‘The Interconnect’ : Resolving Stressed Accounts – tax derailment?
Ketan Dalal (Managing Partner, Katalyst Advisors LLP)
Over a period of time, Indian businesses have expanded significantly and extended their reach to global markets. In order to support expansion, businesses have availed various types of finances / loans for setting up as well as running their business operations, from various stakeholders such as banks, financial institutions, private and strategic investors, etc. However, due to several factors such as downturn in global market conditions, intense pricing competition, technology disruptions, etc. many businesses have not been able to sustain their business operations and have been unable to repay their outstanding loans. Consequently, several accounts have become non-performing assets (NPA).
In the past, the RBI has provided banks several mechanisms to take action against the stressed accounts such as corporate debt restructuring, 5/25 scheme, strategic debt restructuring (SDR), joint lender’s forum (JLF) and scheme for sustainable structuring of stressed assets (S4A). However, these schemes have achieved limited success in resolving the issue of stressed assets.
As on 31 March 2017, the Indian Banking system is saddled with bad loans of over Rs 7 lakh crores. To tackle this serious issue, the Government has already taken up strict actions wherein 50 top stressed accounts (which constitutes around 70%-80% of the total bad loans) have been identified. The powers have been given to the RBI to deal with stressed assets of banks by authorising RBI to issue directions to any bank to initiate insolvency proceedings under the Insolvency and Bankruptcy Code, 2016 (IBC). RBI has already identified 12 accounts with exposures of over Rs 5,000 crore each (constituting 25 per cent of current gross NPAs of the banking system) for immediate reference under IBC. The IBC provides for resolution within a time of 180 days from the date of acceptance of application. In case the same is not resolved in a time bound manner, an official liquidator would be appointed by the NCLT and liquidation proceedings would be initiated against such borrowers. RBI has also asked banks to resolve 55 high value cases of bad loans within 6 months, otherwise, it would examine those cases and may refer the matter for the new insolvency resolution mechanism.
Separately, 100% FDI has already been permitted in Asset Reconstruction Companies (ARC) under Automatic Route, Sponsors are now allowed to hold up to 100% equity in an ARC as well as exercise majority control over its board and Non-banking financial companies (NBFCs) with an asset size of more than Rs 500 crores have also been included as SARFAESI eligible lenders. This reflects the clear intent of Government to clean up the stressed assets from the system.
Generally, banks or financial institutions enter into a one-time settlement with the borrower wherein certain principal and interest pertaining to the loan is waived off. However, income-tax implications for such loan waiver in the hands of borrower has been subject matter of significant litigation. We have analysed below applicability of relevant provisions in case of waiver of loans and key underlying principles emerging from key judicial precedents.
Taxability of Principal waiver u/s 41(1) of the Income-tax Act, 1961 (‘Act’)
Section 41(1) of the Act is a deeming section and covers within its ambit amount obtained (in cash or any other manner) in respect of loss or expenditure or some benefit derived by the assessee on account of remission or cessation of trading liability, which has been allowed as deduction in the assessment of any earlier year. Thus, to trigger the provisions of Section 41(1), the assesse should have been allowed a deduction in respect of the loss or expenditure or a trading liability and subsequently, the assessee must have (i) obtained any amount in respect of such loss or expenditure or (ii) obtained any benefit in respect of such trading liability by way of remission or cessation thereof [Supreme Court decision in the case of Polyflex India (2002) 257 ITR 343].
In case of waiver of loan, the assessee would not have got any deduction for the principal amount and hence, the question of taxability of such principal amount waived u/s 41(1) does not arise irrespective of whether such loan was utilised for acquiring a capital asset (notwithstanding the depreciation which may have been allowed on such capital asset) or was utilized for the working capital requirements of the business. This position has been affirmed by The Delhi High Court in the case of Phool Chand Jiwan Ram (1981) 131 ITR 37 and Bombay High Court in the case of Mahindra and Mahindra Ltd (2003) 261 ITR 501.
Taxability of Principal waiver u/s 28
Section 28(i) covers within its ambit profits and gains of any business or profession carried on by the assessee at anytime during the previous years; Section 28(iv) covers the value of any benefit or perquisite, whether convertible into money or not, arising from business or the exercise of profession as being taxable.
