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Monday, March 11, 2013

Unanticipated consequences of Finance Bill provisions on securitisation

by Bindu Ananth and Kshama Fernandes

Over 2006-12, RBI and SEBI have created a strong and conducive regulatory environment for securitisation, listing of securitised debt instruments, and standards of transparency and reporting. Securitisation volumes have picked up and we recently witnessed the first listed transaction.

In October 2011, the income tax authorities issued a claim on certain securitisation special purpose vehicles (SPVs), stating that the gross income of such SPVs was liable to tax. The matter is presently under sub judice with the Bombay High Court. Several industry participants approached the Ministry of Finance (MoF) to seek clarity and reinforce the "pass through" status of a securitisation SPV.

The Finance Bill, 2013, has sought to clarify the tax position by stating that securitisation SPVs are not liable to pay income tax. However, the Bill also states that trustees of such SPVs must pay tax on distributed income.

The above amendment has an unintentional and significantly negative implication, on account of which taxable investors would be disincentivised from participating in securitisations.

This memo explains the issues and the unintended implications caused by the present draft of the Finance Bill in relation to securitisation SPVs, and provides a possible solution for addressing these issues.

Objectives of the MoF with respect to taxation of Securitisation SPVs

The Finance Minister (FM) in his speech presenting the Budget for the year 2013-14, set out his intent in presenting the proposed changes to the taxation of Securitisation SPVs: "In order to facilitate financial institutions to securitise their assets through a special purpose vehicle".

The depth and vibrancy of the asset securitisation market is an essential building block in transfer of risk and transmission of capital from well capitalised investors to high quality originators. The framework for a well-functioning securitisation market has been laid down in considerable detail by the Reserve Bank of India (in 2006, further strengthened in 2012) and the Securities and Exchange Board of India (detailed guidelines in 2008 and listing guidelines in 2011).

It is our understanding that the objective of the Ministry of Finance in providing the basis of taxation of securitisation SPVs, is to clarify and establish the pass-through status of securitisation.

Changes proposed by the Finance Bill, 2013

Given below is the text proposed to be introduced into the Income Tax Act, 1961 by the Finance Bill, 2013:

CHAPTER XII-EA

SPECIAL PROVISIONS RELATING TO TAX ON DISTRIBUTED INCOME BY SECURITISATION TRUSTS

115TA

  1. Notwithstanding anything contained in any other provisions of the Act, any amount of income distributed by the securitisation trust to its investors shall be chargeable to tax and such securitisation trust shall be liable to pay additional income-tax on such distributed income at the rate of--
    1. twenty-five per cent. on income distributed to any person being an individual or a Hindu undivided family;
    2. thirty per cent. on income distributed to any other person:

    Provided that nothing contained in this sub-section shall apply in respect of any income distributed by the securitisation trust to any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act.
  2. The person responsible for making payment of the income distributed by the securitisation trust shall be liable to pay tax to the credit of the Central Government within fourteen days from the date of distribution or payment of such income, whichever is earlier.
  3. The person responsible for making payment of the income distributed by the securitisation trust shall, on or before the 15th day of September in each year, furnish to the prescribed income-tax authority, a statement in the prescribed form and verified in the prescribed manner, giving the details of the amount of income distributed to investors during the previous year, the tax paid thereon and such other relevant details, as may be prescribed.
  4. No deduction under any other provisions of this Act shall be allowed to the securitisation trust in respect of the income which has been charged to tax under sub-section (1).

115TB.

Where the person responsible for making payment of the income distributed by the securitisation trust and the securitisation trust fails to pay the whole or any part of the tax referred to in sub-section (1) of section 115TA, within the time allowed under sub-section (2) of that section, he or it shall be liable to pay simple interest at the rate of one per cent. every month or part thereof on the amount of such tax for the period beginning on the date immediately after the last date on which such tax was payable and ending with the date on which the tax is actually paid.

115TC.

If any person responsible for making payment of the income distributed by the securitisation trust and the securitisation trust does not pay tax, as referred to in sub-section (1) of section 115TA, then, he or it shall be deemed to be an assessee in default in respect of the amount of tax payable by him or it and all the provisions of this Act for the collection and recovery of income-tax shall apply.

Explanation. -- For the purposes of this Chapter,--

  1. "investor" means a person who is holder of any securitised debt instrument or securities issued by the securitisation trust;
  2. "securities" means debt securities issued by a Special Purpose Vehicle as referred to in the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
  3. "securitised debt instrument" shall have the same meaning as assigned to it in clause (s) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956;
  4. "securitisation trust" means a trust, being a-
    1. "special purpose distinct entity" as defined in clause (u) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956, and regulated under the said regulations; or
    2. "Special Purpose Vehicle" as defined in, and regulated by, the guidelines on securitisation of standard assets issued by the Reserve Bank of India, which fulfils such conditions, as may be prescribed."

The following additions of Section 10 (23DA) and Section 10(35A) are also proposed to exempt from income tax certain income related to Securitisation SPVs:

(23DA) any income of a securitisation trust from the activity of securitisation.

