The Hindu Business Line : They're no country cousins of commercial banks

CORPORATE India has always insisted on a level-playing field while discussing the entry of transnational corporations into domestic market. It is now the turn of the non-banking sector to make a similar plea to the Government.

This sector consists of non-banking financial intermediaries engaged primarily in the business of accepting deposits and making loans and advances, investments, leasing, hire purchases, and so on.

There are various types of such organisations — mutual benefit fund companies also known as nidhis, chit funds, hire purchase finance companies, equipment leasing companies, housing finance companies, and so on.

In 1997, the Reserve Bank of India Act was amended so as to give the central bank comprehensive powers to regulate non-banking finance companies (NBFCs).

It was made mandatory for every NBFC to have minimum net owned funds of Rs 2 crore. They have to obtain RBI registration for commencing or carrying on business. The idea was to ensure that only companies with a healthy background and adequate capital were allowed to carry on the business. They work under the supervision and control of the RBI.

An Expert Committee, comprising Profs Vaidhyanathan and Sriram of IIM Bangalore, considered the role of NBFCs in providing savings and credit delivery in the Indian economy. The committee concluded that the role of the non-banking sector in the credit delivery system in both the manufacturing and service sectors was significant and NBFCs played a more dominant role vis-à-vis commercial banks.

Adverting to the large-scale failure of NBFCs in the past decade, the committee has stressed the need for a healthy environment to guard against bankruptcy and failure. It has highlighted the following salient aspects of the tax framework applicable to NBFCs:

From the income-tax angle, the taxable receipts in the hands of NBFCs include lease rentals, interest component of the hire purchase charges and interest earned on other forms of financing.

In the case of lease transactions, the NBFC is entitled to claim the tax shield on depreciation.

Unlike scheduled commercial banks, an NBFC cannot claim a tax shield on provision for non-performing assets (Section 36(1)(vii a) of the Income-Tax Act, 1961).

From the sales tax angle, the NBFC is required to pay local sales tax on both hire purchase and lease transactions (by virtue of the 46th Amendment to the Constitution under Article 366(29a)).

The Finance Act, 2001 had proposed a 5 per cent service tax on both HP and lease transactions on the ground that both are financial services.

No level-playing field

There is no level-playing field between NBFCs, on the one hand, and financial intermediaries such as banks and financial institutions, on the other.This is because of the differences in the tax framework applicable to these groups.

Two such sources of asymmetry are i) tax shield on provision for bad debts (Section 36 (1)(vii a)); and ii) tax shield on transfer to reserve (Section 36(1)(viii)).

The aforesaid fiscal incentives are available to financial institutions and banks, but not finance companies.

A closer look at Sections 36(1)(viia) and 36(1)(viii a) of the I-T Act would help one gauge the financial impact of non-availability of these tax incentives.

Under Section 36(1)(vii a), financial institutions (including SFCs and SIDCs) and banks can create a provision for bad and doubtful debts up to 5 per cent of the total income and the provision will be treated as a tax deductible expense.

And under Section 36(1)(viii), financial institutions (engaged in providing long-term finance for industrial or agricultural development in India) and banks (with some exceptions) are entitled to a deduction of up to 40 per cent of the total income in respect of the amount transferred by them out of their taxable profits to a special reserve account.

The deduction will be available up to the point the accumulated balance in the reserve account (excluding the amounts capitalised from such reserves) exceeds twice the paid-up share capital.

What are the implications of these concessions?

The accompanying table illustrates these tax implications by comparing a finance company and a financial institution/bank with the same level of pre-tax profit.

It remains to be seen if the coming Budget will extend the benefits of Sections 36(1)(viia) to 36(1)(viii) to NBFCs.