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Introduction
Reserve
Bank of India’s regulatory surgery in 1998 removed the
cancerous elements in the Non Banking Financial Institutions
(NBFI) industry leaving behind a healthy nucleus of responsible
corporate citizens. Given the NBFI sector’s contribution
to the economy, there is a need to rebuild the sector
especially at this time when the sector is people by more
responsible players.
1.
Term Money to NBFCs
The
first important foundational step that we need to take
is to ensure availability of term money to leasing companies
and other non-banks so that they are not compelled to
write 3 to 5 year leases with 90-day money. Presently,
a major source of long term money, the capital market,
is comatose. The Financial Institutions who provide long-term
money are now inactive. Public depositors are disinclined
to place funds with Non Banks. This leaves the Non Bank
sector with restricted access to bank funds alone. The
banks have at the best of times not been eager to finance
Non Banks who they regrettably look upon as competition.
Several banks limit funding to 90 day or 6 monthly note
loans, which make it impossible for a leasing company
to write a one-year let alone a five-year lease.
RBI could most probably help in overcoming this problem
of, mismatch in maturities if they were to permit banks
to roll over their loans to leasing companies and other
non banks rather than insist upon their repayment within
90 or 180 days preferably to give term loans for at minimum
5 years. The banks could in the case of other sectors
continue to provide working capital financial of a year’s
duration.
The
present liquidity (in the system) is deceptive. The liquidity
is more a function of decline in industrial credit requirements
(which in turn is a function of demand / supply mismatch).
A sudden increase in aggregate demand could trigger an
industrial recovery with the attendant higher Industrial
Credit off-take wiping out the liquidity. Most importantly,
key infrastructure sectors like power, telecom and
roadways, etc. require billions of rupees. Right
now, infrastructure is not happening and so there is no
pressure on liquidity. The moment the infrastructure
revolution is ignited, there will be a tremendous pressure
on liquidity. Most importantly, govt. promises to be
a perennial borrower with borrowings approximating to
Rs.1,40,000 crores every year. So Govt. may crowd
out the private sector. Therefore, NBFIs should
focus on long term money/specialised funding arrangements,
right now, rather than regret later.
2.
A Refinance Body
We experience a pressing need for an organization that
will provide refinance for credit worthy transactions
completed by Non Banks with tenors of 3-5 years. The
refinance body that is formed could be funded by subscription
to its debenture paper or capital, by banks with surplus
money. This money could be then put to use to finance
Non banks. An alternative proposal is for major co-operative
banks to be permitted to provide such refinance facilities
to leasing/Non Banks etc and in the process develop strong
realizable credit worthy loan assets which is what the
large Co-operative Banks are looking for.
We also recommend that the “Refinance Body” have some
regulatory role to play. It will ensure that
only those NBFIs, which have an excellent compliance track
record, will be eligible for refinancing. Resultantly,
the Refinance Agency itself will act as a mini regulator
and ensure compliance. Of course RBI will continue to
be the super-regulator of the whole financial system,
including NBFIs. If the refinance agency can play a secondary
role, RBI’s “regulatory energy” can be more productively
focused on those NBFIs, which are in the “High Risk” zone.
3. Standby facilities and assistance from
LIC which is an entity with long term money
We suggest that Reserve Bank of India permit us to obtain
a stand by facilities from commercial banks so that against
bank’s standby facilities we can approach the Commercial
Paper market as also Mutual funds to raise funds. Most
importantly LIC could ear mark may be 0.5% of its resources
to provide refinance / direct finance to Non Banks for
periods of 5-7 years. LIC gets life insurance money,
which is long term and so, could extend term credit.
4. A “Level playing field” with Banks.
Most importantly if non-banks are to make a meaningful
contribution to growth, it follows that since they are
as closely regulated as the banks via prudential norms
relating to Capital Adequacy, Provisioning for NPAs, Concentration
Norms and “Mark-to-Market” applications, that it is understandable
we seek a level playing field with the banks and request
the following benefits which presently are exclusively
reserved for banks:
Deposit
Insurance
Liquidity
Support
Lender of the last resort facility
Entry
into the call market
Authorization
to raise offshore funds, etc.
5.
