Non-Banking Financial Companies (NBFCs), often referred to as the “shadow banking system” are playing an increasingly important role in our country’s financial systems and their growing influence on our nation’s economy is clearly visible in the Union Budget 2019-20 also as a lot of amendments and rationalisation measures concerning NBFCs have been incorporated in the Union Budget.
One of the ‘चौपायी’ (prose) in “the sacred Sunderkand” reads as "भयबिनूहोयीनाप्रीति", which means, “without fear there is no respect and love.”When Lord Rama’s polite request to the Sea to give way to Lanka didn’t work, his threat to dry the Sea worked.
The carrot and stick approach always works well in almostall spheres of life and the amendments/rationalisation measures concerning NBFCs in the Union Budget 2019-20, also revolve around this approach only.
The Union Budget 2019-20 has proposed several amendments/rationalisation measures aimed at encouraging and incentivizing NBFCs and these are discussed as under:
(I) Amendments in Income Tax Act:
The Hon’ble Finance Minister Smt. Nirmala Sitharaman in her budget speech has stated,
“Incentives to certain Non-banking Financial Companies (NBFCs):
“Non-banking financial companies play an increasingly important role in India’s financial system. With the enhanced levels of regulation they are subjected to by the Reserve Bank of India, there is a need to provide greater parity in their tax treatment vis-à-vis scheduled banks. Currently, interest on certain bad or doubtful debts made by scheduled banks and other financial institutions is allowed to be offered to tax in the year in which this interest is actually received. I propose to extend this facility to deposit-taking as well as systemically important non-deposit taking NBFCs also.”
Presently, interest income on bad or doubtful debts made by NBFCs is charged to tax on accrual basis. However, in cases of scheduled banks, public financial institutions, state financial corporations, state industrial investment corporations, cooperative banks and certain public companies like housing finance companies, interest on bad or doubtful debts is charged to tax on receipt basis. To provide a level playing field, it is proposed that interest on bad or doubtful debts in the case of deposit-taking NBFC and systemically important non-deposit-taking NBFC shall be charged to tax on receipt basis. It is also proposed to provide that deduction of such interest shall be allowed to the payer on actual payment.”
The Explanatory Memorandum to Finance (No. 2) Bill, 2019, in this regards explains the rationale of the proposed amendments as under:
“The existing provisions of section 43D of the Act, inter-alia provides that interest income in relation to certain categories of bad or doubtful debts received by certain institutions or banks or corporations or companies, shall be chargeable to tax in the previous year in which it is credited to its profit and loss account for that year or actually received, whichever is earlier. This provision is an exception to the accrual system of accounting which is regularly followed by such assesses for computation of total income. The benefit of this provision is presently available to public financial institutions, scheduled banks, cooperative banks, State financial corporations, State industrial investment corporations and public companies like housing finance companies. With a view to provide a level playing field to certain categories of NBFCs who are adequately regulated, it is proposed to amend section 43D of the Act so as to include deposit-taking NBFCs and systemically important non-deposit-taking NBFCs within the scope of this section. Consequentially, as per matching principle in taxation, it is proposed to amend section 43B of the Act to provide that any sum payable by the assessee as interest on any loan or advances from a deposit-taking NBFCs and systemically important non deposit-taking NBFCs shall be allowed as deduction if it is actually paid on or before the due date of furnishing the return of income of the relevant previous year.”
Further, the newly inserted Explanation 4 to section 43B of the Income Tax Act, provides as under:
‘(e) “deposit taking non-banking financial company” means a non-banking financial company which is accepting or holding public deposits and is registered with the Reserve Bank of India under the provisions of the Reserve Bank of India Act, 1934;
(f) “non-banking financial company” shall have the meaning assigned to it in clause (f) of section 45-I of the Reserve Bank of India Act, 1934;
(g) “systemically important non-deposit taking non-banking financial company” means a non-banking financial company which is not accepting or holding public deposits and having total assets of not less than five hundred crore rupees as per the last audited balance sheet and is registered with the Reserve Bank of India under the provisions of the Reserve Bank of India Act, 1934’.
These amendments will take effect from 1st April 2020 and will, accordingly, apply in relation to the assessment year2020-21 and subsequent years.
The said amendments are indeed a welcome and positive initiative of the Government and will ensure the granting of a level playing field to the NBFCs and will also provide the much-needed parity in their tax treatment of interest income vis-à-vis scheduled banks and other financial institutions.
