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India's Budget 2007
and its impact
on the Financial Services sector

By Vinod Kothari

Like every year, we will bring you a detailed commentary on the Indian Budget 2007. These comments will be posted soon after the presentation of the Union Budget on 28th Feb 2007.

• State of the Indian economy - Vinod Kothari, 27th Feb 2007
• Overview of Indian financial market by Payel Jain, Vinod Kothari Company
• Economic Survey 2006-7 - comments by Vinod Kothari

Important links

• Text of the Budget is here (will be up after the Budget is presented)
• Economic survey 2006-7 (will be up later during the day on 27th Feb 2007)

Comments on the Indian Budget 2007 and the financial sector

Two proposals relating to the mortgage market
At a time when worries about subprime lending in the mortgage market has caused global concerns, the Finance Minister has brought about two proposals for encouraging the mortgage market – reverse mortgages, and mortgage guarantee companies.

Reverse mortgages
The Finance Minister announced the introduction of reverse mortgages.

A reverse mortgage is a product for senior citizens. An elderly person, owning a house, will enter into a reverse mortgage where the mortgage finance company pays a monthly amount to the individual concerned, and upon death of the individual, takes over the house. It is called a reverse mortgage because unlike a straight mortgage where the borrower pays instalments to the lender, here the lender pays instalments to the borrower.

The fixation of the instalments is done based on assessment of the value of the house and the remaining life of the individual. In a plain reverse mortgage transaction, the longer the individual lives, the lesser is the return of the reverse mortgage lender. Typically, the loan is a non-recourse loan; the lender takes interest in the value of the house and not a personal claim against the borrower.

A reverse mortgage comes handy to a retired individual who uses his property to meet his old-age requirements. Meeting social security and health requirements is more important than leaving estate for posterity – at least in the culture of the countries where reverse mortgages have grown.

Reverse mortgages essentially began as a US concept. The total number of reverse mortgage loans granted by National Reverse Mortgage Lenders Association [http://www.nrmlaonline.org/] was about 76000 loans in 2006.

In UK, reverse mortgages are known as equity release mortgages or lifetime mortgages – the market is still quite small.

India does not have any government-sponsored social security schemes for the elderly. Therefore, reverse mortgages may be considered desirable, inspite of the fact that in a typical Indian psyche, a person would long to leave an estate for his successors. A tight regulation is also required as the reverse mortgage lenders deal with a segment of population that is extremely vulnerable.

Mortgage guarantee companies
The National Housing Bank has been pondering over a role of mortgage guarantee for quite some time. An ADB technical assistance program also dealt with this issue.

Finally, the govt has come with a proposal for setting up mortgage guarantee companies. The exact details of the scheme would be known when relevant text is available.

Provision of credit enhancement with regard to mortgage loans is done in several ways in different markets – in the USA, there are loans that are insured by the HUD, and then, there is securitisation of mortgage loans by Ginnie Mae, Fannie Mae and Freddie Mac. It is quite common for primary mortgage insurance companies to provide pool insurance in Australia, UK and certain other markets.

Real estate venture capital funds become taxable
While this may sound surprising to many, but venture capital funds are being used in India for making investments in the real estate sector too. In the negative list of industries in which venture capital funds will not invest, real estate was one. This was removed some years back, for reasons best known to SEBI. Since then, there are several venture capital funds that are dedicated to making investments in the real estate sector. In fact, in absence of a REIT legislation, venture capital funds route was being used for realty investment.

The Budget proposals deny tax exemption to the VCFs other than those investing in certain high-tech industries. Without tax transparency, there is no motivation to use the VCF route for real estate investments. India has not adopted REITs as yet – hence, other than mutual funds, the scope for using a pass through vehicle for real estate investments is ruled out. This creates a significant gap.

The denial of tax exemption is to take effect from the forthcoming financial year – which means even existing VCFs will be affected. The realty VCFs might have a bigger problem, as they would not be able to unlock their investments until the properties in question are sold, at which they will have to pay a tax that was never anticipated at the inception.