A level playing field for domestic and multinational non
banks
Another important issue that needs be addressed is the
absence of a level playing field between Indian and Multinational
Non Banks such as GE Capital and General Motor Finance.
These companies are permitted to issue a paper called
a “Keep Well”, agreement signed by their parent GE Capital
or General Motors, USA which is given a Triple ‘A’ by
international rating agencies. Resultantly banks are
readily prepared to provide them funding, despite the
fact that this the ‘Keep Well’ agreement may not withstand
closer scrutiny in a court of law; as it is merely a piece
of paper.
More
importantly they have an unfair advantage over us because
we have to justify credit on the basis of our operation
in India alone whereas multinationals are prepared to
ear mark their lines of credit for GE Capital and GMAC,
USA to the benefit of their Indian operations. We cannot
possibly get the same benefit. What follows is that the
multinational banks then takes a position that their credit
limits for the Non bank sector are saturated so the Indian
Non Banks are not in a position to get funding. The foregoing
does not amount to a level playing field and NBFCs in
India are placed at a disadvantage in our own country.
6.
An evaluation model that goes beyond the simple quantification
of a Capital Adequacy Ratio
If we are to rebuild the Non Banking sector on firmer
foundations it is important that there be a system based
on a capability / maturity model by which non-bank leasing
companies be evaluated and screened before they are allowed
to engage in leasing activities. We strongly recommend
that the criteria to be adopted not be limited to a quantitative
factor such as a paid capital of Rs.2-3 crores. What
matters most is the experience, track record and financial
maturity of the management to run a financial services
company.
We present a proposed model:
Capability Maturity Model
|
|
Weight |
3 |
2 |
1 |
| Net
Owned Funds |
0.10 |
More
than 50 crs. |
25
– 50 crs |
Less
than 25 crs |
| Existence
(no. of years) |
0.10 |
More
than 25yrs |
More
than 15 yrs |
Less
than 15 yrs |
CEO
Score
1. Industry experience
1. International experience
2. Industry leadership qualities |
0.05
0.05
0.05
|
More than 25 years
More than 3 international cities
Association leadership
And
Involvement in tax/other issues relating to the industry
|
More than 15 years
More than 2 international cities.
Either Association leadership
Or
Involvement in tax/other issues relating to the industry |
Others
Others
Others |
| Credit
rating |
0.10 |
AA-
and above |
A+ |
A- |
| Diversified
portfolio |
0.10 |
More
than 15 Inds. |
10
Inds. |
Less
than 10 Inds. |
| Gross
NPA ratio |
0.05 |
Less
than 5% |
Less
than 7.5% |
Others |
| Predominantly
leasing / hirepurchase company |
0.10 |
75%
of the asset base comprising lease & hirepurchase
assets |
60%
of the asset base comprising lease & hirepurchase
assets |
Less
than 60% |
| Diversified
sources (Dependence
on deposits) |
0.10 |
Deposits
to Total liabilities less than 25% |
25%
to 33.33% |
Others |
| Regularity
of filing RBI Returns |
0.10 |
Regular |
Good
|
Others |
| Litigation
(excluding tax disputes & normal recovery suits) |
0.05 |
Less
than 10 crs |
Value
of 10 – 15 crs. |
Others |
| Advertisement
strategies |
0.05 |
Fair |
Reasonable |
Others |
| |
1.00 |
|
Explanatory
note on Capability Maturity Model (CMM)
The proposed model is designed to serve the following
objectives:
i.The
proposed CMM will help the regulator carve out a separate
class of NBFCs, whose “management capability” will unquestionably
be superior to the rest. The model will help RBI to distinguish
the well managed NBFCs from the rest. In short, NBFCs
who score high on the proposed CMM will pose a lesser
“regulatory risk”. It follows that supervisory concerns
relating to their operations will be minimal. This may
help the regulator to focus “regulatory energy” on NBFCs,
who fall in the “High risk zone” (Those who score low
on the CMM).
ii.
