Detailed analysis of Budget 2001 provisions relating to financial services

By Vinod Kothari

Highlights relating to financial services Service tax on banking and financial services Comprehensive bill on securitization to be introduced Steps to boost the debt market Reduction of rates on Government securities Legislation on foreclosures and enforcement of securities to be introduced Taxation provisions affecting financial services: Leasing and hire purchase companies get a body blow - liable to service tax Hike in depreciation rates on commercial vehicles Deduction of tax at source on interest ECBs lose tax exemption Boost to primary markets - churning benefit on subscription to primary issues Watch out for more details on this site

 

Queries on service tax on leasing and HP Unless you are too dumbfounded, if you have any queries on the service tax on lease /HP transactions, you are welcome to post them here

 

Service tax on banking and financial services

The extension of service tax to services presently not covered by the Act was being deliberated for a long time. Many have also felt, properly so in my opinion, that what India needs is a comprehensive Goods and Services Tax law that covers all goods and all services, to remove the plethora of indirect taxes being imposed.

However, many countries have exempted financial services from the application of Goods and Services Taxes, on the ground that such tax is a tax on input, and will have a cascading impact.

For the first time, the FM has introduced a service tax on financial services. Hearing the Finance Minister speak in Parliament, one would have thought the service he was talking about would be on mainstream banking services.

However, in fact, all mainstream banking services have been left out of the scope of the new tax and the tax is basically on "non-banking financial services", not on banking and financial services.

The services included in the new proposal are:

• leasing and hire purchase, discussed separately below
• credit card services;
• merchant banking services;
• securities and forex broking;
• asset management including portfolio management, all forms of fund management, pension fund management, custodial depository and trust services, but does not include cash management;
• advisory and other auxiliary financial services including investment and portfolio research and advice, advice on mergers and acquisitions and advice on corporate restructuring and strategy; and
• provision and transfer of information and data processing.

One again, in the typical rush-rush style of drafting by the draftsmen, a signficant omission is that the new levy includes only "banks and financial institutions" "Financial institutions" are defined to mean financial companies under sec. 45I (c) of the RBI Act. This would, therefore, leave out subsidiaries or affiliates of banks which undertake such services. For example, asset management activities or merchant banking activities are normally hived off into a separate company which is neither a bank nor a financial company under the RBI definition. Therefore, the services rendered by such an entity will not be liable to service tax.

Same applies to portfolio management - usually handled by portfolio managers who are not banks.

 

Comprehensive bill on Securitization

Indian financial sector is eagerly awaiting this law. The draft of the law has already been recommended by the Andhyarujina panel and is already thereon on Vinod Kothari's securitization site.

In para 37, the FM promises to bring in a comprehensive new bill on securitization.

Steps to boost the debt market:

Most of these steps relate to the market in Government securities.

However, an important measure the FM talks about is clarification on tax treatment of new financial instrument such as STRIPS, zero coupon bonds, deep discount bonds, and the like. The CBDT is issuing clarifications, he says, on the tax treatment of these securities.

Legislation on foreclosures and enforcement of securities:

This is an urgent issue and the financial sector has been pleading before the Govt for a long time for a comprehensive bill to enforce security rights in assets. There are charges on assets, but these come for settlement by civil courts under a slow and tardy process.

A committee has already been constituted to recommend a new law on enforcement of securities. The Executive Director of the RBI has been entrusted with the task - the bill is being drafted and the financial sector should be deeply interested in this development.

Taxation provisions affecting financial services:

Hike in depreciation rates on commercial vehicles

Leasing companies as well as commercial vehicle makers should appreciate this change as this would result into more tax shelters on commercial vehicles. The current depreciation rate on commercial vehicles is 40% - it is proposed to be hiked to 50%.

Given the fact that the CBDT has already issued a circular allowing depreciation on financial leases (see for more on this site), leasing of commercial vehicles should now be the in-thing.

Deduction of tax at source on interest:

While the proposed change that lowers the TDS inapplicability slab for interest from banks from Rs. 10000/- to Rs. 2500/- brings a level playing field between banks and non-banking borrowers, this would certainly cause a tremendous problem for those who depend on bank deposits for a earning. A deposit of almost Rs. 25000/- will come for deduction of tax at source.

Non-banking finance companies might find this a reason to cheer as it removes the competitive disadvantage they had before, but must take this with a big pinch of salt, as the regulatory framework on deposit acceptance is becoming very very strict.

Leasing and hire purchase companies liable to service tax:
Budget deals a body blow to finance companies

Everyone knew, though without any clue to the reasons, that the Finance Ministry officials are not particularly very sympathetic to leasing and hire purchase, but no one ever thought that the Finance Minister had this provision up his sleeve. No one could have even apprehended this hearing him deliver his Budget Speech. But it is there in the fine print - a 5% service tax on the gross receivables of leasing and hire purchase companies.

The Budget deals a body blow to the already moribund leasing and hire purchase sector - imposing a service tax on not just the income but the entire receivables out of lease and hire purchase transactions.

