Finance Industry Development Council

ASSET FINANCING NBFCs

ROLE OF ASSET-FINANCING COMPANIES (NBFC-AFCs) IN SERVING THE SOCIO ECONOMIC OBJECTIVES

A robust banking and financial sector is critical for facilitating higher economic growth. Successive RBI reports have recognized that the financial intermediaries like NBFC-AFCs have a definite and critical role to play in a developing economy such as ours. These intermediaries play an important role, particularly in delivering credit to weaker and un-banked segments of the populace, in a role complementary to the banks.

Unlike in the past, Asset Financing companies are now very well regulated and supervised. Just like banks, they are required:

• To be registered with RBI,
• To follow stringent prudential norms set by RBI in the matters of capital adequacy, credit/investment norms, asset-liability management, income recognition, accounting standards, asset classification, provisioning for NPA and several disclosure requirements.
• To follow KYC norms.

We are also required to file regular returns with RBI and are subject to inspection on site from RBI.

Such a rigorous regulatory framework ensures that the monitoring of these NBFC-AFCs is similar to that of banks, in all respects. Indeed, RBI has clearly articulated its intent of levelling the regulatory playing field between banks and NBFC-AFCs.

1. Role of AFCs in Funding The Road Transport Sector

NBFC-AFCs play a very useful role in channelising funds towards acquisition of commercial vehicles and consequently aid in the development of the road transport industry. NBFC-AFCs are engaged in creation of assets like financing transportation and infrastructure construction equipments and projects. Needless to mention, the road transport sector accounts for nearly 70% of goods movement and 80% of passenger movement across the length and breadth of the country and the role of NBFC-AFCs in the growth and development of this sector has been historically acknowledged by several committees set up by the Government and RBI, over the years.

Road Transport Sector today is the lifeline of our economy. As stated earlier, the Road Transport Industry carries a major chunk of freight and passengers. Recently, Government has accorded a very high priority to this sector. It is a well-established fact that NBFC-AFCs provide 80% to 90% of funding for the Road Transport Sector.

Some of the facts related to Commercial Vehicles and their financing are as follows:

• Indian economy is becoming more dependent on Road than Rail because of the flexibility of roads. Heavy government outlay for mega road projects like the Golden Quadrangle will further accelerate this trend

• Sale of Commercial Vehicles has been growing at over 35% during the current year.

• Ninety five percent of the Commercial Vehicles are acquired under financing.

Heavy replacement demand is anticipated on account of Modernization of old Commercial Vehicles.

It is estimated by various study groups that each commercial vehicle manufactured, sold & financed in this country gives direct & indirect employment to minimum 6 persons, thereby providing employment generation to several lakhs of people all across the country. It is the most geographically well spread network accessing the remotest village in India.

The potential of the commercial vehicles financing industry is estimated at Rs. 15000 crores and is growing fast. Another Rs.6000 crores would be required for phasing out of commercial vehicles, which are more than 15 years old.

• Borrowers’ Profile: Mainly Retail with minimum individual/group exposure and therefore, concentration of risk is reduced.

• Priority of Repayment: Being an earning asset, it ranks high in priority.

• Ticket value of each transaction: Rs. 6 to 10 lacs for new vehicles and Rs.1.5 lacs to Rs.3 lacs for used vehicles.

• CRISIL in its study has placed commercial vehicle financing under the "low risk" category, in its Risk Continuum.

• NBFC-AFCs have a strong presence in the rural markets where they are engaged in financing farming machinery such as tractors, and LCVs and three-wheelers used for transportation of agricultural produce. Given the necessity of increasing agricultural growth through improvements in productivity and also of generating employment in rural areas, asset-financing companies will continue to play a vital role in meeting these objectives.

2. Asset Creation

NBFC-AFCs have demonstrated that their strength has been in creation of productive national assets through leasing and other modes of financing. In fact, most developed economies have relied heavily on lease financing route in their developmental process. NBFC-AFCs have been playing a major role in promoting leasing, hire-purchase, loan disbursals etc. in different economic activities, be it infrastructure creation or developing key support services for such infrastructure. Most developed countries exhibit impressive market penetration of leasing (a measure of leasing in capital creation). US (31.1%), Canada (20.2%), Australia (20%), UK (15.3%), Sweden (13%) and France (12.9%) enjoy double-digit penetration rates followed by Japan, Germany and Italy with near double-digit rates. Compared to these nations, India’s market penetration in leasing stands at somewhere between 2-3%. Even developing economies like Russia, Mexico, Turkey have better market penetration when compared to India. This clearly reflects the conducive legislative and regulatory regime that the respective governments have created towards promotion of leasing.

