Non-Banking Finance Companies Tax Aspects · Non-Banking Finance Companies Tax Aspects ... NBFC-ND...

Non-Banking Finance CompaniesTax Aspects

26 September 2014

Contents

► Non-Banking Finance Company (NBFC) – An Overview

► Tax Aspects

NBFCs - An Overview

NBFCs – An Overview

Reserve Bank of India

Non-Banking Financial Companies

Non Deposit taking

NBFC-ND

Loan

NBFC-ND-SI

(Asset size >= Rs 100 CR)

Deposit taking

Asset FinanceInfrastructure

FinanceInvestment

CIC

What is NBFC?

NBFC has been defined under Section 45-I(f) of the RBI Act:

► „„non-banking financial company‟‟ means–

a financial institution which is a company;

a non-banking institution which is a company and which has as its principal business the

receiving of deposits, under any scheme or arrangement or in any other manner, or lending in any

manner;

such other non-banking institution or class of such institutions, as the Bank may, with the previous

approval of the Central Government and by notification in the Official Gazette, specify.

Section 45-I(e):

► „„non-banking institution‟‟ means a company, corporation or cooperative society

Financial Institution

Section 45-I(c):

► „„financial institution‟‟ means any non-banking institution which carries on as its business or

part of its business any of the following activities, namely:–

financing business

acquisition of securities

hire-purchase business

insurance business

chit fund business

collecting/ disbursement of money, awarding prizes or gifts, etc

► Exceptions: If the principal business of the institution includes

agricultural operations;

industrial activity;

purchase/ sale of any goods (other than securities) or providing services; or

purchase, construction or sale of immovable property, so however, that no portion of the

income of the institution is derived from the financing of purchases, constructions or

sales of immovable property by other persons

Principal Business

► The company will be treated as a non-banking financial company (NBFC) if its financial

assets are more than 50 per cent of its total assets (netted off by intangible assets) and

income from financial assets is more than 50 per cent of the gross income. Both these

tests are required to be satisfied as the determinant factor for principal business of a

company - Press Release 1998-99/1269 dated April 8, 1999

NBFCs – Key Terms

Infrastructure Finance Company

► NBFC which deploys atleast 75% of its total assets in infrastructure loans

► Additional requirements► Shall not accept deposits from public

► Shall have net-owned funds of Rs 300 crores or above

► Shall have a minimum credit rating “A” or equivalent of CRISIL, FITCH, CARE, ICRA or other accrediting rating

agencies

► Shall have a CRAR of 15% (with a minimum Tier I capital of 10%)

Infrastructure loan means a credit facility by way of term / project loan, subscription to bonds /

debentures / preference shares / equity shares in a project company engaged in infrastructure

facility in any of the following sectors

► Road, bridge, rail system;

► Highway project;

► Port, airport, inland waterway / port;

► Water supply project, irrigation project, etc;

► Telecommunication / internet services;

► Industrial park / SEZ;

► Power; etc.

Tax Aspects

NBFC – Key tax aspects

► Interest on Non-performing Assets (NPAs)

► Receipt of additional finance charges (AFC)

► Matching concept

► Provision created in respect of NPAs

► Disallowance of expenses under section 14A of the Income-tax Act, 1961 (Act)

► Income earned from a securitization trust

► Finance Lease

► Mark-to-market loss incurred on account of trading in derivative instruments

► Bad debts written off in the books of account

► TDS under section 194A of the Act

Interest on NPAs

► As per the guidelines issued by the Reserve Bank of India (RBI) on recognition of income on loans,

interest income on NPAs is required to be recognised on a receipt/ realisation basis

► Further as per AS 9 where the ability to assess the ultimate collection with reasonable certainty is

lacking at the time of raising any claim, eg. for escalation of price, export incentives, interest etc.,

revenue recognition is required to be postponed to the extent of uncertainty involved. In such

cases, it may be appropriate to recognize revenue only when it is reasonably certain that the

ultimate collection will be made

► As per Section 43D, in case of Public financial institution, Scheduled Bank and State Financial

Corporation and such other prescribed entities, the interest in relation to Non performing Assets

shall be chargeable to tax in the previous year in which it is credited to the profit and loss account

or year in which it is actually received, whichever is earlier

► As seen earlier, NBFCs are „financial institutions‟, hence even in case of NBFCs following

mercantile basis of accounting, all interest income would be recognised on an accrual basis except

for accrual of interest on NPAs

► However, the Supreme Court in the case of Southern Technologies [2010] (228 CTR 440)

interest from NPAs is taxable on due basis on the basis that the RBI guidelines for

non-recognition of interest income are merely disclosure norms and they are not in any way

connected to computation of total income under the Act. Further, the Supreme Court also observed

that the provisions of section 43D of the Act do not apply to NBFCs on the basis that NBFC s and

banks are functionally different

Interest on NPAs

► Various Courts/ Tribunals have held that (prior to the Supreme Court ruling in the case of Southern

