In normal business practices when company raises a loan from any bank or financial institute, the lender insists for personal guarantees from the Directors of the borrower Company, which is sometimes mandatory. Being Directors of the Company they are not paid any fees for furnishing such Guarantees. However GST department has started raising the issue of payment of GST under Reverse Charge Mechanism (RCM) on the activity of Guarantees by the directors by applying Valuation Rules, even though no consideration flows form Company to Directors
We shall try to analyse various aspects of the issue in this article.
It is important to understand the taxability of Granting Personal Guarantees under the provisions of erstwhile Act i.e. Service Tax.
As per Section 65B (44) any activity carried out by a person for another for consideration is service. Thus under the provisions of Finance Act 1994 (Service Tax) Service Tax could not be levied where there was no consideration flowing for the services rendered.
Accordingly the act of granting Personal Guarantees by Directors to Banks or Financial Institution was not a Service at all.
There is change in levy of tax in new GST regime. Earlier any supply of Service without consideration was totally out of ambit of Service Tax. However in GST regime, GST can be levied by invoking provisions of Schedule I to C / SGST Act, even if supply of service is without consideration.
This schedule defines various scenarios where supply of Goods and / Services without consideration are chargeable to GST and interalia includes following –
‘Supply of goods or services or both between related persons or between distinct persons as specified in section 25, when made in the course or furtherance of business.’
Now GST Department is raising the issue during the course Audit U/s 65 or Assessment (for the period commencing from 1st July 2017 and onwards) that the Personal Guarantees furnished in normal course of Business for availing financial assistance from Bank or Financial Institutions are treated as supply of Services by Directors to company though, no consideration is flowing from the Company to Directors. Further the GST Department is deriving value of Services by following provisions of “Determination of Value of Supply” rules considering the Directors & Company are related Parties and proposes to levy GST under RCM on the same.
This is creating a problem for the Companies and Industries at large. Due to lack of clarity on the issue the Companies have not paid GST on the act of furnishing personal Guarantees by Directors under RCM. Demand of GST with interest and penalty on such transaction of earlier period where the date of claiming ITC for the relevant period has already lapsed, is burdensome to the Companies.
It is to be noted that giving Personal Guarantees by Directors without consideration does not qualify as a Service at all. It is offered compulsory as part of obligation without any commercial consideration. Rather the Directors does not have option other than to offer the personal guarantees to the banks and / or financial institutions, otherwise loans cannot be availed.
It can also be evident form the various decisions, where it is held that offering personal guarantees by directors without consideration is not services.
We need to understand the difference between the Bank Guarantees, Corporate Guarantees and Personal Guarantees.
Bank Guarantees are furnished by Banks to its customers. Corporate Guarantees are furnished by Companies to their Associates or Related Parties and Personal Guarantees are furnished on behalf of Companies or Partnership Firms by the Directors and Partners.
The difference between Bank Guarantees and Corporate Guarantees has been highlighted by Hon’ble Ahemdabad ITAT in Micro Ink Ltd. Vs ACIT 2015 ITL 1382  176 TTJ 8 :  157 ITD 132, though it is in the context of Transfer Pricing Mechanism, it helps in understanding the difference. The relevant paras of the decisions are reproduced below –
“40……….Let us now compare this kind of a guarantee with a corporate guarantee. The guarantees are issued without any security or underlying assets. When these guarantees are invoked, there is no occasion for the guarantor to seek recourse to any assets of the guaranteed entity for recovering payment of defaulted guarantees. The guarantees are not based on the credit assessment of the entity, in respect of which the guarantees are issued, but are based on the business needs of the entity in question. Even in a situation in which the group entity is sure that the beneficiary of guarantee has no financial means to reimburse it for the defaulted guarantee amounts, when invoked, the group entity will issue the guarantee nevertheless because these are compulsions of his group synergy rather than the assurance that his future obligations will be met. We see no meeting ground in these two types of guarantees, so far their economic triggers and business considerations are concerned, and just because these instruments share a common surname, i.e. ‘guarantee’, these instruments cannot be said to be belong to the same economic genus. Of course, there can be situations in which there may be economic similarities, in this respect, may be present, but these are more of an exception than the rule. In general, therefore, bank guarantees are not comparable with corporate guarantees.
41….. As a plain look at the details of corporate guarantees would show, these guarantees were issued to various banks in respect of the credit facilities availed by the subsidiaries from these banks. The guarantees were prima facie in the nature of shareholder activity as it was to provide, or compensate for lack of, core strength for raising the finances from banks. No material, indicating to the contrary, is brought on record in this case. Going by the OECD Guidance also, it is not really possible to hold that the corporate guarantees issued by the assessee were in the nature of ‘provision for service’ and not a shareholder activity which are mutually exclusive in nature. In the light of these discussions, we are of the considered view, and are fully supported by the OECD Guidance in this, that the issuance of corporate guarantees, in the nature of quasi capital or shareholder activity- as is the uncontroverted position on the facts of this case, does not amount to a service in which respect of which arm’s length adjustment can be done.”
The same ratio can be applied to personal guarantees offered by Directors and hence the act cannot be treated as Service.
Therefore, one cannot treat an activity as “Service” which is by substance not.
Relevant RBI Circular on the Issue
The overall system of Personal Guarantees is governed by RBI who is the supreme regulator in Banking and Finance in India. As per the guidelines issued by RBI through its Master Circular RBI/2009-10/70 DBOD. No. Dir. BC. 14 /13.03.00/2009-10 dated 1st July 2009; company shall not pay consideration to Directors against offering personal guarantee.
