Tax dues subservient to dues of secured creditors under SARFAESI Act and RDDB Act

Neha Sinha, Executive, Vinod Kothari & Company

corplaw@vinodkothari.com

Introduction

SARFAESI Act and RDDB Act are specific laws for recovery of debts.  Both these laws provide that  the secured creditors can claim priority for the realisation of dues. On the other hand, State and Central tax authorities can also enforce the payment of tax dues under tax statutes, which often create a statutory first charge in favour of the authorities. This may give rise to situations wherein the secured creditors are competing with the tax authorities in respect of payment of dues. Such competing claims have to be resolved in case of insolvency/deficiency.

A similar situation arose in the case of Jalgaon Janta Sahakari v. Joint Commissioner of Sales.[1] The Division Bench of the Bombay High Court decided on the issue of the conflict between  SARFAESI Act and RDDB Act, and State tax statutes, in respect of priority of claims. The primary that arose in this case was whether State tax authorities can claim priority, by virtue of first charge created under State tax statutes, over a secured creditor for liquidation of their respective dues.

Chapter IV-A of the SARFAESI deals with registration of charges by secured creditors and. Pursuant to section 26D therein,  a secured creditor who has not registered the charge loses his right to enforce the security under SARFAESI. Section 26E, which has a non-obstante clause, accords priority to the secured creditor who has registered the charge in the CERSAI, over “all other debts and all revenue, taxes, cesses and other rates payable to the Central Government or State Government or local authority.” Similarly, section 31B of the RDDB Act gives states that “notwithstanding anything contained in any other law….rights of secured creditors shall have priority and shall be paid in priority over all other debts and Government dues including revenues, taxes, cesses and rates due to the Central Government, State Government or local authority.” Pertinently, the aforesaid provisions in both Acts have a non-obstante clause, having the effect of overriding any other law inconsistent with it.

In the instant case, by virtue of relevant State tax statutes, a first charge was created in favour of State tax authorities. This brings forth the conflict as to who shall have priority in terms of payment-  that State tax authorities with first charge or the secured creditors with the registration of charge in CERSAI?

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Accounting and Tax considerations in Going Concern Sale in Liquidation

By Devika Agrawal, Executive, Vinod Kothari and Company

devika@vinokothari.com

Background

The preamble to the Insolvency and Bankruptcy Code, 2016 (‘Code’) enlists value maximisation as one of its key objectives. In line with the said objective, the Code included ‘Going Concern Sale’ (‘GCS’) of the corporate debtor or the business of the corporate debtor in liquidation, vide the Amendment dated 22nd October, 2018[1] in the Liquidation Process Regulations, as one of the modes of sale. The underlying intent of introducing GCS in liquidation was to maximise value. It was expected that introduction of GCS in liquidation would give a breather and will be looked forward to by Corporate Debtors undergoing liquidation process, however, the statistics presented by the Quarterly Newsletter of the IBBI, for the quarter ended 30th September, 2021[2] give a different view as only six out of the 1419 orders for commencement of liquidation, were closed by a sale as a going concern under liquidation process. For an enhanced understanding of a GCS, our Articles on the topic can be referred to.[3]

One probable reason for lesser use of GCS may be tax considerations attached to such sale, (for example, questions concerning write back of liabilities, continuation of tax benefits, carry forward of losses and unabsorbed depreciation). Besides, given how different GCS in liquidation is from a conventional GCS and a GCS in CIRP, acquirers often face issues in accounting for assets acquired under a GCS in liquidation. Further, there remains uncertainty with respect to the accounting for and recording of transactions. In this article the author attempts to discuss accounting and tax issues in GCS in liquidation.

GCS in liquidation vs. conventional GCS vs. GCS in CIRP

As stated above, it is important to note that a GCS in liquidation is different from a conventional GCS and a GCS in CIRP by way of a resolution plan. The difference lies not just in the circumstances under which a GCS takes place in each of the said three modes but also the manner of treatment of assets, liabilities, profits, losses and share capital. The accounting and tax considerations depend on the same. When one talks about accounting and taxation, it becomes important to see what happens to each component when a transaction takes place.

A snapshot of the treatment of these components under different modes of sale specified above has been tabulated below.