For a developing nation like India where infrastructure creation has been presently accorded highest priority, leasing has immense potential. More particularly in the case of small and medium enterprise (SME) sector which accounts for the lion’s share of the entire economic activities in our country, leasing offers tremendous advantages and hence needs to be promoted in a big way.

3. Observations made by RBI and various Government Committees :

In its Mid-Term Credit Policy 2006-2007, RBI has accorded recognition to the role of Asset Financing NBFCs within the financial sector by classifying them as "Asset Financing Companies", and by segregating them from NBFCs involved in the Investment and Loan business.

As part of the overall NFBC sector, the comments in the various reports are outlined below :-

A. Observations made in the RBI’s report titled "Report on trends on progress of banking in India 2003-2004"

"Notwithstanding their diversity, NBFCs are characterized by their ability to provide niche financial services in the Indian economy. Because of their relative organizational flexibility leading to a better response mechanism, they are often able to provide tailor-made services relatively faster than banks and financial institutions. This enables them to build up a clientele that ranges from small borrowers to established corporates."

B. Observations made by the Parliamentary Standing Committee on Finance in their 45^th Report on The Financial Companies Regulation Bill, 2000

1. NBFCs have higher level of customer orientation, fewer pre and post sanction requirements and provide simple and speedy tailor made services.
2. NBFCs have become an integral part of the Indian Financial System in

view of their complementary as well as competitive role.

3. Non-Bank credit cover 70% of the requirements for the Trading activity and more than 50% of the requirement of unregistered manufacturing.

C. Observations of the Task Force on NBFCs (Vasudev Committee) appointed by Government of India in 1998.

a) Financial intermediaries like NBFCs perform the function of being a link between savers in the society and users of the savings.

b) NBFCs have greater reach and flexibility in tapping resources and they provide retail services to small and medium level business and road transport operators.

c) NBFCs constitute an important link between banks and the requirer of services and are an important component of a diversified financial market.

Therefore, it can be seen that Asset Financing Companies (within the NBFC segment) play a significant role in ensuring cost-effective delivery of credit to the weaker and the un-banked segments of Indian society, act as an intermediary between the banking sector and borrowers in the rural markets, and assist in the creation of real and productive assets, which in turn have a multiplier effect on employment. The role of Asset Financing Companies within the financial sector cannot be understated and it is keeping this in context that we request the Hon. Minister to evaluate the issues outlined in this petition and provide relief to the industry.

Access to ECB Funding for NBFC-AFCs

Both the banks and NBFCs had free access to ECB earlier. However, currently there are

restrictions in accessing ECB for banks and NBFCs in that :-

• Prior RBI approval is required
• RBI approval is given for ECB on a case to case basis only for importing equipments for use in infrastructure projects. In other words, such funding is not available for indigenously manufactured equipents, which is a clear discrimaination.
• Such funding has to be for a minimum period of 5 years

ECBs typically come for longer terms and are in line with the length of an infrastructure projects. There is scarcity of long term funding from domestic sources. Therefore, keeping in view the non-availability of long term funds in India and the requirements of infrastructure projects ( estimated at US$320Bn over the next 5 years) the Government should allow NBFC-AFCs in the infrastructure project financing, vehicle financing and equipment financing segments, to access External Commercial Borrowings (ECBs) without any restriction. This would enable such NBFC-AFCs to access long-term funds at competitive rates from the global financial market and to channelise those funds into financing of infrastructure projects and productive assets, which in turn has a multiplier effect on employment generation.

1. SARFAESI ACT

Banks and Financial institutions have been notified under the Act, giving them the ability to move against defaulting borrowers and secure their assets. Subsequently, specified housing finance companies (HFCs), have also been notified under the Act. AFCs are the only segment of the financial sector that have not been notified under the Act.

It is submitted that in order that the interests of investors be protected, AFCs may also be brought within the purview of the SARFAESI Act. As per the Act, RBI can do this by way of a notification.