Tax deduction for reserves created by financial entities
There is a tax incentive that would possibly be used by a wide range of financial entities – this is in sec. 36 (1) (viii) of the Income tax Act. This provides a deduction upto 20% of profits in respect of a reserve created by a financial entity. So far, this benefit was available only to housing finance companies and infrastructure finance companies. The benefit of this deduction has now been extended to “long term finance for industrial or agricultural development”. Therefore, there is a wider scope of users who may avail of this benefit. Non-banking finance companies which provide funding for a term of 5 years and above may avail this benefit. Effectively, this means the tax rate coming down by 20% - which is a significant benefit.

Rate of withholding tax on lease receivables reduced [sec 194I]
Sec 194I imposes what is most unreasonable – it currently requires 20% tax deduction on the gross receivables on renting of machinery or plant. The reason why this provision is most unfortunate is because it applies on 20% of the gross receivables, whereas the actual income of the leasing company may not be more than 2% of the gross receivables. Since the idea of the section is to withhold a tax on income, the section itself is extremely unjust.

The injustice still remains, though the magnitude has been reduced a bit. The rate of deduction of tax at source has been reduced from 20% to 10%.

Definition of “financial lease” introduced in Service Tax
Currently, service tax is applicable on a financial lease and not on an operating lease. So far, there was no definition of ‘financial lease’ in the service tax law – therefore, the distinction was based on accounting standards. Now, the service tax law has its own definition, and it is much worse than what the accounting standards lay down. Knowing from its past experience of how bad the government is in laying down definitions, it should have stayed away from defining something which is unarguably an accounting concept.

The proposed definition of “financial lease” is:

“financial leasing” means a lease transaction where—
(i) contract for lease is entered into between two parties for leasing of a specific asset;
(ii) such contract is for use and occupation of the asset by the lessee;
(iii) the lease payment is calculated so as to cover the full cost of the asset together with the interest charges; and
(iv) the lessee is entitled to own, or has the option to own, the asset at the end of the lease period after making the lease payment;

Given the wording of this definition, nothing except hire purchase transactions will fall under the definition.

Previous Budget commentaries

India's Budget 2004-5
and its impact
on the Financial Services sector

By Vinod Kothari

The Finance Minister presented the Union Budget 2004-5. On the economic front, as was expected, the inclination of his coalition government to the rural sector was evident and the usual boilerplate statements on pro-poor schemes were present in plenty. However, the non-plan expenditure on defence has been increased and the overall fiscal deficit is at 4.4% of GDP, which is though lower than in the past, but still indicates scope for controls, particularly on non-developmental non-plan expense.

Tax proposals

Significant among the tax proposals was a proposal to replace the existing scheme of long-term capital gains taxation by a tax based on turnover on stock exchanges. The stock exchanges have reacted sharply against this proposal and during the presentation of the speech the Sensex lost something like 50 points on this announcement alone.

Turnover tax on securities

What is turnover tax

The proposal draws upon Entry 90 of Seventh Schedule to the Constitution. As per this entry, the Union Govt has the right to charge a tax, other than stamp duty, on transactions on stock exchanges and futures exchanges.

There are significant differences between a transactions tax and income tax:

• Income tax is based on income - transactions tax is charged on every subject transaction, no matter whether it results into an income or a loss.
• Capital gains tax was based on studies and recommendations done years ago by renowed fiscal economists like Nicholas Kaldor. The lower rate of capital gains tax was based on the inflationery content of the capital gains. Replacing it by transactions tax means the tax is applicable on all transactions, whether short term or long term, and that the tax does not distinguish between the inflationary component or other incomes.

As the Constitutional entry restricts the taxing rights of the government to only transactions in stock exchanges, the tax can be levied only on the transactions routed through an organised stock exchange. Wherever transactions in securities take place other than through stock exchanges, there is no scope for levying such tax.

This provision must be read with sec. 13 of the Securities Contracts Regulation Act under which transactions in securities in certain specified areas cannot be made other than through stock exchanges. The exception is in sec. 18 of the said Act for spot delivery contracts.

In other words, the Securities Act forces transactions to routed through the stock exchanges and the present Budget imposes a tax thereon.

