The exclusion of CAT III AIFS from the rollback of surcharge on FPIs leaves Indian funds at a fundamental disadvantage in India compared with FPIs
By TV Mohandas Pai & Siddarth M Pai
We live in an age of protectionism, where local industries are being protected against global players. The glut of globalisation from the 1990s faces a resurgent spirit of nationalism; policies that previously promoted free trade are being met with protective measures, such as tariffs and trade barriers. The US, the bastion of free trade and capitalism, has started a brutal trade war with China, and has gone so far as to create checks on foreign acquisitions of US companies via the Committee on Foreign Investment in the United States—all to promote local industries under the “America First” policy.
In this protectionist era, instead of giving Indian investors an advantage for investing in India, our tax laws have handicapped Indian investors in their own country!
The 2019 Budget saw the introduction of a 37% surcharge on incomes above Rs 5 crore earned in India; the fine print saw this surcharge being applied to trusts as well as individuals. Many foreign and domestic institutional investors are incorporated as trusts since it gives them the greatest flexibility to manage their investments. This surprise surcharge caused panic in the markets and blood on the street. July witnessed a haemorrhage of over Rs 14 lakh crore in market value, with FPIs pulling out over Rs 22,000 crores. The finance minister took cognisance of this after the consequences became too much to bear, and vowed to introduce mitigative measures. Last Friday, she announced a series of measures to bring relief to the market and the economy. The chief amongst these measures was a rollback of the higher surcharges for FPIs.
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While the foreign investors were celebrating this, Indian investors were left aghast at being left in the lurch and being subject to the same surcharge from which their foreign counterparts were exempt. But, this discrimination is nothing new—Indian investors have consistently been treated as subordinate to foreign investors, beginning from how our laws are drafted.
For investors in Indian markets, there always existed an ambiguity in taxation regarding whether the gains they make are capital gains—having a more favourable tax regime—or should be considered as business income. There are innumerable cases on this subject involving inspections of the business model, different demat accounts, investor intention, etc, yielding a lot of ambiguity. In 2014, then-FM Shri Arun Jaitley spoke about the “uncertainty in taxation on account of characterisation of income” faced by FPIs, causing him to amend the definition of a “capital asset” to include any securities held by an FPI—ending this debate for FPIs. Yet, Indian investors didn’t receive the same courtesy on the issue.
In all fairness, in February 2016, the CBDT did issue a circular stating that it will accept the stance of investors on the issue of whether securities are stock-in-trade or capital assets if they’re held for longer than 12 months. But, in terms of assets held for less than 12 months, the ambiguity for Indian investors continues whereas their foreign counterparts stand relieved.
This issue is especially acute in Category III AIFs, who will be the worst hit by the increased surcharge. Out of the three categories of Alternative Investment Funds in India, Category III AIFs are those “which employ diverse or complex trading strategies”, investing into listed or unlisted securities. But, they lack the pass-through structure afforded to other AIFs in India and suffer taxation at the maximum marginal rate. Worse off, due to our tax codes, if they choose to employ derivatives in the form of futures and options, their income will be taxed at the maximum marginal rate as business income, which is now 42.7%. The FPIs, who do the same, do not suffer from this rate since they’re exempt from the surcharge, and their derivatives are capital assets.
The lack of pass-through status for CAT III AIFs flies in the face of logic when the other two categories are afforded this. These funds are all pooling vehicles—an accumulation of funds from various investors for common investments under common management. The just form of taxation is to ascribe tax rates to the individual investor on the income generated by the fund. Taxing income at the maximum marginal rate due to the common vehicle is absurd. To put things in perspective, this is akin to taxing the savings bank interest of a person with a net income of `10 lakhs and a person with a net income of Rs 10 crore at the same rate just because they both use the same bank! The law cannot turn a blind eye to the end beneficiary, and assume that all investors belong to the highest tax slab, regardless of their actual income. To each his own rate.
For all fund managers, this begs the question of whether the choice, for a given strategy and structure, should be to create an Indian vehicle—which suffers from the deficiencies of higher taxes, ambiguity over the classification of gains, and characterisation of derivative gains as business income—or float a foreign fund, register as an FPI, and rid oneself of these issues? Ceterus paribus, if a change in geography yields such benefits, why would anyone create an Indian fund to invest in India?
This is one of the reasons why foreign investors are reluctant to invest in Indian investment vehicles. India’s CAT III AIFs (including hedge funds) have a corpus of only `40,000 crore ($5.52 billion). To put things in perspective, the largest hedge fund in the world has assets under management of $6.3 trillion and the 10th largest has over $34.3 billion. How can India become an investment destination when its laws are categorically loaded against its domestic funds? This discrimination is especially puzzling to foreign investors, who are looking to back Indian fund managers in India; instead, they’re found in either Mauritius or Singapore.
Even in the unlisted space, discrimination exists in the form of ‘Angel Tax’ or Section 56(2)(vii) (b)—which taxes the premium of Indian investments into private companies as income if such premia exceed the fair market value. It is pertinent to note that this applies only to Indian investors, and not to money received from foreign investors. This is one of the reasons why rupee participation in the Indian startup story is under 10% of the total capital raised by them.
It must be noted that the reports being circulated that Smt. Nirmala Sitharaman created this disparity in taxation are thoroughly untrue. Such disparity has existed for a long time. It is a tragedy that Indian investors are discriminated against in this manner in their own country. In spite of this discrimination, since the budget speech in 2019, domestic investors have been net buyers to the tune of `38,000 crore while foreign investors were net sellers. Domestic participation in the market has been higher than ever before, and the government should recognise this. We need our elected representatives to correct this discrimination in our laws. We need prime minister Modi to unleash the animal spirits of the Indian investor by ending this discrimination. Allow for securities held by CAT III AIFs to be classified as “capital assets” and extend the same benefit to them as was extended to FPIs. Did we gain independence from the British only to still be discriminated against in our own country?
Indian fund managers look forward to the day when the gateway to Indian equities is Mumbai—not Mauritius.
Mohandas Pai is Chairman, Aarin Capital & Siddarth Pai is Founding partner, 3one4 Capital
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