7 December 2018
Advance Ruling - Penal interest charged by financial institutions liable to GST

In yet another ruling which will shock the industry, the Authority for Advance Ruling (AAR), Maharashtra has ruled that penal interest collected by the applicant, a Non-Banking Financial Company (NBFC) for delay/default in repayment of EMI by the customer, would be subject to GST under the CGST Act, 2017.
 
Facts
  • The applicant, Bajaj Finance Limited, is a NBFC engaged in, inter alia, providing various types of loans to customers, such as auto loans, loans against property, personal loans, consumer durable goods loans, etc.
  • In terms of the loan agreements, the applicant collects penal/default interest upon delay in repayment through EMI /ECS, etc. by the customers.
 
Issue
  • Whether the penal interest is to be treated as ‘interest’ for the purpose of exemption under Sl. No. 27 of Notification No. 12/2017-Central Tax (Rate) dated 28 June 2017?
  • Whether the activity of collecting penal interest would amount to taxable supply under the GST regime?
 
Applicant’s contention 
  • Penal interest is an additional interest on the overdue loan instalment, which requires to be given similar treatment as that of the principal interest, and therefore, would be exempt from GST under the above mentioned notification.
  • The amount of overdue loan instalment is virtually a new loan transaction, the consideration for which is the ‘penal interest’ charged thereon, and hence should be exempt from GST.
  • There is no obligation on the applicant to tolerate the act of delay in payment of loan instalments by the customer/borrower and accordingly, penal interest cannot be construed as ‘consideration’ towards ‘deemed supply’ envisaged under Clause (e), Entry 5 of Schedule II to CGST Act[1].
  • Such penal interest is in the nature of ‘liquidated damages’ charged for breach of contract by the customer, not subjected to GST.
 
Ruling
  • The AAR observed that ‘penal charges’ have been defined in the loan agreements as ‘overdue charges’ for non-payment of instalment on due dates and said definition nowhere mentions that such charges are additional interest costs to be incurred by customers.
  • This clearly demonstrates that the applicant is treating such charges as ‘penalty’ which is “collected by them from their customers for the reason that the said customers have delayed the Payment of EMI and the applicant has tolerated the said act of their customers of delaying payment of such EMI.”
  • Therefore, such an activity of the applicant construes as a ‘supply’ under Clause (e), Entry 5 of Schedule II to CGST Act, liable to GST.
  • The assumption of applicant that the defaulted EMI is nothing but a new loan amount, is fallacious, since the rate of interest on the loan advanced and the rate at which penal charges are collected, are different.
  • 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 deviates from the above/fails the test of being a ‘loan’, ‘deposit’ or ‘advance’ or the consideration is not an interest or discount, the exemption is not admissible. In the present case, the penal charges cannot be said to form part of interest on ‘loan’, ‘deposit’ or ‘advance’.
 
[1] (e) Agreeing to the obligation to refrain from an act or to tolerate an act or situation or to do an act.
SKP's Comments
Given the trend of advance rulings generally favoring the revenue, this decision may not be seen as an unexpected one. However, under the GST law, interest or late fee or delayed payment charges has to be specifically included in the value of supply. In view of this, an argument can be made that such penal interest should also take the color of interest and should be treated as an exempt supply. Further, even under the erstwhile service tax law, the taxability of penal interest has been a contentious issue, and it is expected that it would continue to remain so under the GST regime.
 
The potential of ascribing a wide meaning to the term ‘tolerance of an act’ may result in authorities seeking to tax penal charges/interest, late fees, etc. It is important for businesses, especially finance companies, to revisit any GST exposure on recovery of similar charges.
SKP
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