Securitization, and the Diversion of Income by Overriding Title

🏦 There are many ways a lender can take a loan off its books.

▶ One is to securitize the loan (slice it up into securities entitled to its principal and interest and sell those securities to investors).

 ▶ Another is to simply sell the loan (or a part of it) to a buyer who, on acquisition, assumes the risks (the possibility of default) and rewards (cash flows in the form of interest). Several factors, including the borrower’s creditworthiness may mean that the loan sells for a premium or a discount to its principal amount.

There are at least two ways a lender can collect the premium on a high-quality loan.

▶ First, the lender collects the premium upfront. Here, the buyer purchases the loan for its principal amount plus some percentage of the present value of future interest payments. The buyer is then collects the principal and all the interest that accrues on the loan. 

▶ Second, the lender collects the premium over the life of the loan. Here, the buyer purchases the loan for its principal amount. The buyer then collects the entirety of the principal but shares the interest with the lender.

👨⚖️ Recently, the Income Tax Appellate Tribunal dealt with the second scenario, which it thoughtfully described with an example. 

➡ A lender has an outstanding loan with principal of ₹10 million, interest payable at 15%.

➡ A buyer purchases 90% of the loan for ₹900k and agrees to share 5% of the interest payable on that ₹900k with the lender.

➡ If all goes well, the buyer collects the principal of ₹900k and interest at 10% on the ₹900k. The lender collects the remaining principal of ₹100k, interest at 15% on the ₹100k, and interest at 5% on the ₹900k.  

➡ The parties appoint a trustee to distribute the cashflows in accordance with this arrangement.

👨⚖️ The tribunal’s decision addressed whether the buyer was required to withhold tax on the interest the lender collected on the portion of the loan it sold (i.e., 5% on ₹900k). Because tax is required to be withheld on interest payments and payments for certain kinds of services, the Income Tax Department sought to characterize the amount due to the lender as interest, or failing that, payments for services. The tribunal rejected the interest characterization because no borrower-lender relationship existed between the buyer and the lender. The tribunal also rejected the characterization as payments for services because amounts due for services performed by the lender were already accounted for under a separate tripartite agreement. The tribunal ruled against the Department.

❗The following passages from tribunal’s opinion struck me as interesting!

“[t]hough the payment by the borrower [i]s in the nature of interest, [w]hen [a]llowed to be retained with the [lender], [it] is converted to [c]onsideration for the purchase of [the loan]. [T]herefore, it is not necessary that what is received as interest is also interest when paid…”

So far so good. Then,

“[i]t is pertinent to note that [t]he [lender has] already offered to tax [t]he interest earned on loans sold…” 

But the opinion doesn’t say how the lender characterized the interest (at 5%) it received on the portion of the loan it sold (i.e., as interest or as capital gain). Most lenders, especially those selling their loans shortly after origination, would probably be indifferent - short term capital gain and interest are both taxed at ordinary rates.

🤔 The question for a buyer is what position to take with respect to that same interest (5% on the portion of the loan bought) on its tax return. There are two choices.

▶ First, the buyer doesn’t report the interest as income. I’d imagine that a buyer choosing to adopt this position would argue that the interest had been diverted by overriding title. In this formulation, only the lender pays tax on the interest.

 ▶ Second, the buyer reports the interest as income. Given that the buyer agrees to assume the risks and rewards of the portion of the loan it purchased, I think this is a better reflection of the economic reality. When the buyer purchases a loan, it acquires ‘dominion and control’ over the interest that accrues on the loan. The interest that accrues on the loan belongs to the buyer. The buyer then chooses to apply a portion of that interest towards satisfying the premium due to the lender. In this formulation, the buyer pays tax at ordinary rates on the entirety of the interest amount, and the lender pays tax on the premium it receives (presumably also at ordinary rates).

This second approach also ensures parity in tax treatment of the two ways a lender can take to collect its premium.

I'll try explaining the logic behind the second approach using the example of a sole proprietor who sells his business. If the buyer agreed to turn over a portion of the annual profit of the business to the seller for a specified period into the future, I think most of us would agree that the buyer remains taxable on the profits he foregoes. Possibly, the profits paid to the seller increase his tax basis in the business. I don’t think many would contend that the buyer escapes tax on the forgone profit entirely, simply because, despite having acquired the business in its entirety, he has agreed to split the profits with the seller.

What do you think?

The case is State Bank of India v Dpy. Comm'r of Income Tax. Available at: https://itat.gov.in/files/uploads/categoryImage/1715145563-1899%20+%2012%20-%20SSK%20+%20OPK%20-%20State%20Bank%20of%20India%20-%20MEM%20-%20FINAL.pdf