Union Budget 2019: People think these are big investors who can afford to pay huge taxes, but the reality is different. Pension plans and other institutions are often the investors, and behind whom lie large number of small investors.
By Nishith Desai
& Richie Sancheti
Budget 2019 India: Recently, the Chairman of the Central Board of Direct Taxes (CBDT) suggested that FPIs and AIFs could opt to get themselves structured as corporate if they wanted to avoid paying the additional surcharge proposed in the Budget (the proposal provides for surcharge at a rate of 25% for income between Rs 2 crore and 5 crore and at 37% for income above Rs 5 crore). However, implementing such a suggestion may be a legal or regulatory impossibility for many such investing vehicles and a commercial impossibility for many more. Further, invocation of GAAR remains a hanging sword. In short, conversion of a fund from trust into a corporate entity is it just a non-starter.
FPIs and Cat III AIFs are a fairly misunderstood class. People think these are big investors who can afford to pay huge taxes, but the reality is different. Pension plans and other institutions are often the investors, and behind whom lie large number of small investors. It is their lifetime savings that has been impacted by hefty tax that is proposed to be imposed. Let us understand the reality. It needs to be realised that FPIs are often not set up exclusively for India. Often, India’s allocation is a minor portion of global portfolio and it would be unrealistic to expect FPIs to change the operating form for one among many investment jurisdictions.
From a regulatory perspective, various FPIs such as foreign pension funds are statutorily or regulatory, required to be set up in a non-corporate format, mostly as trusts. Often, such FPIs are set up under statutes of respective national and state parliaments, and there is no flexibility under respective home laws to change the choice of form of organisation. These are long-term, patient pools of capital that are some of the most sought after investor classes globally. It would be difficult for them to reset their structures.
In most common law jurisdictions, the capital invested by shareholders cannot be returned (by way of redemption of shares), except out of the profits. The question that then arises is how can you return capital if there is overall loss?
Commercially too, the global funds industry is conversant with the Delaware limited partnership model, and several FPIs are set up in such format and not as companies. These forms of organisations provide greater familiarity to investors, greater flexibility and clarity of treatment vis-à-vis different national laws applying to the FPIs. Therefore, conversion of such structures into companies is commercially impossible, since any such move could be undesirable and impractical for them.
The CBDT chairman’s suggestion also covered AIFs. The proposed increase in surcharge directly affects Category III AIFs, since they do not have a statutorily encoded tax pass through like Category I and II AIFs. The proposed increase in surcharge further highlights the step-motherly treatment meted out to Category III AIFs.
Under mutual funds law, Indian regulations require mutual funds to be established in the format of a trust, with the possibility of having many different schemes running under an umbrella trust. In line with this prevalent model, most Category III AIFs have adopted such a trust–scheme structure. In fact, many mutual fund managers also manage Category III AIFs. Instead of finding a solution in light of industry practices, it is surprising to see the bureaucratic machinery suggest a conversion to company structures.
The trust structure also is well understood from an investment vehicle construct. Beneficial interest, and, rights and obligations of a unit-holder mesh well with investor-level engagement as is globally understood in an LP–GP (investor–manager) construct. The relationship has a high risk of distortion if it were to be covered in a company format, which has not been designed to cater to fund vehicles.
In the case of existing Category III AIF structures, a change to a company structure could entail further adverse consequences, including difficulty in mapping beneficial interests in a shareholder construct, onerous compliance and filing obligations under companies and other laws, imposition of dividend distribution tax (DDT). Such changes could be seen as material changes affecting decisions of investors, and, therefore, be construed as changes requiring investor consent, which may not be forthcoming.
Any conversion to company structure may entail further adverse tax consequences such as DDT, setting off, etc, going beyond any gains saved on surcharge. Instead of saving tax, the corporate structure may be even more onerous.
Also, disallowance of capital losses on transfer of assets in the course of conversion from trust to corporate structure is already under litigation in the Bombay High Court. It will be counter-productive for industry participants to undergo conversion to corporate structure, if ultimately, such conversion is disregarded under GAAR.
For the above reasons, the CBDT chairman should revisit the entire issue of taxation of FPIs and Cat III AIFs. Most countries (including the US) do not tax FPIs. Understandably, after the budget, Rs 5 lakh crore of wealth has already been washed off, affecting large number of small investors. In dollar terms Indian public markets have given about 3.5% returns compared to 7.5% by China, and almost 18% by the US. It would work out better if the government engages with the industry stakeholders who represent significant providers of capital to Indian capital markets, and propose a workable solution to the legitimate concerns of such stakeholders.
Desai is founder, Nishith Desai Associates
Sancheti is leader funds practice, Nishith Desai Associates
Views are personal