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, since the Centre has not extended the concessional rate. Ashley Coutinho takes a closer look at the issue and the likely fallout
Lower tax rate for FPIs
FPIs have hitherto enjoyed a lower tax deductible at source (TDS) rate or withholding tax of 5% on the interest earned on rupee-denominated bonds issued by Indian firms and government securities. This was made applicable from 2013, under Section 194LD of the Income Tax Act.
The Centre had introduced the 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 later years. The lower rate is seen as a significant contributor to the Indian debt market’s attractiveness for overseas investors. It has also reduce borrowing costs for the government and firms.
Likely new rates
It was widely expected that the sunset period for the concessional rate would get extended by another three years—a year at the very least. However, Budget FY24 had no announcement to this effect, which meant that the tax rate is now likely to go up to 20% plus applicable surcharge and education cess. Those availing the benefit of tax treaties may pay a lower 10% or 15%, depending on the treaty jurisdiction.
Overseas investors in the corporate debt market generally invest for longer tenures and look for certainty on tax consequences. 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. Given a hedging cost of, say, 4% per annum on the principal, the FPI gets back Rs 55. If tax deducted, however, increases to 20%, this income reduces to `40, which is lower by 27%.
What will be the impact on FPIs?
This will significantly impact FPI debt investments as there is no grandfathering of existing investments, though there is a likelihood that impacted parties will approach the authorities for a grandfathering provision. Overseas investors in the corporate debt market invest for longer tenures and look for tax certainty vis-a-vis expected income during the period. The higher tax could accelerate selling of such bonds before June by FPIs who do not want to pay higher tax.
In the context of hardening bond yields globally, the impact of this change might negatively affect investments. FPIs were net sellers of debt papers worth $1.5 billion in CY22, in addition to $16.5 billion sold in equities. The previous 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 of Indian debt.
How will corporates get impacted?
FPIs may look to pass on the additional tax burden to the companies they lend to. This will result in the spread going up for some corporates, especially those that are struggling to get money from the domestic market.
These corporates will be compelled to buy from foreign investors, who can then negotiate for better rates. Some foreign lenders pass on the tax cost to the Indian borrowers by making it part of the commercial agreement. It will get a lot more difficult to negotiate for higher coupons from top-rated corporates and public sector undertakings. “In some cases, FPIs pass on the tax to borrowers and in other cases they bear the cost. In the case of the former, there is no additional cost for FPIs despite the higher tax,” said a tax expert. The majority of FPI debt investment, however, is in Indian government securities, where coupons cannot be negotiated.
Companies will have the option to borrow from foreign investors in the debt market, through foreign currency denominated bonds for which grandfathering provisions are provided. The other option is FPIs investing through the
GIFT IFSC route, under which a 10% rate is applicable, along with cess and surcharge.