No GST on penal fees for loan non-compliance, says finance ministry

The RBI in its circular had directed regulated entities to replace "penal interest" with "penal charges" for borrowers who fail to comply with loan terms

The Ministry of Finance on Tuesday notified that penal charges imposed by banks and non-banking financial companies (NBFCs) for non-compliance with loan terms will not attract an 18 per cent goods and services tax (GST).

 

The 55th GST Council meeting addressed this issue after receiving representations seeking clarity on the applicability of GST following the Reserve Bank of India’s (RBI’s) directive issued on August 18, 2023, which said that the use of “penal interest for non-compliance with loan terms” should be discontinued.

 

In its circular, the RBI directed regulated entities to replace “penal interest” with “penal charges” for borrowers who fail to comply with loan terms. Effective January 1, 2024, these charges aim to instil credit discipline among borrowers. The apex bank’s guidelines exclude credit cards, external commercial borrowings, trade credits, and structured obligations, which are governed by separate rules.

 

The Central Board of Indirect Taxes and Customs, in its latest notification, observed that penal charges are not payments for “tolerating an act” but are penalties imposed for breaching loan conditions.

 

It underscored, “The essence of a loan agreement is its performance, not its breach. Borrowers enter into contracts to repay loans on time, and penalties are meant to enforce discipline, not to profit from violations.”

 

“Merely changing the nomenclature of the charge does not alter the fundamental nature of the activity. Therefore, such transactions should not be subject to tax, even for the earlier period when the nomenclature used was ‘penal interest’, retroactively from July 2017. These amounts are recovered to deter specific actions and prevent contractual breaches, stressing that parties do not enter into contracts with the intent of breaching them. Consequently, such charges should not attract GST,” said Abhishek A Rastogi, founder of Rastogi Chambers.