(II) Amendments in the Reserve Bank of India (RBI) Act, 1934:
The proposed rationalisation measures concerning NBFCs also include insertion of a new section 45MBA in the RBI Act, 1934, enabling RBI to consider a resolution of financially-troubled NBFCs through a merger or by splitting them into viable and non-viable units called bridge institutions.
For the sake of ready reference, the newly inserted specific section is being reproduced as under:
“Resolution of non-banking financial company
45MBA. (1) Without prejudice to any other provision of this Act or any other law for the time being in force, the Bank may, if it is satisfied, upon an inspection of the Books of a non-banking financial company that it is in the public interest or in the interest of financial stability so to do for enabling the continuance of the activities critical to the functioning of the financial system, frame schemes which may provide for any one or more of the following, namely:-
(a) amalgamation with any other non-banking institution;
(b) reconstruction of the non-banking financial company;
(c) splitting the non-banking financial company into different units or institutions and vesting viable and non-viable businesses in separate units or institutions to preserve the continuity of the activities of that non-banking financial company that are critical to the functioning of the financial system and for such purpose establish institutions called “Bridge Institutions”.
Explanation. For the purposes of this subsection, “Bridge Institutions” mean temporary institutional arrangement made under the scheme referred to in this subsection, to preserve the continuity of the activities of a non-banking financial company that are critical to the functioning of the financial system.”
(III) Rationalisation Measures in the Financial Sector:
(i) Recognising the significant role of NBFCs in sustaining consumption demand as well as capital formation in small and medium industrial segment, a need for the continuous funding of fundamentally sound NBFCs, from banks and mutual funds, without making them unduly risk averse, has been felt and emphasised and accordingly appropriate proposals have been placed in the Union Budget. For purchase of high-rated pooled assets of financially sound NBFCs, amounting to a total of one lakh crore rupees, during the current financial year, Government will provide one time six months' partial credit guarantee to Public Sector Banks for first loss of up to 10%.
(ii) NBFCs which do public placement of debt have to maintain a Debenture Redemption Reserve (DRR) and in addition, a special reserve as required by RBI, has also to be maintained. To allow NBFCs to raise funds in public issues, the requirement of creating a DRR, which is currently applicable for only public issues as private placements are exempt, will be done away with.
As a balancing measure, the Union Budget 2019-20 has also proposed several amendments aimed at tightening the loose ends in order to ensure better and effective regulatory control over NBFCs, and these are discussed as under:
(I) Amendments in theReserve Bank of India (RBI) Act, 1934:
Appropriate proposals for strengthening the regulatory authority of RBI over NBFCs are being placed in the Finance (No. 2) Bill. The proposed amendments in the RBI Act, 1934, provides for empowering the RBI to supersede the board of NBFCs (other than those owned by the government). The proposed amendments also authorize the RBI to remove the auditors of NBFC, and call for an audit of any group company of an NBFC, and have a say in the compensation of senior management.
For the sake of ready reference and better understanding, the specific amendments in the RBI Act, 1934 as proposed in the Union Budget 2019-20 are being reproduced as under:
Power of bank (read RBI)to Remove Directors(of NBFC) from office
“45-ID.(1) Where the Bank is satisfied that in the public interest or to prevent the affairs of a nonbanking financial company being conducted in a manner detrimental to the interest of the depositors or creditors, or financial stability or for securing the proper management of such company, it is necessary so to do, the Bank may, by order and for reasons to be recorded in writing, remove from office, a director (by whatever name called) of such company, other than Government owned nonbanking financial company with effect from such date as may be specified in the said order.
(3) Where any order is made in respect of a director of a company under sub-section (1), he shall cease to be a director of that non-banking financial company and shall not, in any way, whether directly or indirectly, be concerned with, or take part in the management of any non-banking financial company for such period not exceeding five years at a time as may be specified in the order.
(4) Where an order under sub-section (1) has been made, the Bank may, by order in writing, appoint a suitable person in place of the director, who has been so removed from his office, with effect from such date as may be specified in such order.”
Supersession of Board of directors of non-banking financial company (other than Government Company).
45-IE. (1) Where the Bank is satisfied that in the public interest or to prevent the affairs of a non-banking financial company being conducted in a manner detrimental to the interest of the depositors or creditors, or of the non-banking financial company (other than Government Company), or for securing the proper management of such company or for financial stability, it is necessary so to do, the Bank may, for reasons to be recorded in writing, by order, supersede the Board of Directors of such company for a period not exceeding five years as may be specified in the order, which may be extended from time to time, so, however, that the total period shall not exceed five years.”