Sl. NoBasisGCS in liquidationConventional GCSGCS by way of a Resolution Plan in CIRP
1.Transfer of liabilitiesAll liabilities are settled from the sale proceeds, in accordance with Section 53. Thereafter, pending liabilities, if any stand extinguished.Liabilities associated with the assets  are transferred to the acquirer.Liabilities are in the form of claims on the CD. They are paid off in a manner provided for in the Resolution Plan as approved by CoC.
2.Valuation of AssetsThe successful auction bidder pays a lump sum, without assigning values to individual assets.   In a GCS in liquidation, the value of assets may be  comparatively lower because it bears the burden of a failed resolution process.The buyer pays a lump sum, without assigning values to individual assets.The buyer pays a lump sum, without assigning values to individual assets.
3.Carry forward of lossesThe benefit of carry forward of losses has not been provided for the purpose of a GCS in liquidation. However, in certain rulings[4], the Hon’ble NCLT has allowed carry forward of losses, but again, subject to approval of IT Authorities. See discussion below.The Income Tax Act, 1961, does not allow carry forward and set off of losses when a business is sold as a going concern.Section 79(2)(c) of the Income Tax Act, provides an incentive to resolution applicants and has allowed the benefit of carry forward losses where a change in shareholding takes place pursuant to a resolution plan. 
4.ProfitsProfits during liquidation, if any, get subsumed in the liquidation estate, and distributed in accordance with section 53.Assets and liabilities are transferred on a particular date.As consented to between CoC and resolution applicant – see para 68 of Committee of Creditors of Essar Steel Limited v. Satish Kumar Gupta (SC).

At this juncture, having discussed the difference between the above mentioned modes of sale, it becomes important to discuss the accounting and taxation concerns which may have become the probable reasons for lesser use of GCS in Liquidation.

Accounting Concerns 

Preparation of books of accounts in liquidation – Obligation of the Liquidator or Auction purchaser?

Section 35 of the Code enlists the duties and powers of the liquidator appointed under the Code, which has to be read with the provisions of the Liquidation Regulations.

Liquidation is a terminal process and as such, it is a settled principle that during the liquidation process, the liquidator does not prepare any balance sheet or profit and loss account.  Instead, reg. 15(3) requires the liquidator to prepare a  receipt and payments account on a cash-basis. Hence, the question of any preparation of profit and loss account or balance sheet does not arise.

However, after a GCS is completed, sale consideration is received and a sale certificate is issued by the liquidator in favour of the auction purchaser, the corporate debtor is transferred to the auction purchaser. At this juncture, an important question that raises its head is, who would be responsible to prepare the books of accounts of the corporate debtor post the completion of a GCS – Liquidator or an Auction purchaser.

Once the sale is completed, it becomes the responsibility of the acquirer to take all the necessary steps viz-a-viz the corporate debtor. It was held in the case of Gaurav Jain Vs. Sanjay Gupta (Liquidator of Topworth Pipes & Tubes Pvt Ltd)[5]:  

“The Corporate Debtor survives, only the ownership is transferred by the Liquidator to the purchaser. All the rights, titles and interest in the Corporate Debtor including the legal entity is transferred to the purchaser. After the sale as a ‘going concern’, the purchaser will be carrying on the business of the corporate debtor.”

Thus, it may be concluded that once the corporate debtor is transferred to the acquirer, it should become the responsibility of the acquirer to prepare the books of accounts and annual financial statements of the Company. The Liquidator remains responsible only for the preparation of the receipts and payments account until the liquidation process is over.

However, the situation can get tricky when GCS takes place in the middle of a financial year. In such a situation, the following questions need to be answered for a smooth completion of GCS of the CD in liquidation.

  • What date should be considered as the date of sale?
  • Who prepares the financial statements for the entire financial year in which the sale takes place?

On the first question, one may note Schedule I of the Liquidation Regulations which states:

“On payment of the full amount, the sale shall stand completed, the liquidator shall execute a Certificate of sale or sale deed to transfer such assets and the assets shall be delivered to him in the manner specified in the terms of sale.”

Hence, ideally, the date on which sale certificate is issued should be taken as the date of sale.

On the second question, say, the sale takes place on 15th January, 2022. Should the acquirer prepare the financial statements for the entire FY 2021-22? Or, should the liquidator provide completed financial statements to the acquirer as on 31st March, 2022?

As indicated earlier, after sale, the responsibility to prepare financial statements, is that of the acquirer. Before sale, the liquidator does not prepare any balance sheet/profit and loss statement. Hence, the acquirer shall prepare financial statements from the period 15th January to 31st March, 2022 to close the accounts of the financial year.