Explanation."For the purposes of this clause,"

  1. "securitisation" shall have the same meaning as assigned to it -

    1. in clause (r) of sub-regulation (1) of regulation 2 of the Securities an<>d Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956; or
    2. under the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
  2. "securitisation trust" shall have the meaning assigned to it in the Explanation below section 115TC;"
    And
    "(35A) any income by way of distributed income referred to in section 115TA received from a securitisation trust by any person being an investor of the said trust"

Unanticipated implications of the proposed text

Securitisation of assets by financial institutions requires the existence of a wide range of investors for whom investment in Securitisation SPVs is a viable option. Currently, predominant investors in the securitisation market in India (particularly in the securitisation related to financial inclusion) are banks. Banks are sophisticated investors and sit on large pools of capital that they must deploy appropriately. Securitisation has been an important way for banks to efficiently and effectively deploy capital where it is needed.

Other investors in securitisation, such as Mutual Funds and private investors currently provide significant but far less capital through securitisation. Yet other investors, such as insurance companies and pension funds, are yet to join the market.

However, it appears that the proposed changes would make the investment in Securitisation SPVs unviable for all but a certain class of income tax exempt investors (such as Mutual Funds). To elaborate on this, given below is a brief synopsis of the tax position of an investor in such SPVs, along with that of the SPVs themselves, as well as the issues arising out of the proposed amendments in the Finance Bill:

  • The current language of the proposed provision states that "any amount of income distributed by the securitisation trust to its investors shall be chargeable to tax and such securitisation trust shall be liable to pay additional income-tax on such distributed income" but as SPVs are designed to be mere mechanisms to route payments. It is not clear how its "income distributed" will be determined for the purpose of Section 115TA.
  • The language used in Section 115TA clearly indicates that the liability to pay "additional" income tax is placed upon the SPVs. It is not clear what this tax is in addition to.
  • Howsoever its income may be determined, as a result of Section 14A, no deduction will be permitted for expenses out of its total income.
  • Income under Section 10 (23DA) or under Section 10 (35A) is income not includable in total income.
  • In terms of Section 14A, no deduction is permitted with respect of income described in Section 10 (23DA) or Section 10 (35A).
  • Investors, other than "any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act", however, often do have incomes and incur expenses in raising money to invest in securitisation transactions.

Illustration:

  • A bank uses Rs. 1,000 of money it has accepted as deposits at the rate of 7.5% to invest in PTCs with a principal amount of Rs. 1,000 with a term of one year.
  • The PTC offers a yield of 13%, translating into a sum of Rs. 1,130 of which (assuming the taxable "income distributed" is Rs. 130) Rs. 39 will be deducted as tax in terms of Section 115TA leaving Rs. 1,091
  • But the bank has to return INR 1,075 to the depositors. Under Section 14A, the interest cost of Rs 75 is not deductible
  • For a pre-tax profit of Rs 55, the post-tax profit of the bank is Rs. 16 i.e. a profit of 1.6 percent. The tax paid in this transaction is Rs. 39. Effectively, the rate of taxation relative to income in the hands of the investor is over 70%.

For the investor, Section 10(23DA), Section 10 (35A) and Section 14A have an effect similar to the taxation of revenue rather than taxation of income.

On the other hand, if the investment in the SPVs was treated, as it was traditionally, as pass-through, the bank would treat the income from investment as any other income and pay tax on its net income (in the example above: Rs 130 - Rs 75 = Rs 55), with an effective rate determined by the net income of the bank, which would be far less than the 70 percent indicated by the proposed language of the Finance Bill, 2013.

Therefore, the unanticipated consequences of the present draft of the Finance Bill are:

Higher effective rate of taxation of income from securitisation, when compared to other sources of income of an investor

Tax paying investors will stay away. Banks, NBFCs etc. may not be willing to invest in securitised debt instruments, unless compensated for the higher tax payable

Severe impact on market depth and liquidity. Banks are presently the largest investors in securitisations and their absence would severely inhibit the growth of the market

No incentive for new investor classes to participate. Investors such as private wealth, corporate treasuries, AIFs etc. may find securitisation an unviable investment option

An alternative draft

It may be noted that the taxation of private trusts is well understood and has been relatively stable for a significant period of time. If we wish to avoid the unanticipated consequences as outlined above, we would require reinforcement and restatement the existing position of law.

Attention may also be drawn to the provisions of Section 160, relating to representative assessees, which would also apply to trustees of private trusts, including Securitisation SPVs. The proposed addition of Section 10 (23DA) and Section 10 (35A) should be removed and no changes must be made to Section 10 in this regard.

It may be beneficial if the proposed Section 115TA read (in a restatement of the existing law) as follows:

CHAPTER XII-EA

PROVISIONS RELATING TO INCOME FROM INVESTMENT IN SECURITISATION TRUSTS

115TA.

(1) Any amount of income received by an investor from a securitisation trust shall be chargeable to tax as part of the total income of such investor.

Provided that nothing contained in this sub-section shall apply in respect of any income distributed by the securitisation trust to any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act.