Technologies) the question of accrual can be considered only after recognizing income from such

assets

► In this regard, the Supreme Court in the case of UCO Bank [1999] (237 ITR 889) has held that if the

loan given by the assessee is itself doubtful of recovery, the illusory interest thereon of which recovery

is beyond hope cannot be brought to tax year after year on the ground of accrual

► In the case of Tedco Investment & Finance Services P. Ltd. v. DCIT [2004] (82 TTJ 259), the Delhi

ITAT held that income under mercantile system of accounting could be recognised only subject to the

prudential norms issued by RBI which are to be followed by an NBFC

► The Delhi High Court in the case of CIT v. Vasisth Chay Vyapar [2010] (238 CTR 142) distinguished

the ruling of the Supreme Court in the case of Southern Technologies Ltd and held that:

“U/s 45Q of the RBI Act read with the NBFCs Prudential Norms (Reserve Bank) Directions 1998, it was

mandatory on the part of the assessee not to recognize the interest on the ICD as it had become a

NPA. The assessee was bound to compute income having regard to the recognized accounting

principles set out in Accounting Standard AS-9. AS-9 provides that if there are uncertainties as to

recognition of revenue, the revenue should not be recognized. Accordingly, the argument of the

revenue that the interest on the NPA can be said to have accrued despite it being a NPA is not

acceptable.”

Interest on NPAs

► In the case of CIT v. Motor Credit Co. P. Ltd. [1981] (127 ITR 572), the Madras High Court held

that:

“Where no income has resulted it cannot be said that income has accrued merely on the ground

that the assessee had been following mercantile system of accounting. Even if the assessee makes

a debit entry to that effect, still no income can be said to have accrued to the assessee. If no

income has materialized, there can be no liability to tax on a hypothetical income. It is not the

hypothetical accrual of income based on the mercantile system of accounting followed by the

assessee that has to be taken into account, but what should be considered is whether the income

has really materialized or resulted to the assessee. The question whether real income has

materialized to the assessee has to be considered with reference to commercial and business

realities of the situation in which the assessee has been placed and not with reference to his

system of accounting.”

► Based on the above jurisprudence, a view could be taken that if no “real” income is recognized at

all from such assets, there is no question of applying the principle of accrual. Accordingly, the

interest from NPAs should be taxed in the appropriate assessment years on the basis of actual

receipt

Receipt of AFC

► Typically, NBFCs engaged in the business of asset/ equipment financing levy AFC on its customers

(lessee/hirer) if they do not pay the instalments in time. These AFC charges are accounted for on

accrual basis in the books of account; however for income tax purpose, the AFC are accounted for

on cash basis

► Tax authorities contend that the AFC should be offered as income on accrual basis and not on cash

basis as the NBFCs generally maintain their books of account on accrual basis

► However, the Madras High Court, in the case of Annamalai Finance Limited [2005] (275 ITR 451)

held that in applying the accrual system or cash system, recognition of income is a paramount

factor

► The Court held that as per the terms of the agreements the overdue charges are payable by the

parties concerned to the assessee when they make defaults in paying the instalments as per the

schedule of payments. When the instalment itself is overdue, is not collected, there is no basis for

making out a case that the additional overdue charges payable by the parties would be collectible

with certainty. The terms of the agreements which enable the assessee-company to demand

overdue charges is only an enabling provision and that enabling provision does not guarantee the

collection of overdue charges. It only gives a cause of action to the assessee. In such cases it is

very difficult to recognize income against overdue charges

► In concluding, the Madras High Court held that the change of method of accounting of overdue

interest alone on cash basis was not incorrect on the part of the assessee

Matching concept

► The general principle of law is that business expenditure is deductible in the year in which it is

incurred. Therefore, even if the benefit arising from such expenditure is spread over a period of

time, the full expense would nevertheless be deductible in the accounting year in which it is

incurred

► In order to determine the net income of an accounting year under the mercantile system of

accounting, the revenue and other incomes are required to be matched with the expenses

