De-stressing the distressed sector

“Cross the river by feeling the stones” is a Chinese proverb that the Reserve Bank of India (RBI) seems to be trying to follow by adopting the path of experimentation and incremental liberalisation.

Cleaning non-performing assets (NPAs) from the banking system is a key area where this mechanism is being applied. The period from 2011 to 2015 witnessed a surge in bad loans with NPAs rising from 2.6 per cent of gross advances to 4.62 per cent. We are no strangers to the domino effect a single bank’s collapse can have on a country’s economy and even the global economy.

Asset Reconstruction Companies (ARCs) play an important role in ‘de-stressing’ the banking sector by acquiring illiquid loans from banks and relieving banks of the NPA burden, thus bringing in greater liquidity in the overall financial system. Despite the important role played by ARCs, the sector has been plagued by several hurdles that include funding constraints at the ARC level and an unclear tax regime.

With the RBI mandate to increase the skin in the game of the ARC by investing 15 per cent in the security receipts (SRs) issued by ARC trusts, the ARCs need continuous funding to build a strong book size with sustainable growth. Further, under the current law, a sponsor can invest only a maximum of 49 per cent in the ARC, requiring the ARC to perpetually keep seeking new investors. Due to capital adequacy constraints, the fundraising at the ARC level also needs to be largely equity oriented as against debt funding.

Taxation of trusts remains one of the most litigious areas under the Indian tax regime and ARC trusts face several tax challenges such as characterisation of income, taxability at the trust level vis-à-vis investor level and issues in claiming of tax credit by investors, etc.

As a consequence, there are only about 15 ARCs registered with the RBI as of date. Even amongst them, only two-three players account for more than two-thirds of total assets of ARCs.

The Union Budget 2016 has brought out a slew of reforms to boost the ARC sector and, in turn, release the locked NPAs from the banking system. Now, 100 per cent foreign direct investment (FDI) in ARCs will be permitted through the automatic route. Further, foreign portfolio investment is proposed to be allowed up to 100 per cent of each tranche in security receipts issued by ARCs. This should prove to be a game-changer as it will enable ARCs to bring in unrestricted foreign investment.

This also paves the way for several institutional foreign players to set up presence in this sector without the need to partner with an Indian resident. This will enable them to replicate and bring in global best practices to the distressed assets space in India especially since such players have enormous exposure in the securitisation business across the globe.

Removing the cap on sponsor investment will provide flexibility to existing sponsors to scale up their funding and acquire majority control in the ARCs. The Budget also proposes to open the investment in SRs to retail investors, which will significantly broaden the funding avenues for ARCs and create an active secondary market for SRs.

As far as the tax regime is concerned, while the government has not granted any tax rebate to the sector, it has removed the ambiguity in taxation of ARC trusts by bringing in a clear tax regime. Under the new regime, income earned by the ARC trust shall be exempt from tax in the hands of the ARC trust and taxable directly in the hands of the investors. Instead of levying tax on distribution, the ARC trust is now required to deduct tax at source on the income payable to each investor, enabling investors to take credit of such taxes deducted.

With these regulatory and tax announcements in the Budget, the government has acceded to the long-awaited demands of the ARC industry. This should translate into increased investment in this sector by the existing sponsors themselves as well as foreign investors. This should also result in global players entering this business segment leading to replication of global best practices to the ARC industry in India.

It should also free up the banking system from stressed assets and consequently foster greater credit generation in the economy. The focus should now get enhanced towards streamlining the pricing process by banks and bringing greater transparency in the auction process for NPAs along with judicial reforms so that the ARC sector can realise its true potential in the Indian economy.

Anish Sanghvi is partner, Mayur Gala is director and Dhawal Vora is assistant manager at PwC.

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