Given how liabilities and assets are dealt with in a GCS in liquidation, the accounting shall be done as follows:

Asset Side:

In a GCS, the buyer pays a lump sum amount as sale consideration, without assigning values to individual assets. Therefore, the valuation of individual assets of the corporate debtor after completion of sale as a going concern shall be the responsibility of the acquirer. The acquirer puts a value on the assets of the corporate debtor, which is his bid price – it may, therefore, spread the purchase consideration paid by him to various assets of the corporate debtor as is commonly done in case of a slump sale.

Liabilities side:

All liabilities of the corporate debtor, including the share capital becomes a claim on the liquidation estate. As such the same are settled in terms of sec. 53 of the Code. Therefore, the question of carryover of any liabilities of the corporate debtor onto the books of the entity, acquired under GCS, does not arise. 

In the matter of Gaurav Jain v. Sanjay Gupta (Supra), it was held by the Hon’ble NCLT, Mumbai bench that,

“The Applicant shall not be responsible for any other claims / liabilities / obligations etc. payable by the corporate debtor as on this date to the Creditors or any other stakeholders including Government dues. All liabilities of the Corporate Debtor as on the date stands extinguished, as far as the Applicant is concerned.”

“Creditors of the corporate debtor which include creditors in any form or category including government departments shall stand extinguished qua the Applicant”

[Emphasis Supplied]

As it has been discussed, there is no case of remission or cessation of liability, as it becomes a claim on the liquidation estate and not the corporate debtor. Thus, the question of writing off liabilities does not arise, let alone the taxability of the same under section 41(1) (a) of the Income Tax Act, 1961.

Note that, in certain cases, by agreement, buyers may take over certain liabilities. In that case, the acquired liabilities too, will appear on the new balance sheet.

Share Capital:

As for the share capital of the Corporate Debtor, the existing shares shall stand cancelled without there being any payment to the shareholders, since such shareholders assume the nature of claimholders upon commencement of liquidation, who shall be paid  in terms of sec. 53 of the Code, only if proceeds from liquidation estate are that sufficient.

As regards recording of capital by the auction purchaser, the corporate debtor issues new shares to the extent of the share capital. It is understood that the consideration received from the acquirer will be split into share capital and liabilities, based on the capital structure that the acquirer decides.

Reference may be drawn from the IBBI Discussion paper dated 27th April, 2019,[6] which discusses the modalities of a GCS and says as follows;

“The consideration received from the sale will be split into share capital and liabilities, based on a capital structure that the acquirer decides. There will be an issuance of shares by the corporate debtor being sold to the extent of the share capital. The existing shares of the corporate debtor will not be transferred and shall be extinguished. The existing shareholders will become claimants front he liquidation proceeds under section 53 of the Code”

[Emphasis Supplied]

Tax Considerations

Tax issues under GCS would arise as a result of confusion surrounding the following:

  • Carry forward and set off of losses and unabsorbed depreciation – Section 115JB and Section 79(2)(c) of Income Tax Act, 1961.
  • Writing off Liabilities

Carry forward and set off of losses and unabsorbed depreciation – Section 115JB and Section 79(2)(c) of Income Tax Act, 1961

  • Carry Forward and set off of losses and unabsorbed depreciation – Section 115JB

Section 115JB of the Income Tax Act, 1961,[7] provides for levy of a minimum alternate tax (MAT) on the “book profits” of a company. For the purpose of computation of book profits, the said section allows a deduction in respect of the amount of loss brought forward or unabsorbed depreciation, whichever is less as per the books of accounts.

However, for companies whose application for CIRP under the Code has been admitted by the AA, a carve out has been provided. Accordingly, an aggregate of unabsorbed depreciation and loss brought forward shall be allowed to be reduced from the book profits, if any.

The Act provides that;

“(iih) the aggregate amount of unabsorbed depreciation and loss brought forward in case of a—

 (A) company, and its subsidiary and the subsidiary of such subsidiary, where, the Tribunal, on an application moved by the Central Government under section 241 of the Companies Act, 2013 (18 of 2013) has suspended the Board of Directors of such company and has appointed new directors who are nominated by the Central Government under section 242 of the said Act;

(B) company against whom an application for corporate insolvency resolution process has been admitted by the Adjudicating Authority under section 7 or section 9 or section 10 of the Insolvency and Bankruptcy Code, 2016 (31 of 2016).”

[Emphasis supplied]

It can be clearly deduced from the provisions of the said section that the above mentioned carve out has been provided specifically for the purpose of a Resolution Plan during CIRP and not for a GCS in liquidation. 

