The Kelkar Task Force on Indirect Taxes first suggested the notion of a national GST in India in the year 2000. But the Constitution (122nd Amendment) Bill of 2014, was submitted to the parliament after years of discussion and negotiation between the federal and state governments. The bill would change the Constitution to allow for the establishment of the GST. Both Houses approved the Constitution Amendment Bill, which became the 101 Constitution Amendment Act of 2016 after being signed into law. The financial relationships between the Central Government and the State Governments in India have undergone a significant change as a result of the adoption of GST. Multiple indirect taxes imposed by both the Central and State Governments were replaced by the one tax system known as the GST. The Central and State Governments each have a joint right to impose and collect taxes on goods and services under the GST. This has increased tax structure uniformity and harmony between States, fostering economic integration.
Long-term economic growth has been predicted to be significantly boosted by the tax reform. Unfortunately, the GST has not been an exception to the rule that any significant transformation has short-term difficulties. Regarding its applicability and specifics on the supply of different goods and services, the GST Council has received a great deal of questions and doubts from the diverse sectors and trading groups. One of these issues has been the question of whether it applied to additional or penal interest. To address the issue, the Council recently released a circular titled “Clarification regarding applicability of GST on additional/penal interest” on June 28, 2019.
What do you mean by the penal charges?
Regardless of whether you are an individual or a corporation, you should have a reliable repayment plan in place prior to taking out any type of loan. Loan EMIs that are late will cost you money in addition to harming your credit score.
You will be fully responsible for paying a late payment fee in the form of punitive interest for each of your overdue EMIs. What exactly is this criminal interest? How do we determine the GST on penal charges? Let’s examine it now.
If a borrower does not pay the loan EMI in accordance with the loan’s repayment schedule, the loan provider may impose a sort of penalty interest known as the penal rate or penal interest. If the lender does not receive the loan payment by the due date, regardless of whether you pay the loan in monthly EMIs, quarterly payments, or annual payments, you will be obliged to pay penal interest on the same.
The amount of the penalty is disclosed upfront. It may be uniformly applied to all loans and borrowers or may vary depending on the type of loan, the degree of credit risk, and the terms and conditions mutually agreed upon by the borrower and the lender. However, such fees must adhere to basic RBI guidelines that they must not be “excessive” or “exorbitant,” and they must also be fair and transparent. Additionally, they must include any applicable penal interest in bold.
Generally speaking, there are two (2) types of debt default:
- Financial defaults: The most typical type of financial default is the late or missed payment of an installment.
- Mistakes in technology, which may include:
- Breach of a covenant involving late financial reporting (such as personal borrowers’ income tax returns or business borrowers’ accountant-prepared financial statements).
- Breach of significant or major “representations and warranties,” which means that a loan contract may have been made based on assumptions or conditions believed to be valid at the time of the contract but later determined to be false.
In addition, breaking any other “material” terms and conditions may result in penalties. The concept of materiality would, however, be arbitrary. Typically, the lender decides what would be considered material. There can also be a grace period available in some circumstances. Therefore, the conditions of the particular loan deal will define what will constitute default.
The Supreme Court of India declared that in the case of Punjab & Sind Bank v. M/S Allied Beverages Company, “…Penal interest can only be assessed once for a single default period; therefore, capitalization is not an option. Even though interest can be capitalized using the analogy that interest that is accumulated and unpaid on the accrued date has the same characteristics as the amount advanced on that day, penal interest, which is assessed as a penalty for non-payment, cannot be capitalized. It is not possible to claim further interest on interest on the sum of criminal interest. Capitalizing penal interest is not permitted. It must conflict with public policy”.
Recent developments for Penal charges In its Statement on Developmental and Regulatory Policies dated February 8, 2023, the Reserve Bank of India (the “RBI”) announced a number of policy measures, including the introduction of guidelines for regulating the penal charges levied by financial institutions in cases of delay or default in loan repayment or where there is a violation of “material” terms and conditions. RBI noted that several financial institutions were charging exorbitant penalties. RBI has repeatedly expressed concern about financial institutions charging exorbitant fees under various titles, including punitive charges, penal interests, litigation fees, notification fees, levy fees, etc. The regulator has been prompted to think along these lines by a significant number of customer complaints over exorbitant penalty charges and different business practices.
