Rules of taxation in securitization in India

A lack of regulation and unclear definition initially characterised the emergence of securitisation in India. To our knowledge, the initial securitisation transaction in India was completed in the early 1990s. However, it is worth noting that until 2006, there was a lack of dedicated legislation governing securitisation transactions and the associated taxation.

The primary objective of this article is to present a thorough and all-encompassing analysis of the origin and evolution of securitization in India. This will involve an exploration of its historical progression, theoretical foundations, and the regulatory structure that governs the market. This article further analyses the regulatory structure that oversees securitization in India, emphasising the essential legislation and rules that have influenced the sector, with a comprehensive comprehension of the existing taxation policy in securitisation necessitates thoroughly examining the conceptual and legal framework encompassing securitisation in India.

What do we mean by securitisation in India?

The securitisation transactions in India have shown a notable enhancement subsequent to the pandemic, as evidenced by a 70% increase in volumes, reaching INR 73,000 crores during the financial year 2023, in comparison to INR 43,000 crores in the preceding financial year. Despite the worldwide economic slump caused by the epidemic, securitization transactions in India experienced significant popularity. The presence of a dynamic securitization market is crucial in light of the driving force behind this financing method. This achievement can only be realised through establishing a comprehensive governing framework for taxation.

The term “securitisation” encompasses a broad range of processes that involve transforming a financial relationship into a transaction.

The practise of securitisationin India has become increasingly significant within the financial sector, serving as a crucial mechanism for generating a wide range of investment prospects while concurrently mitigating risk. Securitisation is an economicpractice involving consolidating various financial assets into a collective pool, such as loans, mortgages, or credit card receivables. This pool is the basis for issuing securities supported by the cash flows created by these underlying assets. The stakes are subsequently sold to investors who accrue returns contingent upon the performance of the underlying assets.

The implementation of securitisation in India was initiated in 1999 as a component of the broader financial reforms to enhance the funding capabilities of banks and non-banking financial corporations (NBFCs). Securitisation refers to consolidating and restructuring homogeneous illiquid financial assets into tradable securities, which can then be offered to potential investors.                                        

This process entails the transfer of assets, including associated risks and underlying investments, from an Originator to its Investors via a special purpose vehicle (SPV). The assets are transferred to the balance sheet of the Special Purpose Vehicle (SPV), which is established with the explicit objective of consolidating, subdividing, repackaging, and transforming the assets into tradable securities. These securities are backed by the pooled assets and afterwards offered to investors in the form of pass-through certificates (PTCs) or security receipts (SRs).

Securitisation of underlying assets is a prevalent practice in India:

1. Vehicle loan receivables;
2. commercial loan receivables;
3. mortgage loan receivables; and
4. Trade receivables.

Securitisation of the following receivables is in the developing phase:

1. lease rental receivables;
2. Infrastructure related receivables; and
3. Other receivables arising from non-financial contracts.

Case laws:

• ICICI Bank Securitization Case

In 2009, the Securities and Exchange Board of India (SEBI) levied charges against ICICI Bank, a prominent private bank in India, for contravening securitisation regulations. The bank is purported to have provided inaccurate information regarding the value of the assets it had securitised and neglected to disclose significant details to investors. The case underscored the necessity for enhanced openness in securitisation transactions and more stringent regulatory supervision.

• Essar Steel Securitization Case

The securitisation of Essar Steel’s debt, a bankrupt steel business, was authorised by the Supreme Court of India in 2019. The securitization process entailed the transfer of the outstanding debt due by Essar Steel to lenders to a specialised entity known as a special purpose vehicle (SPV), which ArcelorMittal, the successful bidder for the acquisition of the company, established. The Special Purpose Vehicle (SPV) issued bonds to the lenders in return for the debt, which subsequently received repayment from the cash flows generated by Essar Steel. The case underscored the potential efficacy of securitisationin India as a mechanism for addressing distressed assets within the Indian context.

What is the process of securitisation transactions?

The securitisation process in India involves the following steps:

1. Asset Pooling:

Asset pooling is a fundamental element of securitisation in India, an intricate procedure employed by financial institutions to generate and distribute securities that are supported by collections of underlying assets. The financial institution consolidates comparable assets, such as mortgages or car loans, during this procedure. Subsequently, it transfers them to a specialised entity known as a special purpose vehicle (SPV). Specific criteria, including factors such as credit quality and maturity, determine the selection of assets.

