitization would fall under any of these:

  1. Master Direction – Reserve Bank of India (Securitization of Standard Assets) Directions, 2021(‘SSA Master Directions)
  2. SEBI (Issue and Listing of Securitised Debt Instruments and Security Receipts) Regulations, 2008 (SDI Framework)    
  3. Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002  

While the SSA Master Directions primarily pertain to financial sector entities, and will not directly apply to this domain; however, there exists a possibility that the securitization of music royalties could fall under the purview of SEBI’s SDI Framework.

The same has been discussed in detail in the artcile- The Promise of Predictability: Regulation and Taxation of Future Flow Securitization                                                                                                                                                           

Benefits of Music Royalty Securitization:

Music royalty securitization offers a range of benefits for both investors and rights holders:

Diversification: Investors gain exposure to a diversified portfolio of music royalties, potentially reducing risk compared to investing in individual songs or artists.

Steady Income Stream: Music royalties often provide a stable and predictable income stream, making them attractive to income-oriented investors, such as pension funds and insurance companies.

Liquidity: By securitizing music royalties, rights holders can access immediate capital without having to wait for future royalty payments, providing liquidity for new projects or business expansion.

Risk Mitigation: Securitization allows rights holders to transfer the risk of fluctuating royalty income to investors, providing a hedge against market uncertainties and industry disruptions.

Challenges and Considerations:

While music royalty securitization presents compelling opportunities, it also poses certain challenges and considerations:

Market Volatility: The music industry is subject to shifts in consumer preferences, technological disruptions, and regulatory changes, which can impact the value of music royalties.

Due Diligence: Thorough due diligence is essential to assess the quality and value of music assets, including considerations such as copyright ownership, market demand, and revenue potential.

Potential Risks:

  • Market Risk: Changes in consumer behavior, technological advancements, or regulatory developments could impact the value of music royalties.
  • Legal Risk: Disputes over ownership rights, copyright infringement, or licensing agreements could lead to litigation and financial losses.
  • Concentration Risk: Investing in a single music catalog or genre exposes investors to concentration risk if the popularity of that catalog or genre declines.
  • Cash Flow Variability: While music royalties can provide steady income, fluctuations in streaming revenues or changes in licensing agreements may affect cash flow stability.
  • Reputation Risk: The success of music royalty securitization depends on the ongoing popularity and commercial success of the underlying music assets. Negative publicity, controversies, or declining relevance can adversely affect investor confidence and returns.

Implications for the Music Industry:

While music royalty securitization presents exciting opportunities, it also raises certain considerations for the music industry:

Artist Empowerment: Securitization can empower artists by providing them with alternative financing options and greater control over their financial destiny.

Industry Evolution: The emergence of music royalty securitization could reshape the traditional music business model, fostering innovation and collaboration between artists, labels, and investors.

Way Forward

Music royalty securitization offers a compelling investment opportunity for investors seeking exposure to the lucrative music industry. By securitizing future royalty streams, music rights owners can unlock liquidity while providing investors with access to a diversified portfolio of music assets.

As the music industry continues to evolve, music royalty securitization is likely to play an increasingly prominent role in the financial landscape, providing new avenues for capital deployment and revenue generation. It has the potential to transform the rhythm of creativity into the melody of investment opportunity.

See also our article on:

  1. Securitization of future flows
  2. Bowie Bonds: A leap into future by a 20th century singer

[1] https://www.spglobal.com/ratings/en/research/articles/240220-abs-frontiers-music-royalty-securitizations-are-getting-the-band-back-together-13003585

[2] https://incometaxindia.gov.in/Pages/acts/income-tax-act.aspx

[3] https://www.rbi.org.in/scripts/bs_viewmasdirections.aspx?id=12165

[4] https://www.sebi.gov.in/sebiweb/home/HomeAction.do?doListingAll=yes&search=Securitised%20Debt%20Instruments

[5] https://www.indiacode.nic.in/bitstream/123456789/2006/1/A2002-54.pdf

Finance Ministry to modernize the Indian Stamp Act

/0 Comments/in , /by

Archana Kejriwal | corplaw@vinodkothari.com

The Ministry of Finance, Government of India, through its Department of Revenue, has issued a draft Indian Stamp Bill, 2023[1] on 17th January, 2024 inviting public comments and suggestions within 30 days, with an intent to align it with the modern stamp duty regime. Once enacted, the Bill seeks to replace the Indian Stamp Act, 1899[2].

