NOVEMBER 28, 2018

By Vijay Kumar

GST on Penal Interest

WHEN you take a loan from a Bank or a Non Banking Financial Company and you don't repay the loan and interest (generally called EMI - Equated Monthly Instalments), you are burdened with another penal interest over the regular interest for your delay in EMI payments. Normally you don't pay the EMI and invite the wrath of penal interest, only when your liquidity does not allow you to make the payment, unless you happen to be some political businessman determined to contribute his mite to the NPAs of the banks. But when you make this extra payment, the taxman is watching. If you are so poor that you cannot pay your EMI, your Bank has to ensure that the penal interest is recovered from you with GST.

The History: Lending was brought under Service Tax net with effect from 10.09.2004 by the Finance Act, 2004, but it was stipulated in Section 67 of the Act (Finance Act, 1994) that the value of a taxable service does not include - interest on loans. Later, an identical provision was included in Rule 6(2)(iv) of the Service Tax (Determination of Value) Rules, 2006. From 01.07.2012, the Negative List introduced by Section 66D had services by way of - extending deposits, loans or advances insofar as the consideration is represented by way of interest or discount, in the negative list and so, not taxable.

In HDFC Bank vs Commissioner - 2014-TIOL-2285-CESTAT-MUM, the Tribunal observed, "Prima facie we are of the view that the penal interest is payable on delay of the advance given by the applicant to their clients. Therefore, same also form part of the interest of loan. Accordingly, service tax is not payable." In the case of Waltair Club vs Commissioner, the Tribunal observed, "We find prima facie, the demand of service tax on penal interest is not sustainable." Disputes are pending at various stages.

Bajaj Finance Ltd, in its Annual Report 2017-18, states, "The Company has received a show cause notice from service tax authorities claiming service tax on penal interest/charges, aggregating Rs.53.87 crore. The Company, in line with the opinion obtained from a legal counsel is of view that the said demand is not tenable and has filed reply on 23 March 2018."

Then comes the Good and Simple Tax - GST. Is Penal interest taxable under GST?

Interest on loans is exempted from payment of CGST under Serial No. 27 of the Notification No. 12/2017 Central Tax (Rate) dated 28.06.2017 -

Services by way of (a) extending deposits, loans or advances in so far as the consideration is represented by way of interest or discount (other than interest involved in credit card services).

The same Bajaj Finance, which was of the opinion that Service Tax demand on Penal Interest was not tenable took the issue to the Authority for Advance Ruling with two questions -

1. Whether the Penal Interest is to be treated as interest for the purpose of exemption under Sr. No. 27 of Notification No. 12/2017 Central Tax (Rate) dated 28.06.2017;

2. If the answer to the above is negative, whether the activity of collecting penal interest by the Applicant would amount to a taxable supply under the GST regime?

They submitted inter alia that:

1. Penal Interest is an additional interest on the overdue loan instalment, and therefore, would be exempt from GST. To further emphasise, penal interest should be treated as a part of interest, and therefore, would be exempt from GST.

2. The amount of overdue loan instalment is virtually a new loan transaction given to the borrower/customer for the period of delay, the consideration for which is the penal interest charged on such overdue loan instalment.

3. The penal interest collected by the Applicant is nothing but interest on loans only.

The AAR wisely RULED: 2018-TIOL-264-AAR-GST

1. The interest is calculated on the entire tenure of the loan given and then on that basis and the amount of loan EMIs are collected from their customers. The interest amounts are not calculated on a monthly basis and therefore it cannot be said that the default charges is for the period of delay not included in the EMI/installment amount.

2. They have also submitted that the amount of overdue loan installment is virtually a new loan transaction, the consideration for which is the penal interest charged on such overdue loan installment.

3. This assumption by the applicant that the EMI is nothing but a new loan amount advanced to the applicant is not only fallacious but also devoid of merit because from the agreements it is seen that the rate of interest on the loan advanced and the rate at which penal charges are collected on the so called new loan amount (i.e. the defaulted EMI) are also different.

4. The penal charges, which are termed by them as additional interest, such so called additional interest is also levied on interest component of the EMI.

5. Another important point is that the applicant themselves have submitted that the percentage of penal interest varies from customer to customer. This clearly shows that such amount collected by them in case of default by their customers does not have a fixed rate as in the case of interest on advances of loans, etc.

6. The receipt of penal charges on delayed payment of EMIs would be receipt of amounts for tolerating the act of their customers for having delayed/defaulted on their EMI payments within due dates

7. Thus there is clearly an agreement that the applicant, in the case of default of payment of EMI by their customer, the applicant would tolerate such act of default or a situation and the defaulting party i.e their customer was required to compensate the applicant by way of payment of extra amounts in addition to principal and interest as per the terms and conditions of the Agreement.

8. The exemption for financial transactions under GST laws is only in respect of the interest/discount earned or paid for loans, deposits or advances. If the transaction, as in the subject case deviates from the above, the same fails the test of being a "loan", "deposit" or "advance", or the consideration is not an interest or discount, the exemption is not admissible.

9. Thus, the applicant has agreed to do an act (the act of tolerating, of delayed payment of EMIs by their customers) and therefore the amounts received by the applicant for having agreed to do such an act, would attract tax liability under GST laws.

10. The said activity squarely falls under clause 5(e) of the Schedule II of the GST Act, 2018 and therefore such amounts received, would attract tax liability under GST laws.

PwC in its recent newsletter commented, "This ruling adopts a position that appears contrary to the approach adopted historically by the financial services industry as no differentiation between 'general' and 'penal' interest from an indirect tax perspective has been adopted. While the ruling is binding only on the applicant and its jurisdictional officers (subject to appeal), this creates another area of potential dispute and the industry may need to represent this issue to the CBIC."

The Finance Industry Development Council had long ago in April 2017, even before GST made its good and simple appearance, had represented to the Government:

Interest on loans and advances, including the penal interest/ charges for delayed payment, are purely an income which are subject to income tax. As such, there has not been, and there should not be, any further tax levied on interest.

We request that a clarification exempting interest and penal interest be issued.

And the Government also responded through one of its FAQs as:

Clarification is sought for the following: Penal Interest on loans and advances:

Penal interest is a consideration for tolerating an act and it is a supply of service and will be taxable.

The AAR was only echoing the views of the Government. What will happen is, that not only GST will be collected on penal interest, but also service tax demands for the period prior to 01.07.2017 will be issued and luxurious litigation for the next ten years or more is assured.

It is beyond comprehension as to why businessmen, who are otherwise smart and clever, go to the AAR with their doubts. Do they really expect two Joint Commissioners to decide the LAW in their favour? If they do, they deserve the kind of orders they are getting.