SERVICE TAX ON SECURITIZATION OF DEBTS

[Dr. Sanjiv Agarwal]

Many banks and NBFCs sell portfolio of loan receivables under buy out programme of various banks at mutually agreed discount to the book value. The sale of loan portfolio is done under an agreement and entire gain on sale of portfolio of loan receivables is recognised as income in the year of sale.

Such companies receive income, in addition to "Interest" on loans, in the form of "Admin Charges for insurance", "Loan Processing Fee", "Registration Fee", "Membership Fee", "Income from Managing Securitized Portfolio", "Hire Charges Earned", "Gain on Sale of Portfolio to Banks", etc., The above charges received by these entities are shown in their audited financial accounts under the heads "Income". Such entities  pay the Service Tax due on the income receive in the form of "Admin Charges for insurer’s", "Loan Processing Fee", "Registration Fee", "Membership Fee", "Income from Managing Securitized Portfolio", "Hire Charges Earned" under the category of "Banking and other Financial Service" and also  file the Service Tax returns regularly.

Sale of Portfolio

Premiums on sale of loan portfolio is considered as profit on sale of asset and is not covered under the scope of taxable services.

Loans assigned to the banks are no more receivables in the books of account of NBFCs  and that the assigned loans are receivable for the assignees, ie, banks and not for NBFCs. This is also adequately explained in significant accounting polices and notes to accounts of audited financial statements.

NBFCs assign the rights acquired due to lending amount to various borrowers (obligers) to banks or financial institutions. NBFCs also enters under separate agreement to act as collection agent to collect the debts on behalf of assignee and remits the same on collection thereof. This obligation is done for a consideration as per the agreement between the two parties.

Business Auxiliary Services

The services provided by NBFCs are not the services provided on behalf of the banks / financial institutions and NBFCs are neither a commission agent nor provide services of commission agent so as to be covered under ‘business auxiliary services’

The definition covers ‘provision of service on behalf of the client’. Business auxiliary services generally cover all type of services undertaken on a commercial basis for, or on behalf of the client. It is clear that services to the client are not taxed under this category but services provided on behalf of client are sought to be covered under business auxiliary services. The basis of chargeability of service tax under this service is providing stipulated services on behalf of the client. In the instant case, no service whatsoever, is provided on behalf of the client.

Securitization of Debts- Guidelines

The Guidance Note on Accounting for Securitization issued by the Institute of Chartered Accountants of India (ICAI), has dealt with issue of securitization of debts (transactions undertaken by NBFCs as under-

• Securitisation is the process by which financial assets such as loan receivables, mortgage backed receiv­ables, c-edit card balances, hire-purchase debtors, lease receivables, trade debtors, etc., are transformed into securities. Securitisation is different from 'fac­toring' in that 'factoring' involves transfer of debts without transformation thereof into securities.

• The originator may continue to service the securitised assets (i.e., to collect amounts due from borrowers, etc.) with or without servicing fee for the same.

• The originator may securitise or agree to secu­ritise future receivables, i.e., receivables that are the time of entering into the transaction and the purchase consideration for the same is received by the Originator in advance. Securitisation can also be in the form of 'Revolving Period Securitisation' where future receivables are transferred as and when they arise or at specified intervals; the transfers being on pre-arranged terms.

Reserve Bank India (RBI) has issued guidelines on securitization of standard assets vide RBI Circular No DBOD No. BP. BC.60/21.04.048/2005-06 dated 1.2.2006. Accordingly, following extracts are relevant -

Securitisation is a process by which assets are sold to a bankruptcy remote special purpose vehicle (SPV) in return for an immediate cash payment. The cash flow from the underlying pool of assets is used to service the securities issued by the SPV. Securitisation thus follows a two­ stage process  the first stage there is sale of single asset or pooling and  sale of pool of assets to a 'bankruptcy remote' special purpose vehicle (SPV) in return for an immediate cash payment and in the second stage repackaging and selling the security interests representing claims on incoming cash flows from the asset or pool of assets to third party. investors by issuance of tradable debt securities.

