The Foreign Portfolio Investor regime (FPI) has brought in good foreign exchange inflows for India over the years. The year 2018 has been particularly good. More than 600 new investment funds registered with the Securities and Exchange Board of India (SEBI), bringing the total to 9,246.
The current taxation regime for FPIs is governed under section 115AD of the Income Tax Act, 1961 (IT Act), if the FPI does not claim to be taxed under the more beneficial provisions of applicable tax treaty between India and its home jurisdiction. Where the tax rate is prescribed in the tax treaty, then the said rate is the final rate in respect of the income of the FPI. Where the applicable tax rate is as per the IT Act, for e.g. in case of capital gains tax or lower withholding tax of 5% on interest which falls under Section 194LD, the total tax rate applicable will be the rate plus applicable surcharge and cess. Currently, the applicable surcharge for foreign companies is 2 per cent if the total income of the foreign company is between Rs 1 crore and Rs 10 crore and 5 per cent if it is above Rs 10 crore. The surcharge applicable to individuals, HUFs, association of persons, body of individuals, or artificial juridical person (not being a company or a partnership), is 10% if the income is between Rs 50 lakh to 1 crore and 15% if the income is above Rs 1 crore.
As can be seen, the surcharge applicable in case of non-corporate and non-firm tax payers is high under the current laws compared to the surcharge applicable to foreign corporates.
The Finance Bill 2019 now proposes to raise the rates of surcharge on the second category of persons to 25 per cent if the income is between Rs 2 crore and Rs 5 crore and to 37 per cent if the income is above Rs 5 crore. Where the FPI is organised as foreign company, and where its income is taxed under the tax rates prescribed by the IT Act, there would be no change in taxation of the FPI’s income from India under the new provisions of the bill. However, where the FPI is organised as a trust and is assessed to tax in India either as an AOP or an artificial juridical person, the surcharge rate applicable to the income of such FPIs would be increased either by 25 per cent or 37 per cent depending upon the taxable Indian income of the FPI.
Thus, whereas such FPI was paying long term capital gains (inclusive of surcharge that was applicable if the gains were realised on-market) at the rate of 11.96 per cent, it would now pay tax at the rate of 14.25 per cent, i.e. an approximately 19 per cent increase in the effective tax rate. Likewise, on short term capital gains, the tax payable (for on-market transaction) which was 17.94 per cent would now go up to 21.38 per cent, i.e. also a 19 per cent increase. Where the tax rate was 35.88 per cent on short term capital gains, it would now be 42.744 per cent.
As can be seen, the gap between the tax rates applicable to a FPI organised as a foreign company and those organised as a trust or other artificial juridical person would increase significantly under the current proposals. This is certainly not a happy situation for the FPIs, for whom trust or other structures work well from the perspective of their investor class and their home jurisdictions. It is important to note that investment by funds such as under the FPI route are made purely for returns to their investors. There is no other business. If the returns are adversely impacted by change in taxation law, during the course of the lifetime of the FPIs, they will clearly have a difficulty answering their investors on the attractiveness of India as an investment jurisdiction.
What could be the solution for such FPIs, to respond to their investors? Clearly, one solution seems to be for them to convert their entity into corporate. This may or may not be as simple as it seems for a variety of reasons. The conversion needs to be possible under the laws and applicable regulations of the jurisdiction where such FPI is organised. Even if such conversion were possible, the reasons for which they were so organised in the first place may not permit them to convert. Such conversion may even trigger taxation in India. Last but not the least, this may not be acceptable under the General Anti Avoidance Rules (GAAR), since this would clearly be done to reduce the tax liability.
Let us talk about the applicability of GAAR.
Can this provision be invoked where the government is changing the rules of taxation midway through the period of licence granted to the FPIs? Their strategy, necessarily is dependent on a stable cost structure, and taxation structure in the investment jurisdiction is essentially an element of cost for them. They are indeed eligible to organise and reorganise to remain cost efficient. To trigger GAAR against this reorganisation would seem unfair.
It would not be a legitimate ask of the FPIs to seek a grandfathering provision, as has been done in case of changes in tax treaties with Mauritius, Singapore and Cyprus. It can be provided that the higher rate of surcharge would not apply to income arising to FPIs from all investments made by them till July 5 (the day the change in surcharge is announced). This would ensure that the FPIs may consider to make their new investments in a structure which is more favourable from a tax cost perspective. Viewed from this angle, such a reorganisation should not be considered to be done for avoidance of tax. The courts have upheld the right of the tax payer to organise its affairs such that it may take advantage of the various tax saving devices that are legitimately available to it.
After all, if India recognises the role played by FPIs to the depth and breadth of its capital markets as positive, then making its investment in India more expensive cannot be the way to do it. On the one hand, the minister has announced rationalising the KYC norms to make it easier for FPIs to be registered as also increase FPI investment in an Indian company to the level of sectoral cap for foreign direct investment. It seems strange that in the same budget such a heavy tax change should be proposed without providing and permitting them the opportunity to reorganise. If the FPI chooses to continue in this manner, even after this opportunity is provided, there is nothing wrong in it being subject to higher tax same as the Indian high tax payers.
Reports that the government is seeking to probe into the beneficial ownership of FPIs organised as trusts or AOP with the apprehension that they are opaque structures, also seem rather strange in view of the manner in which FPIs are granted registration and how they need to report change in their beneficial ownership to the SEBI on regular basis. Beneficial owner disclosures are required to be made periodically by a registered FPI of investors holding more than 25 per cent on an ownership or control basis for corporate FPIs / 15 per cent on an ownership or control basis for trusts or limited partnerships.Daksha Baxi is head, international taxation, Cyril Amarchand Mangaldas. Views are personal.