In the said Circular in para 22.214.171.124 Part C it is specifically stated that no consideration whether by way of commission, brokerage, fees or any other form, would be paid by borrowing company to directors. We are producing the relevant extract herewith –
“C. Worth of the guarantors, payment of guarantee commission, etc. Where personal guarantees of directors are warranted, they should bear reasonable proportion to the estimated worth of the person. The system of obtaining guarantees should not be used by the directors and other managerial personnel as a source of income from the company. Banks should obtain an undertaking from the borrowing company as well as the guarantors that no consideration whether by way of commission, brokerage fees or any other form, would be paid by the former or received by the latter, directly or indirectly. This requirement should be incorporated in the bank’s terms and conditions for sanctioning of credit limits. During the periodic inspections, the bank’s inspectors should verify that this stipulation has been complied with.”
Personal guarantees are issued in order to safeguard and support the financial health of their Associate enterprises or to facilitate smoother functioning of the enterprise. However, the bank provides bank guarantees as a part of their general course of business and charge the consideration accordingly.
Therefore, accepting consideration for offering personal guarantees whether by way of commission, brokerage, fees or any other form is prohibited in India.
For determination value of such services, department is applying Valuation Rules and opting the rate of commission charged by Banks or Financial Institution in their normal course of business as Open Market Value.
E.g. If the bank has furnished Guarantee of Rs.100 Crores and charging commission / guarantee charges @ 1% of Guarantee i.e. Rs.1 Crore ; then department is opting the same value for the loan obtained by Bank for which directors have furnished Personal Guarantees for the same and valuing the service at Rs.1 Crore and proposes to levy GST @ 18% on such value.
Department is relying on Valuation Rule which is as follows –
The value of the supply of goods or services or both between distinct persons as specified in sub-section (4) and (5) of section 25 or where the supplier and recipient are related, other than where the supply is made through an agent, shall-
(a) be the open market value of such supply;
(b) if the open market value is not available, be the value of supply of goods or services of like kind and quality;
(c) if the value is not determinable under clause (a) or (b), be the value as determined by the application of rule 30 or rule 31, in that order:
Provided that where the goods are intended for further supply as such by the recipient, the value shall, at the option of the supplier, be an amount equivalent to ninety percent of the price charged for the supply of goods of like kind and quality by the recipient to his customer not being a related person:
Provided further that where the recipient is eligible for full input tax credit, the value declared in the invoice shall be deemed to be the open market value of the goods or services.
Open market value and value of supply of goods or services of like kind and quality is also defined in explanation to Chapter IV of CGST Rules 2017 as below –
Let us further elaborate the concept of “open market value” and “supply of goods or services or both of like kind and quality” as per above explanation –
“Open Market Value”
1. Full Value of Money excluding GST
2. By Same person to other than related person and price is the sole consideration
3. At the same time when such supply is being valued
“Supply of goods or services or both of like kind and quality”
1. Any other supply of goods or services or both
2. Made under similar circumstances
3. Having the characteristics, quality, quantity, functional components, materials, and the reputation
4. Which is the same as, or closely or substantially resembles with supply already made
Let us see the transaction of offering Personal Guarantee in above parameters –
1. As we have seen the Directors are not regularly in the activity of giving personal guarantees against consideration. It is compulsion by the Banks to give their personal Guarantees to Banks without which Banks or Financial Institutions are not granting Credit Facilities to the Company. Therefore, market value of services is not available where Directors are offering personal guarantees without consideration to Banks or Financial Institutions as a precondition to make available Credit Facilities to Company.
2. Directors have offered Personal Guarantees to Banks and Financial Institutions only. There are no comparable transactions of such type are available, as Directors are not in the business of giving Personal Guarantees.
In the above exmaple, rate of commission normally charged by Banks / Financial Institutions where the they are in the “Business of offering Guarantees” cannot be considered as open market value or value of supply of goods or services of like kind and quality; since Bank Guarantees and Personal Guarantees are not comparable and stand on totally different footings.
In the absence of comparable Open Market Value for of Services of like Kind and Quality; valuation cannot be made under valuation rules and hence it is difficult to tax the transaction and therefore, levy of Tax is not possible. Hon’ble Supreme Court in the case of Govind Saran Ganga Saran Versus Commissioner of Sales Tax and Others 1985 (4) TMI 65 – Supreme Court it is held that –
“The components which enter into the concept of a tax are well known. The first is the character of the imposition known by its nature which prescribes the taxable event attracting the levy, the second is a clear indication of the person on whom the levy is imposed and who is obliged to pay the tax, the third is the rate at which the tax is imposed, and the fourth is the measure or value to which the rate will be applied for computing the tax liability. If those components are not clearly and definitely ascertainable, it is difficult to say that the levy exists in point of law. Any uncertainty or vagueness in the legislative scheme defining any of those components of the levy will be fatal to its validity.”
As the act of accepting consideration for furnishing Personal Guarantee is prohibited in India, value cannot be ascertained in absence of actual consideration.
Considering the valid legal backing, the Department’s intention to levy GST on the notional value for the act of furnishing Personal Guarantees to the Banks or Financial Institutions, by applying Valuation rules, is unjust and creating unnecessary hardship to the Taxpayers.
Act of furnishing Personal Guarantees without consideration by Directors to Banks / Financial Institutions is not “Supply of Service” within the meaning of GST.
In the absence of comparable Transactions valuation cannot be made by invoking Valuation Rules.
Levying GST on such services though on RCM, on notional value, will open Pandora’s Box and Taxpayers may be dragged to unnecessary litigations involving huge cost.
The GST Council and/or Board (CBIC) need to consider the issue positively by issuing clarification or by amending the legislature accordingly.