Chennai Tribunal upholds deferred recognition of excess interest spread (EIS) on securitization of loan portfolio

In the case of Cholamandalam Investment & Finance Co. Ltd. (Taxpayer) vs. ACIT^[1] , the issue before Chennai Tribunal was on the year of taxability of excess interest spread (EIS) arising on loan portfolio securitized by the Taxpayer-NBFC. The EIS represents the difference between interest expected to be collected from securitized loans as per loan agreements with borrowers and interest payable to the holders of pass-through certificates (PTCs) in the securitized trust. 

The Taxpayer is a non-banking finance company (NBFC). In the tax year 2015-16, under a securitization agreement, the Taxpayer transferred a portfolio of loans having tenure ranging from 4 to 16 years and generating a weighted average return of approximately 14% per annum (p.a.) , to a trust being a special purpose vehicle (SPV), for a consideration equal to the book value thereof. For payment of consideration for such securitization, the SPV raised funds by issuing PTCs to its beneficiaries with an average yield of approximately 7% p.a.  As per securitization agreement, the Taxpayer was entitled for EIS of approximately 7% p.a. being the difference between the interest realized from securitized loans (14%) and the yield payable to the beneficiaries (7%). 

On the due date of each loan installment, the Taxpayer collected the debts on behalf of SPV and deposited it in a separate bank account maintained by the trustees. The securitization agreement provided a waterwall mechanism wherein the collections were to be utilized towards various payments  in the specified order of priority such that EIS will be last in priority payable to the Taxpayer, if any amount is left after meeting all other obligations.

As per the revenue recognition method consistently followed by the Taxpayer in accordance with the Reserve Bank of India (RBI) norms, the Taxpayer offered EIS to tax over the tenure of the loans, as and when EIS crystalized and accrued to it as per agreed waterfall mechanism. However, the tax authority ruled that the entire EIS is taxable in the year of securitization/transfer (i.e., tax year 2015-16) itself as the securitization transaction resulted in an absolute sale of loans on an irrevocable basis without any recourse against the Taxpayer. For this purpose, the tax authority computed the EIS accruing in future years by applying a discount factor of 9.7% to the amount of EIS appearing in the agreement.

However, the Tribunal ruled in Taxpayer’s favor and upheld the deferred recognition of EIS followed by the Taxpayer as per regular method of accounting in accordance with RBI norms and revenue recognition accounting standard. The Tribunal held that while the sale of loan portfolio may be unconditional, but the revenue by way of EIS arises on a deferred basis as per agreed waterfall mechanism. The receipt of EIS was uncertain as the Taxpayer was entitled to it only after meeting all other payments as per the waterfall mechanism. There could be situations of NIL entitlement in view of shortfall in collections or excess entitlement in view of pre-payments or foreclosures by the borrowers. Hence, deferred recognition followed by the Taxpayer was acceptable and could not be faulted with.

Furthermore, the Tribunal rejected tax authority’s method of computing the net present value of EIS by holding that such a method is not recognized under the Income Tax Act (ITA) wherein only the real income is assessable to tax. .

^[1] Such as payment for statutory/regulatory dues, expenses to rating agency, due diligence fees to auditor, etc., as also the payment of yield, principal payouts (including prepayments from borrowers) to beneficiaries, maintenance of cash collateral towards EIS, etc.ress release dated 26 September 2022