It results in an arbitrage between FPIs, per their legal status,and thus paints India as a country lacking stable tax policy
FPIs, with investments in Indian equity markets of around $450 bn, are a critical source of capital for the growth of the Indian economy. FPIs play a large role in helping the government reach its ambitious target of divestment and fund India’s current account deficit. Unfortunately, India’s unstable and unpredictable tax regime is giving them pause. Frequent changes in taxation and regulations, and the imposition of new surcharges without a formal consultative process are tarnishing the perception of Indian capital markets among FIIs.
The imposition of long term capital gains (LTCG) taxes in last year’s budget has already taken its toll on FPI interest in India. We have not yet seen the full impact because, since the imposition in last year’s Budget, markets in India have been depressed. Once markets recover, the full brunt of the imposition of the capital gains taxes and surcharges will become evident. India must head this off.
Equity markets are an important barometer on the state of the economy. Today, a large retail population invests savings in equities. Equity markets are important for raising resources for companies and for private equity funds exiting private companies. A problem for one constituency of the market is thus a problem for all, because of the interconnectedness of financial markets.
If India aspires to replicate China’s economic success, an investor-friendly policy framework is a prerequisite. India stands alone, perhaps the only country in the world that taxes the income of foreign residents from the income earned on the sale of shares. Most countries exempt FPIs from taxation in their jurisdiction. The current regime makes investing in India less competitive and goes against global best practices.
The MSCI India index has delivered a compounded five-year annual return of 3.5%, ( far) less than the returns delivered by China (estimated 7%) and the US (estimated 18%). Last year’s Budget imposed a tax on FPIs’ LTCG at the rate of 10% plus a surcharge, taking it to 10.9%. The latest Budget raises this tax to 14.92% for FPIs set up as non-corporate bodies. This raises the effective rate of capital gains tax on FPIs constituted as non-corporate entities vis-a-vis those organized as corporate entities or firms. For instance, the effective peak tax rate on short term capital gains tax on sale of equity shares for a FPI constituted as a company will be 16.38%, whereas the corresponding rate for a FPI organised as a trust will be 21.37%.
Imposing LTCG created several operational challenges dissuading genuine FIIs from investing in India. In order to mitigate any friction on account of taxation, the government should revert to the earlier regime of exempting FPIs from LTCG taxation. Taxing LTCG strikes at the heart of the fund management business.
First, capital gains are not an income, they are not something that come to you regularly. Second, the current tax regime goes against the nature of the business of fund management, especially for foreign funds, which are open-ended. Over the course of the year, the FPI fund entity has to estimate and pay the tax, making it difficult to calculate the NAV of a fund, leaving it subject to interpretation and unfairly penalising some investors. The problem arises because the taxable entity in India is the “fund” and it is not possible to attribute the taxes paid to the underlying investor.
The fund can’t issue a tax credit certificate to each individual investor to claim the credit for the taxes paid in India. This leads to a situation where the investor would be taxed twice on the same income, once in India and the second time in their country of residence. The taxes are effectively an expense for the investor and would make a sharp dent on their returns from Indian markets.
In addition, around 50% of the world invests passively via index funds/ETFs. Returns on index funds/ETFs in India are unable to replicate the returns on the index because the index does not have any taxes in it. Thus, all India index funds are underperforming their benchmark index, making them even more uncompetitive compared to their global counterparts. Most US pension funds are not subject to capital gains tax in the US, so taxing their capital gains in India eats into their returns without giving them the ability to get a tax credit.
Moreover, in a year when the rupee depreciates, the FPI fund entity would be paying taxes on notional gains in rupees while the fund would be losing capital in dollars. These issues create substantial hurdles for new foreign portfolio flows.
Additional surcharges on capital gains tax worsen the situation.
A significant proportion of FPIs, an estimated 40%, and (about 95%) of Cat III AIFs are set up in non-corporate form and represent small investors through pension plans or otherwise. This has the potential to cause negative impact on small investors and, therefore, be very disruptive for the capital markets. As things stand, these pooling vehicles have not been able to provide adequate returns from Indian markets.
Our research shows there is no other tax jurisdiction that targets non-corporate entities such as “trust” structures. Why this mistrust of trust structures in India when the NIIF was itself set up by the Government of India as a trust? (May be, UTI too). Most pension funds (global FPIs) and Category III AIFs (India-based pooled funds) are set up in the form of umbrella trusts with segregated schemes to effectively ring fence liabilities (on similar lines as ‘mutual funds’ in India). These are global standards used by large and small institutions for ease of doing business and consistency.
Admittedly, a differential surcharge is currently applicable to corporate vehicles vis-a-vis others. With the proposal to now increase the surcharge, the impact on the effective tax rates for FPIs (driven by their legal status) is highly significant. In addition, given that this change will be effective April 1, 2019, in the case of open ended funds, where investors have already exited, the implementation of the higher tax will create additional challenges. Such a high delta in effective tax rates, in our opinion, is possibly unintended and certainly not desirable. It results in an arbitrage between FPIs, driven by their legal status, and thereby has the potential to tarnish India’s reputation as a country with stable tax policy for foreign investors.
There is no apparent basis for taxing FPIs differentially based on their legal status. The higher surcharge will impact a number of large foreign mutual funds and pension funds investing in the Indian markets for the long term, which are typically organised as non-corporate vehicles in their home countries. This will certainly impact the competitiveness of Indian capital markets and impede their ability to attract fresh flows.
The author is President, Asset Managers Roundtable of India