Explanation.--For the purposes of this Chapter, --

  1. "investor" means a person who is holder of any securitised debt instrument or securities issued by the securitisation trust;
  2. "securities" means debt securities issued by a Special Purpose Vehicle as referred to in the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
  3. "securitised debt instrument" shall have the same meaning as assigned to it in clause (s) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956;
  4. "securitisation trust" means a trust, being a-
    1. "special purpose distinct entity" as defined in clause (u) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956, and regulated under the said regulations; or
    2. "Special Purpose Vehicle" as defined in, and regulated by, the guidelines on securitisation of standard assets issued by the Reserve Bank of India, which fulfils such conditions, as may be prescribed."

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5 comments:

  1. nitesh ranjanWednesday, 13 March 2013 at 13:01:00 GMT+5:30

    I have a different view so far tax impact is concerned. In your hypothetical case, for an investment of Rs.1000 in SPV by a bank where return in 13%, income of the bank is Rs.130 and 30% tax is to be deducted on this. Your point is that bank incurs expenditure of Rs.75 for deposit of Rs.1000, hence net taxable income is Rs.55 (130-75) and tax be deducted on this amount.
    Even otherwise, bank in its final tax assessment will show Rs.75 (on account of deposit cost) as deductible from its income. Therefore, it may claim double benefit - one if allowed to deduct expenses at SPV stage and second when it prepares final financial statement. Hence, it is better not to allow any expenses at SPV stage. I am not a tax expert hence might be missing the nuances.

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    Replies
    1. Kshama FernandesWednesday, 13 March 2013 at 20:15:00 GMT+5:30

      Agree with you. The hypothetical case illustrates that if the investor were taxed on the Rs.130, i.e. on the "income distributed", this would amount to taxation of revenue not income of the investor. Our view is that calculating taxable income / deducting expenses etc. at the SPV level is regressive. The investor should be ultimately liable for his / her tax payments to ensure (a) uniformity of treatment for investors who may have different tax rates and (b) facilitating a secondary market for such securities. This is similar to what has already been done for non-convertible debentures, where interest income / capital gains is calculated for the investor’s tax computation and no deduction at source is required

      Delete
    2. AnonymousMonday, 18 March 2013 at 13:51:00 GMT+5:30

      In the above case:
      1. Will the Bank be able to claim the deposit cost amongst overall cost?
      2. Will the Bank be liable to pay income tax on the income of INR 91, which would effectively mean a case of double taxation.

      Also the article highlights the significance of the words "additional tax", but as per a blog by Vinod Kothari, this is simply a case of historical usage rather than a case of something 'additional'.

      Delete
    3. AnonymousMonday, 18 March 2013 at 17:15:00 GMT+5:30

      I am not sure how both the cases are similar. In one case the Bank/any corporate will have to pay tax on INCOME and in the other case the tax will be on return ( Income - Cost).

      Delete
  2. vinodkothariMonday, 11 January 2016 at 16:18:00 GMT+5:30

    Let us appreciate that distribution tax on securitisation is a problem, and we are now trying to approach the problem to look for solutions.
    There are two ways to address a problem - trying to find a way to correct the scenario, or trying to a fundamental question as to whether the distribution tax , in the first place, was justified at all?
    Distribution tax exists in case of corporate dividends and mutual funds distributions, where the premise is that there may be a revenue leakage if we taxed the recipients, whereas, if we tax at the time of distribution, that possibility is minimised.
    The type of investors who invest in shares and mutual fund units, and those who invest in securitisation, are fundamentally different. Investors in securitisation are mostly banks, financial institutions, etc. The question of any revenue leakage, if the recipient of the income was tax rather than taxing at source, does not exist at all. Therefore, there is no case, in the very first place, for a tax at the time of distribution.
    Let us appreciate that distribution tax is essentially inequitable, as it fails to look at the net income of the recipient.
    In the instant case, if a securitisation trust receives 10% income on an investment of Rs 100 made by the investor, and pays 30% tax on that, the investor gets a post-tax return of 7%. The investor mostly may be a leveraged institution having its cost of funding, which may mostly be higher than 7%. This makes the investment eminently unprofitable. All the more, the model completely divorces taxability of the income from the expenses incurred in generating the income.
    Let us realise that we are one out of 100 odd countries in the world, which have securitisation, much more developed than ours. Hence, we do not have to invent a model that does not exist anywhere in the world. Securitisation taxation world-over tries to neutralise the tax on the SPV, so that the existence of tax at SPV level does not make the transaction tax-inefficient. Securitisation is not a tax shelter, but it cannot end up being a tax burden. Hence, the objective of the law is to ensure that the law puts conditions on tax transparency, which adequately safeguard the transaction from being a tax shelter.
    In India, there is no evidence in the past of securitisation resulting into any tax leakage. Hence, the very concern that distribution tax tries to address does not exist.
    On the hand, the impact of distribution tax in the past 3 years is quite evident. Most transactions have moved away from securitisation model to bilateral assignments, which is like being primitive.

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