Budget 2013: Foreign Investor Friendly?

He started his speech by saying “I have been at pains to state over and over again that India, at the present juncture, does not have the choice between welcoming and spurning foreign investment. If I may be frank, foreign investment is an imperative.”  But in the hour and a half after that he delivered several blows to foreign investors. One half-baked proposal, 2 justified but negative tax moves and finally a tax change that brought back unhappy memories of the last Budget. So at the end of it all, has Budget 2013 made foreign investors more welcome? To answer that, I have with me Keki Mistry, Vice Chairman & CEO of HDFC; Cyril Shroff, Managing Partner, Amarchand Mangaldas and Rohan Shah, Managing Partner, ELP.

Doshi: Do not look at the parts because I will get to them in just a bit. Look at the sum-of-parts; what did you make of the message that the Budget sent out to investors, foreign investors, specifically because that is the most important constituency that we need to talk to right now? Mistry: I think, as you said in the beginning, foreign investment has become so imperative that he had to have measures in the Budget to make sure that foreign investors were comfortable, were happy with what was happening. A lot of expectations were built around the Budget before the Budget was delivered. So, to that extent, maybe the expectations were not met but when you look at it impartially, the Budget does have certain provisions which will facilitate growth that is number one. Number two you have to understand that it was issued or it came out at a time when there was a huge necessity to go for fiscal consolidation so there was that much he could do and no more. What has spooked foreign investors probably is the lack of clarification on things like residency status and buyback of shares and stuff like that. Even buyback of shares, I would have a different view, we will talk about that but I think it is the residency thing which spooked people off. Doshi: So you are saying broadly he managed to balance or do the tightrope walk but for certain negative measures? Mistry: Yes. Doshi: Of all the things we expected, we did not expect him to announce this monetary threshold that divides foreign institutional investor (FII) and foreign direct investment (FDI)- the 10 percent limit, so to speak, that distinguishes between the two. In principle this seems to be borrowed from several international examples including an Organisation for Economic Co-operation and Development (OECD) paper as he put in his speech as well but I am sure the implementation in a country where we have so many complex sectoral caps and different treatments towards FDI and FII investors both from the regulatory as well as the tax point of view- this is going to be a mine field. What do you make of how this proposal will work. Budget 2013-14
Shareholding of 10% or less will be treated as FII & shareholding of more than 10% will be treated as FDI Shroff: That is absolutely right. I think the headline point of simplification by having this 10 percent line is a good one. Prima facie it suggests that this is simplifying the road for more dollars to come in. However, I think it is ridden with a number of unintended consequences. To start with it, there is a lot of history to this, which is starting from Foreign Exchange Management Act (FEMA) itself – the FEMA regulations – where you have two fundamental schemes, a portfolio scheme and an FDI scheme, and they are qualitative in terms of what the nature of the investment is, how it is regulated, how do you take account of the limits, how they are computed, who can issue participatory notes (P-Notes) and things of that nature. At one stroke, you abolish the qualitative distinctions and now draw a financial line of 10 percent and that sets you up for all sorts of problems. So for instance, an FDI investor who wants to come in, does he need to register in, what would otherwise be like an FII, there is a reference to a know-your-client (KYC) being the only requirement but we know it is going to probably land up being a lot more than that. Would an FDI investor sub-10 percent be interested in all that additional paperwork that is involved? You have to see the qualified foreign investor (QFI) scheme that was introduced last and one of the reasons this it has not taken off is considerations like this. How are you going to deal with cases of people who start off as FIIs under this new definition and cross the 10 percent limit or for people who hold P-notes above 10 percent limit. Private equity funds who have big private equity houses, who have different fund set up, fund for FII, FVCI and an FDI. Are you going to just draw a financial line across these three, are you going to look through behind the beneficial ownership and see who is controlling the company and then compute the limits or are you going to allow separate limits for each of them. So the consequences for strategic investors, different types of funds who have been designed particularly with the old regime in mind are going to have to do a lot of rethinking and they will be spending the next several months thinking of all of this rather than signing cheques for sending in the dollars. Doshi: So you have created or introduced another aspect of uncertainty in the minds of foreign investors who maybe looking to enter India either through the strategic route or the portfolio route because now they are not sure what the prevailing regime will be a year down the line? Shroff: Exactly, absolutely. Doshi: Do you think this was warranted, unwarranted; principally it is a good thing to do so even if interim or short-term confusion is the outcome, we should push ahead with it? Shah: I would agree with Cyril that you have effectively created a regime and you have got people to invest on that basis of that