CESTAT, Chennai in its recent order in the case of Repco Home Finance Ltd has adjudged that Foreclosure charges collected by the Banks and NBFCs on premature termination of loans are not leviable to service tax under ‘banking and other financial services’ as defined under section 65(12) of the Finance Act.
The above judgment is briefly discussed below alongwith its applicability under GST law.
Facts of the Case:
- The Respondent M/s Repco Home Finance Ltd is registered with the Service Tax Department for payment of service tax on “banking and other financial services”. It provides housing loan to customers.
- During the course of verification of the Trial Balance of Repco Finance by the Internal Audit Group of the Service Tax Commissionerate for the period commencing from October 2004 upto June 2007, it was noticed that it had shown income on charges received from the clients for foreclosure of loans under the head “miscellaneous income”, but had not paid service tax to the extent of Rs. 20,50,399/- leviable on such charges collected by it from the customers for premature termination of loans.
- The Joint Commissioner, confirmed the demand by Order dated 31 March 2009 but refrained from imposing penalty under section 76 of the Finance Act.
- Feeling aggrieved by the order passed by the Joint Commissioner, Repco Finance filed an appeal before the Commissioner (Appeals). The Commissioner (Appeals), by order dated 27 May, 2011, allowed the appeal and set aside the order passed by the Joint Commissioner for the reason that the activity of foreclosure of loan cannot be treated as banking and other financial services‘ and the amount collected towards the foreclosure of loan is not for rendering any service.
- Against this order of the Commissioner (Appeals) the Department has filed the appeal before CESTAT.
Contention of the Revenue:
- The termination of the loan prior to the agreed term is a facility available to a borrower at a price in the same way as other facilities are available to a borrower at a price.
- This activity, therefore, according to the Revenue would be a service falling within the ambit of banking and other financial services and would be leviable to service tax.
- The Revenue contends that the foreclosure charges are levied over and above the interest that is charged from the borrower and do not have the character of interest income and cannot also be termed as penal interest since penal interest is chargeable only in case of default in making the regular payments and not for making payments before the stipulated period.
Arguments of the Respondent:
- The contention of the banks and NBFCs is that the foreclosure charges are not towards any consideration for a service provided by them but are collected to compensate the banks for the breach of the contract as the borrower seeks to make the payment before the agreed period of time.
- According to the banks, it is not the desire of the banks that a borrower should cut short the period of loan and make the entire payment, for the business of a bank is to earn income out of the interest that it gets on the amount that is given as loan to a borrower.
- The banks contend that it is the borrower who unilaterally decides to cut short the period of loan by making the payment before the stipulated time. Thus, the promise to service the loan for an agreed period of time gets repudiated resulting in a breach of the contract. This unilateral act of the borrower is considered by the banks to be against their interest.
- It is contended by the banks that instead of leaving the banks to claim damages for such breach of contract, the amount is usually incorporated in the loan agreement to provide a certainty in dealings. The banks, therefore, believe that the foreclosure of the loan by making payment before the agreed time cannot be said to be a service under ‘banking and other financial services’ since the foreclosure seeks to end the existing service.
CESTAT Order: Deliberations and Judgment
- Consideration must flow from the service recipient to the service provider and should accrue to the benefit of the service provider and that the amount charged has necessarily to be a consideration for the taxable service provided under the Act. It should also be remembered that there is marked distinction between ‘conditions to a contract’ and ‘considerations for the contract’. A service recipient may be required to fulfil certain conditions contained in the contract but that would not necessarily mean that this value would form part of the value of taxable services that are provided.
- As per definition of consideration under section 2(d) of the Contract Act, consideration should flow at the desire of the promisor. Thus, if the consideration is not at the desire of the promisor, it ceases to be a consideration. The banks and NBFCs are promisors and the promisees are the borrowers. The contractual relationship between the banks and NBFCs and the customers is repayment of the loan amount over an agreed period.
- The Banks and NBFCs would not desire pre-mature termination of the loan advanced by them as it is in their interest that the loan runs the entire agreed tenure for the banks thrive on interest earned from lending activities. As premature termination of a loan results in loss of future interest income, the banks charge an amount for foreclosure of loan to compensate for the loss in interest income. It is the customer who has taken the loan, who moves for foreclosure of the loan by making the payment of the loan amount before the stipulated period and thereby breaching the promise to service the loan for the agreed period of time. This results in a unilateral act of the borrower in repudiating the contract and consequently breach of one of the essential terms of the loan agreement. A breach of contract may give rise to a claim for damages.
