Foreign portfolio investors (FPIs), who are enjoying a concessional tax rate of 5% on the interest income of rupee-denominated bonds, could be staring at a higher tax outgo after June 30, 2023.
Under Section 194LD of the Income Tax Act, also referred to as withholding tax, FPIs have been given this tax benefit on rupee-denominated bonds issued by Indian firms and government securities since 2013. However, there are fears that this may not be extended in the upcoming Budget, according to people in the know.
This would mean that the tax to be paid on the interest income would shoot up to 20% or higher, going up to 40% depending on the type of debt and tax treaty available.
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“There’s a fair chance that the government may not extend the concessional rate considering that the inflows in debt have been muted in the past year. But considering that this a pre-election Budget, it may not tinker with the tax rates at this juncture,” said Ajay Manglunia, managing director and head of the investment grade group at JM Financial.
FPIs have been net sellers of debt papers worth $1.2 billion in 2022 in addition to the $16.9 billion sold in equities. Last year, they were net buyers in Indian debt to the tune of $3 billion. In the past five years, however, FPIs have cumulatively net sold in excess of $10 billion in debt.
The government had introduced these lower tax rates in 2013 after a wobble in the rupee led to a flight of foreign money. These were applicable on interest payable till May 31, 2015. Record FPI inflows in the debt segment in 2014 prompted the Centre to extend the concession thrice in subsequent years.
“Private equity investors and FPIs are hoping for an extension of the 5% withholding tax rate beyond June 2023. The lower rate has provided a significant boost to offshore lending in g-secs and corporate debt. If the benefit is not extended, the government might want to consider a gradual rate increase to say 7.5% to start with so that the tax burden does not suddenly increase to 20%/40%,” Rajesh Gandhi, partner, Deloitte India, said.
Experts believe the lower tax rate is a significant contributor in making India’s debt market attractive to overseas investors. The concessional rate has also helped in reducing borrowing costs for the government and firms.
Subramaniam Krishnan, partner, private equity tax, EY India, said: “With rising interest rates pushing up the cost of capital globally, debt-focussed FPIs would once again be hoping for an extension of the beneficial tax regime, as any increase in tax would effectively reduce net yield for FPIs, thereby reducing its attractiveness.”
Overseas investors in the corporate debt market generally invest for longer tenures and look for certainty on tax consequences vis-a-vis income expected to be earned during the period. A decision to discontinue the lower rate should be taken only after providing sufficient notice to investors to avoid any disruption in FPI flows, according to experts.
Let’s say an FPI invests in a `1,000-bond with a coupon rate of 10% per annum. If `100 is the interest received, the 5% withholding tax reduces the income to `95. Deducting the hedging cost of, say, 4% per annum on the principal, the FPI gets back `55. If tax deducted, however, increases to 20%, this income reduces to `40, which is lower by 27%.