Levy of charges and penalties
It is also critical to grasp the mechanics of the charges and penalties imposed by the regulated businesses.
Prior to anything else, it is important to understand the difference between “Penal Interest” and “Interest,” the latter of which is based on the theory of compensating for the passage of time rather than the former on the theory of penal action. Penal charges and penal interest have different meanings. Punitive charges are the charges that must be separately imposed and paid at a specific rate only on the amount of the default. In contrast, punitive interest is an interest on the interest previously imposed.
Penal charges may be levied either on an ad-hoc basis, wherein the charges are levied separately upon the event of default as, for example, each event of default/delay by the borrower shall attract a penal charge of ‘x’ amount, or on interest overdue basis wherein the default in the payment of interest or the installment attracts further interest in addition to the existing interest rate, for example, the delay in payment shall attract an additional interest of 1 percent on the overdue amount.
Financial institutions sometimes impose “penal interest” on loans in the event of defaults that is in addition to the rate of interest; for example, if the loan has a 10 percent interest rate, an additional 2 percent penal interest is imposed on the EMI amounts (which already included the rate of interest portion). Because of this practice, “interest compounding,”
What is the changeability of GST on penal charges?
There is a penalty assessed whenever there is a supply of goods or services or when there is a money-to-money transaction with a payment that is delayed. Let’s first determine if the penal interest will be factored into the supply value. The value of supply includes “interest or late fee or penalty for delayed payment of any consideration for any supply,” according to Section 15(2)(d) of the CGST Act. As a result, any interest or penalties paid for late payments in a loan transaction or when providing products or services must be included in the value of the supply or the consideration amount. Further, where the provision of services includes “agreeing to the obligation to refrain from an act, to tolerate an act or a situation, or to do an act,” Schedule II- Activities to be treated as a supply of goods or services in Clause 5(e) will not apply to penal charges. The phrase “to tolerate an act” used in the preceding clause should be understood to refer to situations in which one person is charging a consideration in order to permit another person to engage in a specific activity. Therefore, it is evident that from the beginning of the transaction, one party intends to engage in an activity, and the other party shall permit such activity without any hindrance. To put it another way, the contract is entered into to permit the other party to engage in a particular action, not to punish or restrict that party from engaging in that activity in the future.
Additionally, the term “obligation”, as used in Clause 5(e) of Schedule II, refers to a contractual relationship in which the service recipient requests that the service provider tolerate an act or situation, and the service provider agrees to do so in exchange for payment. As a result, it can be claimed that the contracting parties have reached an agreement in writing. Contrary to what was stated above, penal interest or charges are only collected when an event occurs, such as when a loan transaction or supply of goods or services has a payment default. When parties engage in a contract, they do so with the intent of either receiving services in the form of a loan or a delivery of products. Punitive charges must be paid when there is a contract violation; thus, this does not imply that the parties have agreed to pay punitive interest. As a result, penal charges are not included in the list of presumed supplies in Schedule II of the CGST Act. Penal interest is covered by serial no. 27 of the notification from June 28, 2017, since it falls under the definition of “interest” therein and is therefore charged by parties that enter into a loan-giving contract. Thus, the lender’s penalty fees assessed in a money-to-money transaction will not be subject to GST. Services that involve extending deposits, loans, or advances in which the consideration is represented by interest or a discount are exempt from taxation. Still, penalties imposed by the vendor for late payments when goods or services are supplied are subject to GST.
In the Bajaj Finance Limited case, an advance judgment was made against Bajaj Finance Limited (BFL), and it was determined that the penal charges that BFL collected would be subject to GST. In the above case, it was also stated that the applicant tolerated the customer’s failure to pay their EMIs on time and that the customer was responsible for compensating the applicant by paying additional sums in addition to the principal and interest. Additionally, the additional interest comes in the form of punitive charges rather than interest.
As a result, Clause 5(e) of Schedule II of the CGST Act will apply to the fees assessed for any default in loan repayment. Additionally, the same is not a tax-exempt service and will be subject to GST tax.
How to imply GST on penal charges
As a result, there are several GST consequences that are addressed using examples. One can lend money to a borrower in the following ways:
Situation 1: Mr. A (the borrower) purchases an automobile from ABC Co (the lender/shopkeeper), who sold it to him for $6,000,000. However, the car’s selling price can be paid by Mr. A over 24 months (24 installments) for a total of 26,250 (principal repayment of $25,000 plus interest of 5 percent, or $1250). Every tenth of the month, the installment is due; failure to do so will result in a penalty interest charge of 500 rupees each day.