In this context, the landmark Supreme Court judgment, which has been applied in most of the subsequent major judgements, in the matter of CIT vs T.V. Sundaram Iyengar & Sons Ltd. (1996) 222 ITR 344 while taxing the waiver of trading loan, has held, “If an amount is received in course of trading transaction, even though it is not taxable in the year of receipt as being of revenue character, the amount changes it character when the amount becomes the assessee’s own money because of limitation or by any other statutory or contractual rights. When such a thing happens, common sense demands the amount should be treated as income of the assessee.” Therefore, a critical parameter to determine the taxability of waiver of principal liability pertaining to any loan would depend on the purpose for which the loan has been utilized (for capital purpose or for trading purpose).
- Waiver of loan utilized for the acquisition of capital asset:
In order to get covered u/s 28(iv), the receipt must be arising from the business. Waiver of bank loan availed for the purpose of acquisition of capital asset is a capital receipt, and waiver of such a loan cannot be treated as any benefit or perquisite arising from the business. As such, the grant of loan by a bank for acquisition of a capital asset cannot be termed as trading transaction. Also, mere waiver of a loan by the bank does not change the character of the receipt, which was capital in nature at the time of receipt. This position has been affirmed by the Bombay High Court in the case of Mahindra & Mahindra (supra) and Xylon Holdings (P.) Ltd (2012) 26 taxmann.com 333, the Madras High Court in the case of Iskraeco Regent Ltd.(2011) 331 ITR 317 and the Delhi High Court in the case of Tosha International Ltd (2008) 116 TTJ 941.
Further, the words ‘whether convertible into money or not’ require the benefit or perquisite to be in kind in order get covered by Section 28(iv). In case of Alchemic (P.) Ltd (1981) 130 ITR 168, the Gujarat High Court has held that Section 28(iv) triggers only if the benefit or the perquisite is non-monetary benefit or non-monetary perquisite. Similar view has also been adopted by Courts / Tribunals in other cases. In case of loan waiver, there is a cash benefit and relying on the above judicial precedents, one may contend that waiver of loan cannot be taxed u/s 28(iv).
With regard to taxation u/s 28(i), one can contend that the receipt which does not bear the character of income cannot be taxed u/s 28(i) until and unless there is a specific provision to that effect. In the given case, the loan per se is a capital receipt and mere waiver of a loan does not alter the character of the receipt, which was capital in nature at the time of receipt and hence, cannot be taxed u/s 28 in the absence any specific provision.
In view of the above, waiver of loan utilized for the acquisition of capital asset should not be subject to tax u/s 28.
Waiver of loan utilized for the working capital / business purposes:
As mentioned above, Section 28(iv) is restricted only to non-monetary benefit or non-monetary perquisite arising from the business, whereas Section 28(i) considers the receipt which bears the character of income. Just because the loan is utilized for the working capital / business purposes, the character of loan cannot be changed to a trading receipt. Accordingly, such waiver should also not be taxed u/s 28.
However, courts have taken a contrary view that waiver of loan utilised for the working capital purposes is to be considered as revenue receipt liable to tax. The Delhi High Court in the case of Logitronics Pvt. Ltd (2011) 333 ITR 386 has held that if the loan is taken for trading purpose, was treated as such from the very beginning in the books of account, as per T.V. Sundaram Iyengar & Sons Ltd.’s case (supra), the waiver thereof may result in the income more so when it was transferred to Profit and Loss account. This judgment has noted the argument of the assessees that Section 28(iv) is not applicable to monetary benefits. However, the Court has not appropriately dealt with this contention and no specific reason is given for deciding the issue against argument of the assessee that Section 28(iv) is not applicable to monetary benefits. This judgement has been followed by the Delhi High Court in the case of Rollatainers Limited (2011) 339 ITR 54.
The Bombay High Court has also in the case of Solid Containers Ltd. (2009) 308 ITR 417 held that the amount of loan taken for trading activity is taxable upon waiver. However, in this case also, the context of non-application of Section 28(iv) to cases of monetary benefits was neither taken up by the assessee nor it was considered by the High Court.