regime. Now you sort of announced that we are going to take a relook at this. So at the very least you are going to get the people to say “hey, let’s hold back, think this through” and then there is always that question in India when will that next change come. Doshi: We have touched upon how complex this will be for the investor, what about companies that they are investing in. How do you look at this because you have a history of both FDI and FII investors? Are you perturbed with what this change could mean? Mistry: Very honestly no. To my mind, whether it is an FII investor or an FDI investor, there is no difference. There is really no line in between as far as we are concerned as a company, but again to go little on what Cyril mentioned, my personal belief is that by defining FIIs under 10 percent you are facilitating, you are easing the process of money coming into India instead of going through the process of applying for Foreign Investment Promotion Board (FIPB) approval, which is going to take that much more time. So, I see this as making things administratively simpler for an investor rather than making it more complex. Doshi: But what you are saying is exactly opposite actually? Shroff: But I think from a headline intention I agree it is sort of well-conceived and it is thought about in the right direction, but there is a lot of history which – for instance you will have to start with basically amending the Foreign Exchange Management Act (FEMA) regulations and abolishing the two schemes, which currently exists at least below 10, you have to redefine them completely from a (interrupted…). Doshi: And even if an FDI investor wants to be an FDI investor, if he invests less than 10 percent, he is an FII investor? Shroff: If he invests less than 10 percent you would artificially call him a portfolio investor unless you are giving him the option. Doshi: Now there are different tax treatments to both? So would that matter in what route you choose to come in? Shah: From a tax perspective again the situation is the tax position is on an annualised basis and this could literally change on a day-to-day basis depending upon what positions they take in terms of their holding. So how are you going to map the two is going to be one of the key challenges because I will not have a constant status through the whole year given this 10 percent cut off. Doshi: So, assuming the tax position doesn’t change, maybe Mr. Chidambaram believes that the Committee will recommend a clean up of all the regulations - the core ones, the FEMA-related ones, as well as the associate ones that have to do with tax? Shroff: To be fair, I think we are discussing only on the basis of the Finance Minister’s speech and when the final regulations, after the committee comes up with its recommendations, may deal with all of these issues. I think the only point that I would like to make is it is not as simple as drawing a 10 percent line. There is a lot of hidden complexity at several layers that lies beneath this. Doshi: Okay, but are you in-principally in favor of something like this. Do you think that’s what will work for us as a country? Shroff: I think if it is done prospectively yes, I think we will have to figure out. The cleaning up the history on this is going to be complicated. Doshi: You are in favor because you think it’s a far more simpler regime to work with? Mistry: Yes, going forward I agree, it is good. But going backwards, going back to what…(interrupted). Shroff: How are you going to grandfather all the old cases? Mistry: But that is what one has to figure out. Shah: It is the way to go if you can articulate a very clear path of transition, but if you don’t articulate a path of transition, you will leave a lot of people uncertain and unhappy. Doshi: Maybe in principle having a monetary threshold that distinguishes between FII and FDI is the way to move forward. I just wish he had not located this for the first time in the Budget speech because it is so widely watched. Maybe this proposal would have been easier to accept if that have been put out as a discussion paper by FIPB or some such because it then wouldn’t have come as such a big shock or a surprise. What this Budget speech did was introduce yet another element of uncertainty in the minds of foreign investors as to what kind of regime they are going to have to deal with let’s say in the near-term. This is not the only thing- there were some tax proposals that also that went down negatively. I want to take up the negative tax proposals - the first one being the most contentious one, the Finance Bill saying that Tax Residency Certificate is necessary, but not sufficient to avail of tax treaty benefits.  Now the fact that this found no mention in the Finance Minister’s speech and that it was a retroactive amendment, made it highly reminiscent of Budget 2012. But to be fair, since then, there has been prompt clarifications. The finance ministry is saying that Circular 789 of 2000 will stand and that Mauritius-based investors do not need to be worried. Are you satisfied with what you have heard in terms of clarifications from the Finance Minister. Budget 2013-14
TRC ‘necessary’ but not ‘sufficient’ for availing DTAA benefits Fin Min Clarification
TRC will be accepted as evidence of residence Fin Min Clarification
Concerns w.r.t DTAA to be addressed suitably in Finance Bill Fin Min Clarification
Circular 789 of 2000 continues to be enforceable Fin Min Clarification
Nothing new introduced in FY14 which was not there in FY13. No intention of I-T officials to question TRC holders Fin Min Clarification