The RBI Circular also provide for warranties. An originator that sells assets may make representation and warranties concerning  those assets subject to certain conditions. 

In terms of these RBI guidelines, banks can sell assets to SPV only on cash basis and the sale consideration should be received not later than the transfer of the asset to the SPV.

The quality of assets in question (debt portfolio) is of crucial  importance to ascertain its credit worthiness and ascertainment of premium. The servicing of portfolio sold thus, assumes significance. The seller of portfolio assures the prospective buyer of performance of assets by commuting to the buyer to service the portfolio. In effect, it becomes one of the conditions (just like a warranty ) to sell the portfolio.

Normally, the transfer of loans is done through the securitization transactions wherein the loan receivables are securitized both through bilateral direct assignment route as well as transfer to special purpose vehicles (SPV). The transferred loans are de recognized in the balance sheet as and when these assets are sold and the consideration received.

Securitisation means a process by which a single performing asset or a pool of performing assets are sold to a bankruptcy remote SPV and transferred from the balance sheet of the originator to the SPV in return for an immediate cash payment.

SPV means any company, trust, or other entity constituted or established for a specific purpose –

(a) activities of which are limited to those for accomplishing the purpose of the company, trust  or other entity as the case may be; and

(b) which is structured in a manner intended to isolate the corporation, trust or entity as the case may be, from the credit risk of an originator to make it bankruptcy remote.

The securitization of assets generally being undertaken by the banks is on the basis of 'True Sale', which provides 100% . protection to the Bank from the default. All risks in the securitised portfolio are transferred to the Special Purpose Vehicle (SPV). Post-securitisation, banks continues to service the loans transferred under securitization. Banks also provides for credit enhancements in the form of cash collaterals.

In bilateral arrangement, the portfolio is directly sold / securitized without any SPV and without rendering any service, whatsoever.

Substance over Form

According to Accounting Standard- 1 issued by the Institute of Chartered Accountants of India and Central Government, the primary consideration in presentation of financial statements and selection of accounting policies by a business enterprise is that it should represent a true and fair view of the state of affairs and profit and loss account of the enterprise. The major considerations governing the selection and application are prudence, substance over form and materiality.

Accordingly, the accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form. Thus, substance should take precedence over its legal form. In any commercial transaction, substance must be recognized rather than its form.

It is a settled rule that in the determination of liability to taxation under a taxing Act, the court has regard to the substance rather than the form of the transaction sought to be taxed, that is to say, in the case of an instrument that the court is not bound by its apparent tenor but will decide according to the real nature of the transaction. It is not the name of the tax but its real nature which must determine into what category it falls, at the same time it is not proper to take the motives of the assessee, in bringing about a particular arrangement, into consideration, and a subject is entitled, if he can, in any legal manner, to circumvent the incidence of a particular taxing or financing Act. It is open to parties to conduct themselves of any camouflage that the law allows and does not forbid especially in the case of an enactment for revenue purposes, such as Court Fees Act. It is not open to a court in such circumstances to neglect the actual form of the instrument and determine the question of court-fees having regard to what may be said to be the substance of the claim. Lord Summer in Levene v Inland Revenue Commissioners, observed as follows:

Before determining the nature of the taxes which can attract in the context of the Agreements, it is essential to determine the intention of the contracting parties and the true nature of the transaction as per the law declared by the Hon’ble Supreme Court in various judgment including the judgment in the case of Bharat Sanchar Nigam Ltd v Union of India reported in 2006 -TMI - 309 - (Supreme court).

In addition, it is submitted that it is an established principle of law that commercial documents must be construed in a manner as are understood in commercial parlance. These are business agreements and must be read as a businessmen would read them (Refer to W T Suren & Co. (P.) v. CIT 80 ITR 602 at page 616).