Entry barrier
CMM will also serve as an effective entry barrier so that
any one, who does not possess the required “intellectual
capital” in terms of “skill sets” that are required to
manage NBFCs will be shut out. It will not stop at measuring
capability to inject the “financial capital”. But it
will also focus on the “quality of management” and their
ability to act as a custodian of the savings of thousands
of retail investors.
iii. The capability maturity model will help the regulator
to link the dispensations / concessions that are to be
given to various NBFCs to the actual scoring. This will
help the regulator extend dispensation only to those deserving
NBFCs in a fully transparent manner, so
that others, who are not merit worthy cannot clamour for
the same set of dispensations irrespective of their size,
strength and capability.
Other
issues
The model may appear to be biased in favour of existing
NBFCs with a track record of more than a decade. A question
may arise as to how effective the model will be as an
entry barrier. Any new entrant may loose out on parameters,
such as existence, quality of portfolio, etc. As the
model will be in the “Public Domain”, it is open to aspiring
new entrants to attempt to improve their score by working
on other balancing parameters, such as NOFs, credit rating
and the CEO score. To illustrate, new entrants may be
forced to bring in close to Rs.50 crores, if they are
to offset the low score on other parameters. If any large
industrial houses or an MNC operation with a strong track
record elsewhere, propose to operationalise a new NBFC,
they need arrange for a parent guarantee / comfort to
the rating agency and obtain a better credit rating on
day one, say AA- and above. This way, we mitigate the
perils of the “halo effect”. Anyone who claims “strong
parentage” or “international presence” is forced to deliver
on day one ie. at the stage of commencement of
business. Some start ups may be forced to hire a “high
calibre” CEO with relevant international experience to
improve the score.
7. Statement
of Chairman of ALFS on Kelkar Committee report on December
4, 2002
ALFS
has expressed concern over the Kelkar committee’s proposal
to align the depreciation on a company’s books with the
depreciation adopted for its Income Tax (IT) returns.
The industry body contends that the move would depress
corporate profits, therefore making capital market less
attractive for investments. There is a need to re-ignite
the capital market as the leasing industry needs long-term
funds to finance lease assistance. Mr. Farook Irani,
Chairman of ALFS, said.
At
the same time, ALFS has welcomed several recommendations
of the committee like the removal of long term capital
gains tax, the non-taxation of dividends in the hands
of the shareholders, removal of dividend tax, scrapping
of minimum alternate tax and reducing corporate taxes.
The
arrangement of charging higher depreciation rates in the
tax return and lower depreciation on the books has proved
itself over the years, as India compared with most other
countries in Asia, including China, has had a more vibrant
capital market. This has helped in India’s impressive
capital asset formation.
Apart from increasing tax outflow for India Inc., the
proposal may also negatively impact capital asset formation
and GDP growth as explained in the following lines:
a. Capital
asset formation
We cannot strongly enough emphasise that this is not merely
a problem of the Leasing Industry, but affects the entire
Capital Goods Industry and resultantly is more than likely
to negatively impact GDP growth rate, leading to lower
capital asset formation. Parliament in its wisdom allows
corporates to accelerate depreciation in the tax return
(IT Act) and to adopt lower depreciation rates in the
Books (Companies Act) to achieve the twin objectives of
encouraging capital asset formation on the
one hand and boosting the capital market
on the other.
b. GDP
growth
Most importantly, if we analyse the GDP growth pattern,
Agriculture presently registers a “nil” growth rate, Services
are booming, but regrettably it’s the negative growth
in the “capital goods industry”, which pulls down the
GDP growth rate. The bulk of capital asset acquisition
over the last 3 years was in the area of IT Products or
automobiles. Industrial assets ie. plant & machineries
are not in the “hot favourite” list (weightless world
syndrome). But India still needs physical infrastructure
and capital asset formation
c. Loss
of a key economic Administration tool.
The tax depreciation rate is an important tool in the
hands of policy makers to direct / channelise capital
flow into specific sectors / economic activity to fulfil
a particular national priority. To illustrate, when the
govt. wanted to encourage non-conventional energy, the
easiest way was to increase the depreciation rate to 100%.
No one can deny that, but for this important “fiscal stimuli”
India would not have benefited by a huge capacity expansion
in a non-polluting, inexhaustible source of wind energy.