Resident of contracting state to be entitled to DTAA benefit Shah: Firstly, I think they get credit for the fact that once they understood the sensitivity (interrupted…). Doshi: Are you trying to say they don’t understand their own Budget document? Shah: The situation is – I don’t think sometimes you can completely anticipate the intensity of what some thing will do. Doshi: How can you not anticipate, in this environment, when you say a TRC is necessary but not sufficient that there won’t be a big push back to it? Shah: The situation is – they had it earlier. At that stage they got no real adverse comment on it. Now that they sort of brought it centre stage, they did. So all I am saying is they could have waited and sat on this, but they have come through and said look we are going to correct it. Even yesterday he said thrice I will explain my explanation, having said which if you see that particular clause if he is on this basis to say that the TRC now has restored the position that it had under Circular 789 and as that was interpreted by the Supreme Court and Azadi Bachao, then TRC is definitive and you need to see nothing more. If that is what he now intends, then really that clause has no significance. Doshi: But it has to be removed from the Finance Bill? Just a clarification is of no help? Shah: So, the issue is it has to be withdrawn and struck off rather than saying I will find a way to deal with it because if you intend now to say that the TRC is definitive and I will look no further, then all you have to say is I will withdraw that provision. I don’t think as yet we have heard anyone say that we are withdrawing this provision. Doshi: I think they have said things to the effect that we will change the Finance Bill, but I am not sure, I guess the test of their intention will be to see if that really does happen. How difficult can it be to withdraw that clause from the Finance Bill? Shah: But even now that you have such an escalated crisis on this issue, you will not appease people till you do not actually withdraw it because if you still leave something in play, people will always be skeptical and suspicious. So, I think now the greater the onus that he takes a definitive step and just kills the issue. Doshi: Rohan is giving them brownie points for having at least reacted to the reactions that this TRC issue brought up. I am not feeling that charitable, I can’t for the life of me understand why they would throw something like this out at a time when they know that the slightest change in tax is going to sort of yield outsized reactions? Mistry: Ambiguity of any form in any manner whatsoever is something investors detest. So you need clarity. So long as there is clarity, people know what the tax regime is they are fine, but once you bring in ambiguity in any tax law then it creates it down degree of problems, its own series of problems. So yes, I was surprised. Doshi: I am wondering if you were fielding calls from clients, wondering what in heavens is happening?
 
Shroff: Absolutely. And as we know that in a Budget exercise there are so many pulls and tugs all around. So, there must have been a segment they wanted to have a go at it, but when they saw the reaction I think they backed off. Doshi: Yes and I think it hurts even more because this whole Mauritius route is so plagued (interrupted…)? Shroff: I don’t buy this don’t understand theory; not at all. Doshi: I don’t buy that either, I am not feeling that charitable about it. I am happy that they have claimed that they will clarify it and take it out, but I guess that will be tested. They did two other things specifically on the tax front that is negative to multinational corporations and some kinds of foreign investors, but maybe justified. I think the Finance Minister himself said that in an attempt to impose a buyback distribution tax, as I am calling it, he is plugging a commonly used avoidance route. He is probably fair in doing that. I am wondering whether he has overreached in any fashion and thrown the baby out with the bathwater whereby legitimate transactions will now also have to bear the burden of that 20 percent tax. Budget 2013-14
20% tax on distributed income on buy back of shares by an unlisted domestic company Shah: In terms of intent to plug a loophole, I don’t think you can fault him, but there are going to be consequences which will weigh heavily in certain instances on a legitimate scheme to get minority out through this route. There will be unintended consequences in terms of double taxation. So for example let us say in a closely held company, I bought a share at 10, sold it to you at 25, you are now the holder and the buyback comes at this point in time. I have already paid on my 15 percent of capital gain. This will get taxed again. So there will be some adverse impact even on your local holders, but given the larger intent in terms of saying look here is something which was being used in a manner to denude our tax opportunity, I think you can’t fault him, but there are a series of issues which will practically impact people and those need to be properly dealt with. Mistry: I will give you an example of stock options- you take an Indian unlisted company, which has given stock options to its employees. Let’s assume that the price at which the options can be exercised, for argument sake, it is Rs 100 and the fair market value is Rs 500. So on Rs 400 you are already paying tax when you exercise the option. Now when the company buys back the shares - because in a unlisted company the company buys back the shares- when you buy back the share at Rs 500, again the difference between Rs 500 and Rs 100 to my mind will attract this 20 percent tax. Doshi: So you are bringing up another instance of double taxation? Mistry: Yes, so these kind of issues, if it can be identified….