No service- no service tax is a general rule- it should be applied to prepayment charges and other non service charges levied by banks.

[Uma Kothari]

Charges in lieu of interest should also not be taxed.

Banking and financial services:

The bank levy several type of charges to customers when there is in fact any service is not rendered. Such charges are in fact in nature of damages or penalty for customers failure in performing his duties fully or partly. For example charges may be levied for:

Minimum commitment charges for not utilizing borrowing facilities charges.

Cheque returning charges.

Delayed payment-- this is in nature of interest so it will be exempt as per valuation Rules.

Loan prepayment charges- this is not for any service rendered by the money lender, rather it is in nature of damages.

Balance transfer charges:

In relation to credit cards most of card issuers provide facility of balance transfer(BT) and levies some charges (1.5 -2.5%) for 90 days. No interest is charged for this period. The fact is that a money is lent as a loan named BT facility. Instead of charging interest, the bank charges BT processing charges, this is nothing but interest. Therefore, such charges should not be burdened with service tax. This is also clear when we consider other schemes of BT in which card issuer/ bank charge interest fro the period of using of BT, and any processing charges are not charged or nominal charges are levied. Therefore suppose in case of a BT of Rs.50000/- if 2% BT processing fees that is Rs.1000 is charged, it is wrong to say that BT processing charges is not interest. Because under other scheme the card issuer/ bank may not charge BT processing fees but interest for a minimum period or for actual period as per terms and conditions.

Therefore, when a charge is levied, which is in lieu of interest, service tax should not be levied.

Loan processing charges- this is levied as a percentage of loan. Therefore, charges can be considered as service charge to some extent and the rest can be considered as a part of interest on loan. For example suppose a loan of Rs.ten lakh is processed and a processing charges of say minimum or 1% of loan amount that is Rs.Ten thousand are collected. In another loan of Rs. One crore processing charges are levied @ 0.50% amounting to Rs.50,000. In this case it cannot be said that the entire amount is for services in relation to processing of loan document. Charges for such services can be say Rs.10,000/- as minimum and Rs.5000 for extra efforts. Thus charges for service is Rs.15,000 and balance Rs. 35000 is in fact not for any service but it is a collection because the bank is in a position to collect extra sum and it can be considered as a part of miscellaneous charges in nature of interest.

Pre payment charges TRU directs to charge service tax:

There is no service rendered by bank when a borrower prepay loan. Therefore pre-closure charges received by the banks / financial institution on pre-payment/ for closure  of loan should not be taxable. Prepayment charges are in fact in nature of damages for the loss of interest suffered by the money lender for the period of early payment. However, as discussed later on, TRU says otherwise in its circular of  11.06.08.

Service tax is a tax on value of service:

It is needless to mention that service tax is leviable only when a person renders a service and other person receive service. Thus rendering and receiving of service for a consideration is a precondition for levy of service tax. Besides this precondition, other conditions relating to nature of service, service receiver and service provider, relationship between two parties and nature of consideration are also important. All conditions laid down in relevant provisions must be satisfied to make a service charge taxable. As per the Finance Act 1994 vide section 65 (105) taxable services are defined as follows;

"taxable service" means any ¹[service provided or to be provided], -

xxxx

Thus, the precondition for levy of service tax is that there must be a service provide or to be provided   by one person to another person. 

Pre closure charges of loan are not for any service:

While granting a loan the bank lent money and in consideration of use of money charge interest. Thus, the function is of a money lender and reward is in nature of interest. In fact 'interest' cannot be called a consideration for service or service charge or fees. It is not necessary to go into this controversy because as per present Rules interest on loan is excluded from taxable service.

In case of a pre-closure of a loan, the borrower payback loan before its scheduled re-payment dates. To keep a check on pre-closures of loan banks charge certain percentage (present range is 3-6%) of principal amount which is repaid earlier than schedules repayment date, as pre-payment charge. For example, suppose a loan of Rs. ten lakh was granted for a period of five years. The borrowers have repaid EMI's for 30 month and now want to prepay entire amount which would otherwise be repayable in 30 months in 30 EMI. Suppose, the principal portion outstanding after payment of 30 EMI's is Rs.640000/-.