2. DEBT RECOVERY TRIBUNALS (DRTs) :

We request you to grant access to AFCs to DRTs. We also request you to increase the number of DRTs if the existing set-up is found inadequate. This would fulfil a long felt need of the AFCs and lead to speedier realisation of their dues.

Direct Tax Issues

1. Sec.36 (1) (viia) / 43D Of The Income Tax Act, 1961

Benefits allowed to the banks and housing finance companies, but NBFC-

AFCs left out

Under the existing provisions u/s 36(1)(viia) of 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 7.5% from the gross total income. Alternatively, such banks and FIs 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.

NBFC-AFCs are also compulsorily required to make provisions for Non-Performing Assets (NPA’s). However, provisions made by NBFC-AFCs in line with such prudential norms fixed by RBI are disallowed by tax authorities when assessing their income tax liabilities. These provisions made against NPAs are in the nature of business expenses incurred wholly and exclusively for business operations by an NBFC-AFC.

Therefore, these provisions should be allowed to be deducted while arriving at the taxable profits of NBFC-AFCs. Any recovery made against these allowed provisions would automatically get taxed later on.

Banks / HFCs / FIs enjoy tax benefit on income deferred as per RBI directives on NPA. NBFC-AFCs are also required to follow these prudential norms as per RBI directives, but they are the only segment of the financial sector denied this tax benefit.

Benefit allowed to banks, but NBFC-AFCs left out

As per Section 194A of the Income Tax Act 1961, tax has to be deducted out of the interest payments made by specified borrowers to the lender at the rates in force. The rates vary depending on the constitution of the payee (lender). For the category of domestic companies in which NBFC-AFCs fall, the rate of TDS is presently 22.44% including surcharge of 10% and education cess of 2%.

Banking companies, Cooperative 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 these entities, the borrower is not required to deduct TDS out of the interest payment. This is not available to NBFC-AFCs even though they are in similar lending activities. Consequently, their margins and cash-flow are severely affected.

3. TDS on Financial lease rental payments under Section 194-I of Income Tax Act

Gross lease rental subjected to TDS and not the interest portion alone

Section 194-I of the Income Tax Act deals with TDS on rent payments. The present TDS rate is 22.44% (20% TDS + 10% surcharge + 2% education cess).

In this section, the definition of ‘rent ’ has been enlarged to include lease, sub-lease, tenancy or any other agreement or arrangement for use of machinery, plant, equipment etc. besides land and buildings.

NBFC-AFCs operate on very thin margins. On that, if a 20% TDS is applied on gross lease rentals, this will result in negative cash flows. It must be pointed out that unlike renting, leasing is a mode of financing and major portion of lease rentals includes repayment of principal just like a loan repayment. If TDS is deducted on entire lease rental, it means not only will the TDS be deducted on the interest, but also on the principal amount. This can spell disaster for the NBFC-AFC sector in India leading to its extinction.

4. Fringe Benefit Tax (FBT) –

Certain specific sectors such as Software, Construction, Pharma industry etc. have been provided with concessional rate of FBT on specific nature of expenditure incurred by them relevant to their business. Similar benefit of concessional rate may be extended to NBFC-AFC’s also, especially on a/c of conveyance, staff welfare expenses & Hotel Boarding & Lodging.

3. Lease and sub-lease should not be included in Section 194-I of Income Tax Act.

4. Benefit of concessional rate of FBT should be extended to AFCs.

Indirect Tax Issues

1. Service Tax on Hire Purchase/ Lease Transactions

thanks to your action

Last year, subsequent to the discussions held with our representatives during the Pre-Budget meeting, it was due to your prudent understanding and prompt action that Service tax on the interest component of Lease/HP transactions was given the much needed relief.

However, the relaxation given was to the extent of 90% while 10% of the interest component in a Lease/Hire-Purchase transaction still continues to be subject to levy of service tax whereas the basic objective was to bring parity between a simple loan transaction and a Lease/Hire-Purchase transaction. Levy of service tax @ 12.24%, even on the 10% of interest component makes Lease/Hire-Purchase costlier to the borrower and so economically unfavourable as compared to a loan transaction where 100% of the interest component is exempted from the levy of service tax.

We, therefore, request you to kindly exempt the total interest component in a Lease/Hire-Purchase transaction from the levy of service tax so that only the Management fee/Processing charges are subject to the levy, as is the case with a loan transaction.

