GST Issue: Banks Struggle with RBI's Directive on GST Penal Charges

The Reserve Bank of India's directive to levy penalties only as 'penal charges' is creating a tax dilemma for banks. Banks are concerned that the indirect tax on these levies would attract the goods and services tax (GST). The new rule, effective from April 1, 2024, was introduced by the central bank to ensure "reasonableness and transparency" in the disclosure of penal interest. However, banks have requested clarification from the tax authorities regarding their stance on this issue. 

The ban on 'penal interest' for borrowers is creating a tax dilemma for banks. Banks are concerned that the Reserve Bank of India's (RBI) directive to impose penalties only as 'penal charges,' instead of the previous practice of imposing 'penal interest,' would make these levies subject to goods and services tax (GST). 

While interest rates are exempt from GST, the indirect tax does apply to certain service fees, such as those for processing loan proposals. Last month, banks requested clarification from the tax authorities on this matter, according to two senior industry officials who spoke to ET. 

In accrual accounting, banks may be required to pay the tax before collecting the corresponding amounts from customers. In many instances, this could prevent banks from recovering the additional tax paid to the government.

"This can be a problem. For instance, a bank or a non-banking finance company may charge a penalty of X amount, but subsequently reduce it following negotiation with the customer. However, since the GST is paid on X amount, the bank would not be able to obtain any refund once the penalty is lowered to X minus Y. Also, a loan account may become a non-performing asset with the borrower having stopped paying even the regular interest," said a banker.

The new rule, announced over a year ago and effective from April 1, 2024, was introduced by the central bank to ensure "reasonableness and transparency" in the disclosure of penal interest. The RBI believes that such charges should not be used as a revenue enhancement tool beyond the contracted rate of interest.

According to advocate Shailesh Sheth of SPS Legal, it is established law that foreclosure charges by banks and NBFCs on the premature termination of loans are not subject to service tax, and this legal position is also applicable under GST. "Similarly, additional/penal interest levied on the delay in payment of EMI is also not leviable to GST as clarified by the Board by its circular dated June 28, 2019. GST is also not leviable on the interest charged by a bank to a credit card holder. However, the banks apparently do not wish to take any chance and want clarity from the government, though none is really warranted," felt Sheth.

According to the directive, banks are prohibited from levying penalties in the form of 'penal interest' that is added to the interest rate charged on advances.

Thus, banks have been instructed to refrain from 'compounding' the penalty. However, this change in nomenclature—from 'interest' to 'charges'—has left banks uncertain about how GST authorities will interpret it. Some banks have already started accounting for GST on these charges.

"The possibility of such a levy of GST on penal charges crops up as charges are not included under a specific exemption list. However, it's a challenge in cases of delays or failure of borrowers to meet terms and conditions due to genuine hardship," said Mitil Chokshi, senior partner at the CA firm Chokshi & Chokshi.