By aligning the book depreciation and the tax depreciation,
the govt. denies itself this motivational trigger
especially at this time when after repeated interest rate
reduction, any further drop in interest rates is unlikely
to encourage economic growth.
d. Deferred Tax
One may argue that alignment is anyway achieved by the
“Deferred tax” provision. This present provision is harder
hitting than deferred tax. Whilst deferred tax is an
accounting provision and thus “cash neutral”,
the tax bite in this provision is real and undeniable.
So, the proposed recommendation would result in higher
tax outflows for corporates possibly impacting the repayment
capacity of the corporate sector, which could trigger
a “Rating Migration” and negatively impact the capital
market.
There is an urgent need to have a complete re-look at
the various issues affecting NBFIs, be it taxation or
regulatory and administrative issues, so as to provide
the sector with a level playing field with banks and Financial
Institutions with whom NBFIs have to compete in line with
the global trends of Universal Banking and Financial Supermarkets.
We have listed some important issues, resolution of which
is very important for the industry to survive and contribute
effectively towards economic development of the country
so as to address the issues effectively, in an organized
manner and to find solutions, we request the formation
of a special committee of 10 members with equal representation
from Ministry of Finance, CBDT, RBI, Empowered Committee
of States Finance Ministers to Sales Tax and introduction
of VAT and the NBFI industry. The committee besides going
into details of the various issues can also provide a
long-term strategy and vision statement for this sector,
in the larger interest of depositors, shareholders and
employees.
8. Extension
of Income Tax Benefits Under Sec.10 (23G) & 36(1)(viii)
for Leasing or Hire Purchase Finance as well as Loans
Granted in Infrastructure Activities
The existing provisions of Sec.10 (23) and 36(1) of Indian
Income Tax Act, 1961 do not extend the Income Tax benefits
to a lease or hire purchase transaction. As of now, an
infrastructure Capital Company (ICC) or Infrastructure
Capital Fund (ICF) as defined under Section 10(23G) is
entitled to tax exemption in respect of all its earnings
arising out of its investments (equity or debt) made in
infrastructure projects listed under Section 90-1A. Similarly,
under Section 36(1)(viii) notified Companies, who are
engaged in providing long term finance for construction
or for purchase of houses for residential use can claim
deduction upto 40% of their profits for creating a special
reserve. However, an NBFI is not entitled for the same
tax breaks in so far as its investments in the specified
infrastructure projects through lease or hire purchase
of loan transactions are concerned. It is imperative
to extend these benefits to NBFIs also as long as the
objective of channeling investments in certain designated
infrastructure projects are met.
We would, therefore, strongly recommend that the benefits
provided under Section 10(23)(g) and Section 36(1)(viii)
of Indian income Tax Act, 1961 be extended to lease and
hire purchase transactions and loan transactions also.
9
. Mandatory
Provisions by leasing companies to be allowed as deductible
expenses
NBFIs are now subject to directions of RBI as regards
income recognition and provisioning norms.
Under the existing provisions under section 36(1)(viia)
in the Income Tax Act, a provision for bad and doubtful
debts made by banks and financial institutions is allowed
as a deduction to the extent of 5% from the gross total
income. The last budget has increased this limit to 7.5%.
Alternatively, such banks and financial institutions have
been given an option to claim a deduction in respect of
any provision made for assets classified by the RBI as
doubtful assets or loss assets to the extent of 10% (increased
from 5%) of such assets. There are no such provisions
for NBFIs they are required to write off bad debts and
satisfy other conditions to claim deduction just like
any other business.
The stand of NBFIs have also been endorsed in a recent
ruling of the ITAT Bench of Madras in the case of Overseas
Sanmar Financial Ltd. The Bench held that provisioning
against bad and doubtful debts by an NBFI as per the norms
of the RBI is deductible against the income of the company.
If RBI issues mandatory circulars or accounting standards
the CBDT must give effect to it for tax purpose as well.
RBI’s directive to account for income on cash basis is
an appreciation of the fact that it does not make sense
to account the income on accrual basis giving no credence
to the actual recovery and later allowing deduction for
irrecoverable debts including debts that could not be
recovered in full from the security provided because of
erosion in the value of the security.
Therefore, along with banks and FIs NBFIs should also
be appropriately covered under Section 36(1)(viia) of
the Income Tax Act.