Asset pooling is an integral aspect of securitisation in India, enabling financial institutions to transform assets with limited liquidity into securities that are easily tradable. This process facilitates risk transfer to investors and allows institutions to secure funding at a reduced expense.

• Creation of Special Purpose Vehicle (SPV):

After the identification of assets, a specialised entity known as a special purpose vehicle (SPV) is established with the goal of acquiring and overseeing the management of those assets. The Special Purpose Vehicle (SPV) is a legally distinct entity from the asset originator, established exclusively to retain the aggregated assets and facilitate the issuance of securities supported by those assets. The assets are thereafter utilised as collateral for the securities that are issued by the Special Purpose Vehicle (SPV) and afterwards sold to investors in the capital markets.

The Special Purpose Vehicle (SPV) plays a vital role in the process of securitisation. It serves as a legal framework that facilitates the transfer of assets from the originator to the investors. Additionally, the SPV offers credit enhancement and ensures that the investors are protected from the risks associated with bankruptcy.

The primary functions of a Special Purpose Vehicle (SPV) within the context of securitisation in India encompass asset acquisition, securities issuance, cash flow management, credit enhancement provision, and ensuring bankruptcy remoteness.

• Transfer of Assets to SPV

The individual or entity responsible for initiating the transfer of assets relinquishes ownership of those assets to the Special Purpose Vehicle (SPV), which then generates securities based on the value of the transferred assets. The individual or entity responsible for initiating the transaction transfers the designated assets to the Special Purpose Vehicle (SPV). The transfer of ownership is commonly facilitated by means of a sale agreement or a contribution agreement, which delineates the specific terms and conditions governing the transfer process. The Special Purpose Vehicle (SPV) compensates the originator for the assets that have been transferred. The payment may be made using cash, securities, or a combination thereof. The Special Purpose Vehicle (SPV) assumes responsibility for the management of the assets that have been transferred to it, as well as the collection of the cash flows that are created by these assets. The special purpose vehicle (SPV) has the option to engage the services of a third-party servicer in order to carry out this particular activity.

• Credit rating

The credit quality of the securities issued by the Special Purpose Vehicle (SPV) is assessed in order to assign them credit ratings. The numerical value provided by the user is insufficient to generate an academic response. Please provide the assessment of creditworthiness for securities being offered, which is significantly influenced by credit ratings, hence establishing the crucial role played by these ratings in the securitisation process.

• Sale of securities:

The securities are subsequently marketed to various investors through a public or private offering, including mutual funds, insurance companies, and banks. These investors then receive a series of payments contingent upon the cash flows produced by the underlying assets.

• Repayment of Securities

Under Securitisation in India, investors commonly receive payments in the form of interest and principal on the securities they have acquired. The disbursements are often made at regular intervals, such as on a monthly or quarterly basis, and are determined by the underlying cash flows produced by the securitised assets. In the normal scenario, the servicer is responsible for collecting the cash flows generated by the underlying assets and managing them on behalf of the particular purpose vehicle (SPV).

What key Issues One Can Face During Taxation in Securitization in India?

The author has discussed some significant matters pertaining to taxation in securitization that necessitate careful attention in relation to securitization transactions:

In relation to the originator,

• The tax implications associated with the transfer of receivables to the issuer should be considered, such as whether the sale would result in a taxable gain or loss for the party transferring the receivables. Additionally, it is important to assess whether the transfer will be subject to transfer duties and other indirect taxes, such as value-added tax (VAT).
• The topic under consideration is the taxation of profits derived from the issuer, explicitly focusing on the timing of profit recognition for tax purposes.
• The primary objective is to guarantee that the framework would deliver efficient tax relief for the occurrence of bad debts associated with the receivables.
• The tax implications of the service arrangements with the issuer need to be considered. This includes determining if the servicing costs will be subject to value-added tax (VAT) and whether the servicing operations will result in the issuer being subject to taxation in the originator’s nation, particularly if the issuer is located abroad.
• The examination of how the securitisation transaction affects the thin capitalisation status of the entity initiating the transaction.
• The taxation of credit enhancements, such as subordinated loans and guarantee arrangements, granted to the issuer is an important consideration.
• The influence of the transfer pricing regime on the organisational framework.

