What is an Escrow Accounts: Definition, Examples and Benefits

escro accounts — (source : corporatefinanceinstitute)

An escrow account is a third-party account in which funds are kept until all the conditions have been met by purchasing and selling parties. On successful completion of a transaction, this temporary account closes, and funds get transferred to the seller's account.

The new age escrow accounts developed with modern technology have made it a secure mechanism to fulfil payment obligations. Read on to know how to open escrow accounts in India.

What Is an Escrow Account?

An escrow account means a temporary account which helps in completing large value transactions like mergers and acquisitions, high-value real estate projects, cross-border projects, etc. Under an escrow account, a buyer will deposit a sum of money required to complete the transaction. However, this account will release funds to sellers only after the fulfilment of all commitments.

Let's understand how an escrow account works with the help of an example related to real estate transactions. Suppose XYZ Developers decide to build a residential housing complex of 1000 units, each unit having a value of Rs. 75 lakh each.

However, buyers are sceptical about the authenticity of these projects and doubt whether the developers will deliver the flats on time. In order to allay such fears, XYZ Developers offers buyers the choice to deposit the money in an escrow account with a financial institution.

Buyers can deposit the entire value of their flats in the escrow account. Funds will be kept in those accounts till the developer completes the handover of projects. However, there is a mechanism for developers as well which allows them to withdraw sufficient funds needed to carry out the construction work.

Why Do You Need an Escrow Account?

An escrow account provides security of transactions to both buyers and sellers and removes trust issues between transacting parties. It helps in minimising fraud in high-value transactions. Depositors can track the movement of money in these accounts and keep a tab on the fulfilment of contractual obligations as well.

If you are entering any merger and acquisition deal, an escrow account will be hugely beneficial in that case. It serves as a security for buyers of the deal. They can retrieve their funds from these accounts in case the seller walks back on its commitment.

Mergers and acquisitions involve a holdback escrow in which a percentage of the whole transaction is kept in the respective escrow account. The escrow provider can transfer this amount back to the seller if contractual obligations are not met.

Therefore, escrow accounts serve as a safety net for entities involved in high-value financial transactions. It helps to overcome the risk of trust deficit among parties involved.

How to Open an Escrow Account?

Here are the steps by which you can open escrow accounts:

Step 1: Both buying and selling parties must agree to open an escrow account. They have to sign an escrow agreement mandating the opening of the account.

Step 2: After reviewing the agreement, the buyer can deposit the required funds in the accounts.

Step 3: The escrow account provider validates the receipt.

Step 4: The next step entails regular monitoring of this account by the escrow provider to see whether the buyer is making payments in the account as agreed.

Step 5: Once the transaction is completed, the escrow agent will review the conditions of the agreement, and upon a positive response from the parties involved, the escrow provider will release the asset from his/her control.

In case a party is aggrieved with the decision taken by the escrow provider, they can approach a dispute resolution body, i.e. courts or tribunals. The verdict given by these bodies will decide the future of assets under escrow accounts.

What Are the Examples of Escrow Accounts?

Following are some of the examples of escrow accounts:

1. Escrow Account for Real Estate

Escrow accounts in the real estate industry are quite common. There is a trust deficit in this sector as buyers are sceptical of the timely delivery of their units. On the other hand, sellers or developers are constantly worried about timely payments.

This account acts as a trust builder and helps in executing the contracts in a hassle-free manner. The Government of India has mandated that developers must keep 70% of the buyer's deposit in an escrow account. This guideline is mandatory under RERA Act, 2016.

2. Escrow Accounts for Mergers and Acquisitions

Another industry that maintains escrow accounts is M&A or mergers and acquisitions. Again, in this industry, there are chances that both parties may fall back on their commitments.

In order to maintain and ensure fulfilment of contractual obligations, parties take the help of escrow accounts.

3. Escrow Accounts for Rental Deposits

These accounts are quite useful in case of rental deposits. A tenant has to pay a security deposit to the landlord while leasing a property. This account helps in preserving the security deposit of tenants.

Tenants transfer rental deposit in this account and, on vacating the premises, will receive their deposit subject to fulfilment of the rent agreement.

4. Escrow Accounts for Software

A transaction related to software routed through an escrow account preserves the sanctity of its source code. The buyer receives exclusive user rights to the software, and the source code of the developers remains secured.

What Are the Benefits of Escrow Accounts?

Some benefits of escrow accounts are as follows:

It provides security to both parties as funds related to the transaction are under the custody of a non-biased third party.
These accounts are high-tech mechanisms using automated processes that allow debit or credit to the account automatically subject to fulfilment of the escrow agreement.
These accounts help in taking a transaction to its logical conclusion in a simple and hassle-free manner.
Another advantage associated with escrows is that they keep the identity of the parties involved a secret. This provision allows parties to act freely without any fear of ill-will.

An escrow account is an efficient way of executing a financial transaction. These are short-lived and temporary accounts that get closed when their objectives get fulfilled. Individuals can use the services of escrow providers when they are not confident about going ahead with a transaction.

Frequently Asked Questions

✓ Do you receive interest on escrow accounts?

In India, as per RBI guidelines, banks are not liable to pay interest on funds deposited in escrow accounts. However, if funds of these accounts are treated as bank deposits, then banks will have to pay interest at applicable rates.

✓ What is the maximum time period of an escrow account?

As per Schedule 5 of RBI guidelines, the maximum time period for which escrow accounts can remain operational is 6 months.