10. Hike in depreciation rates on construction
equipment, similar to vehicles used for hiring out
The
Income Tax Act allows depreciation at the rate of 100%
in case of certain equipment’s meant for pollution control,
solid waste control, mineral oil concerns, mines and quarries,
energy saving devices and renewable energy devices etc,
the Act also allows higher rate of depreciation (50%)
to motor cars, buses, motor lorries and taxis used in
a business of running them on hire. The idea behind such
higher allowance of depreciation, apart from providing
for the wear and tear of the equipment is also the requirement
and acute need of such investments because of their positive
effect on the economy of the country. Similarly construction
equipments should also enjoy higher rate of depreciation
to compensate for the higher wear and tear and also to
encourage development of infrastructure since they are
primarily used in the infrastructure sector.
10. Long term foreign currency swaps for asset financing
companies (AFC)
As mentioned earlier, some of the NBFIs are engaged in
the business of financing of infrastructure equipment
and small to medium sized infrastructure projects. It
is understood that long-term funds are needed for infrastructure
development. These NBFIs are, therefore, extending credit
to the infrastructure projects out of the line of credit
to be availed from IFC, Washington or any other bilateral
or multilateral financial institutions or a foreign bank.
If they assume the entire forex (FX) liability and extended
credit in rupee terms, they would need to hedge their
risks, which are many a time compulsorily stipulated by
the foreign lending institutions. Such a hedging involves
Foreign Currency-Rupee swap and it required MOF’s specific
permission.
A general permission for the said swap transactions should,
therefore, be provided for, as it would help channelise
long-term foreign funds for infrastructure development
in the country and simultaneously mitigate the forex risk
of the domestic financial companies.
11.
Coverage of NBFCs engaged in Lease & Hire Purchase
in the new NPA
Act
On June 21, 2002, the Government has promulgated the new
NPA Ordinance, which deals with three distinct actions
in respect of financial assets with regard to banks and
financial institutions in the form of securitisation of
assets, setting up of asset reconstruction companies and
enforcement of security interest. However, although the
coverage of banks in this Ordinance has been adequate,
the issue of recovery of outstandings plaguing NBFIs have
not been suitably addressed.
Section 2(m) of the Ordinance defines a Financial Institutions
and includes any Non-Banking Financial company as defined
in clause F of Section 45-1 of the RBI’s Act, 1934 which
the Central Government may by notification specify as
financial institution for the purposes of this Ordinance.
All NBFIs involved in lease and hire purchase of assets
should be notified in terms of Clause 2(m) of the Ordinance.
Furthermore, all the NBFIs involved in leasing and hire
purchase of assets should be notified under the Section
as a category, irrespective of the fact whether they are
advancing loans against the security of an asset or financing
the asset by way of Lease or Hire Purchase since the nature
remains same in both the forms, which is essentially financing
the assets. But due to the form of lease or hire purchase
whereby the Lessor (financier) is considered to be the
owner (in form, not in substance), no security interest
can be created. However, the exclusions defined in Chapter
VI, Section 31(3) of the Ordinance say that any conditional
sale, hire purchase or lease or any other contract in
which no security interest has been created will not be
covered in this Ordinance. This is a severe blow for
category of NBFIs stated above, since they will not have
any right in this Ordinance. We do not find any rationale
for excluding such a vital and important financial transaction,
out of the purview of this Ordinance.
12.
Nominee directors appointed by NBFIs – Level playing field
with FIs
Nominee Directors appointed by financial institution or
banks on the Boards of the companies assisted by them
are accorded certain special privileges by virtue of overriding
provisions contained in the enactments.
To safeguard their interests NBFIs also have to appoint
nominees on the Boards of their borrowers, but the above
mentioned privileges are not accorded to the Directors
so nominated by them. The need to protect the interest
of the lender is same for FIs, Banks or for that matter,
NBFIs. Hence this is again area where level playing field
must be provided to NBFIs.
13.