► The matching of income and expenses is to be done on accrual basis. Under this matching

concept, revenue and income earned during an accounting period, irrespective of actual cash

inflow, is to be compared with expenses incurred during the same period irrespective of actual

outflow of cash

► The Act charges for payment of tax, the income which is to be computed in the manner provided by

the Act

► As per the provisions of section 145 of the Act, income chargeable under the head profits and gains

of business or profession or Income from other sources is required to be computed in accordance

with either cash or mercantile system of accounting that is regularly employed by the assessee

Matching concept

► The Supreme Court in the case of Kedarnath Jute Manufacturing Co. Ltd v CIT [1971] (82 ITR 363) has held that whether the assessee is entitled to a particular deduction or not will depend on the provision of law relating thereto and not on the view which the assessee might take of his rights nor can the existence or absence of entries in the books of accounts be decisive or conclusive in the matter.

► A similar view was expressed in the case of Sutlej Cotton Mills v CIT [1979] 116 ITR 1 (Supreme Court) wherein it was reaffirmed that the way in which entries are made by an assessee in his books of account is not determinative of the question whether the assessee has earned any profit or suffered any loss

► The Mumbai High Court in the case of Taparia Tools Ltd. v. CIT [2003] (260 ITR 102) held that “revenue expenditure which is incurred wholly and exclusively for the purpose of business must be allowed in its entirety in the year in which it is incurred. It cannot be spread over a number of years even if the assessee has written it off in his books, over a period of years. However, the facts may justify an assessee who has incurred expenditure in a particular year to spread and claim it over a period of ensuing years. In fact, allowing the entire expenditure in one year might give a very distorted picture of the profits of a particular year”

The Mumbai High Court held that in ascertaining true profits under the Income-tax Act, true accounting principles in light of the method of accounting followed by the assessee would be required to be adopted. Further, in cases involving special types of assets, where profits cannot be deduced by following the method adopted by the assessee, the Assessing Officer is free to make adjustments to the profits determined by the assessee

Provision for bad debts/ NPAs

► As per the RBI guidelines, NBFCs are required to classify their assets into:

► standard assets - no default in repayment of principal or amount are perceived;

► sub-standard assets - classified as a NPA for a period not exceeding 18 months;

► doubtful assets - an asset which remains a sub-standard asset for a period exceeding 18 months and

► loss assets - an asset identified by the RBI or an asset which is adversely affected by a potential threat of non-

recoverability or non-availability of security

► However, given that provisions of section 36(1)(viia) in relation to provision for bad and doubtful

debts are applicable specifically to a banking company and not to NBFCs, a deduction in respect of

the said provisions is not available to an NBFC

► The Supreme Court in the case of Southern Technologies [2010] (228 CTR 440) has held that

that NBFCs shall not be allowed a deduction in respect of the provisions created for NPAs

► A similar view has been adopted in the following judicial precedents:

► New India Industries Ltd v ACIT (2007-TIOL-389-ITAT-DEL-SB)

► ITO v Maruti Countrywide Auto Financial Service (P) Ltd (2008-TIOL-101-ITAT-DEL)

► JCIT v India Equipment Leasing Ltd [2008] 111 ITD 37 ( ITAT Chennai)

Disallowance under section 14A of the Act

► Disallowance of expenses, under section 14A of the Income-tax Act, 1961, incurred in relation to

earning exempt income

► Rule 8D of the Income-tax Rules, 1962 (Rules) provides for mechanism to determine the quantum

of disallowance. As per Rule 8D of the Rules the disallowance shall be aggregate of the following

amounts:

► The amount of expenditure directly relating to income which does not form part of the total income

► (Interest which cannot be directly attributed) x (Average value of investment related to tax free income,

appearing in the balance-sheet on the first and last day of the Financial Year) / Average total assets in the

balance-sheet on the first and last day of the Financial Year

► 0.5% of the average value of the investment related to the tax-free income, as appearing in the balance-sheet

on the first and last day of the financial year

► It is worthwhile to note the following principles with respect to section 14A read with Rule 8D:

► Section 14A disallowance operates only in respect of expenditure incurred in relation to the exempt income –

Accordingly, only those expenses which have proximate nexus with the exempt income is required to be

disallowed; and

► The Assessing Officer can compute the disallowance under section 14A as per the prescribed method (Rule

8D) only if has not reached an objective satisfaction about the correctness of the assessee‟s claim

Disallowance under section 14A of the Act – Key judicial precedents

► Provisions of section 14A of the Act not applicable if no exempt income is earned during the year.

