Penal Interest On Delayed Loan EMIs Not Liable To Service Tax: CESTAT Chennai

The Chennai Bench of the Customs, Excise and Service Tax Appellate Tribunal (CESTAT) has held that penal interest charged by banks on delayed or defaulted EMIs cannot be subjected to service tax under the Finance Act, 1994.

The tribunal said such charges are not linked to any service offered by banks but flow automatically from a borrower's failure to repay on time.

“Penal interest is not a charge levied for any independent activity undertaken by the banks but is a contractual consequence of breach, intended to act as a deterrent and to compensate the lender for delayed recovery of funds,” the bench observed.

The ruling was delivered by a bench of Judicial Member P. Dinesha and Technical Member Vasa Seshagiri Rao while partly allowing appeals filed by Karur Vysya Bank Ltd. and City Union Bank Ltd. against service tax demands raised by the tax department.

The tribunal set aside service tax demands on penal interest and notice period pay recovered from employees but upheld tax, interest and penalties relating to certain CSR spending that involved branding and promotional visibility.

The cases followed departmental audits covering periods between October 2013 and June 2017. Tax authorities alleged that penal interest collected from borrowers for delayed EMIs, liquidated damages or notice period pay recovered from employees, and expenditure incurred under Corporate Social Responsibility were all taxable.

According to the department, penal interest and notice period pay amounted to consideration for “tolerating an act”, while CSR payments that resulted in the display of logos or brand names qualified as sponsorship services taxable under reverse charge.

These allegations led to show cause notices and confirmation of demands by the adjudicating authority.

Before the tribunal, the banks said penal interest and notice period pay were not payments for any service but were consequences of breach of loan and employment terms.

They also argued that most CSR spending consisted of donations for social welfare activities and could not be treated as sponsorship unless there was a clear promotional benefit. The tax department countered this by pointing to instances where CSR spending was linked to brand visibility and argued that such arrangements amounted to sponsorship under the service tax law.

Agreeing with the banks on penal interest, the tribunal said there was no conscious or independent agreement by banks to tolerate default in return for money. On notice period pay, it held that recoveries from employees arise out of the employer–employee relationship and fall outside the scope of service tax.

On CSR spending, however, the tribunal drew a clear distinction. It said genuine donations without any reciprocal benefit would not attract tax.

“However, where the factual matrix demonstrates that the contribution is linked with visibility of the sponsor's logo, brand name, or other promotional exposure in an event, such activity falls within the ambit of 'Sponsorship Service,'” the bench said.

It added that merely labelling an expense as CSR would not change its character when records showed branding or promotional intent and upheld the tax demand, interest, and penalties to that extent.

For Appellant: S. Ananthan, Chartered Accountant

For Respondent: Anandalakshmi Ganeshram