In relation to the issuer

• The objective is to minimise or eliminate taxable profits within the issuer, thereby avoiding potential direct tax liabilities. This can be achieved through strategies such as mitigating tax mismatches or timing differences between receivables income and incurred funding and other expenses. Additionally, the effectiveness of the profit extraction method employed should be ensured for tax purposes.
• It is important to verify that the issuer is not a tax resident and does not have a taxable presence in any other jurisdictions since this could potentially result in a tax liability, such as in the case of offshore issuers and their servicing activities.
• The primary objective is to minimise the likelihood of any withholding taxes being levied on the issuer’s receivables income or the interest payments made by the issuer for the issued bonds.
• One important objective is to minimise indirect taxes, such as value-added tax (VAT) and transfer charges, at the issuer level.
• One crucial factor to be taken into account in relation to the aforementioned matters will be the geographical placement of the issuer, namely whether it is located onshore or offshore.

Regulatory framework for securitisation transactions

The regulation of the securitisation process in India is governed by the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act). The legislation establishes a formal structure for securitisationin India and grants banks and financial institutions the authority to enforce security interests in the underlying assets in the event of borrower default. Securitisation in India is subject to regulatory oversight by the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI), which enforce a range of rules and circulars. The Reserve Bank of India (RBI) has established prudential guidelines for securitisation transactions, which encompass specific provisions about the minimum retention obligations for originators and the due diligence requirements for investors. However, the Securities and Exchange Board of India (SEBI) exercises regulatory control over the general accessibility of underlying assets and securities to the market by virtue of several authorities conferred upon it under Section 30 of the SEBI Act, 1992.

1. SARFAESI Act of 2002

Some of the salient features of the SARFAESI Act are:

• The Act is applicable to loans and advances provided by banks, financial institutions, and other specified entities.
• The legislation grants banks and financial organisations the authority to seize the collateral or security offered by the borrower without requiring court involvement if there is a failure to repay the loan.
• The Act grants banks and financial institutions the authority to enforce security interests independently, without the need for court participation, by issuing a notice to the borrower.
• The legislation allows for the creation of asset reconstruction companies (ARCs) with the objective of acquiring non-performing assets (NPAs) from banks and financial institutions.
• The Debt Recovery Tribunals (DRTs) are authorised by the Act to adjudicate and resolve cases submitted by banks and financial institutions seeking to recover outstanding debts. 6. Appellate Recourse: The Act stipulates the provision of an appellate recourse to the Appellate Tribunal in response to an order issued by the Debt Recovery Tribunal (DRT).
• The Act includes provisions that aim to safeguard the rights and interests of borrowers, explicitly prohibiting banks and financial institutions from seizing collateral or security without prior notification to the borrower.
• The Act includes provisions for a redressal procedure that allows borrowers to lodge grievances against the activities of banks and financial organisations.
• On its whole, the SARFAESI Act establishes a comprehensive structure facilitating the retrieval of non-performing loans by banks and financial institutions, concurrently safeguarding the rights and welfare of borrowers.

• RBI

The initial set of guidelines pertaining to securitisationin Indiawas introduced by the Reserve Bank of India, which serves as India’s primary financial regulatory authority, in 2006. Following the occurrence of the financial crisis, the Reserve Bank of India (RBI) undertook a revision of the standards pertaining to securitisationin India, in the year 2012, implementing a series of rigorous procedures. In 2021, the Reserve Bank of India implemented comprehensive revisions to the guidelines governing securitisationin India, with the aim of aligning them more closely with established markets.

The framework for securitisationin Indiahas been extensively revised by the Reserve Bank of India (RBI) through the introduction of new rules in 2021. The primary modifications encompass:

• Introducing the framework for simple, transparent and comparable securitisation transactions (which will provide a reduced and uniform risk weightage for participants);
• Incentivising residential mortgage-backed securitisation; and
• Removing the prohibitions on single loan securitisation and securitisation of acquired assets.

Overall RBI

• Securities Transaction Tax (STT)

The Securities Transaction Tax (STT) is a form of financial transaction tax that has a resemblance to the concept of tax collected at source (TCS). The stock Transaction Tax (STT) is a form of direct taxation imposed on all transactions involving the purchase and sale of stocks listed on recognised stock exchanges in India. The governance of the subject in question is carried out in accordance with the provisions outlined in the Securities Transaction Tax Act (STT Act). The introduction of the subject matter occurred in the year 2004. The calculation of STT is expressed as a percentage of the transaction value, resulting in an additional expense for the buyer and ultimately raising the overall expenditure. The relevant rate of Securities Transaction Tax (STT) is contingent upon the specific characteristics of the transaction being conducted or the particular type of security being traded.