If the borrower  prepay this amount, the bank will loose further interest earnings. Again it may take some time to redeploy Rs.6,40,000/- in fresh loan. If rate of interest has fallen, then the bank will be able to redeploy this money at lower rate. Suppose bank can charges prepayment charge @ 3% that is Rs.19200/-. However, the borrower insists to reduce it and bank agrees to Rs.15,000/-. This sum of Rs.15,000/- is nothing but a charge in nature of interest for the non-utilization of credit facility granted by way of loan, it is also  in nature of damages for early termination of contract for loan by the borrower. Thus it is clear that the banks do not render any service when a borrower prepay loan.

Reasons for pre-payment:

Generally pre-payments takes place when:

a. market rate of interest falls.

b. The borrower receives extra fund inflow and he is unable to earn interest or other return or reward on surplus money which are better than the interest payable on loan.      

Consequences of pre-payment of loan:

The money lender find that a profitable loan deployed has been repaid causing shrinkage in loan portfolio. The money lender may not be able to utilize fund flown by prepayment, immediately, by granting fresh loan and therefore, for some time the funds may remain idle. The new loan to be granted may be at lower rate of interest, if there is fall in interest rates. Funds may remain idle for some time or may earn lower returns by way of temporary investments in commercial paper, inter bank loan or by way of keeping funds with RBI or in government securities etc.

Therefore, on a prepayment the money lender- bank suffers loss due to idleness of funds or lower earnings for some time.

In pre-payment by borrower there is  no service by money lender:

When a borrower prepays a loan, the banker or moneylender does not render any service to the borrower. The borrower approaches the banker and offer to prepay the loan, the banker charges prepayment charges as per agreement or as per negotiation, and receives prepayment of loan. Therefore, there is no service rendered by banker/ money lender. When a charge is not for a service, the charge cannot be subject to service tax.

Pre-payment charge is in nature of damages or compensation:

As discussed earlier, prepayment charges is in nature of damages or compensation for loss or likely loss which the bank or money lender may suffer. This is on account of loss of interest which the bank or money lender may suffer during intervening period of repayment and redeployment of funds. Therefore, prepayment charges is in nature of damages and not a charge for service. In any case as prepayment charge is in nature of damages for loss of interest on loan, it will assume character of interest on loan as it is for nonavailment of loan for the full period of loan and is for early termination of contract of loan by the borrower.

View taken in Circular:

Department has issued show cause notices and demanded tax therefore Banks and financial institutions are facing uncertainty on issue about  Service Tax on  pre-payment charges collected on pre-payment of loans from borrowers. Though matters are pending before adjudicating authorities and appellate authorities. The  departmental circular has been issued as clarification holding the view that such charges received by the banks / financial institutions can not be treated as interest on loan  and therefore, liable to service tax. The circular dated 11.06.08 vide file no. F No. 345/6/2008-TRU issued by Tax Research unit reads as follows (high lights provided):

Subject: Service Tax on pre-closure under banking and other financial Services - regarding Commissioner (Service Tax), Chennai has brought to the notice of the Board that divergent practices are being followed in respect of levy of service tax on services provided by banks and other financial institutions on the amount collected as pre-closure / fore-closure charges in relation to lending.

2. Services provided by a banking company or a financial institution or any other body corporate or any commercial concern in relation to banking or other financial services is leviable to service tax under Section 65(105)(zm) of Finance Act, 1994. 'Banking and other financial services' defined under Section 65(12) include lending. Any amount collected by the service provider on account of lending is either interest or service charges. Pre-closure / fore-closure charges are not charges collected for delayed payment. These charges not being 'interest' are to be appropriately treated as consideration for the services provided and accordingly leviable to service tax under Section 65(105)(zm).

3. Field formation may be advised to take appropriate action. This is issued with the approval of Member (Budget).

Unmesh Wagh, Under Secretary (TRU)

Analysis:

It appears that the view taken is that if there is any charge levied by bank etc. in respect of loan or credit facility, it is charge for a service which is taxable unless it is interest on loan. This appears from the  highlighted sentences in the circular given above.

Whether the charge is for any service or not has not been considered, rather merely because there is a levy of a charge, a service has been presumed in Circular of TRU. Merely because a service provider has levied a charge, it cannot be said that it is for a taxable service rendered.

