Deconstructing the Supreme Court Ruling Declassifying Chit Funds from Asset Management

The 4th of July, 2017 marked a landmark date for the chit fund industry. In the case of Union of India & Ors. vs Margadarshi Chit Funds (P) Ltd. etc., the Supreme Court ruled in the favor of chit funds, stating that chit fund activity should not be treated as a business of cash management. The most direct implication of this is that chit funds no longer fall under the purview of Service Tax.

Sidd Gandhi, co-founder and CEO at KyePot says, “With such a macro push on making India cashless, we should not forget the truly financial inclusion asset class that has remained ingrained in the Indian culture for many years. This ruling has clearly given the industry a reason to celebrate by stamping clarity on the definition of “fund management” and “Cash management” which are very different from the Chit Funds.”
With over 15 years in Banking and Cash Management, Shradha Kampani, Product Head at KyePot, believes it is about time this misclassification was clarified.

“Contrary to the sophisticated products offered by banks, a chit fund is a form of peer to peer lending — albeit in a group formation. A foreman is merely a facilitator, who brings the group together and is subject to certain obligations to avoid mismanagement. For this he charges a fee in the form of a commission. A chit fund transaction is not that of a borrowing or loan. The funds accumulated do not belong to the foreman nor do they belong to a single person, rather they belong to all the subscribers in the group. None of the activities within the chit fund allows the participant to use their cash in the same essence of ‘cash management’.”
In order to understand the court’s ruling better, we asked Mr. Krishnamohan K Menon, Advocate-on-Record, Supreme Court of India to shed some much needed light on the matter.
If the government does not want something, it would not regulate it but simply ban it.
Chit Funds are an important source of microfinance in India. Anyone who holds a contrary view should speak to the village women who run co-operatives and the small traders who are saved from money lenders. They would surely give you a piece of their mind.
The question therefore is whether the Government views it as a savior of the common man or as the masquerading marauder. It cannot be denied that encouragement for Chit Funds has always flown in from the State Governments; a bold statement to make considering that they have been licensed, regulated and controlled with statutory dues since 1961.
But this positivism has an underlying logic — if the government does not want something, it would not regulate it but simply ban it. When the scanner of the law is placed upon any economic segment, it only means that it is important and deserves to be protected from unscrupulous and fraudulent players. The Real Estate Regulatory law and the Insolvency Code are the latest and the brightest shining examples of the above mentioned Governmental Activism.
If something is too good to be true, it probably is
Now that being clear, the question is — does the government want to impose the indirect transaction taxes on Chit Funds? The introduction of Banking and Financial Service in the taxable segment of the Finance Act, 1994 w.e.f. 16.7.2001 may have marked the commencement of the legal scrutiny but notably, there was complete peace till 1.6.2007. The reasons for this were two-fold — firstly there was a specific exclusion of the term ‘Cash Management Services’ from the definition of ‘Banking and Financial Service’ and secondly there was a reassurance in the form of the CBEC Circular dated 15–3–2002 which accepted the position that the whip of the taxation law would not strangle the Chit Fund operators.
The Chit Funds may have escaped the taxation laws but they seemed to be susceptible to Murphy’s Law which mandated that “If something is too good to be true, it probably is”. The 2007 amendment to the definition of the ‘Banking and Financial Service’ under the Finance Act, 1994 saw the deletion of the exclusion clause for ‘Cash Management Service’ and the issuance of a hostile circular dated 23.8.07 making the Governmental intent clear — no more free riding for Chit Funds.
Omission of exclusion is not inclusion
Miraculously, the Chit Funds managed to confound Murphy, and the Hon’ble AP HC quashed the above circular in AP Chit Funds Case on 14.7.08 [2009 (13) S.T.R. 350 (A.P.)]. The HC found merit in the petitioner’s plea that “omission of exclusion is not inclusion” and that Chit Funds are not covered within the term ‘Asset Management’.
The above view of the AP HC met a dissenting voice in Hon’ble Ramachandra Menon J of the Kerala HC. The All Kerala Association of Chit Funds’ Case 2013 (29) S.T.R. 557 (Ker.) was unequivocally concluded, with the declaration that the term ‘all forms of fund management’ in the definition of service, was wide enough to cover Chit Fund operators. The resultant dichotomy meant that Chit Fund operations in Kerala would be less profitable when compared to Andhra Pradesh.
The change in the Service Tax Regime from specified taxable services to ‘negative list’ in 2012 may have initially sent a wave of concern among Chit Fund Operators — since it was the public perception then that “everything that is not excluded, is deemed to be included”. Indisputably, there was no exclusion for Chit Fund operations in the negative list; but did that mean that these operations are deemed to be included?
The Govt. seemed to think so and issued a tax abatement notification №26/2012-ST dated 20.6.12 wherein the rate/value of Service Tax for Chit Fund operations was reduced to 70% from the standard rate. This met with a prompt challenge from the Delhi Chit Funds Association who prayed to the Delhi HC for striking down of the above notification and declaring that there is no Service Tax whatsoever of Chit Funds. The challenge received the nod of the Delhi HC in 2013 (30) S.T.R. 347 (Del.) wherein it was held that Chit Funds being a ‘transaction in money’ was outside the scope of the definition of ‘Service’ itself and hence not taxable. To add sweetness to this victory, the AP HC also held the same and both the above orders were affirmed by the Supreme Court. The task was complete. Or was it?
Chit Funds are not cash optimizers and consequently cannot be covered within the term ‘Cash Management’
The most interesting legal development however, happened recently when the Hon’ble SC, in the judgment delivered in the case of Margadarshi Chit Funds, upheld the above decision of the AP HC and disagreed with the view of the Kerala HC. The Hon’ble Court categorically held that Chit Funds are not cash optimizers and consequently cannot be covered within the term ‘Cash Management’.
Further it was also held that conventionally the term ‘Fund Management’ pre-supposes a fund i.e. a demarcated resource created by a business for a particular purpose; but since the same was not existing in the context of Chit Funds, the same are not covered there also. The Court interestingly reproduced some RBI Circulars which carried the plea that Chit Funds be kept out of the taxation regime in the interest of the economy.
Chit Funds will therefore continue to thrive
Moving forward, anyone with reasonable legal acumen would say that GST is a different ball game but can the Chit Funds ride this wave? The answer would be yes. The way forward can be one among the following:
- They could challenge the rate notification and the underlying taxability on the ground that Chit Funds are not covered in ‘activities relating to the use of money’ and hence they are outside the scope of Service/GST particularly in view of the SC judgment above, OR
- Accept the inevitable — that with the all encompassing definition of supply, the clear inclusion of ‘activities relating to the use of money’ and the limited exclusion being only for ‘actionable claims’, GST is applicable to them.
If the former succeeds, there is nothing like it. But even if it fails, there are still reasons to rejoice. Chit Funds have been kept in the middle slab of 12% only with credit on input services (excluding only input goods). This is a special treatment as other financial services have been taxed at a higher rate of 18%. Further, there is a seamless credit regime in place meaning that whatever tax one bears will no longer form part of the cost and will get reduced from the output tax liability. Simply put, this means that Chit Funds bear lesser tax burden and would therefore be far more affable to the micro investor than other schemes. Moreover, with the Pan India uniformity and clarity in the law, there is no state-wise concern as to which state has the more ‘Competitive Fund’ and which doesn’t.
Chit Funds will therefore continue to thrive even in such a dynamic economy. Murphy would definitely be scratching his head now.
How do you think this ruling will impact your business? Is there a need for the industry to band together to make the most of the scenario? Let us know in the comments below.
