GST on Chit Funds – Why higher GST on Chit Funds is a Bad Idea?

Recently, the Government of India has revised the applicable rates of GST on chit funds from 12% to 18%. Below, we understand the implications of the rate hike and how it adversely impacts the chit fund companies and their investors.

Applicability of GST on Chit Funds

In India, chit funds can only be created after receiving the express sanction of the respective state governments. These funds are regulated under the Chit Funds Act 1982. 

This act allows the ‘foreman,’ i.e., the manager of a chit fund, to charge a maximum commission of 7% of the total chit amount received.

GST is levied on the commission paid to the foreman of a chit fund for the services rendered in relation to chit. This is because the foreman’s commission is considered a ‘supply of service’ under the remit of the GST law.

GST Rate on Chit Funds Commission and HSN Code

The applicable HSN code for chit funds is Heading 9971: Financial and related services.

Per the latest recommendation by the 47th GST Council meeting, the GST rate on chit fund commission has been raised from 12% to 18%. This is subject to the condition that no input tax claims (ITC) have been availed on the goods used for supplying chit services.

But why does it spell doom for chit fund companies and those investing in such companies? Let’s break it down.

How to Calculate GST on Chit Funds?

To better understand the impact of the rate hike of GST for chit funds, let’s consider a hypothetical situation. Assume a chit fund consists of 40 members who contribute about Rs.25,000 per month. This means the cyclical contributions will last at least 40 months, as there are 40 members in the chit fund.

After the first month, the contribution collected, also known as the money pot, becomes due for auction. This is because multiple people could be vying for the money to meet their capital expenses. So, how to calculate chit fund returns?

Let’s further assume that three people bid for the pot and place their bids to the tune of

Person A: Rs.9,50,000

Person B: Rs.9,00,000

Person C: Rs.8,50,000

Because Person C has bid the lowest amount, he will be handed out the money. However, this amount will further be reduced by the amount of commission paid to the foreman. 

Now, if the foreman charges a 5% commission (the general rate before the GST rate hike), then the money pot will be reduced by 

Chit fund commission = Rs.10,00,000 * 5%

Chit fund commission = Rs.50,000

GST charged on commission = Rs.50,000 * 12%

GST charged on commission = Rs.6,000 

Thus, Person C will only receive

Final amount to C = Rs.8,50,000 – Rs.50,000 

Final amount to C = Rs.8,00,000

After the first monthly iteration, the contribution for all the members for the next cycle will be reduced by the amount foregone by the bid’s winner, Rs.1,50,000. To clarify, Rs.3,750 will be reduced from the second monthly contribution made by chit fund members. The calculation is given below.

Contribution Reduction = Rs.1,50,000 / 40

Contribution Reduction = Rs.3,750

New Contribution = Rs.25,000 – Rs.3,750

New Contribution = Rs.21,250

Impact of GST Hike

But it is now believed that after the proposed GST rate hike to 18%, the chit fund companies will raise their commission to the maximum prescribed limit of 7% under the Chit Funds Act.

Going back to the previous example, if the foreman starts charging a 7% commission, then

Chit fund commission = Rs.10,00,000 * 7%

Chit fund commission = Rs.70,000

GST charged on commission = Rs.70,000 * 18%

GST charged on commission = Rs.12,600 

Hence, Person C will only receive

Final amount to C = Rs.8,50,000 – Rs.70,000

Final amount to C = Rs.7,80,000

Therefore, the chit fund members receive an even lower amount despite similar contribution levels. 

Individuals investing through chit funds generally pay only about 10-18% in interest costs—a far cry from the exorbitant rates of 36-60% applicable on sourcing credit from private moneylenders.

However, it is believed that with increased commission rates in response to higher GST rates, borrowing costs are likely to rise by another 0.85%. This will cause a huge blow to the already minuscule savings made by these investors.

The matters are further worsened for those savers who generally cash out at the end of the chit fund’s tenure. Such members typically end up saving more as they pay a lower contribution. Still, their savings will be reduced against a higher commission and rising interest rates.

Consequently, another pitfall of the GST rate hike will be the reduced participation of savers in the chit fund. This can result in the collapse of the chit fund industry as a whole, as a successfully-run chit fund requires a heady mix of borrowers (the ones who cash in early) and savers. This will leave many small-time borrowers at the mercy of informal lenders.
 

Input Tax Credit (ITC) Claims

Under Heading 9971, ‘Financial and related services,’ services provided by the foreman in relation to the chit fund business attract an 18% GST. However, this rate is applicable subject to the condition that no input tax credit has been claimed on the goods used to provide services in the chit fund business. 
 

You can know more about when ITC cannot be claimed on goods and services from here.
 

Advance Rulings on GST on Chit Fund Business

The majority of the rulings in the context of chit funds have been related to the taxability of income received. This is because the IT Act isn’t very clear about the treatment of the discount received on the final pot of money by the chit subscribers. However, a better understanding of the applicability of GST on chit funds can be gleaned from the following case.

In Ushabala Chits (P.) Ltd., In re [2020], the Appellate Authority for Advance Ruling stipulated that the collection of delayed/defaulted instalments of chit funds along with the liable penal interest should be considered a supply of service by the foreman within the ambit of the GST Act. 

A hike in GST on chit funds will adversely impact small savers, as it will raise the opportunity cost of investing in chit funds. This may, in turn, shrink the chit fund industry further, thus depriving savers of an alternate source of financing. This may not bode well for those who cannot easily access formal banking services.