Taxing A Promise: The Unsettled Story Of GST On Corporate Guarantees

Navigating through a tedious loan sanction process is something that every company has gone through at least once. When a bank requires security for a loan, a subsidiary may offer what it can with the best it has and routinely a parent company provides a corporate guarantee undertaking to meet the subsidiary's loan obligations in the event of a default. Here, there is no actual flow of cash, but a promise basis which the transaction moves forward.

A fundamental issue therefore arises: can taxes be imposed on a mere promise. And if so, how is the value of such promise determined? The issue has been examined by the GST Council and courts and is also presently pending before the Delhi High Court in a group of petitions. For taxpayers, the uncertainty in the law results in having to deal with show cause notices and tax demands.

Treatment of Corporate Guarantee

Under the erstwhile service tax regime, the Supreme Court held that a corporate guarantee provided to group companies without consideration could not be treated as a taxable service

GST laws treat transactions between related persons as a 'supply' even in the absence of any consideration (Rule 28 of the CGST Rules 2017). In 2023, Rule 28(2) was introduced in the CGST Rules, 2017 to specifically provide for the valuation of a corporate guarantee issued by a related party and a deeming value of 1% of the amount guaranteed on annual basis was fixed as the value of the supply. In 2024, further clarifications were issued.

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Validity of the 2023 Amendments

The constitutional validity of Rule 28(2) and the 2023 and 2024 amendments were challenged before various High Courts. The Bombay High Court in a recent judgement held that a corporate guarantee is enforceable only if the principal debtor defaults. Further, in the absence of any consideration flowing to the guarantor, there is no "taxable supply" in terms of Section 9 of the CGST Act. The Court relied heavily on the principles laid down by the Supreme Court in the case of Edelweiss but refused to strike down the provisions of Rule 28(2) of the CGST Rules.

Interestingly, the Gujarat High Court in the case of Torrent Power Ltd. v. Union of India took a significantly divergent view. The Court read down the phrase "whichever is higher" used in Rule 28(2) of the CGST Rules, holding that mandating taxpayers to adopt the higher of actual consideration or the 1% benchmark was arbitrary. It further held that Rule 28(2) cannot be applied to corporate guarantees furnished before 26 October 2023, when the rule was introduced.

Applying this rule retroactively would create an entirely new tax burden on taxpayers and, according to the Court, would be violative of Articles 14 and 19(1)(g) of the Constitution. Lastly, the Court quashed the proceedings invoking extended period of limitation under Section 74 of the CGST Act, on the ground that a genuine interpretational issue cannot by itself take the colour of wilful suppression with the intent to evade tax.

Liquidated damages: A useful contrast

It is useful to compare the treatment of liquidated damages under GST laws as both corporate guarantee and liquidated damages are in the nature of contingent liabilities that crystallise into an actual payment only when there is a default or breach. Interestingly, the CBIC through a circular dated 3 August 2022, clarified that GST is not payable in case of liquidated damages paid for breach of contract, since such payments are compensatory in nature and does not represent consideration for any service.

Conclusion

In light of the conflicting views of the Bombay High Court and Gujarat High Court, the issues pertaining to GST on corporate guarantee remain unresolved and it is likely that GST authorities will appeal before the Supreme Court.

Several issues need clarity, particularly why 1% benchmark needs to be adopted annually, how it should work for long term open ended or auto-renewed guarantees, and whether valuation should be linked to the actual amount drawn or outstanding rather than the entire sanctioned amount. Clarity is also needed on continuing guarantees, renewals, rollovers, amendments, refinancing, lender changes and guarantees that are never revoked. More fundamentally, the question of whether a valuation rule can apply before establishing a taxable supply continues to remain open.

These concerns are particularly relevant for businesses in the infrastructure, real estate, power and EPC sectors, where guarantees run for several years over the duration of the project and involve substantial amounts. The provisions also create cash flow, invoicing and credit mismatch issues, especially for businesses that cannot fully utilise input tax credit. Given the representations from the industry, it would be useful for the GST Council to consider these concerns and provide clear recommendations on annualization, tenure, partial drawdowns, undrawn limits and transitional treatment, in the larger interest of trade and industry.

The article has been authored by Brijesh Kothary, partner, and Saundarya Sinha, senior associate at Khaitan & Co.

Disclaimer: The views expressed in this article are solely those of the author and do not necessarily reflect the opinion of NDTV Profit or its affiliates. Readers are advised to conduct their own research or consult a qualified professional before making any investment or business decisions. NDTV Profit does not guarantee the accuracy, completeness, or reliability of the information presented in this article.

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