Reliance in this regard can be placed on the following judicial precedents:► Delite Enterprises (ITA 110 of 2009) (Bombay High Court)

► Shivam Motors (ITA 88 if 2014) (Allahabad High Court)

► Cortech Energy (ITA 239 of 2014) (Gujarat High Court)

► Provisions of section 14A of the Act not applicable if exempt income is earned during the year out

of investments made from interest free funds i.e. owned funds. Reliance in this regard can be

placed on the following judicial precedents:► Deputy Commissioner of Income Tax v M/s. Maharashtra Seamless Ltd. (ITA No 4063/DEL/2006),

► CIT v Reliance Utilities & Power Ltd. [2009] 313 ITR 340 (High Court Bombay)

► Yatish Trading Co. Pvt Ltd v ACIT (ITA No. 456/MUM/2009)

► Godrej Agrovet Ltd. v ACIT(ITA No. 1629/MUM/09)

► Provisions of section 14A should not be applicable in case where investments are held as stock-in-

trade. Reliance in this regard can be placed on the following judicial precedents:► Ethio Plastics Pvt Ltd. V. DCIT (ITA No.848/Ahd/2012)

► CCI LTD. vs. JCIT (2012) 71 DTR 141 (Karnataka High Court)

Income earned from a securitisation trust

► Securitisation trusts distributing income to its investors (other than those exempt from tax) are liable

to pay tax on income distribution. Income received by an investor from securitisation trusts is

exempt from tax

► The payment of tax on income distribution by the Securitization trusts results in disallowance under

section 14A of the Act (since the income from securitisation trust is exempt in the hands of

investors, such investors are not eligible to set-off expenses incurred for earning exempt income) in

the hands of the investor who effectively borne additional income tax under section 115TA of the

Act

► The issue is extremely relevant for NBFCs (majority of the investors in the Securitization trusts) who

previously were able to set-off existing losses/ claim expenses against the income from

Securitisation trust

Finance Lease

► A finance lease is a lease that transfers substantially all risks and rewards incidental to ownership of an asset. The main characteristics of a finance lease are as under:

► Transfer of ownership to the lessee by the end of the lease term► At the inception of the lease the present value of the minimum lease payments amounts to at least substantially

all of the fair value of the leased asset► Leased asset is of a specialized nature such that only the lessee can use it without major modifications

► Given the above characteristics, unlike renting, leasing is a mode of financing and a major portion of the lease rentals include repayment of principal just like a loan repayment. There is lack of clarity in the Act with regards entitlement of depreciation in case of a finance lease . Judicial precedents do exist which give rise to conflicting views

► However, the Supreme Court in the case of ICDS Ltd. v CIT [2013] 350 ITR 527 , held that the Act imposes a twin requirement of „ownership‟ and „usage for business‟ for a successful claim of depreciation under section 32 of the Act. The Supreme Court, observed the following key features in the lease agreement supporting the ownership of the asset by the lessor:

► The lessor was the exclusive owner of the vehicle at all points of time► If the lessee committed a default, the lessor was empowered to re-possess the vehicle (and not merely recover

money from the lessee)► At the conclusion of the lease period, the lessee was obliged to return the vehicle to the Taxpayer; and ► The lessor had the rights to inspect the vehicle at all times

► Clarifications on entitlement of deprecation will enable NBFCs to price their leasing transactions consistently and competitively

Mark-to-market loss

► As per the guidelines prescribed by the RBI, investments held as stock-in-trade are required to be valued at lower of cost or market value

► Derivative futures have to be valued on a daily basis so that if there is any diminution in the value of the derivative instruments at the end of the day, the same is accounted for in the books of account to reflect the true and fair value

► As per Circular No 599 dated 24 April 1991 issued by the CBDT, securities (including derivatives) held by the banks would constitute their stock in trade and consequently any loss claimed by the banks on the valuation of the securities would be allowed as a deduction in computing their taxable profits

► Section 145 of the Act requires that accounting standards prescribed by the CBDT are to be followed in computing the business income of an assessee

► As per AS 1 issued by the ICAI, as a prudent practice, provisions should are required to be made for all known liabilities and losses even though the amount cannot be determined with certainty and only represents a best estimate in the light of available information

► This provision for such loss on account of fair value of derivatives is in accordance with the standard

► To determine the taxable profits as per the Act, the books of account prepared by the assessee forms the basis for the computation of taxable income

Mark-to-market loss

► However, in certain instances, the tax authorities are adopting a contrary position and seeking to disallow the mark-to-market loss on the basis that the said loss is notional in nature; a mere entry in the books of accounts would not qualify the same for a deduction for tax purposes

► However, reliance can be placed on the following judicial precedents where a deduction is claimed by the NBFC:

► The Supreme Court, in the case of United Commercial Bank v. CIT [1999] (240 ITR 254) observed:

► That for valuing the closing stock, it is open to the assessee to value it at the cost or market value,

whichever is lower

► In the balance-sheet, if the securities and shares are valued at cost but from that no firm conclusion can be

drawn. A taxpayer is free to employ for the purpose of his trade, his own method of keeping accounts, and

for that purpose, to value stock-in-trade either at cost or market price

► A method of accounting adopted by the taxpayer consistently and regularly cannot be discarded by the

departmental authorities on the view that he should have adopted a different method of keeping accounts or

of valuation

► The concept of real income is certainly applicable in judging whether there has been income or not, but, in

every case, it must be applied with care and within their recognised limits

► In the case of accounting for exchange fluctuation loss, the Supreme Court, in the case of Woodward

Governor India Pvt Ltd v CIT [2009] (312 ITR 254) held that in terms of the mercantile method of accounting,

the exchange fluctuation loss arising on mark-to-market (MTM) restatement of liability in foreign currency at the

year end is an allowable loss, where the liability is on revenue account.

t

Bad debts written off in the books of accounts

► The provisions of section 36(1)(vii) of the Act was amended by the Direct Tax Laws (Amendment)

Act, 1987 w.e.f. 1 April1989.

► Prior to the amendment, the section required that the debts must be established to have become

bad in order to be allowed as a deduction

► However, post-amendment, the requirement to establish whether the debts had become bad was

removed from the statute and the section was redrafted to provide that bad debt would be allowed

as a deduction in the year of write-off

► The Explanatory Circular No 551 dated 23 January 1990 explaining the change clarifies the

rationale behind the amendment and states that the same was done to end disputes in relation to

year of allowability of bad debts as a deduction and has made it redundant by allowing the

deduction straightaway in the year of write-off

► The clause, as amended, grants deduction in respect of „…any bad debt or part thereof which is

written off as irrecoverable in the accounts of the assessee for the previous year‟

► Under the amended clause, the requirement of „establishing‟ that the debt has become bad in the

relevant accounting year is dispensed with. All that the assessee has to show is that the bad debt

has been written off as irrecoverable

Bad debts written off in the books of accounts

In support of the above contention, reliance may be placed on the following judicial precedents:

► However, the Supreme Court, in a decision contrary to the above, in the case of Vijaya Bank v.

CIT (2010-TIOL-31-SC-IT), held that a mere credit entry in individual debtors account is not

necessary to constitute actual write off of bad debt and that it is sufficient if the amount of bad debts

debited to the profit and loss account is reduced from the debtors reflected on the asset side of the

balance sheet

► Oman International Bank SAOG. v. DCIT [2006] (100 ITD 285) (Mum SB) wherein it was held

that the decision to write off the debts on the part of the assessee with whom the information rests

is a prima facie evidence for allowability of bad debts and is a sufficient requirement with respect to

amended provisions of the Act

► CIT v. Autometers Limited [2007] (292 ITR 345) ( Del) wherein the Delhi High Court held that the

amendment made to section 36(1)(vii) of the Act was a conscious decision taken to eliminate

litigation with regard to establishing what is bad debt

► CIT v. Morgan Securities & Credits (P.) Ltd [2007] 2(92 ITR 339) wherein the Delhi High Court

held that „A conjoint reading of s. 36(2) and s. 36(1)(vii) makes it clear that the assessee would be

entitled to a deduction of the amount of any bad debt which has been written off as irrecoverable in

its accounts for the previous year

TDS under section 194A of the Act

► As per section 194A of the Act, interest payments to NBFCs are subject to TDS at 10%. However,

no TDS is required to be deducted on interest payments to similar financial institutions such as

Banks, LIC etc

► The aforesaid distinction in the Act (between NBFCs and similar financial institutions) puts NBFCs

in a disadvantageous position and creates severe cash flow constraints since NBFCs operate on a

very thin spread/ margin on interest which at times is even lesser than the tax deductible on the

gross interest and reduces the effective interest rate of the NBFCs on the loans given

► Apart from this, given that NBFCs provide financing mostly to retail customers in unorganized

sectors i.e. high net worth individuals, partnerships, proprietorships, etc, herculean follow-ups have

to be made with the customer for TDS certificates every quarter. This is practically cumbersome

and at times it becomes almost impossible. Further, despite having received TDS certificates, on

account of technical errors, the tax credit is refused to NBFCs, resulting in protracted litigation with

the tax authorities for grant of credit

Thank you

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