Power to take action against auditors
‘‘45MAA. Where any auditor fails to comply with any direction given or order made by the Bank under section 45MA, the Bank, may, if satisfied, remove or debar the auditor from exercising the duties as auditor of any of the Bank regulated entities for a maximum period of three years, at a time.”.
Power in respect of group companies
“45NAA. (1) The Bank may, at any time, direct a non-banking financial company to annex to its financial statements or furnish separately, within such time and at such intervals as may be specified by the Bank, such statements and information relating to the business or affairs of any group company of the non-banking financial company as the Bank may consider necessary or expedient to obtain for the purposes of this Act.
(2) Notwithstanding anything to the contrary contained in the Companies Act, 2013, the Bank may, at any time, cause an inspection or audit to be made of any group company of a non-banking financial company and its books of account.
Explanation.- For the purposes of this section, -
(a) “group company” shall mean an arrangement involving two or more entities related to each other through any of the following relationships, namely:
(i) subsidiary - parent (as may be notified by the Bank in accordance with Accounting Standards);
(ii) joint venture (as may be notified by the Bank in accordance with Accounting Standards);
(iii) associate (as may be notified by the Bank in accordance with Accounting Standards);
(iv) promoter-promotee (under the Securities and Exchange Board of India Act, 1992 or the rules or regulations made thereunder for listed companies);
(v) related party;
(vi) common brand name (that is usage of a registered brand name of an entity by another entity for business purposes); and
(vii) investment in equity shares of twenty per cent and above in the entity;
(b) “Accounting Standards” means the Accounting Standards notified by the Central Government under section 133, read with section 469 of the Companies Act, 2013 and subsection (1) of section 210A of the Companies Act, 1956.”.
(C) Analysis of Present Disciplinary and Regulatory Action of RBI concerning Cancellation of Licenses of NBFCs post Infrastructure Leasing and Financial Services Ltd (IL&FS) Crisis:
Considering the pivotal role of NBFCs as the “shadow banking sector”, these have always been considerately and liberally regulated by the Regulator RBI.
However, the surfacing of the Infrastructure Leasing and Financial Services Ltd (IL&FS) Crisis in September 2018, has compelled RBI to tighten the loose ends and to heighten the scrutiny and monitoring of the asset-liability and risk management framework of the NBFCs.
The crisis unfolded when IL&FS defaulted on debt loan repayments of Rs 1,000-crores, resulting in drying up of liquidity in the sector.
Stepping up and tightening its supervision and regulatory control over NBFCs, the RBI has cancelled the registration of total 5048 NBFCs, uptill 31.3.2019 as per RBI’s official website. These included NBFCs that had failed to meet prudential and capital adequacy norms and also those that voluntarily surrendered registration.
Over half of the cancelled NBFC licenses were attributable to shortfall in Net Owned Funds (NOFs) of NBFCs. At present, the threshold amount that has to be maintained as NOFs by NBFCs is stipulated at Rs. 2 crores. The failure to maintain this threshold NOFs of Rs. 2 crores by 31.3.2017 had led to this spurge of license cancellations in 2018 and 2019, post IL&FS crisis.
Previously, since 9.1.1997 when the RBI (Amendment) Act, 1997 came into existence, the requirement in relation to the threshold limit of NOFs of NBFCs was confined to Rs. 25 lakhs only.
Further, by virtue of section 45IA(3) of RBI Act, the then existing NBFCs, whose net owned funds (NOFs) were less than twenty-five lakh of rupees, were allowed to continue their business for a period of three years from such commencement. This three year time period was further extendable to three more years at the requests of NBFCs, at the discretion of RBI, by recording reasons for extension in writing by virtue of proviso to section 45IA(3) of RBI Act.
The above requirement of having the minimum net owned fund of twenty-five lakh rupees was enhanced to Rs. 200 lakhs rupees vide RBI Notification No. DNBR.007/CGM(CDS)-2015, dated 27.03.2015.
The said Notification further provided that an NBFC holding a Certificate of Registration (CoR) and having NOFs of less than two hundred lakhs of rupees may continue to carry on the business, if such company achieves the NOFs of one hundred lakhs of rupees before 01.04.2016 and two hundred lakhs of rupees before 01.04.2017.
Therefore a large number of licenses of NBFCs falling short of having the NOFs of Rs. 2 crores as on 31.3.2017 have been cancelled by RBI quoting its Notification No. DNBR.007/CGM(CDS)-2015, dated 27.03.2015.
However, the rationality and appropriateness of the said RBI Notification No. DNBR.007/CGM(CDS)-2015, dated 27.03.2015 is to be examined in view of the express provisions in the Governing RBI Act, 1934.
