Indian corporates could see higher debt costs in deals involving foreign portfolio investors (FPIs) as the central government plugged a key anomaly in the tax rates pertaining to offshore funds. In the budget for FY26, the government clarified that non-equity—in other words debt—investments by FPIs were also subject to 12.5 percent long-term capital gains (LTCG) tax, against the 10 percent that is applicable currently.
The tweaks would affect private syndicated financing that some companies use by roping in select large foreign funds to raise debt by issuing non-convertible debentures. Also, long-term derivatives owned by the FPIs will be impacted by these tweaks.
Tax experts say FPIs may pass on this higher tax rate via a higher interest rate. The development assumes significance as interest rates in India have been firm for the last two years. On the other hand, interest rates have been heading down worldwide including in the US, and Indian companies that have tapped foreign funds or banks have been availing debt funding at rates higher than global standards.
FPIs that are structured as trusts will see an even higher change in tax rates as the effective tax goes up from 11.96 percent to 14.95 percent, say tax experts. About a third of FPIs are structured as trusts, according to industry estimates.
FPIs are allowed to invest in both equity and non-equity instruments. Debt investments of FPIs include their purchases in the corporate bond market, both listed and unlisted. According to NSDL data, FPIs own debt instruments worth Rs 5.78 lakh crore of which Rs1.1 lakh crore is in corporate bonds.
“The proposed rationalisation aims to further align the taxation of capital gains on the transfer of capital assets by FPIs. It is proposed that the rate of tax on other assets will also be subject to tax at 12.5 percent. Due to this amendment, the tax on listed debentures or long-term derivatives will increase from 10 percent to 12.5 percent. In the case of non-corporate FPIs, this will increase the effective tax rate from 11.96 percent to 14.95 percent, which is a significant change. This rationalisation is intended to create a more uniform tax structure and ensure equitable treatment of different types of capital gains,” said Suresh Swamy, partner, Price Waterhouse & Co LLP.
Experts say the tweaks will also affect the private deals FPIs undertake in the corporate bond market. For instance, some FPIs invest in unlisted debt via private deals with a company. In such deals, typically, three or four large investors form a consortium to provide debt funding to a specific company.
“FPIs are allowed to invest in unlisted debt securities. However, any long-term gains arising from said unlisted debt securities continues to be taxed at 10%. This was an anomaly, which has now been rectified by increasing the long term capital gains tax to 12.5%, at par with other long term capital assets.” said Amit Singhania, founder, Areete Law Advisors.
The anomaly in the law happened after the government revamped the capital gains tax structure in the budget presented in July 2024. Earlier, each asset class had a different effective tax rate, which created lot of confusion. In order to simplify this, the government brought in a uniform capital gains tax structure across asset classes. While making these changes in Budget FY24, the government made the new tax rates applicable to all the assets specified in Section 112A of the Income-tax Act. The section covers only capital gains arising out of equity and equity-related investments (such as mutual funds).
However, there is a special section in the act—Section 115AD—that deals with taxation of FPIs' income arising out of the sale of securities. This section was introduced to attract more FPI investment into India and provides for 10 percent LTCG tax rate for FPIs. This covers both equity and debt instruments owned by FPIs. Since Section 115AD was not covered under the FY24 budget announcement, effectively the tax rate for non-equity investments for FPIs continued to remain at 10 percent. However, the tax rate on equity investments by FPIs went up to 12.5 percent since the budget announcement covered the equity assets owned by FPIs.
Long-term derivatives are the contracts that FPIs buy essentially as a hedging tool against their India portfolio. These contracts are held by the funds for longer durations compared to regular derivatives which are used for trading purposes.
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