2. Treatment of Hire Purchase & Lease Transactions – Multiplicity of Taxes

(i) As per the 46th Amendment to the Constitution of India, Hire Purchase & Lease Transactions are defined as deemed ‘sale’ activities. As such, they were subject to sales tax @ 4 to 14% in different states and are now subject to Value Added Tax (VAT) in all the states.

(ii) Finance Act, 2001 defined Hire Purchase & Lease Transactions as "service" and as such, the interest component in these transactions is subject to service tax @ 12.24%.

(iii) The Lease Rentals /Hire Purchase transactions are also subject to Tax Deduction at Source (TDS).

(iv) The Income Tax Department looks at all the Lease Transactions with suspicion. As such, Depreciation benefits to the lessor (who is the owner of the asset) are often denied.

At various instances, the same transaction is being treated as Sale Transaction, Finance and Service simultaneously. This anomaly and confusion has created enough regulatory problems, which will compound further in future and will be severely detrimental to the interest of every player in the economy.

As a result of multiple taxation, Hire Purchase/Leasing, which has a critical role to play in the Indian economy is being killed by making such transactions economically unviable. This can only nullify the Government’s efforts to increase tax revenues from this segment.

There is an urgent need to establish clarity on leasing. A clear definition and as such a clear tax treatment of Hire Purchase/leasing needs to be defined without ambiguity.

3 January 2007

Shri.P. Chidambaram

Finance Minister

Government of India

North Block

New Delhi - 110 001.

Hon'ble Finance Minister Sir,

SUB: PRE-BUDGET MEMORANDUM 2007-08 - ISSUES RELATING TO ASSET FINANCING COMPANIES (AFC’s)

As you know, Sir, the Asset Financing NBFCs, (NBFC-AFC) registered with Reserve Bank of India and authorized to accept public deposits, have joined hands and formed a Self Regulatory Organization (SRO) under the name of Finance Industry Development Council (FIDC). FIDC is an All India body and is registered as a Company U/s. 25 of Companies Act, 1956. Our main objective is to work towards bringing discipline amongst our members by enforcing a model code of conduct, represent the views of the industry to the appropriate authorities where necessary and present a unified face of this sector.

Recognising the role played by the NBFCs engaged in asset financing, RBI has recently given a separate classification for Asset financing NBFCs. Please permit us to refer to our industry as NBFC-AFC for the purpose of this paper.

Sir, you had been good enough to start a pre-budget dialogue with our industry last year when you and your officials gave us a patient hearing to some of our issues. The industry is grateful to you for covering our issues in your budget speech and providing relief to us in the matter of Service tax.

Encouraged by your initiative, we are pleased to submit herewith the issues and concerns of the NBFC-AFCs for your consideration in the forthcoming Union Budget 2007-08. These have been classified into 4 categories:

• Direct Tax Issues (Annexure – I)

• Benefits under Sec.36 (1) (viia) and Sec.43D of the IT Act to be extended to NBFC-AFCs in line with Banks, FIs and HFCs.
• Exemption should be granted from TDS on interest payment to NBFC-AFCs u/s 194A (3) (iii) of the I.T.Act.
• Lease and sub-lease should not be included in Section 194-I of Income Tax Act.
• Benefit of concessional rate of FBT should be extended to AFCs.

• Indirect Tax Issues (Annexure – II)

• Removal of service tax on Hire Purchase and Leasing transactions.
• Removal of multiple taxation on HP and Lasing transactions.

• Access to ECB Funding (Annexure – III)

• Removal of restrictions on ECB funding for NBFC-AFCs

• Recovery Mechanisms (Annexure – IV)
• SARFAESI Act and Debt Recovery Tribunals to be extended to NBFC-AFCs

In recognition of the role played by NBFC-AFCs, we request the Ministry of Finance to treat NBFC-AFCs on a different footing, as part of the mainstream financial sector of the economy and favourably consider the submissions made in this memorandum, some of which are now pending for several years.

We will be glad to supplement this representation with any additional information that may be required.

We do hope that, like last year, you would give us an opportunity to present our views and concerns to you in person, at a Pre-Budget Meeting, to enable you to consider them in depth and provide suitable redress in your forthcoming presentation of the Union Budget.

We thank you in anticipation of a positive response and look forward to communicating our views to you personally.

Thanking you,

Yours Faithfully,

For FINANCE INDUSTRY DEVELOPMENT COUNCIL

DIRECOR GENERAL

Encl. As above