The increase in tax surcharge had a negative impact on Indian stock markets, when affected FPIs started to exit by redeeming their holdings.
By TV Mohandas Pai & S Krishnan
Indian citizens are treated as Children of a Lesser God in India and blatantly discriminated against for the Sin of Being Indians! The finance minister, in her 2020 budget speech, announced complete tax exemption on the interest, dividend, and capital gains earned by Sovereign Wealth Fund of foreign governments for investments made in infrastructure and other notified sectors before March 31, 2024, subject to a minimum lock-in period of three years. This tax-free regime was created to attract long-term funds of foreign governments to invest in India’s priority sectors.
To attract foreign funds at a lower cost, the FM extended the 5% withholding tax concession up to June 30, 2023, to Foreign Portfolio Investors (FPIs) and Qualified Foreign Investors (QFIs), for interest payments from rupee denominated bonds issued by Indian companies, government securities, and municipal bonds. The period of 5% withholding tax concession for interest payment on moneys borrowed and bonds issued to non-residents was also extended up to June 30, 2023.
The government could have also raised resources from domestic investors, by issuing long-term tax-free infrastructure bonds. Securities issued by government institutions carry high investment-grade ratings. Domestic investors would have flocked to invest in these risk-free securities in a scenario where rating downgrades and default in payment of interest and principal amounts have been on the rise. High net worth investors and retirees prefer to invest in these bonds since they can invest a large amount for a long duration, with fixed and assured returns.
Indian regulations permit foreign investors to invest in India through different routes depending on the purpose of investment. Domestic investors in India have been discriminated against in taxation, compared to foreign investors. FPIs (erstwhile FIIs) have enjoyed a beneficial tax regime in India since 1993, when the Government of India decided to attract foreign investment to India, much needed when India had a shortage of dollars! The concessional tax regime was extended over the years to interest income and capital gains, but did not include business income. Many FPIs operating through their employees located in India, created a permanent establishment (PE) in India. This resulted in litigation when the income tax department treated their income as business income instead of capital gains, resulting in a higher tax outflow.
This uncertainty was ended in 2014, when the government amended the Income Tax Act to provide that any securities held by FPIs in accordance with SEBI regulations would be treated as capital assets, thereby resulting in only capital gains on their sale. The Finance Act 2015 provided that an eligible investment fund shall not be treated as a resident in India merely because the eligible fund manager, undertaking fund management activities on its behalf, is domiciled in India.
Long-term capital gains arising from listed equity shares, and units of equity mutual funds were tax exempt till March 31, 2018, after which LTCG beyond Rs 1 lakh is subject to 10% income-tax, exclusive of applicable surcharge and health cess. The FM, in her maiden budget in 2019, increased the surcharge on income tax paid by high income individuals. A significant number of FPIs operating in India automatically came under the higher tax regime since they were investing in India through a non-corporate entity such as trust, Association of Persons (AOPs), or Body of Individuals (BOI). These entities are taxed at the highest rates. FPIs structured as companies or limited liability partnerships were not affected. The increased surcharge resulted in an effective tax rate of 39%-42.74%. The increased surcharge applied to both the cash and derivatives segments (futures and options).
The increase in tax surcharge had a negative impact on Indian stock markets, when affected FPIs started to exit by redeeming their holdings. Considering the economic scenario and the various representations received, the government rolled back the higher surcharge on long-term/short-term capital gains from transfer of equity shares in a company, units of an equity-oriented fund, or units of a business trust. FPIs were allowed to treat the derivatives as capital assets, and consequently, they were also exempt from the levy of enhanced surcharge on any gains from the transfer of such derivatives. However, gains arising from transfer of derivatives for Category III Alternative Investment Funds registered in India, invested in by Indians citizens are still treated as business income and subject to increased surcharge, leading to discrimination.
Applicability of Minimum Alternative Tax (MAT) on FPIs became controversial when the Authority for Advanced Rulings pronounced, in 2012, that even foreign companies are subject to MAT. The Finance Act 2016 clarified that MAT would not apply to FIIs since they normally don’t have a place of business in India, and this clarification was applied retrospectively from 2001.
Investments in unlisted equity shares carry higher risks compared to those listed ones. However, to qualify as a long-term capital asset, the holding period is 24 months for unlisted shares, compared to 12 months for listed shares. LTCG tax on sale of listed shares is 10% while it is 20% for unlisted shares. Even non-residents pay LTCG tax at 10% on unlisted shares. Considering that angel investors having high income generally invest in unlisted and startup companies, the LTCG tax for them after surcharge and cess would be over 28%! There is no rationale for this difference. In addition, unlisted companies that are not startups face the threat of angel taxation on investments made by resident investors, and not on investments made by non-residents. There is an unsaid presumption that non-resident investors have more wisdom to determine the fair market value of unlisted companies than poor Indians! There is no incentive for domestic investors to set aside a portion of their investment corpus towards unlisted companies.
Various types of financial assets carry risks associated with returns. Defaults in interest payment of debt securities in India in the recent past indicate that debt securities also carry significant risk. There is no rationale for debt securities being considered long-term capital assets after a holding period of 36 months instead of the 12 applicable for listed equity securities and equity mutual fund units. Ditto for the difference in tax rates.
To encourage investments from domestic investors, the FM should have introduced an exclusive capital gains tax regime for financial assets, whereby investments in equity and debt instruments are taxed similarly for both Indian and foreign investors. Tax on unlisted equity should have been reduced to no more than 15% with no cess/surcharge. To incentivise investments in startup companies, a tax deduction of 50%, up to, say, Rs 25 lakh, could have been provided in the year of investment. This will enable investors to choose investments based on risk and reward suitable to them, rather than on tax considerations.
Sadly, the FM lost an opportunity to rectify the discrimination between foreign and domestic investors. Indian investors are discriminated against in their own country despite having a very large forex reserve of $465 bn!
Pai is Chairman, Aarin Capital Partners & Krishnan is Tax Consultant. Views are personal