ICAI suggests on Income-tax exemption for securitization trusts, levy of distribution tax on income distributed by such trusts U/s. 10(23DA)

Issue/Justification

The securitization trust has so far been treated as a pass through vehicle for tax purposes i.e. all the income of the securitization trust has been offered to tax by its investors (unless the investor is tax exempt viz., a mutual fund). This is consistent with the tax rules that apply to trusts under the tax law which prescribes a single level tax on a trust’s income (i.e. tax is levied either on the trustee or on the beneficiaries). The interest income arising to such trusts from securitized debts is taxed directly in the hands of the contributories.

The tax implications may be summarized as follows:-

➢ If contributory is a Mutual Fund, it will be entitled to exemption under section 10(23D).

➢ Any other contributory can claim deduction for corresponding expenses against such income (eg. interest and overheads)

➢ Contributories can claim credit of TDS, if any, made by the borrower

However, due to disputes regarding the person on whom tax incidence lies, tax demands were raised on the securitization trusts rather than the investors, by treating such trusts as AOPs. In order to set at rest such controversies, the Finance Act 2013 :

➢ Exempted the securitization trust from tax on income earned.

➢ Imposed a distribution tax on income distributions by the securitization trust @ 25% in case of distributions to individuals and HUFs and @ 30%in other cases.

➢ Distribution tax will not be payable on income distributed by the securitization trust to a person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act (viz. mutual funds).

➢ Exempted the investors in the securitization trust from taxation on income distributions received.

The above mentioned provisions have, however, created certain problems or securitized structures in vogue on account of the following reasons:

(a) The exemption to the investors in the securitization trust means that investors (other than exempt investors such as mutual funds) in pass through certificates (PTCs) will now earn exempt income instead of taxable income as was the case hitherto. This implies that the investors would not be able to set-off expenditure/ losses against income earned from PTCs in view of provisions of section 14A which prohibits deduction of any expenditure incurred in relation to exempt income. This may result in the entire transaction becoming unviable for investors, which is illustrated below.

If the investor is a bank investing Rs.100 crores in a Securitized debt yielding interest @ 10% p.a. Assuming, that the bank’s own cost of borrowing is say 8% p.a., its tax liability on interest income from securitized debt pre and post amendment and profit after tax is as follows :-

The above illustration highlights that a structure which was commercially viable prior to amendment made by Finance Act, 2013 has the effect of becoming unviable solely due to change in the basis of incidence of taxation. It may be noted that the financial sector works on spread between yield from investments and own cost of borrowing. Levy of distribution tax severely impacts the spread and make securitization structures commercially unviable defeating the object of SEBI and RBI guidelines for orderly development of securitization market.

(a) The trading of PTCs (most PTCs are tradable instruments) also creates dual points of taxation (i.e. at the time of distribution of income by the securitization trusts and at the time of realization of gain when the PTC itself is sold for a profit) which seems to be unintended.

(b) Ambiguity also arises for the borrower while evaluating withholding obligation at the time of payment of interest. Since the securitization trust is assessable as a separate tax entity and not a mutual fund or bank exempt from withholding, the borrower will be required to withhold tax unless the trust provides NIL withholding certificates. The securitization trust will be required to file return to claim refund of such TDS. The securitization trust should be able to set off TDS credit against distribution tax payable by it.

There is no grandfathering provided for existing securitized trusts. Hence, any income distributed by existing securitized trusts on or after 1 June 2013 will also be subject to the new tax regime.

Suggestion

Instead of distribution tax model, a complete pass through model identical to pre 1st June 2013 regime be made applicable to Venture Capital Funds/Venture Capital Companies under section 10(23FB) read with section 115U, since the participation in PTCs is largely restricted to well regulated financial institutions.

(SUGGESTIONS TO REDUCE / MINIMIZE LITIGATIONS)

Source-  ICAI Pre-Budget Memorandum–2018 (Direct Taxes and International Tax)