  • Carry forward of losses – Section 79(2)(c)

Additionally, Section 79(2)(c) of the Income Tax Act, 1961 (‘Act’)[8], provides that the benefit carry forward of loss cannot be taken where there has been a change in shareholding. However, to provide an incentive to resolution applicants, the Income Tax Act has allowed the benefit of carry forward losses where such change in shareholding takes place pursuant to a resolution plan. 

However, no such exemption has been provided for the purpose of a GCS in liquidation. Hence, there exists uncertainty w.r.t the same. At this juncture, reliance may be drawn to certain NCLT rulings[9], wherein such benefit has been allowed by the Adjudicating Authority, subject to the approval by the concerned Income Tax Authorities under the relevant provisions of the Act.

Conclusion

While the process w.r.t. conduct of GCS has been explained by the Liquidation Regulations, the above discussed points have not been explicitly mentioned or ascribed in any guidance note or standards. Due to these uncertainties, these questions have often been subject to litigation, which leads to further delays. Hence, the need of the hour is a clear set of rules and standards, addressing the questions discussed above, as a result of which GCS is expected to gain further traction and deliver better results.


[1] The Insolvency and Bankruptcy Board of India (Liquidation Process) (Second Amendment) Regulations, 2018

[2] IBBI Quarterly Newsletter, July – September, 2021

[3] Enabling Going Concern sale in Liquidation – by Resolution Service Team, Vinod Kothari & Company

  Liquidation sale as a Going Concern – The concern is Dead, Long Live The Concern, authored by Vinod Kothari

  Concerns on Going Concern Sale under IBC – to be or not to be, authored by Parth Ved

  Sale of Legal Entity as an asset: A step towards value maximisation, authored by Megha Mittal

[4]Nitin Jain Liquidator of PSL Limited vs. Lucky Holding Private Limited

[5] Gaurav Jain (Supra)

[6] Discussion Paper dated 27th April, 2019

[7] Section 115JB of Income Tax Act, 1961

[8] Section 79 of the Income Tax Act, 1961

[9] Gaurav Jain (Supra)

Nitin Jain Liquidator of PSL Limited vs. Lucky Holding Private Limited

Can companies avail GST benefits on CSR spending?

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

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

Background

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

Input Tax Credit

Eligibility

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

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

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

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

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

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

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

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

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

Contrary ruling: Free Supply of Goods

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

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

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

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

Availing Benefit through Beneficiary

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

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

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

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

CSR Contribution: Pre-GST or Post-GST?

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

Conclusion

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

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Our other resources on related topics –

  1. https://vinodkothari.com/2020/03/buy-back-of-shares-during-covid-19-pandemic/
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Are financial leases subjected to TDS?

Yutika Lohia

yutika@vinodkothari.com 

Introduction

In today’s time, leasing has become an indispensable element of businesses – Any and every asset movable or immovable, equipment or software can be taken on lease. Colloquially, lease refers to an arrangement where a property owned by one is given for use by another, against regular rentals. In India, there are two types of lease transactions-financial lease and operating lease. Typically, a financial lease is a disguised financial transaction whereas operating lease is akin to rental contracts.

While leasing has gained much importance and relevance over the years, its feasibility and viability depends a major deal on its tax implications – they could easily make or break the deal. The technical aspects with respect to taxation on implementation makes it all the more significant.   Issues like depreciation, lease rentals, tax deduction at source and exposure to GST are key concerns. Further, though leases are classified as finance or operating, it is important to note that such distinction is essentially from an accounting perspective – the Income Tax Act, 1961, however, does not distinguish between the two.

A rather significant but overlooked aspect of leasing is the ‘tax deduction at source’ (‘TDS’). As is known TDS is a key element of the Indian taxation framework which aims to collect tax at the source of generation of income. In case of a lease transaction, the lessee is required to deduct tax under 194-I of the Income Tax Act at the time of payment of lease rentals to the lessor.

While there are several judicial precedents dealing with TDS vis-à-vis lease transactions, the Hon’ble High Court of Karnataka in a recent order, in the case of Commissioner of Income Tax vs. Texas Instruments India Pvt Ltd (2021),[1] concluded that in case of a financial lease, the lease financing company did not provide any particular service as a driver or otherwise for the purpose of usage of the car. The only transaction entered between the assessee and the lease financing company was to make payments of the amount due to the company. To say there was a mere financing arrangement and therefore section 194-I of the IT Act shall not be applicable in case of a financial lease transaction.

In this article we shall discuss the above stated ruling in detail.