Discriminatory

Not only are leasing and hire purchase companies proposed to be brought under tax, they are also grossly discriminated against: as loans from banks, an alternative to lease and hire purchase, have not been brought under the tax.

Constitutional validity to be questioned

Surprisingly enough, leasing as well as hire purchase are not a part of services under the Constitution - as they are defined as "sales" in the Constitution and are liable to sales-tax. In my opinion, service tax cannot be imposed on leasing and hire purchase activities as they are defined as sales under the Constitution and the Constitution places restrictions on tax on sale or purchase of goods - leasing and hire purchase being defined as sale and purchase of goods. The Central Govt's right to tax such sales is only limited to inter-state transactions with the States having the right to tax intra-state transactions. The receivables from lease and hire purchase transactions are therefore, sale revenues under the Constitution, and they cannot be taxed as value for services.

Features of the levy

While the Constitutional validity of the amendment might be argued and challenged over time, here are the details of the proposed law:

• Leasing hire purchase are defined as a part of "banking and other financial services" in the newly amended definition of "services" under the Finance Act 1994. Surprisingly enough, there is no tax really on "banking services", as none of the mainstream banking services have been included in the new levy.
• These services are included in the definition only when they are offered by a bank or a "financial institution". A financial institution borrows its meaning from sec. 45I(c) of the RBI Act which includes all NBFCs as defined in the RBI law.
• Thus, all leasing and hire purchase companies are hit by the new tax but unincorporated players are not.
• Again, ironically, the word "financial institution" is defined with reference to the RBI law, under which chartered financial institutions such as IDBI, IFCI, or State level Institutions are not included. As not too many banks are presently active in leasing and hire purchase business, the service tax on leasing and hire purchase activities will essentially remain a tax on non-banking companies only.
• The tax is at the rate of 5% on the "value of the service".
• The value of the service is defined under sec. 67 as the gross amount charged by the service provider for such service. Evidently, for a lease contract, the gross amount charged is the lease rental, and similarly, in case of a hire purchase contract, the gross amount charged by the hire vendor is the gross amount of hire instalments, including repayment of principal.

"Grossly unfair" - you are likely to say. Am I goofing up in interpretation. I wish I were, but unfortunately I am not.

Gross value of services

Does this mean, in case of a bank, even the repayment of the loan is to be charged to service tax? Not really. First of all, because bank loans are not even included in the definition of financial services. And two, because the splitting of interest and principal is defined in the bank's loan agreement. In case of hire purchase, the splitting of interest and principal is an accounting adjustment, and is not recognised in law as interest or principal. In case of lease transactions, the lease rental is surely the gross value for the leasing service.

 

So as it seems, leasing and hire purchase companies better pack up - since they have to shell out a 5% of their own principal, and 5% of their income, to the Government before they can take up anything to their revenue account.

Will the section be applicable to existing lease/ hire purchase contracts too - sec. 66 (5) provides that the tax is applicable to value of services with effect from the notified date. From what it appears, it sounds like the tax will be applicable to existing lease and hire purchase contracts too.

An evil idea:

The new provision reminds one of the terrible mistake made in 1994 when Modvat was introduced on capital goods - some one had the evil idea of writing a specific clause that would deny Modvat on lease and hire purchase transactions. The present proposal is comparable - while the idea of expanding service tax is laudable idea, but how can you possibly think of imposing service tax in a sphere which is already bearing sales-tax? After all, service tax is supposed to apply in cases where excise and sales-tax are not applicable.

Impact on business:

I tried doing a calculation as to what will be the cost of the new tax on a lease or hire purchase transaction, supposing the tax were to be passed on the customer. The cost of funding for the customer, if it were 15% without the service tax, goes up by 209 basis points to 17.09% for a 5-year contract. If the contract were for 3 years, the cost goes up even more - by 299 basis points.

In the competitive scenario where leasing and hire purchase companies have to compete headlong with banks, it would be impossible to survive in the market with 299 basis points higher cost of funding to the customer, even though with no advantage to the service provider.

And how about existing contracts - if the existing lease and hire purchase contracts are included, as per the inference I draw, profitability of most leasing and hire purchase companies will be more than wiped off by the new tax.

Queries on service tax on leasing/HP transactions [Post your query here pertaining to service tax on leasing and HP transactions. The queries and their answers will be published on this page] Anonymous: What is the effective date for the new tax? Answer: The Govt. has to notify this, but from the Explanatory clauses, one finds that the Govt. will make the new tax effective from 1st July 2001.

 

ECBs lose tax exemption:

The tax exemption available on certain ECBs under sec. 10 (15) (iv) is being scrapped for all money borrowed or debt incurred on and from 1st June 2001. Therefore, the withdrawal of the exemption will not have a retrospective application: those who have already borrowed will be spared of the new tax but new ECBs will presumably become difficult, or will have to be routed through tax haven jurisdictions.

Churning benefit to primary issues:

As an important incentive to primary market, if any capital gains arise from sale of a long term asset being a listed security or a unit, and sale consideration is reinvested in a public offer by a listed company, then the capital gains will be fully exempted. The new shares have to be held for a period of at least one year. This should provide a major impetus to primary issues.

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