Considering hypothecation of infrastructure assets as
part of EL/HP
Assets for classification of an NBFI as Equipment Leasing
or Hire Purchase finance Company
RBI in it’s Circular No.DNBS (PD) CC No.18/02.01/2001-02
dated January 1, 2002 decided to include loans against
hypothecation of all types of automobiles like trucks,
buses, tractors, cars, three wheelers, two wheelers and
dumpers, which are registered with Road Transport Authority
and the charge is recognized by Motor Vehicles Act; aircraft
registered with Director General of Civil Aviation and
ships registered with Director General of Shipping, along
with other equipment leasing and hire purchase assets
for the purpose of classification of NBFI as equipment
leasing or hire purchase finance company. But very importantly
the circular ignored a large and important segment, which
is loans against construction equipment and other equipment
used for infrastructure development and also loans granted
for infrastructure projects. We feel there is no justification
at all for their non-inclusion.
For the purpose of classification of an NBFI as equipment
leasing or hire purchase finance company.
a.
Loans against hypothecation of all types of construction
equipment and infrastructure related equipment.
b.
Loans granted for infrastructure projects, which
have the security of infrastructure asset, itself.
14. Exemption to Asset Financing Companies u/s 194A(3)(iii)
of the IT Act
As per Section 194A of the Income Tax Act 1961, tax has
to be deducted out of the interest payment made by any
borrower to the lender at the rates in force. The rates
vary depending on the construction of the payee (lender).
For category of domestic companies in which NBFIs fall
it is presently 20.4% (inclusive of surcharge of 2%).
Banking companies, Co-operative Societies engaged in banking
business, public financial institutions, LIC, UTI, Insurance
Companies and some other notified institutions are exempted
from the purview of this section implying that if the
payment of interest is made to them, the borrower is not
required to deduct TDS out of the interest payment.
This stipulation puts NBFIs in a disadvantageous position
and creates severe cash flow constraints since NBFIs operate
on a very thin spread of interest income. If we analyze
a typical loan transaction of NBFI, we may find lending
say at 16% and borrowing say at 13%, giving a gross margin
of 3%. The interest income of the NBFI will be subject
to TDS of 20.4%, implying 3.26% out of 16% will go for
TDS deduction, which is more than the total margin available.
Therefore, there is no justification in imposing TDS stipulations
on the interest repayment made to NBFIs.
Such
a stipulation forces NBFIs to avoid granting loans or
offer high rates of interest to borrowers, which acts
as a alternate system for the borrower and defeats the
very purpose of NBFIs in the financial sector.
RBI has now allowed loans against hypothecation of certain
assets to be considered along with the lease/hire purchase
assets to satisfy the 60 per cent norms for classification
of an NBFI as equipment leasing or hire purchase finance
company. Hence, it is expected that there will be increased
financing by NBFIs in the form of loans. It is thus essential
that the TDS anomaly explained above is rectified immediately
in order to reduce the cost of intermediaries and ensure
flow of capital to infrastructure sectors of the economy,
which is the direct focus area of Asset Financing NBFIs.
This will also ensure uniformity in taxation of similar
business.
Therefore, exemption should be granted from TDS on interest
payment to NBFIs under Section 194A(3)(iii) of the IT
Act. To avoid misuse of the exemption, CBDT can stipulate
that only NBFIs registered with RBI shall be entitled
to the exemption.
15.
Withdrawal of tax deduction of interest paid on foreign
borrowings
The Union Budget 2001-02 has withdrawn the External Commercial
Borrowings (ECB) tax exemption in respect of interest
paid effective from 1st of June, 2001. This
withdrawal of exemption, has raised the cost of borrowings
to the extent of tax deducted as the foreign lenders are
insisting upon gross interest payment, i.e., without deduction
of tax. All external commercial borrowing documentation
carry a standard clause that interest shall be paid on
gross basis. According to this clause the borrower for
example an Indian Company would pay the withholding tax
to the government and also pay the full amount to the
lender. ECB route has been a cheap source of finance
for the Indian companies, but the withdrawal of tax exemption
has jeopardized the operation of all companies in the
country who follow the ECB route for raising their funds.
The withdrawal of the exemption is also eroding the Indian
Corporate Sector’s cost competitiveness vis-à-vis other
Asian countries like Hong Kong, Malaysia, Singapore and
Taiwan, which do not impose withholding taxes. It is,
therefore, suggested to revert back to the earlier provisions
and grant exemption from deduction of tax on interest
paid on ECB loans.
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