Sunil Gidwani, Partner – Nangia Andersen LLP
Sunil.gidwani@nangia-andersen.com
09821131945

Background

Looking at the increased stress on lending institutions in recent past resulting in increased defaults by the borrowers, one cannot underemphasise the importance of Asset Reconstruction Companies in resolving such loans.

ARCs are specialist asset management companies for acquiring and recovering loans given by banks (distressed assets or NPAs or bad loans). They buy large corporate loans from banks at a discount and make profit by recovering them or by selling the loans to other ARCs. They enjoy power to take over management of companies, convert debt into equity, enforce collateral to sell underlying assets. Recovery may be done through liquidation of assets or resolution. ARCs are traditionally seen as recovery mechanism and not resolution mechanism. Hence most of NPA transferred to ARCs in the past have larger underlying asset value and less business value. They invest their own money and the pool investments from banks / institutional investors in  (generally in the ratio of 15:85). Like managers of other asset classes, these asset managers charge an asset management fee of 1-2% plus a share in upside/profits (e.g. 80:20) like in PE / AIF industry. Such players are governed primarily by SARFASEI Act, 2002 and the prudential norms and guidelines issued by RBI and hence regulated largely by RBI and partly by SEBI.

Just to give a flavour of who the ARC industry is currently structured, currently, about 30 ARCs manage aggregate assets of about ₹100,000 cr, while the aggregate NPAs of banking industry are in excess of ₹10 lakh crore. It believed that 70% of NPAs belong to infra, construction and metal industry. The average recovery rate is about 40-45% of debt acquired and the average recovery period is 4-5 years. In the recent years a shift has been noticed from funding by domestic institution to global fund investment. Currently 60% investment by global funds as against selling banks earlier.

Regulatory framework

Before diving into tax aspects, it may be worthwhile for the general understanding of the readers to provide an overview of some of the major regulatory requirements. First is obviously the RBI licence required for undertaking ARC business. As one can notice, substantial changes in the regulatory framework have been made in last five years. The sponsor can hold 100% equity in ARC (increased from 50% in 2016). Further 100% FDI is now permitted (increased from 49% under the automatic route in 2016). Further, the minimum capital or the Net Owned Fund (NOF) required is  ₹100cr (increased in 2014 from ₹2 crore). Financial assets / loans have to be held through a trust which issues Security Receipts (SRs) to investors. As mentioned earlier, the ARC must invest at least in 15% of SRs (increased from 5% in 2014). One ARC can acquire debt from another ARC. It can convert debt into 100% equity shares of borrower company and such share acquisition does not trigger an open offer under the takeover code.

A typical ARC structure keeping the above in mind, would look like the following:

Taxation of ARCs

The income of ARCs like asset managers of other classes is the fee from the ‘pool/fund’ for managing the fund/assets. Income from various streams of income from recoveries from borrowers and management fees is to be accounted as per the accounting guidelines issued by the RBI. Such income received by ARC is taxable as business income. Hence as such, barring certain complications around accounting as per RBI guidelines, the taxation of ARCs is relatively straightforward.

Taxation of ARC trust and investors

The pool of funds wherein investors including the ARC pool their investments for the purpose of acquiring loans from original lenders is formed as a trust as mentioned above. Section 10 (23DA) read with Section 115TCA effectively grants a pass-through status to the Trust, hence there is no tax at trust level. Thus, income is taxable in the hands of the investors in the same manner as if investments were directly  made by the investor, and it is taxable in same nature and  proportion as received by the Trust. The undistributed income is deemed to be credited to investors at the end of the financial year, hence investors are taxed in the year of collection or receipt by the Trust and not in the year of distribution by the trust. The ARC trust is required to withhold tax @10% on the income distributed or accrued.

With this broad overview, one can consider some of the nuances and complexities relating to different streams of income. The income could arise or accrue to the trust from surplus from recovery or sale of loans, redemption of bonds/preference shares, buy-back of shares (if the investment happens to be in the form of shares) or interest and dividends. As mentioned above, investors are taxed in the same manner as if the investments were directly made by the investors and as if the income were of the “same nature” as received by the trust.

The income from sell, repayment, redemption of loans or securities could be business income or capital gains, while income from revenue streams like interest or dividends is treated as business income or other sources depending on various factors discussed in subsequent paragraphs. The foreign portfolio investors which are governed by a special provision on income from securities would stand on a slightly different footing.

The characterisation of income could be considered based on whether the investors are Indian investors are foreign investors.

Domestic investors

In case of domestic investors the factors in support of business income characterization would be (a) requirement of the “same nature” in section 115TCA denoting same character / head of income as received by the trust; (b) trust is engaged in the business of acquisition and recovery of loans, hence surplus on recovery, gains on disposal of securities, etc. are all part of business income; and (c) the trust would treat all assets as stock in trade, not as capital assets. Incidentally, the CBDT circular on characterization linked to the period of holding does not extend to loans and hence does not help in this matter. Characterization done based on the above factors at trust level would flows through to the investors.

On the other hand, there are certain factors that support the capital gains characterization. One could take the position that the “same nature” as envisaged in section 115TCA denotes types of income streams from various types of investment such as repayment of loan, interest, dividend, sale proceeds, redemption, etc. Hence each of these types of income, considering the investor categories and their individual fact pattern will determine characterization or head of income.

Appropriate charaterisation is important because while the business income would get taxed at the higher rate (generally 30%, and depends on the status of the investor), capital gains are generally taxed at 10/15/20/30% depending on the nature of asset class and holding period.  

Foreign investors

The only category of foreign investors that can invest in the trust are foreign portfolio investors who are allowed by the concerned regulations to invest in the security receipts issued by the trust. Though there are special provisions contained in section 115AD governing this category of investors these provisions cover business profits but do not provide for any special rate. In other words the special provisions do not bar any income to be taxed as business income, or there is no mandatory charaterisation of every source of income including that from ARC trust as capital gains. Hence a view emerges that even such investors can be taxed on income from the trust as business income attracting the normal non-resident rate (subject to treaty provisions and an argument such as that there is no taxation in the absence of a permanent establishment).

However, the other view is that the special provisions governing foreign portfolio investors cover income in respect of securities which could cover any income paid through the holding of such securities and not just interest or dividends. Security receipts issued by the trust are treated as securities and hence would cover income even in the nature of business profits and not just interest or dividends, hence taxable at the rate of 20% subject to lower treaty rates. In the case of a transfer of a security receipt itself by the investor, the gains should be taxed as capital gains.

As in the case of domestic investors, the business income would be taxed at a higher rate (subject to treaty benefit in the absence of a permanent establishment), and capital gains are generally taxed at 10/15/20/30% depending on the nature of asset class and holding period. 

Other aspects

There are certain other minor tax aspects one must bear in mind. The trust is required to deduct tax at source on interest income of FPI either under section 196D (20%) or section 194LBC. In the author’s opinion, the better view is that the latter section should prevail. Further in respect of dividends, the trusts will suffer TDS on dividends even though they are pass through entities (though dividend payments by NPA corporates are not very significant or common, this could potentially be a cash flow issue). For AIFs the CBDT circular provides for exemption from TDS on dividends but similar dispensation is not given for ARC trusts.