- It would thus be seen that clauses relating to damages for foreclosure of loan are usually incorporated in contracts as an agreed measure of damages which can be enforced in the event there is a breach of contract with a view to bring about certainty in contracts. These clauses do not and cannot give rise to any ‘consideration’. These clauses also come into effect only after the contract comes to end.
- Foreclosure charges are recovered as compensation for disruption of a service and not towards ‘lending services’. In fact, the amount for processing charges and documentation charges or like charges are subjected to service tax because they are essential for the activity of lending and are treated as activities in relation to lending. Foreclosure is anti thesis to lending and, therefore, cannot be construed to be in relation to lending. The phrase ‘in relation to lending’ cannot be so stretched so as to bring within its ambit even activities which terminate the activity.
- These foreclosure charges should not be viewed as ‘alternative mode of performance‘ of the contract because they arise upon repudiation of specified terms of contract and are intended to compensate the injured party banks and non banking financial companies. This is because ‘alternative mode of performance‘ still contemplates performance, whereas foreclosure is an express repudiation of the contractual terms giving rise to the levy of foreclosure charges.
- Thus, merely because the clause relating to damage is featuring in a contract, it would be incorrect to conclude that the party has been given an option to violate the contract. Hence, to treat eventuality of foreclosure as an optional performance is incorrect. The contract cannot be understood to be providing an option to the parties to either perform or not perform/violate.
In view of above deliberations the CESTAT adjudged that Foreclosure charges collected by the banks and non banking financial companies on premature termination of loans are not leviable to service tax under ‘banking and other financial services’ as defined under section 65 (12) of the Finance Act.
Our view:
The above judgment is really a good one and in consonance with the legal position prevailing under service tax law prior to the introduction of negative list regime viz 1st July,2012. It is important one in view of fact that divergent views had been expressed by Division Benches of the Tribunal on this issue.
It may be noted that post negative list regime, definition of ‘banking and financial services’ upon which the judgement hinges was omitted. Further declared services were mandated under Section 66E of the Chapter V of the Finance Act,1994. Clause (e) of said Section prescribes that agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act as one of the declared services. Thus the CESTAT judgment cannot be directly applied in negative list regime under service tax law.
Further the question arises as to whether the judgment can be applied under GST law also. In this regard it is important to note that is no separate definition of ‘banking and other financial services’ in GST law rather the expression ‘services’ has been defined in a very broad manner under Section 2(102) of the CGST Act to mean anything other than goods. Further the definition of consideration has been defined in a comprehensive manner under Section 2(31) of the CGST Act.
In view of above, the judgment cannot be applied directly to GST regime. However it can be argued that basis of the judgment that as per definition of consideration under section 2(d) of the Contract Act, if the consideration is not at the desire of the promisor, it ceases to be a consideration, is still valid as in case there is no consideration there can be no supply as per Section 7(1)(a) of the CGST Act,2017.
Further though tolerating of an Act is regarded as supply of service as per Section 7(1A) read with para 5(e) of Schedule II. However it can be regarded as supply only if such activity constitutes supply as per Section 7(1). Thus if any activity is not supply as per Sec 7(1) , it cannot be treated as supply under Section 7(1A) of the CGST Act,2017.
In this regard in FAQs on Banking, Insurance and Stock Brokers Sector issued by CBIC it has been stated that Fines and penalties are imposed for breaking the law by a person. They are not in the nature of a consideration for an activity and hence, would not constitute a supply of service. Though the above FAQ is in regard to breaking of law, however same principle should apply to breaking / breach of contract by early repayment of loan for which bank charges foreclosure charges.
However despite above discussion, not applying of GST on foreclosure charges would be a risky call for Banks / NBFCs as Department would definitely raise demand in this regard and any relief can be expected only through judicial intervention.
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Frah Saeed is a law graduate specializing in the core field of indirect taxes and is the Co-founder of taxwallah.com. She has authored many publications on GST and is into full-time consultancy on GST to big corporates. She as a part of taxwallah.com heads a team comprising of Chartered Accountants and Advocates and plays a key role in our mission to disseminate GST knowledge to all.
