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Union Budget 2021: Will it act as a catalyst to heal the ailing BFSI sector?

Taxmann |
Manoj Purohit, Partner & Leader
Tax & Regulatory Services

01 February 2021

The impact of the pandemic in terms of economic activity has been largely disruptive not only in India, but world over. While the government has attempted to introduce various measures periodically to dilute the impact of the pandemic, it is important that it takes bolder steps which could facilitate in accelerating the pace of the economy.

Having said that, it shall be pertinent to spur the sentiments of the propulsion system of the economy - the Financial Services sector, which has been largely affected on account of the pandemic. Foreign inflows in the form of Foreign Portfolio Investors and or Foreign Direct Investments have substantially increased in the recent past, however it is time for a V-shape recovery, and it is imperative that the government does not miss the bus. A huge impetus is expected from the government with some bold propositions to strengthen the sector.

Highlighted below are key budget expectations from a direct tax perspective with respect to the Financial Services sector:

Banking industry:

   i.Rationalisation of tax rates for branches of foreign banks to be at par with domestic banks:

   •  Presently, the tax rate for an Indian branch of a foreign bank is 40% vis-à-vis tax rate of 22%/25%/30% for a domestic bank, as the case may be, both the rates being exclusive of applicable surcharge and cess.

   •  It may be pertinent to note that for business models on similar lines there should be a parity in the corporate tax rate, for both domestic banks and Indian branches of foreign banks.

   •  India has entered into various tax treaties which contain provisions of non-discrimination against foreign enterprises i.e. a foreign enterprise in India will not be subjected to any taxation which is more burdensome than the taxation to which Indian enterprises are subjected to under similar conditions.

   •  Despite the above, Explanation to Section 90 of the Income-tax Act, 1961 (the Act') allows imposition of higher rate of tax on a foreign company in India compared to the tax chargeable from an Indian company and the same shall not be regarded as less favourable charge of levy of tax in respect of such foreign company.

   •  In order to create a level playing field for foreign banks operating in India by way of an Indian branch and to recognise the principles of international taxation, it may be worthwhile for the government to bring the tax rates at par with the Indian banks.

   •  In order to bridge the revenue gap, the government may also consider introducing a branch profit tax for foreign companies, as was recommended by the Direct Tax Code, on the amount repatriated to their overseas shareholders.

  ii.Increase in deductibility of Head Office expenditure for Indian branch:

   •  Section 44C of the Act provides for deduction of 'executive and general administrative expenses' incurred by Head Office ('HO') to be restricted to 5% of the adjusted total income, while computing the taxable income of the Indian branch.

   •  The said section was introduced in 1976 and there have been no subsequent amendments with respect to the limit of 5% as prescribed under the said section.

   •  On account of the pandemic and the new normal, wherein geographical boundaries are diluted, various additional expenses are required to be incurred to ensure that the ecosystem works well.

   •  In such a case, it is expected that the government increases the limit for allowability of the said expenses while computing the total income of the branch from the existing 5% to 10%.

Non-banking Financial Corporation and Housing Finance Corporation:

  i.Exemption under Section 194A to be extended to NBFC and HFC:

   •  As per section 194A of the Act, any person making payment of interest is required to deduct tax at source. There are certain exemptions given under this section wherein the person making payment to various institutions like Banking Company, UTI etc., is not required to deduct taxes

   •  However, no such exemption has been provided to NBFCs and HFCs from the applicability of Section 194A of the Act. Accordingly, tax is required to be deducted at the rate of 10% from interest paid to NBFCs and HFCs.

   •  This creates severe cash flow constraints since NBFCs and HFCs operate on a thin spread on interest. Further, on account of the pandemic, profitability has been severely impacted, running them into liquidity crisis. Additionally, due to voluminous transactions, NBFCs and HFCs have to face severe administrative hardships in terms of collection of TDS certificates from their numerous customers.

  ii.Expansion of Section 72A for carry forward and set off of accumulated loss and unabsorbed depreciation allowance in amalgamation or demerger, etc. to NBFCs and HFCs:

   •  As per section 72A of the Act, at the time of amalgamation of banking companies, the accumulated losses are allowed to be carried forward and claimed by the amalgamated entity.

   •  However, similar benefit is not specifically available to NBFCs and HFCs resulting in lapse of accumulated losses upon amalgamation.

   •  It is only fair that the tax benefits available to banks should also be made available to NBFCs and HFCs as distinction in the applicability of various tax provisions puts NBFCs in a disadvantageous position vis-à-vis banks. Moreover, NBFCs and HFCs largely perform similar functions to that of a bank.

   •  Such reliefs will help in ailing the severely constrained NBFCs and HFCs.

  iii.Exemption under thin capitalisation regulations to be extended to NBFCs

   •  Thin capitalisation refers to the ratio of debt to equity. Where entity is heavily capitalised by debt, it is considered to be thinly capitalised.

   •  Thin capitalisation rules provide for disallowance of interest expense where interest exceeding Rs 1 crore is paid in respect of the debt raised from a foreign associated enterprise, subject to certain limits.