Implications of Principal waiver vis-à-vis MAT u/s 115JB
Income-tax implications of loan waiver under the provisions of Minimum Alternate Tax has been recently dealt by Mumbai Tribunal in the case of JSW Steel Limited (2017) 82 taxmann.com 210 wherein it has been held that if an assessee company is in receipt of a ‘capital receipt’ which is not chargeable to tax at all, that is, it does not fall within any of the charging Section or can be classified under any heads of income under the Income Tax Act, then same cannot be treated as part of net profit as per Profit & Loss account or reckoned as ‘working result’ of the company of the relevant previous year and consequently, cannot be held to be taxable as ‘book profit’ under MAT in terms of Section 115JB regardless of treatment in the books of accounts.
Taxability of Interest waiver
In respect of interest waiver, if the interest amount which was allowed as a deduction in any of the earlier years, the waiver of such interest liability being in the nature of trading liability, can be subject to tax u/s 41(1) (Solid Containers Ltd). On the other hand, if such interest was disallowed to the assessee by virtue of Section 43B, then subsequent waiver of such interest can not be taxed in the hands of the assessee (Spel Semiconductor Ltd (2013) 59 SOT 114 (Chennai Tribunal)).
Additionally, in case the loan is utilised for acquiring a capital asset and interest pertaining to such loan has been capitalised to the cost of such asset, then waiver of such interest liability cannot be taxed u/s 41(1) since no deduction of interest expenditure has been allowed to the assessee. In this context, in the case of Shri Kansara Modular Ltd. (2013) 155 TTJ 79, Jodhpur tribunal has held that depreciation is outside the ambit of Section 41(1) and what is actually covered in Section 41(1) is \'profits\' derived in respect of loss or expenditure or some benefit in respect of trading liability by way of remission or cessation thereof. Tribunal has held that \'Availing of loan\' and \'claim of depreciation\' are two distinct things, which cannot be clubbed together and, therefore, remission of loan alongwith interest (on which assessee got no deduction u/s 36(1) (iii) or u/s 37) will not amount to remission of depreciation. Similar position has also been adopted by the Bangalore tribunal in the case of Akzo Nobel Coatings India (P.) Ltd. (2012) 28 taxmann.com 82.
Manner of bifurcation of waived amount
In some cases of lumpsum settlement, it may not be possible to apportion the principal and interest component. This issue has been dealt by Bombay High Court in the case of Akay Organics limited (IT appeal No.5481 of 2010) where the principle has been laid down that when the amount paid as “one time settlement” cannot be separated as that paid towards the principal loan liability and that towards the interest, in such a case, it is to be assumed that the whole of the such sum is first paid in settlement of principal loan amount outstanding and the balance is towards the interest.
Tax implications u/s 56(2)(x) in the hands of Banks / Lenders
The Finance Act, 2017 has inserted Section 56(2)(x) in the Act which has widened the scope of deemed income provisions u/s 56. Section 56(2)(x) provides for taxability in the hands of the recipient, on receipt of any sum of money or specified property (which includes shares) received without consideration or for inadequate consideration by any person. Consequently, where as a part settlement or debt restructuring, the banks / lenders convert their outstanding loans into equity of the borrower company at a price which is less than the fair market value of such shares determined in the prescribed manner, a question may arise as to whether the difference between the fair market value of such shares and the price at which shares are converted into equity shall be subject to tax as gift in the hands of the banks / lenders.
Section 56(2)(x) is introduced as an anti-abuse provision to curb the practice of receiving specified property under the garb of gift. In case of a commercially negotiated deal between two unrelated parties, there cannot be any element of gift involved and hence, transactions of such nature (ie acquisition of shares by banks pursuant to debt restructuring, settlement, etc.) should not be hit by the applicability of Section 56(2)(x). However, one would recommend that an express clarification from CBDT to this effect would help to avoid litigation which can otherwise needlessly distract attention.
The strict action under IBC and amendments to the SARFAESI Act clearly reflects the intent of the Government to address the serious stressed account issue; however, uncertainty over tax consequences in the hands of the borrower upon waiver of the principal amount is not conducive to such resolution. Taxing the waived principal amount of loan which is in the nature of capital receipt (even if obtained for working capital purposes) as income in the hands of the borrower does not fall in line with legislative intent; As such, expecting to collect income-tax from the borrower who is already struggling to repay the huge outstanding loans may not even commercially feasible.
It is crucial for the Government to take proactive steps to address above issues by coming out with a clear Circular, a holistic and pragmatic view needs to be taken and fortunately, even the judicial precedents support such an intent and action.
*This article has been co-authered by Deep Chandan.