ESCROW ON A NEED-TO-KNOW TANGENT
Author: Pratiksha Roy
Let’s say you are transacting with a party whose books might look perfect but you are speculating about the payment receipts post completion of the project. The same goes for the party that is investing in your project. Under such circumstances, both the parties can opt for a third-party account for guarding the funds or evidence of title or shares till the completion of the contingent. In this way, both the parties stand in a win-win position knowing their demands will be met. Such a third-party account is called an Escrow account. The party with whom it is kept is called the Escrow agent. The funds or property is given in trust to the escrow agent, who always stands in a neutral position. It provides security against scams and gives assurance for transactions involving bigger stakes. Escrow accounts are set in such a way that the party receiving the money doesn’t get to withdraw the amount until the obligations are fulfilled. “Escrow accounts are the stepchildren of the mortgage business”[i]. The funds are held in the escrow account until it receives the appropriate written or oral instructions from both parties. When the escrow conditions are fulfilled, the depositary is expected to deliver the escrowed item, in case he fails to deliver, a remedy lies against the service provider.
Escrows have a major role to play in –
- Real estate- Where the funds are disbursed by the purchaser or mortgagor for payment of various taxes and insurance premiums. Payments are either made in a lump sum or periodically as contracted by the parties.
- Share purchase- Mergers and acquisitions often require shares of the target company to be held in escrow until the deal is finalized.
- Overseas Direct Investment or Cross border deals like imports and exports- RBI allows corporates involved in exports and imports to hold escrow accounts for net payments adjustment purposes with its permission. Such counter-party proposals include adjustments of the value of goods imported into the country against the value of goods exported from as part of an agreement voluntarily entered into between the local party and the overseas party through an escrow account opened in the country in the US dollars. [ii] Automobile sector- It’s the least known sector in the escrow users list. An escrow service authenticates that money is exchanged in return for a vehicle and that neither party walks away empty-handed.
Setting up an escrow-
Although there are special institutions for providing escrow services, parties usually tend to opt for escrow accounts provided by the banks. The first step in the process of opening an escrow account is sending a letter of request to the concerned service provider by the transacting parties. The format and contents of the letter are readily available on the concerned bank website. As mandated, a letter of request (LOR) needs to set out a detailed statement of purpose for which the escrow services are availed along with the necessary details of the parties. The LOR is supplemented by an application form provided by the bank. Escrow service providers have a fiduciary duty to both the parties and a contract is created once the LOR is received. Escrow instructions are given by the escrow agent to the services providers in the format of T&C provided by the bank. In case the service provider breaches the conditions of escrow it can be held liable for damages under the Contract Act. The reason for choosing a bank over any other service provider is because escrow agents have a duty –
- to follow the instructions given by the parties without any bias towards one party
- to use good faith and reasonable skills
- to redeliver the funds or property entrusted to them on completion of the condition
- to have sound knowledge of legalities in times of disputes between the parties
Statutes Guarding The Escrow
The Reserve Bank of India (RBI) has permitted banks to hold trade-related surpluses of their customers’ escrow accounts as short term deposits for three months in a year. Banks are not required to pay interest on the surplus balances credited to the escrow account. However, if these balances are held as bank deposits, the banks will have to pay the applicable rate of interest, the RBI said. The central bank clarified that no overdraft will be permitted in the escrow account nor will any loans be granted against funds in the account.[iii]. Usually, escrows are guarded by-
- Indian contract act, 1872
- Foreign Trade Policy and Foreign Exchange Management Act, 1999
- Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“Non-Debt Rules”)
- Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019
- Foreign Exchange Management (Deposit) Regulations, 2016 (“Deposit Regulations” / “FEMA 5(R)”); and
- Master Direction – External Commercial Borrowings, Trade Credits and Structured Obligations (“ECB Master Directions”) issued by the Reserve Bank of India[iv]
Taxes With Regards To Escrow Accounts
“The Delhi High Court (“Court“), in the case of AAA Portfolios Pvt. Ltd. v. DCIT1 held that funds lying in an escrow account cannot be appropriated by the tax authorities as recovery of taxes in connection with a taxpayer’s liability, when such funds are not held by the escrow agent on behalf of the taxpayer, or owed by the third party to the taxpayer.”
Benefits Of Escrow
- Escrows are the safest and most unbiased mode of transaction.
- The transactions and agreements can be customised according to the terms set by the parties.
- Open and operate multiple accounts for deals with the waterfall mechanism.
- Escrow agents or services providers which, here in India are mostly banks have a dedicated team addressing all the concerns of an escrow. In times of remittance, deposit or redressal the escrow team efficiently helps the parties with their equipped team.
- Escrow also have a regularised and simplified documentation process and it makes tracking very easy via online portals[v]
Escrows pave way for the most secure transactions involving large stakes. Nowadays, even e-commerce giants have also chosen to transact via escrows. However, as a personal opinion, e-Commerce transacting with escrows are very largely prone to frauds and should be avoided. It’s better safe than sorry when comes to transactions via escrows all the terms and conditions should be read cautiously and then voluntarily and mutually agreed between the parties. For transactions beyond e-commerce, escrows are the best sought financial instrument for a secure transaction.
[iv] ibidat ii.