   •  While this rule is not applicable to banking and insurance companies, a similar exception has not been carved out for NBFCs whose modus operandi is similar and are regulated at par with banks. Further, the exemption should also be widened to NBFCs given the fact that a lot of foreign private equity investment flows in NBFCs.

   •  It may be pertinent to appreciate that for an NBFC, the highest incurrence of expenditure would be in the form of payment of interest on the funds raised for conducting business. It is generally the case whereby the resultant interest expenditure is generally always higher than 30%of its EBITDA. On application of thin capitalisation rules, the NBFC faces difficulties on account of disallowance of interest expense and consequent increase in tax outflows, impacting the profitability and viability of these entities, moreover during the pandemic.

   •  We may expect Budget 2021 to announce this much-awaited exemption for NBFCs from the barbaric thin cap provisions, especially considering the fact that during the pandemic, various waivers were offered to borrowers resulting in a liquidity crisis to NBFCs and therefore, NBFCs had to resort to loans, etc. for discharging even primary obligations.

  iv.Increasing the allowability of provisioning of bad and doubtful debts:

   •  The provisions of the Act allow a deduction of bad and doubtful debts up to 8.5% of the 'adjusted total income in addition to maximum 10% of aggregate rural advances for provision for doubtful debts.

   •  A similar exemption was provided to NBFCs to claim such a deduction from FY 2017-18, however the deduction was restricted to 5% of their total income.

   •  Given that banks and NBFCs are facing sluggish loan recoveries, they expect greater leeway to be provided by the government with respect to claiming a higher deduction of at least a blanket rate of 10% for the next 2 years for provision with respect to bad and doubtful debts.

Alternative Investment Funds

   i.Passthrough status to be extended to Cat-III AIF

   •  Currently, the provisions of the Act has accorded a pass through taxation regime to Cat-I and Cat-II AIF (i.e. any income earned by the AIFs is chargeable to tax directly in the hands of investors, except where the income of AIF is characterised as 'business income').

   •  However, the taxation of Cat-III AIF works on a different footing, wherein all the income earned by a Cat-III AIF will be taxed at the fund level itself. The rate of tax, again, depends on the legal form of the fund (Company, LLP, trust etc.)

   •  Given that modus operandi for Cat-III AIF does not differ from other categories, it is expected to address the incoherence by according the pass-through status to even Cat-III AIF

  ii.Deduction for expenses while computing taxable income:

   •  As stated above, Cat-I and Cat- II AIFs registered with the SEBI have been accorded a pass -through status i.e. income is taxed in the hands of the investors, as if the investment was made directly by them. Earlier, AIF was not permitted to pass on its losses to the investors, however, this incongruity has now been removed and thus, AIF has adopted the pass through regime for losses in relation to transfer or acquisition of the relevant asset being transferred.

   •  However, AIF would have incurred expenses in the form of fees to the fund manager, bankers, lawyers and other administration expenses. The anomaly remains that the investors are not allowed to claim benefit of the said expenditure, allocated to them in proportion of the investment made. This results in investors paying tax on notional income. Further, such expenses of an AIF are not consummated at the fund level as well i.e. an AIF shall have to write-off the expenses. Thus, effectively, neither the AIF nor their investors are able to offset the expenses against income/gains that may eventually arise from the investment.

   •  It is expected that Budget 2021 will introduce provisions in the Act permitting allowability of such deductions by the investor so as to pay taxes only on the real income. This could be in the form of capitalising the cost of improvement while computing capital gains at the time of divestment.


   i.Clarification on non-applicability of Equalisation Levy to inter-company transactions

   •  Over the past few years, India has made notable amendments to its domestic tax law in order to ensure that it receives its fair share of tax with respect to the digital economy.

   •  One of the measures India took early in 2016 was to introduce Equalisation Levy ('EL') at 6% for digital advertisements and related services from non-residents.

   •  In 2020, the government expanded the scope of equalisation levy to include cross-border e-commerce transactions within its ambit which includes a wide range of sale, service and facilitation transactions that are conducted online through a digital or electronic facility or platform.

   •  The intention of the government, as it could be comprehended was to target only highly digitalised business models. However, the provisions are drafted in a manner which could also cover a number of routine transactions of a multinational group and their inter-group transactions. This may include IT support services provided by offshore holding company to subsidiary, other digital or electronic facilities, etc.

   •  In this regard, several representations have been made to the government so as to provide clarification to exclude inter-company transactions from the scope of the EL ambit and we expect the government to propose to amend the regulations to that extent.

The countdown to Budget 2021 has begun and it is expected that it will address two key aspects - healing the ailing economy and keeping up tax collections. India has been on the growth trajectory and in the current situation any bold measures in the form of tax reforms and policy changes will act as a catalyst to overcome the existing crisis and move ahead with a new vision. It would be interesting to see how the government maintains the acceptable level of fiscal deficit target, thereby safeguarding the economic interest along with presenting a balanced set of direct tax proposals.

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