Exemptions under STT: According to Section 36 of the Income Tax Act 1961, the Securities Transaction Tax (STT) can be considered a deductible business expenditure for income tax purposes. This applies if the STT amount paid is reported as share income under the category “Profits/Gains from Business and Profession.” In other words, if the trading of stocks is being conducted as a professional endeavour and is being approached from a business perspective.

What are the Rules of Taxation for Securitisation in India?

The tax regulations pertaining to transition of securitisation in India remain ambiguous due to the idea of relatively recent emergence and increasing popularity. The Income Tax Act, 1961 (“ITA”) has no explicit rules specifically addressing the unique aspects of securitisation transactions. The determination of taxation is typically contingent upon the structural arrangement of the transaction-related papers, the classification of the transaction as determined by the income tax authorities, and additional factors elucidated in the subsequent discussion. If there are no explicit requirements, it becomes imperative to analyse the tax consequences of a securitisation transaction for each of the entities involved, namely the originator (often a firm, whether it be a financial institution, bank, or commercial corporation), the special purpose vehicle (SPV), and the investors. Moreover, the engagement of servicing and payment agents and other service providers gives rise to tax problems. Income derived through securitisation transactions can be classified into various categories, including business income, interest income, income from capital gains, and income from other sources. The subsequent paragraphs provide a concise examination of the matters pertaining to the inherent characteristics of revenue within a securitisation transaction and its susceptibility to taxation.

Tax can be imposed on securitisation transactions in relation to the following elements:

• Taxation of the income derived by the Special Purpose Vehicle (SPV) from the underlying loan assets;
• Taxation of the fees that the SPV is obligated to pay to any service provider, such as collection and servicing agents, escrow banks, or credit enhancement providers;
• Taxation of the income distributed by the SPV to the investors.
• The imposition of a tax on the transfer of assets from the originator to the special purpose vehicle (SPV).

New regime for Securitisation in India

The suggestions made by the Reserve Bank of India (RBI) regarding the securitisation of standard assets by banks, All India Term-Lending and Refinancing Institutions, and non-banking financial companies (NBFCs) had its origins in February 01, 2006. Securitisation in India is a financial process wherein assets are moved to a dedicated entity known as a special purpose vehicle (SPV), which is safeguarded against the risk of insolvency. In return for this transaction, an immediate inflow of funds is obtained. The cash flow derived from the underlying pool of assets is subsequently employed to meet the obligations associated with the securities issued by the Special Purpose Vehicle (SPV). The paper additionally delineated the criteria used to ascertain a ‘genuine sale’ and set the parameters for offering credit enhancement facilities, liquidity facilities, and the suitable accounting methodology for such transactions. The regulations failed to outline the distribution of resources specifically.

Taxation of parties to securitisation transactions

• The Originator

The tax liability of the originator generally depends on:

• This inquiry pertains to two aspects of securitisation transactions. Firstly, it examines whether the securitisation process leads to the legitimate transfer of assets being securitised.
• Secondly, it explores how tax authorities classify the resulting gain or loss, specifically in cases when property transfer occurs, as either a business gain or loss or a capital gain or loss.

Let us begin with a more comprehensive analysis of the aforementioned points.

Whenever an asset is transferred, the transferor will inevitably experience a form of income, which can manifest as either a gain or a loss. This gain or loss can be categorised as either business income or income derived from capital gains. In the context of a securitisation transaction, the party responsible for initiating the process (referred to as the originator) will transfer the property in question (referred to as the asset being securitised) to a separate entity (often known as a bankruptcy distant entity) in exchange for a predetermined price.

From an accounting standpoint, the determination of the consideration in the form of gain on sale is contingent upon assessing the residual interest in the transaction, specifically the valuation of the excess spread. This valuation is, therefore, regarded as an integral component of the selling consideration. This is an accounting estimate of future profitability recognised at the time of the sale transaction. However, including such profit as a component of the taxable gain for tax purposes would diverge from the fundamental principle that income tax should only be levied on income that is earned or for which reasonable certainty of collection can be proved rather than on projected income. Nevertheless, a pertinent concern that emerges is the practice of distributing the aforementioned profit across a duration, thereby postponing the obligation to pay taxes. The matter was considered by the Income Tax Appellate Tribunal in the case of Axis Bank Limited vs.Addl—Commissioner of Income Tax Range-1. The Tribunal expressed the view that while it is well-established in law that the focus for income tax purposes is on the actual income, the receivables recorded as gains by the originator will not be immediately subject to taxation. This is because the Reserve Bank of India Directive stipulates that the gain from securitization should be recognised over the duration of the underlying securities issued by the Special Purpose Vehicle.

