Lending institutions to restructure their loan exposures to borrowers who are experiencing financial distress resulting from the pandemic by implementing a Resolution Plan (RP).
Mehul Bheda, Partner and Kushal Parikh, Principal, at Dhruva Advisors LLP
While the country is seeing no relief in the surge of COVID-19 cases and the accompanying economic slowdown, the Reserve Bank of India (‘RBI’) has endeavoured to comfort the distressed borrowers with a series of measures. The most recent measure enables lending institutions to restructure their loan exposures to borrowers who are experiencing financial distress resulting from the pandemic by implementing a Resolution Plan (‘RP’) for such borrowers.
The acceptance of the recommendations that were made by the K V Kamath Committee has proved as a welcome step towards this. The committee recommended introducing sector-specific thresholds for a number of financial ratios (such as total debt to EBITDA, current ratio, debt service coverage ratio, etc.) in 26 different sectors, with the thresholds acting as floors or ceilings, as necessary. Lending institutions are now required to factor these thresholds into the preparation of the RP, taking into account the borrower’s pre-COVID-19 operating and financial performance.
The Covid-19 resolution framework provides great flexibility regarding the formulation of the RP. The RP may involve the restructuring of a debt, in a variety of ways, such as by (i) extending the residual tenors of loans, (ii) introducing payment moratoriums, (iii) converting portions of the debt into equity or other marketable securities (such as non-convertible debt securities), (iv) selling exposures to other entities/investors, etc. However, compromise settlements are not permitted under this framework, and compromise settlements will continue to be governed by the existing guidelines. It is also expected that borrower accounts will be classified into mild, moderate, and severe stress categories. Although the mild and moderate categories may only require simplified restructuring, cases involving severe stress may require more comprehensive restructuring.
From an accounting perspective, under Ind-AS, any substantial changes to the terms of a loan or interest rate (such as an extension of the tenure or a reduction in the rate of interest) requires the borrower to first derecognise the carrying amount of the loan and then recognize the restructured debt at its fair value. Such an accounting treatment could give rise to the recognition of a profit in the profit and loss account. Under the Income-Tax Act, 1961 (‘the IT Act’), such a gain should not result in any tax implications for the normal computation of income-tax, but it may lead to a Minimum Alternate Tax (‘MAT’) outflow for companies. This may be especially relevant for companies that have not opted for the concessional corporate tax regime of 25.17 per cent, and that are liable to MAT.
Furthermore, the conversion of debt into equity/other securities may similarly trigger a MAT liability, in the event that the carrying value of the debt is greater than the fair value of the equity shares or other securities that are issued. Therefore, any companies undertaking debt restructuring must carefully evaluate the tax implications of their restructuring before deciding the best course of action, including the possibility of opting into the concessional corporate tax regime.
In cases involving severe stress, borrowers may also need to raise equity funding from promoters/ investors as part of the RP. In the event that any shares are issued by an unlisted company at a price exceeding the fair market value determined for tax purposes (‘Tax FMV’) or shares are issued by a company (irrespective of whether listed or unlisted) at a significant discount to the Tax FMV some tax challenges may arise. Any companies conducting fundraising would be well advised to ensure that such tax valuation parameters are not breached.
The framework also allows lenders to sell their exposures to other entities/investors. It will be interesting to see if and how lenders utilize this option with regard to stressed accounts resulting from COVID-19. From the draft guidelines on sale of loan exposures (standard as well as non-performing) and securitisation of standard assets that the RBI published earlier this year, it is clear that the RBI wishes to promote the secondary market. Given the needs of the hour, it is imperative that the RBI implements these reforms as soon as possible.
From an income-tax perspective, a very robust and a friendly regime to facilitate this already exists, since certain securitisation vehicles enjoy a pass-through status under the IT Act, eliminating multiple layers of taxation by levying taxes directly in the hands of investors.
On the whole, the steps that have been taken by the RBI are both timely and very welcome, and, together with the favourable tax regime that exists, they should facilitate the resolution of the financial stresses that are being suffered by borrowers.
(The authors were assisted by Radhika Bihani, Senior Associate, Dhruva Advisors LLP. Their views are their own.)