(interrupted)  Doshi: So how do you fix this; I don’t understand. You start caveating what transactions will not come under this buyback distribution tax. Do you make it a case-by-case situation? Shah: No, you don’t make it because if you leave it to individual discretion, it is too inefficient a system and it is too loaded in terms of somebody’s personal preferences, but there is no harm in clarifying that here are instances in which we believe there will be double taxation and his whole focus is the domestic player in this; in any case pays his 20 percent. So, I am trying to really address the foreign player who was getting a certain benefit. I have an unintended consequence on the domestic player, here is what I am clarifying. So there is nothing which prevents him from stepping in to reinforce what conceptually seems to be a good thing to do. Doshi: What about royalties? He has enhanced the rate on royalties payable. Now I understand this is not going to yield him much revenue simply because a lot of companies that pay royalty pay them to companies that are in countries where we have treaties, where the royalty is capped at 15 percent. So this increase to 25 percent- what does it amount to? Budget 2013-14
Tax applicable on income from royalty and fees for technical services (FTS) increased to 25% from the current 10% Shah: In practical terms probably not very much because as you rightly said with most of the countries where you are getting in technology you have a treaty; plus there is a balance of your transfer pricing provisions also which sort of comes into play in terms of ensuring that there is an arms length and an adequacy and a functionality criteria. So, let me sort of say while practically it wouldn’t have yielded much, so why did he go this route and one unfair and probably mischievous view is that if you couple this with the TRC issue then the situation is TRC is not sufficient. I now look at beneficial ownership that beneficial ownership test you will not meet. The treaty protection goes, now 25 percent is real. Doshi: For everybody irrespective of what the treaty says? Shah: So, the situation is if you sort of project it far enough to say he knows he is not getting enough revenue then why? And then if you marry up the two as some people are doing then it has (interrupted…). Doshi: But you are not? Shah: He has addressed the issue. So it is off the table, but that could then have led to a pretty significant amount of revenue collection and quite a few issues. Doshi: I would think Mr. Shroff that what minority shareholders were unable to do in the recent past (interrupted…). Shroff: I think it is actually a tax response to a governance problem; that’s how I saw it. Doshi: Isn’t it because what minority shareholders have been unable to do in the last few months with regards to the big hikes in royalties. Shroff: And we know many companies which have done this to pull out cash. Doshi: He has, in a sense disincentivised royalty payments out? Shroff: At least partly. Doshi: Especially if they are companies in tax havens or lower tax jurisdictions where we may not have treaty protection and hence then the highest rate applicable, which is 25 percent, have I got that correctly? Shah: He didn’t need to sort of step in. (interrupted…). Doshi: I don’t think he did it for minority. I think every country in the world is looking at royalty as one component of profit (interrupted…). Shroff: So, this was a cash extraction strategy for sure. Doshi: Yes, so they are all looking at royalty as a profit shifting exercise and they are all trying to find ways to get around it. To me, cumulatively, all of this sent out a fairly negative message in the speech that otherwise started of by saying foreign investment is imperative? Shah: I think there was an expectation that he will, in some way, deal with the Shome Committee report on Section 9 and this whole thing on indirect transfers and I think many clients internationally were very disappointed that this has nothing on that. There is one more issue, which I think is troubling and MNCs are waking up on this. Across the board, in indirect taxes -customs, excise and service tax- at a threshold of an evasion of Rs 50 lakh, he has introduced a situation where offences will be cognizable and non-bailable. Doshi: This applies to all taxpayers, not just domestic, foreign everybody? Shah: And that is a real problem in terms of building investor confidence because what has happened is if you have targets which are not met, officers are under pressure and they have the instrumentality of arrest, then they have used it in the past and they have used it against MNCs who they believe are most vulnerable. They have seen the payback of that because payments have been made overnight. You have put that instrument back in their hands and there was a Supreme Court judgment, which protected this sort of thing saying that if it is fiscal or tax; ultimately you can pay, why therefore have arrest and why life and liberty issues. They have brought this back and they have brought this back with vigor and at a Rs 50 lakh threshold- there are many companies whose daily tax payment is in excess of a crore. So if your situation is that at a Rs 50 lakh threshold, there is a vulnerability to arrest now this is no longer about on what profits do I pay, I don’t pay etc. Now it is my expat MD, my expat CEO effectively at a risk and it has played itself out in the past. So, I think between the larger statements, which you could not fault in terms of sentiment or analysis, but that compared with the detailing - a lot of the detailing actually widens the credibility gap and that’s a worry. Doshi: Final word, Mr. Shroff, despite what the Finance Minister says, it still seems like this Budget is being run by the bureaucrats who run the tax administration? Is that a fair way to sort of wrap this up? Shroff: I think that’s a bit of an overstatement, but they have had a disproportionate influence and I am not just playing with words. Doshi: However, you want to put it, the Finance Minister started by wanting to attract more foreign investment to the country, I suspect Budget 2013 may have done quite the opposite.