The case of Texas Instruments India Pvt Ltd

The Assessee, Texas Instruments India Pvt Ltd being in the business of manufacture and export of computer software had taken motor vehicle on finance lease for its employees. It considered the lease rentals as business expenditure and claimed deduction of the same under the head income from business and profession. TDS was not deducted on the finance lease rentals as the assessee contested that the same did not fall under the provision of section 194-I or 194-C of the IT Act.

However, the Assessing Officer disallowed the claimed expenditure on the grounds that the lease rentals were being paid to the vendor under the contract and therefore the payment/ expenses would be attracting the provisions of section 194-C.

Aggrieved by the order of the A.O., the Assessee preferred an appeal before to the CIT(A). Upon such appeal, the CIT(A) overturned the A.O’s order and held that the payments made by assessee were not in the nature of service rendered by the leasing company for the carriage of goods or passengers. The CIT(A) also held that the assets were in the disposition of the Assessee.

Following such order, the matter was appealed before the Income tax Appellate Tribunal (ITAT) where it was held that provisions of Section 194-C will not be applicable on lease rentals.

Once again, the matter was taken for appeal before the Hon’ble Karnataka High Court where it was held that the leasing financing company did not provide any particular service as a driver or otherwise for the purpose of usage of car. The maintenance was carried by the employees of the assessee. The only transaction entered between the assessee and the leasing company was to make payments of the amount due to the company. Since no services were being provided by the leasing company and is a mere financing agreement, provisions of section 194-C and 194-I shall not be applicable.

Understanding the Provisions of Law

Section 194-I of the Income Tax Act, 1961: TDS on Rent

Section 194-I of the IT Act 1961 governs tax deduction at source in case of lease rentals. As already mentioned, Income Tax Act does not draw any line of distinction between financial lease and operating lease, let us understand whether TDS needs to deducted on lease rentals in case of both financial lease and operating lease.

Section 194-I of the IT Act explains rent as follows:

“rent” means any payment, by whatever name called, under any lease, sub-lease, tenancy or any other agreement or arrangement for the use of (either separately or together) any

(a)  land; or

 (b)  building (including factory building); or

 (c)  land appurtenant to a building (including factory building); or

 (d)  machinery; or

 (e)  plant; or

 (f)  equipment; or

 (g)  furniture; or

 (h)  fittings,

whether or not any or all of the above are owned by the payee;

Rent has been broadly defined under section 194-I and shall be applicable when asset is given for use for any payment under lease, sub lease, tenancy, or any other arrangement or agreement.

Section 194-C of the Income Tax Act, 1961: Payment to contractors

(1) Any person responsible for paying any sum to any resident (hereafter in this section referred to as the contractor) for carrying out any work (including supply of labour for carrying out any work) in pursuance of a contract between the contractor and a specified person shall, at the time of credit of such sum to the account of the contractor or at the time of payment thereof in cash or by issue of a cheque or draft or by any other mode, whichever is earlier, deduct an amount equal to—

 (i)  one per cent where the payment is being made or credit is being given to an individual or a Hindu undivided family;

(ii)  two per cent where the payment is being made or credit is being given to a person other than an individual or a Hindu undivided family,

of such sum as income-tax on income comprised therein.

XX

Conclusion

The judgement highlights that by virtue of the fact that no services were provided by the leasing company and that it was a mere financing agreement, section 194-C and 194-I would not be applicable in the given case.

Therefore, it seeks attention on the fact whether TDS has to be deducted on financial lease rentals.

Also, one must contemplate whether TDS should have been deducted under section 194-A of the IT Act as the lease transaction was considered as a mere finance agreement. This remains unanswered.

 

 

 

 

 

 

 

[1] https://indiankanoon.org/doc/59654437/

Complete Guide to Sale and Leaseback Transactions

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

 

– Qasim Saif (finserv@vinodkothari.com)

 

Contents

Sale and Leaseback transaction. 2

Advantages to the Lessee. 2

Unlocking value, the hidden value of asset 2

Tax Benefits. 2

Legal issues in SLB: 3

Taxation of SLB transactions. 3

Direct Tax Aspect 3

Goods & Service Tax. 5

The Sale. 5

The Lease. 5

Place of supply. 6

Disposal of Capital Asset 6

Example of GST Calculations on Sale and Leasebacks. 6

Sale of Asset 7

Leasing of asset 7

Accounting of Sale and leasebacks. 7

Criteria for Sale. 8

Transfer of asset does not qualify as sale. 10

Transfer of asset qualifies as sale. 10

Sale at Fair Value. 10

Sale at a discount or premium.. 10

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

Calculations. 11

Rental Schedule. 11

Accounting Entries at Inception. 12

 

