Co-Lending and GST: Does the relationship between co-lenders constitute a supply that may be subject to GST?
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:
GST on Corporate Guarantees: Understanding the new regime
– 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/
Loan Penal Charges: Accounting and GST implications
Abhirup Ghosh, Qasim Saif & Aanchal Kaur Nagpal | finserv@vinodkothari.com
Background
Levying of penal charges or late payment charges are claimed as ‘just’, owing to the underlying breach of contract under the Contract Act, 1972. A breach or a non-performance by one party entitles the other party to receive compensation for any loss or damage suffered due to such breach. Penalties may not only be compensatory; they also have a deterrent element.
In order to ensure compliant behaviour, lenders charge penalties to their borrowers for various ‘events of default’; the predominant ones being penalty for delayed payments (in the form of charges or interest) and prepayment penalties. However, such charges stopped being ‘just’ and ‘reasonable’ when lenders started maneuvering such penalties as revenue enhancement tools, rather than as a deterrent measure and compensation for a breach. Such unreasonable penalties coupled with non-disclosures, compounding of penal interest, etc. were highly prejudicial to consumer interest and accordingly, caught the eye of the regulator.
The RBI introduced guidelines to the lenders to ensure reasonableness and transparency in the disclosure of penal interest vide its Circular on ‘Fair Lending Practice – Penal Charges in Loan Accounts’(RBI Guidelines on penal charges’) dated August 18, 2023. Our article and FAQs[1] on the same may be read here[2].Our YouTube video discussing the guidelines may be viewed here.
However, charging penal interest also raises several practical questions for lenders, mainly indirect taxation and accounting of penal charges, which will be discussed in detail in this article.
Read more →