The Indian Stamp Act, 1899 is a fiscal legislation enacted for the purpose of generating revenue to the Government. Being enacted during the British era, the Act has undergone several amendments from time to time, however, most of the provisions still stand redundant, for instance, proviso under section 8(2) of the Act provides for the treatment of stamp duty on bonds, debentures or other securities issued by the local authority prior to 26th March, 1897, the Act at several places uses denomination of money in ‘anna’ which has no role in the present. Such transitional provisions hold no stand anymore, thus may be removed. Therefore, it has been proposed to modernise the legislation to enable it to deal with the present realities and objectives.

 In this article, we have made an attempt to analyse the changes proposed.

Read more →

Shorn of tax benefit, MLDs now face tax deduction on payouts

/0 Comments/in , , /by

Dayita Kanodia | Executive

finserv@vinodkothari.com

Background

The Finance Bill, 2023[1], has quite nearly caused the demise of the so-called “Market-Linked Debentures” (MLDs)[2]. The changes made pursuant to the Finance Bill, 2023, took away what seemed to be a strong reason for popularity of MLDs, i.e., the tax arbitrage.

Prior to the change, listed MLDs had the advantage of being exempt from the withholding tax under section 193 of the Income Tax Act, 1961, as well as being taxed at 10% as Long Term Capital Gains (LTCG) tax, if held for at least 12 months.

Finance Bill, 2023 inserts a new section 50AA to the Income Tax Act, 1961, which makes MLDs to be taxed at slab rates as a short term capital asset in all cases at the time of  transfer or redemption on maturity, irrespective of the period of holding, therefore losing out on the earlier lower LTCG rate of 10%.

In addition, the earlier exemption from withholding tax on listed debentures has now been removed pursuant to an amendment in section 193, which means that interest paid on listed debentures would now be subject to withholding tax with effect from April 01, 2023[3].

Read more →

Taxation in Securitisation: A judicial overview

/0 Comments/in , , /by

-Anirudh Grover, Executive | finserv@vinodkothari.com

Introduction

Securitization transactions in India post the pandemic has seen significant improvement with volumes growing by 70% to Rs. 73000 crores in FY 2023 compared to Rs. 43000 crores in FY 2022.[1] This growth was also highlighted in one of our recent write up wherein it can be seen from the data laid down that despite the global slowdown in the world economy on account of the pandemic, the volume of securitization transactions in India gained a lot of popularity. Given the impetus of this fundraising mode, it is important to have a vibrant securitization market. This can be only achieved if the governing framework with respect to taxation does not impose an additional taxation burden on the parties. Through this article, the writer will be reviewing the stance of various courts by highlighting the principles with respect to the taxation of the parties involved in a securitization framework i.e. Originator, Special Purpose Vehicle(‘SPV’), and the Investors. For a better understanding of the framework of securitization, the readers can also refer to our Article on Securitization: A Primer.

Read more →

Market-linked debentures: Is it the end of the market for them?

/4 Comments/in , , , /by

– Aanchal Kaur Nagpal, Manager | finserv@vinodkothari.com

Tax proposal to tax gains on MLDs as short-term capital gains

The Budget proposes that the capital gains on market linked debentures (MLDs) will be taxed as short term capital gain.

Presently, MLDs are mostly listed, and as listed securities they have 2 advantages:

  • First , there are exempt from withholding tax. This is one of the carve-outs in sec. 193
  • Secondly, the holding period for capital gain purposes is 12 months,  as opposed to 36 months in case of normal capital assets. This comes from sec. 2 (42A) of the Act. Therefore, if a listed security is held for at least 12 months, and transferred or redeemed thereafter, the gain will be taxed as long term capital gain, with a rate as low as 10%.

Market linked debentures is a concept that prevails world-over, with different names such as equity-linked bonds, index-linked bonds, etc. However, in India, the issuance of MLDs was being exploited as a regulatory and tax arbitrage device.

Read more →