In the case of The Commissioner of Income Tax vs. Shriram Investments Limited, the Madras High Court discussed an interesting rationale regarding the recognition of securitization income. The court concluded that if not securitised, receivables would have been subject to tax over time. Therefore, the assessee’s decision to book gain from securitised receivables over some time was deemed to be revenue neutral. However, the Bombay High Court, in the aforementioned case, held a contrary opinion. The comparison put forth by the assessee regarding the spreading of spending or the matching concept was rejected. The reasoning behind this rejection was that, as the gains in question are realised, they must be subject to taxation at the statutory rate at the time of transfer only.

In addition, the Income Tax Appellate Tribunal (ITAT) Hyderabad, in the legal matter of AsmithaMicrofin Ltd. v. Assistant Commissioner of Income Tax (ACIT), levied a tax on profits derived from a securitization transaction. However, it is crucial to comprehend that in this particular scenario, the benefits, represented by the present value of future interest, were already obtained during the transaction as a component of the sale consideration. The cases of L&T Finance and AsmithaMicrofin demonstrate the courts’ inclination to acknowledge the claims of the Revenue and thus impose taxation on securitised receivables alone when there is actual realisation of gain or income. Nevertheless, the principles established in the Shriram Investments Limited case present a counter-argument that the involved parties in the securitisation arrangement have the ability to depend on.

• SPV

The entity assuming ownership of the securitisation arrangement in question is commonly referred to as a particular purpose vehicle (SPV), which can be established as either a trust or a company. When a particular purpose vehicle (SPV) is structured as a trust, it typically needs to exhibit a pass-through characteristic, wherein no taxation is imposed on the SPV itself. However, the aforementioned stance may not hold true in the case of a revocable trust being incorporated.

In the context under consideration, we can examine the legal case of ITO-21(3)(2) v. Scheme A1 Arcil CPS XI Trust. This case established that the presence of a clause in the trust deed requiring the consent of contributors holding 75 per cent of the units for revocation does not automatically render the trust irrevocable. Furthermore, it was determined that the pass-through benefits would still be applicable in such a scenario.

The aforementioned premise was supported by citing the case of BehramjiSorabjiLalkaka v. CIT, in which the Honourable High Court observed that the legal understanding of the term “revocable transfer” remains intact, even if the settlor is unable to exercise the power of revocation without the consent of the specified individuals or any of them. As per the observations made by the Honourable High Court, it has been determined that a transfer remains reversible, even though its revocation is contingent upon obtaining the approval of specific individuals. The aforementioned stance was further supported in the legal matter of ITO-23(1)(2) v. Indian Corporate Loan Securities Trust 2008 Series 14 &Ors. In this case, Bombay’s Income Tax Appellate Tribunal (ITAT) ruled that the income derived only from a securitisation trust that can be revoked is subject to taxation for the investor.

• Investor

The taxation framework pertaining to investors is adequately elucidated in Section 61 and Section 63 of the Income Tax Act 1961. These sections establish that the particular purpose vehicle (SPV) functions as a representative assessee for the investor, resulting in the taxation of all trust income in the hands of the investors or beneficiaries. It is worth noting that the tax withheld by the Special Purpose Vehicle (SPV) will be eligible for offsetting against the tax burden of the investors.

Conclusion

In summary, comprehending the present condition and future prospects of the securitisation market in India necessitates a thorough grasp of its conceptual and regulatory framework.  Although there are certain challenges that require attention, it is worth noting that securitisation holds the potential to assume a substantial role within the Indian financial system. This potential lies in its ability to enhance liquidity and broaden the range of investment alternatives available. Tax neutrality is a primary objective in securitisation arrangements. This stipulates that the involved parties must take necessary measures to prevent any additional tax obligations arising from their agreement. Moreover, the necessity for tax certainty can be attributed to the fact that rating agencies will also request guarantees about the absence of unforeseen tax liabilities for the issuer, specifically the Special Purpose Vehicle (SPV). Therefore, it is imperative for the parties involved in a securitisation arrangement to consider the importance of tax certainty. The aforementioned statements may convey a sense of assurance to the entities engaging in securitization, as they establish certain standards that are recognised and upheld in legal proceedings.

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