Sale and Leaseback transaction

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

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

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

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

Advantages to the Lessee

Unlocking value, the hidden value of asset

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

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

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

Tax Benefits

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

Legal issues in SLB:

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

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

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

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

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

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

Taxation of SLB transactions

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

Direct Tax Aspect

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Goods & Service Tax

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

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

The Sale

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

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

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

The Lease

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

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

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

Place of supply

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

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

Disposal of Capital Asset

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

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

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

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

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

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

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

Example of GST Calculations on Sale and Leasebacks

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

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

(GST @ 18%)

Sale of Asset
Disposal of assets

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

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

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

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

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

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

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

Leasing of asset

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

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

Accounting of Sale and leasebacks

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

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

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

Criteria for Sale

IFRS 16/Ind AS 116 state that

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

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

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

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

The para states that:

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

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

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

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

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

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

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

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

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

Transfer of asset does not qualify as sale

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

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

Transfer of asset qualifies as sale

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

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

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

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

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

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

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

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

Sale at a discount or premium

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

These adjustments would be as follows:

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

Example of Sale and Leaseback Accounting under Ind AS 109

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

Calculations

 

Particular Amount Remarks
Sale considerations ₹ 10,00,000.00
Carrying Amount ₹ 5,00,000.00
Term 15 year
Rentals/year ₹ 80,000.00 year
Fair Value of Building ₹ 9,00,000.00
Incremental borrowing rate 10%
PV of rentals ₹ 6,08,486.36
Additional Financing ₹ 1,00,000.00 Sale Consideration
– Fair Value
Payments towards Lease Rentals ₹ 5,08,486.36 PV of Rentals
– Additional Financing
Ratio of PV of rentals and
Payment towards lease Rentals
16%
Yearly payments towards Add. Financing ₹ 13,147.38 Rental X Ratio
Yearly payments towards Lease Rental ₹ 66,852.62 Rental – Payment toward Add. Fin.
ROU of Asset ₹ 2,82,492.42 Carrying Amount X
[Payments towards Lease Rentals/Fair Value of Building]
Total Gain on sale ₹ 4,00,000.00 Fair Value – Carrying Amount
Gain recognised Upfront ₹ 1,74,006.06 Total Gain X [(Fair Value of Building-Payments towards Lease Rentals)
/Fair Value of Building]

 

Rental Schedule

 

NPV NPV
₹ 5,08,486.36 ₹ 1,00,000.00
Year Lease Rentals Additional Financing
0
1  ₹ 66,852.62  ₹ 13,147.38
2  ₹ 66,852.62  ₹ 13,147.38
3  ₹ 66,852.62  ₹ 13,147.38
4  ₹ 66,852.62  ₹ 13,147.38
5  ₹ 66,852.62  ₹ 13,147.38
6  ₹ 66,852.62  ₹ 13,147.38
7  ₹ 66,852.62  ₹ 13,147.38
8  ₹ 66,852.62  ₹ 13,147.38
9  ₹ 66,852.62  ₹ 13,147.38
10  ₹ 66,852.62  ₹ 13,147.38
11  ₹ 66,852.62  ₹ 13,147.38
12  ₹ 66,852.62  ₹ 13,147.38
13  ₹ 66,852.62  ₹ 13,147.38
14  ₹ 66,852.62  ₹ 13,147.38
15  ₹ 66,852.62  ₹ 13,147.38

 

Accounting Entries at Inception

 

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

 

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

Employee share based payments: Understanding the taxation aspects

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

Introduction

Employee share based payments (ESBPs) are an effective way of incentivising employees. ESBPs work as a two way growth strategy for both company as well as the employees. On one hand, it helps the employees to participate in the growth of the entity and in turn reap out the benefits from it, on the other hand it helps the entity to boost the growth rate and align the vision of the employees with that of the company. The ESBPs work as a catalyst for the employee growth as well as the growth of the company.

The theme of this article revolves around the taxation aspects of different types of ESBPs, but before we proceed further, let us have a quick understanding about the different types of ESBPs. Read more

Whether burden shared by captives comes under GST?

Extended clarification required

-Yutika Lohia

yutika@vinodkothari.com

Introduction

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

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

The case of Daimler Financial Services India Private Limited

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

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

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

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

The following points were put up by the department:

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

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

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

The law behind interest subvention

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

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

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

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

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

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

Conclusion

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

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

 

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

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

Applicability of GST on penal charges

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

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