Provisions for the tax

Like in the case of service tax, no separate enactment has been proposed for the new tax but provisions have been proposed in the Finance Act itself for imposition of the Securities Transactions Tax. Sections 86 to 105 of the Finance Bill relate to the proposed tax.

The collection mechanism is through the stock exchanges - whereby it is obvious that the tax will be charged on all transactions coming to the exchange.

The tax base is

• In case of normal marke transactions, the purchase price of the security
• in case of derivatives, the strike price Plus the premium
• in case of futures, the futures price.

As the tax is on spot, futures and derivatives transactions, the tax will put to considerable jeopardy arbitrage transactions. Arbitrage transactions seek to exploit market differentials which will be now curtailed by 15 bps by the new tax.

The tax is applicable to all securities trades - this includes equities as well as debt trades. As long as a trade is conducted through an exchange, it is chargeable to the tax.

The applicable date is to be notified.

Buyers and sellers in securities do not have to be concerned about returning or procedural formalities - the exchanges are supposed to comply with the same. The exchanges have to submit monthly returns of the tax collected by them. The exchange becomes the "assessee" of such tax. Therefore, penalties for non-payment of tax are also imposed on the stock exchanges.

The administration of the tax will be done by the Income tax Authorities

How does the tax compare with existing capital gains tax

As the existing rate of capital gains tax is 20%, on a capital gain of 0.75% on the purchase price of the security the seller is neutral between the existing scheme and the new scheme. However, for gain rate higher than 0.75%, the new scheme is better than the existing scheme. On all transactions where the rate of gain is less than 0.75%, or there is a loss, the new scheme is an additional burden.

Tax rate on short term capital gains:

A new provision, sec. 111A, reduces the rate of tax for short term capital gains to 10%. This is also as in case of the securities transactions tax, a tax on securities transactions transacted through recognised stock exchanges. The tax is on the gain, and is in addition to the transaction tax dealt with above.

This provision is applicable with effect from 1st April 2005 - therefore, has a retroactive effect.

By reducing the rate of tax on short term capital gains, the Finance Minister has virtually opened gates for clandestine dealings - black money will be channelised into the system masquerading as short term capital gains with merely 10% tax.

Aircraft leases to be charged to tax:

The exemption to aircraft leases under sec. 10 (15A) is proposed to be removed. This is a highly retrograde provision and would adversely affect the business of leasing aircraft. Most Indian airlines, particularly the private carries, have obtained aircraft on lease from foreign lessors, and if anything, this activity was sharply growing.

By way of a saving grace, the withdrawal of the exemption is not retroactive, as the exemption is to be withdrawn only for agreements entered into on or after 1st Sept 2004.

The key issue in case of cross border aircraft leases is that the withholding tax is not limited to the interest component but is applicable to the entire rental income. This would make the cross border lease transaction completely unviable.

SARFAESI to be tightened up:

The Finance Minister said that the Securitisation and Reconstruction of Financial Assetes and Enforcement of Security Interests Act will be tightened up to overcome the problems arising out of the Supreme Court ruling. This would require amendments to the Act - in all likelihood, the amendments will be placed before the winter session of the Parliament. Note that an Asian Development Bank assistance is already on to advise the government on amendments in security interest legislation and the domestic consultants include Mr Cyril Shroff and Vinod Kothari.

The group is likely to submit its report by early September.

Service tax net on banks/FIs widened:

Though the Finance Minister did not talk about it, but between the lines in the Budget, there is a considerable widening of the service tax net as applicable to banks and financial services. The taxable services now include "other financial services". There is a word there that is likely to cause tremendous confusion - it is "lending". The intent is unlikely to be to include interest as a taxable service. The initial reaction of most people after reading this clause was that interest on loans is also included in service tax, but It is notable that interest on loans is specifically excluded by clause (viii) of Explanation I below sec 67.