The relationship between service provider and service receiver is crucial element to be considered for the purpose of levy.  In the matter of levy, it is always a question of hiring a person for rendering service and relationship is one of client to service provider.  Person who provides service should be one who is engaged in business of rendering service to any one who requires such services from him is an essential element in considering leviability of service tax. 

Sale v Service

Service tax is leviable on the transactions or activities falling under any of the clauses of section 65(105) of the Finance Act, 1994. The taxable event for service tax must necessarily be the rendition of services as per section 66 of the Finance Act, 1994.                        

Service tax is applicable on rendition of services and not on sale. While goods or intangible goods may be sold, services will have to be rendered. There is nothing like sale of service. Service tax is a tax on activity where as sales tax is a tax on sale of things or goods.

In a transaction involving sale, transfer of goods or transfer of right to use is essential in case of a deemed sale under article 366 of the Constitution. If this does not happen, the transaction would only be a service and a taxable service if covered as per clause 105 of section 65 of the Finance Act, 1994. The question as to whether a transaction would amount to sale a service depends on individual transaction which is the subject under discussion is only a sale of portfolio or in other words, assignment of debt receivable which is not a taxable service as on date.

In All India Federation of Tax Practitioners' case 2007 -TMI - 1556 - Supreme Court Supreme Court explained the concept of service tax and held that service tax is a Value Added Tax ('VAT' for short) which in turn is a destination based consumption tax in the  sense that it is levied on commercial activities and it is not a charge on the busi­ness but on the consumer. That, service tax is an economic concept based on the principle of equivalence in a sense that consumption of goods and consumption of services are similar as they both satisfy human needs. Today with the techno­logical advancement there is a very thin line which divides a "sale" from "ser­vice". That, applying the principle of equivalence, there is no difference between production or manufacture of saleable goods and production of market­able/saleable services in the form of an activity undertaken by the service pro­vider for consideration, which correspondingly stands consumed by the service receiver. It is this principle of equivalence which is inbuilt into the concept of service tax under the Finance Act, 1994. That service tax is, therefore, a tax on an activity. That, service tax is a value added tax. The value addition is on account of the activity which provides value addition, for example, an activity under­taken by a chartered accountant or a broker is an activity undertaken by him based on his performance and skill. This is from the point of view of the profes­sional. However, from the point of view of his client, the chartered account­ant/broker is his service provider. The value addition comes in on account of the activity undertaken by the professional like tax planning, advising, consultation etc. It gives value addition to the goods manufactured or produced or sold. Thus, service tax is imposed every time service is rendered to the customer/client. This is clear from the provisions of Section 65(105)(zm) of the Finance Act, 1994 (as amended). Thus, the taxable event is each exercise/activity undertaken by the service provider and each time service tax gets attracted. The same view is reiter­ated broadly in the earlier judgment of  apex  in Godfrey Phillips India Ltd. v. State of U.P. 2005 -TMI - 105462 - SUPREME COURT OF INDIA in which a Constitution Bench observed that in the classical sense a tax is composed of two elements: the person, thing or activ­ity on which tax is imposed. Thus, every tax may be levied on an object or on the event of taxation. Service tax is, thus, a tax on activity whereas sales tax is a tax on sale of a thing or goods.

We can not draw an analogy which is sustainable that a transaction which is not a sale is a service or vice versa. Such an attempt would jeopardize the legislative intention as well as principle of equity in taxation.

In such cases, a NBFC provides banking and other financial services. Also, no services are provided ‘on behalf of’ service recipient for recovery of debts. This fact also disqualifies NBFCs  from being considered to be covered under business auxiliary services.

Considering the classification norms as per section 65A of the Finance Act 1994, any service needs to be classified based on such principles. It is not that all agents could be taxed as commission agents under business auxiliary services. A specific service should be classified into most appropriate category of taxable service and that’s why there are categories such as custom house agent, rail travel agent, air travel agent, real estate agent, C & F agent, insurance agent, stock broker, recovery agent etc. One has to follow the criteria of classification as per section 65A. It is also important that a particular service has to be classified into one category only.

 = = = = = = = =