Here, rather than being a money-to-money exchange, the transaction between Mr A and ABC Co. is one of the provisions of taxable products. The store owner has divided the payment into installments, known as the EMI service. The interest component of the aforementioned EMI is additionally subject to GST. Additionally, a penalty interest is added to the late payment. As a result, the interest and fines paid on the late payments must be included in the value of the supply, bringing them inside the GST’s purview.
Additionally, Article 5(e) of Schedule II of the CGST Act will not apply in this circumstance. When the offending party faces penalties for late or non-payment, the phrase “tolerate an act” cannot be stated to apply in that case.
The aforementioned is not exempt and is subject to GST because it is not covered by serial no. 27 of the notification.
Situation 2: ABC Co. offers Mr. A an automobile for $6,000, which is the selling price of the vehicle. Mr. A has the option to purchase the car from XYZ Co. using a car loan with an interest rate of 12 percent annually. The loan from XYZ Co. stipulates that A has 24 months to pay it back, along with an additional penalty interest of 1 percent per year for each day the loan is late.
In the present instance, XYZ Co. and Mr. A. engaged in a money-to-money transaction. According to serial number 27 of notification number 12/2017 Central Tax (Rate) dated June 28, 2017, “services by way of (a) extending deposits, loans, or advances in so far as the consideration is represented by way of interest or discount (other than interest involved in credit card services are exempt”.
As a result, in this instance, the “penal interest” assessed on the transaction between XYZ Co. and Mr. A would not be taxable under the GST law. For GST purposes, the value of the supply made by ABC Co to Mr A would be $6,000,000. The interest and additional/penal interest levied by XYZ Co (lender) will not be subject to GST because they are exempt supplies.
As a result, the vendor has the following choices for the buyer when selling the vehicle:
- Provide a deferred payment facility by the vendor himself on account of the purchase of the car, or
- Provide a loan facility to purchase the asset through the vendor’s captive lending unit, or
- Provide a loan facility to purchase the asset through any bank/NBFC.
GST taxability will vary in each of the three situations mentioned above. If the vendor offers a deferred payment option and the borrower delays making their EMI payment, GST will be applied to the extra interest that results from the delay. However, the additional interest levied on the postponed repayment would not be subject to GST if a loan facility has been provided by the vendor’s captive lending arm, an independent bank, or an NBFC.
Understanding the scope of entry at para 5(e) of Schedule II –
As per para 5(e) of Schedule II, the following supply is declared explicitly as a supply of service:
- Agreeing to the obligation to refrain from an act –
- Some of the relevant examples are –
- Non-compete agreement,
- An industry refraining from carrying out the manufacturing activity per certain specified hours
- Agreeing to the obligation to tolerate an act/ a situation –
- Some of the relevant examples are:
- A hawker can operate in front of the shop on payment of a monthly amount to the shopkeeper.
- You are agreeing to the obligation to do an act.
- Going through the above examples, it is clear that the intention was to cover such services within the ambit of para 5(e) of Schedule II. However, taking the recourse of para 5(e) of Schedule II, demands were being raised on:
- Amount of charges, i.e., fine/ penalty levied on dishonor of the cheque;
- Liquidated damages paid on account of breach of contract;
- Late payment charges collected by the service provider on account of late payment of bills;
- The penalty levied for violation of any law;
- Notice pay recovery, etc.
- Some of the relevant examples are –
In light of the foregoing discussion, it can be concluded that any transaction involving considerations for refraining from acting would be subject to GST taxation under Schedule II Entry 5(e) as the supply of services must benefit both parties and not be a payment for breach of contract.
According to Section 15(2) (d) of the CGST Act, penalties for late payment of an installment of a supply of goods or services must be factored into the value of the supply. The same will be subject to GST tax. According to Section 15(2)(d) of the CGST Act, penalties for late installment payments in money-to-money transactions shall be added to the supply’s value. The same will be excluded by notification number 12/2017-Central Tax (Rate), dated June 28, 2017, serial number 27. As a result, the fines, in this instance, are exempt from GST.
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