In case of prepayment of loan, the service provider (money lender) does not render any service.

The view taken by revenue is therefore not at all in accordance with the concept of levy of tax on value of a service rendered as envisaged in the charging and other provisions.

Secondly the purpose of prepayment charge has not been considered. As discussed earlier, prepayment charge is nothing but a damage or compensation for earlier than scheduled repayment time. For the period subsequent to the prepayment date the borrower would have paid interest, if prepayment was not made. Again new borrower, to whom funds may be lent, will start payment of interest after some time, and therefore prepayment charge is nothing but a compensation of loss of interest caused due to early repayment of loan.

As discussed earlier, large scale prepayments take place only when interest rates have fallen. In case of firming up of rate of interest, pre-payment are rare. Therefore, in case of prepayment, there is generally also loss of interest to the money lender due to lower rates of interest at which he can deploy funds.

In view of these commercial aspects and business realities it can be said that  clause for prepayment charge is inserted in agreements due to contingencies of borrower returning money before scheduled repayment, fall in rate of interest and period required for redeployment of funds etc. Therefore, pre-payment charges is nothing but in nature of damages for loss of interest, and therefore it is not in nature of charges for any service.

In any case prepayment charges is in nature of charge for underutilization of loan and therefore it will partake character of interest on loan, and therefore it is not to be included in the taxable value of service as per relevant Rule which reads as follows:    

Definition of interest: There appears no definition of 'loan' and 'interest' in the law relating to service tax. We find meaning or definition of 'interest' in the income-tax Act, 1961 in section 2 (28A) which reads as follows:

Definitions.

2. In this Act, unless the context otherwise requires,—

[ (28A) "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) and includes 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 ;]

As per section 2 of the Interest Act the meaning is as follows:

(7) "interest" means interest on loans and advances made in India and includes—

(a) commitment charges on unutilised portion of any credit sanctioned for being availed of in India; and

(b) discount on promissory notes and bills of exchange drawn or made in India, but does not include—

(i) interest referred to in sub-section (1B) of section 42 of the Reserve Bank of India Act, 1934 (2 of 1934);

(ii) discount on treasury bills;]

Some relevant definitions from Britannica ready referencer:

Loan:

1 a : money lent at interest b : something lent usu. for the borrower's temporary use
2 a : the grant of temporary use hire purchase: purchase on the installment plan.

Interest

a : charge for borrowed money generally a percentage of the amount borrowed

b : the profit in goods or money that is made on invested capital

c : an excess above what is due or expected 

Analysis:

On perusal of the above definitions we find that 'interest', has been defined in a wider manner and it specifically includes items like any charge for relevant obligation, charge for unutilized facility, commitment charge on unutilized portion of any credit etc. The prepayment charge, as discussed is nothing but a charge for non-utilization of loan facility for entire period or entire amount. Pre-payment charge is also levied as a percentage of principal outstanding, which is prepaid. Therefore, such charges are in nature of 'interest' as defined in the two fiscal enactments, as well as general meaning in dictionaries.

Service Tax (Determination of Value) Rules, 2006

We also  find that as per Rule 6 of the above Rules  the interest on any loan is to be excluded from the value of taxable service. The relevant portion of the Rule is reproduced below:

6. Cases in which the commission, costs, etc., will be included or excluded.- (1) Subject to the provisions of section 67, the value of the taxable services shall include‚-

XXXXXXX - there is no specific clause to include prepayment charges.

(2) Subject to the provisions contained in sub-rule (1), the value of any taxable service, as the case may be, does not include-

XXXXX

(iv) interest on loans."         

                                                     *****

In these rules there is no definition of interest, therefore we have to adopt a wider meaning to include any payment in nature of and in lieu of interest also.

Keeping in view the above discussion it appears that the circular issued is not correct for the following reasons:

(a) prepayment charges is not for any service rendered,

(b) prepayment charge is nothing but damages for early termination of contract by the borrower and

(c) in any case the prepayment charges are also 'interest' or in nature of interest and in any case they partake character of interest receivable from borrowers.

Therefore, the circular appears to be incorrect.