However, there is quite a lot which is in the nature of interest, and is yet included under service tax:

• discount charges on discouting of bills of exchange or other commercial paper
• all discounting charges on corporate CP
• since the net is now wide enough to include even corporates and other commercial concerns, even discount charges earned by corporates on discounting of bills of exchange will be included. Discounting of trade paper such as rukkas, hundis etc is a major practice in Indian trade: as there is no de minimis exemption in case of service tax, the same will be chargeable to tax without any exemption..
• A million dollar question is - whether the discounting charges earned on discounting of receivables will also be included? Our answer is no. The definition of in the proposed sec. 65 (12) is exhaustive and not illustrative. That is to say, only those words which are specifically included here will be considered for the purpose of tax. Discounting of bills of exchange is covered by the clause, but discounting of receivables is not. Therefore, securitisation and factoring services will not be affected.
• Issuance of letters of credit by bank is another form of quasi-lending activity. This will be taxable.
• Issuance of guarantees by banks is taxable now.
• Nay, even issuance of guarantees by corporates is taxable - if a corporate or other commercial concern receives guarantees charges for guarantees provided by it, such guarantee fee will be a part of taxable service charges.

Other tax provisions

TDS provisions become all the more tedious:

If tax has not been deducted on an income by way of interest, brokerage, commission, fees, etc on which tax is required to be deducted, or having been deducted, has not been paid, such income shall be deemed to be the income of the deductor. Most strangely, this provision is applicable with effect from 1st April 2005, therefore, with a retrospective effect as part of the year has already elapsed.

Amendment to the definition of Income: Income-tax is no more "Income" tax

This provision may go unnoticed in the maze of the Budget provisions but would be one of the most challenging provisions inserted in the Budget.

What it does is to completely alter the scope of "income" under the Income-tax law and include all forms of "receipts". Therefore, the Income-tax law may now more appropriately be called Receipts Tax Act.

Although the Finance Minister benignly explained this provision as intended to tax gifts from unrelated persons, as a matter of fact, the actual drafting of the provision goes much beyond that intent. It includes, in the fold of "income", and hence, taxable income, all sums received other than in consideration for sale of goods or supply of services, received in cash, cheque or by similar modes. Therefore, not only gifts but all forms of capital receipt will be included as income.

Therefore, the Court rulings over hundreds of years that sought to make distinction between "capital receipts" and "revenue receipt" will become meaningless.

However, in view of the language of the law, the tax will be only for receipts in cash, by cheque or similar modes. Receipts in kind will not be included - applying the doctrine of ejusdem generis. Also, the words "sum received" clarify that the tax will only apply in case of receipts in cash.

There is an instant shocking reaction that the clause will apply in case of loans too, since the language used is "any sum received". However, a loan is a bailment, and not a receipt. It is received, to be returned. In any event, this clarification will surely be inserted either in the language or by circular. However, the most significant change which has come to stay is to bring into the taxing net all forms of capital receipts.

Eventually, as people use gifts or capital receipts in kind as an escape route, the language of the section will be expanded to include receipts in kind as well. Therefore, what the Finance Minister has opened in sec. 2 (24) is a new avenue altogether - an avenue to tax capital receipts of all kinds.

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There is apparently no provision that affects the banking or financial services sector directly. Notably:

• The deduction under the IT Act for provisioning for NPAs by banks stays unchanged, except to the extent that if banks agree to go for the redemption of their loans to the Central Govt against their NPAs, they might claim the premium they gain on such redemption also as an added deduction.
• Service tax on banking and financial services remains the same in scope, except the rate of tax has been increased from 5% to 8%.
• On leasing and asset-based financing: there is no change at all. CST rates have been brought down to 2% but that will be effective only on implementation of VAT.
• There is nothing apparently done to clarify the problems on withholding tax applicable if loans are transferred to securitisation or asset reconstruction companies.
• The confusion on the pass-through or entity-tax status of SPVs as trusts prevails and there is no attempt to streamline the representative tax system at all.

In short, the Budget is miles away from Kelkar, and miles away from any attempt to simplify or rationalise the tax system.

If you have any thoughts, please do not hesitate to write back.

Analysis of Union Budget 2002-3

Securitization proposals:

• To strengthen the enforcement of security interests in financial transactions, the RBI had drafted last year a foreclosure and enforcement of security interests legislation. This bill is expected to be moved into the Parliament now. One of the highlights of the Bill is that registered security interests will be enforceable without having to resort to Courts through recovery officers to be appointed for this purpose. On our securitization site, we had carried highlights of this Bill as well.