It is a trite law that no notification or circular can override the legislative provisions of the Governing Act.
The Governing Act i.e. the RBI (Amendment) Act 1997, by virtue of the provisions contained in sub section (3) of section 45IA, read with its proviso, itself stipulates the granting of a time period of 3 years (further extendable to 3 more years), for the NBFCs to enhance their net owned funds by giving them sufficient time to continue to carry on the business and comply with the requirements of increased threshold of NOFs.
Therefore the stipulation of the granting of the time period of 3 years(further extendable to 3 more years) for the NBFCs to comply with the requirement of having the enhanced minimum net owned funds of Rs. 200 lakhs as envisaged in proviso to section 45IA(3) of the RBI (Amendment) Act 1997, has to be read from the date of issue of the said RBI Notification, i.e. from 27.3.2015.
Thus the maximum time period which ought to be granted to NBFC’s to comply with the requirement of having the enhanced net owned funds of Rs. 200 lakhs ought to be considered as 6 years from the date of issue of RBI Notification No. DNBR.007/CGM(CDS)-2015, dated 27.03.2015, i.e uptill 27.3.2021 and not 31.3.2017 as has been stipulated in the said notification.
In view of above, the RBI’s Notification No. DNBR.007/CGM(CDS)-2015, dated 27.03.2015,being in contradiction to the categorical legislative provisions in the Governing Act, needs a review and reconsideration.
In this regards, reliance can be placed upon the recent judgement of the Hon’ble Madras High Court dated 29-1-2019, in the Consolidated Group of Cases in M/s. Nahar Finance and Leasing Limited & M/s.Lodha Finance India Limited &Valluvar Development Finance Pvt Ltd&M/s Senthil Finance Private Limited Vs. The Regional Director, Reserve Bank of India.
The Hon’ble Madras High Court, in its said judgement have held the cancellation of licenses of NBFCs by RBI on account of non-fulfillment of the stipulated threshold criteria of NOFs of Rs. 2 crores as on 31.3.2017, as unlawful and have categorically held that a time period of three years further extendable to three more years from the date of issue of RBI Notification no. DNBR.007/CGM(CDS)-2015, dated 27.03.2015, ought to be granted to NBFCs to enable them to fulfil the said criteria.
It is pertinent to mention here that an amendment concerning the requirement of minimum NOFs of NBFCs has been proposed in the Finance Bill (No. 2), 2019 by clause no. 136 of the Finance Bill, wherein, it has been provided as under:
“136. In the Reserve Bank of India Act, 1934, in section 45-IA, in sub-section (1), for clause (b), the following shall be substituted, namely:
“(b) having the net owned fund of twenty-five lakh rupees or such other amount, not exceeding hundred crore rupees, as the Bank may, by notification in the Official Gazette, specify:
Provided that the Bank may notify different amounts of net owned fund for different categories of non-banking financial companies.”
However, it is duly evident that no amendment has been made in subsection (3) of section 45IA of the RBI Act and its proviso and as such the proposed amendment will also not make any difference in the legal position as laid down by the Hon’ble Madras High Court in its judgement (as mentioned supra).
Further, the first proviso to Section 45-IA(6) of RBI Act, specifically stipulates that before the cancellation of the CoR on the ground that the NBFC has failed to comply with the provisions of clause (ii) of sub-section (6) of section 45IA of RBI Act, concerning the requirement of having minimum net owned funds, the NBFC shall be given an opportunity on such terms as the RBI may specify for taking necessary steps to comply with such provision or fulfillment of condition. The second proviso provides for a mandatory reasonable opportunity of being heard to be given to NBFC.
However, it was observed by the Hon’ble Madras High Court that CoR of NBFCs were cancelled by the Regulator, without giving them suitable opportunity for taking necessary steps to comply with the requirement of having minimum NOFs and also without granting them proper opportunity of being heard as stipulated in first and second provisos respectively, of section 45IA(6) of the RBI Act, 1934.
The cancellation of licenses of willful and habitual defaulters by RBI is fully justifiable and is in order but blatant and blind cancellation of licenses on account of even minor irregularities and technicalities is surely not desirable and will be detrimental to the interests of all stakeholders involved.
The casual, lethargic and undue liberal regulatory framework over NBFCs, before the IL&FS crisis and the arbitrary, adhoc, knee-jerk and reactive regulatory framework, post the IL&FS crisis, both are undesirable and unjustified. Instead a balanced, pragmatic, consistent, prudent and effective regulatory framework over NBFCs is the need of the hour, in order to ensure the success and growth of this shadow banking sector.