Indian tax laws tax any business income of a trust at the maximum marginal rate and treat gains from hedging instruments such as futures and options as business income. This renders all income from any CAT III AIF to be taxed at 42.7%
By Siddarth Pai & Vishak Nathan
Those who tracked the markets during the Budget speech can attest to the inordinate sway every word can have on the market. The finance minister’s statement that the government does not “look down upon legitimate profit earning” and the proposal of “a number of initiatives as part of a framework for kick-starting the virtuous cycle of domestic and foreign investments” during the early parts of the speech rallied the market, which was anticipating several much-needed measures to galvanise investments in the country. The proposed measures, such as easier KYC norms for FPIs, increased FDI limits, opening up new investment vehicles for foreign participation, etc, hold a lot of promise for the future. But, the rudest shock came when the finance minister discussed revenue mobilisation measures and the increased surcharge on incomes above Rs 2 crore.
A tax on the super-rich was expected, with rumours about such measures doing the rounds before the Budget. But, what was especially shocking was that this was extended not only to individuals but also to all association of persons and trusts—whether domestic or foreign. And therein, as the bard would tell us, lies the rub.
Many foreign portfolio investors consist of pension funds, insurance funds, etc, that are incorporated as trusts. This highlights the fiduciary responsibility they have towards their thousands of beneficiaries and the governance norms that they must adhere to. Their structure also allows them to pass-through the gains to their beneficiaries—people who rely on this income to sustain themselves in their retirement. But, as per the latest proposals, they’re going to suffer a surcharge that is much higher than that attributed to foreign companies and which turns a blind eye to their pass-through status. The very structure adopted by these FPIs renders them liable to tax at much higher effective rates than foreign corporations. These measures run the risk of countering efforts to facilitate greater foreign participation in structures such as REITS, InvITs, etc.
This also adversely affects Indian Category III AIFs, who are already reeling from an 18% GST on fees which cannot be claimed as well as the lack of any pass-through status for any income. Most of them are also structured as trusts as it offers the greatest flexibility and is the most tax-effective structure. Indian tax laws tax any business income of a trust at the maximum marginal rate and treat gains from hedging instruments such as futures and options as business income. This renders all income from any CAT III AIF to be taxed at 42.7%! Hedge funds across the world have pass-through status, thus allowing any gains to be taxed in the hands of the investors as though they invested directly into the underlying portfolio, something Indian hedge funds were denied since 2014. CAT III AIFs in India have long suffered under an unfair tax regime wherein ambiguity abounds. Though the government has taken great pains in addressing the needs of FPIs, even amending the definition of the term “capital asset” to include any securities held by an FPI, no such generosity has been extended to Indian investors. While India seeks greater domestic capital participation in the country, its own tax laws cripple investor appetite due to such draconian measures.
A pass-through status for pooling vehicles such as CAT III AIFs and trusts is a just form of taxation as it follows the principle of ascribing tax rates as per the individual investor’s income. A common investment pooling vehicle cannot imply the highest tax rate to its investors. To put things in perspective, this is akin to taxing the savings bank interest of a person with a net income of Rs 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.
The impact of this proposal on investor sentiment is visible to all. The markets shed over 1000 points over the past 3 days, lead primarily by FPIs who’re looking to rethink their India strategy. Many domestic fund managers have reached out to the government to plead their case.
The budget speech did not intend for this distortion. The honourable finance minister stated, and I quote, “I, therefore, propose to enhance surcharge on individuals having taxable income from 2 crore to 5 crore and 5 crore and above”. Thus, it is the unintended, inadvertent consequence to tax FPIs and CAT III AIFs with these surcharges that deserves to be rectified immediately.
The government cannot roll out the red carpet to investors, then bolt the door and shake them down for all they are worth.
India requires investments of at least $300 billion a year as per the 2019 Budget speech. With a savings rate of 10% of our GDP of $2.7 trillion, India needs capital from all sources to meet its investment needs. Our ratio of foreign investment to GDP is already low compared to other large economies worldwide. In order to become a $5 trillion economy by 2025, India needs a growth rate of 12% and access to low-cost capital. But, the proposed measures of lop-sided surcharges and the mistreatment of Indian investment vehicles will make these proposals the architect of India’s misery.
Pai is founding partner 3one4 Capital; Nathan is founder Suvitta Capital (Views are personal)