Capital inflows from foreign portfolio investment ("FPI") have been pivotal for India's economic growth. In 2015, the total net foreign portfolio investment flows stood at USD 10.6 billion.1 FPI inflows up until September, 2016 already stand at approximately USD 5.92 billion. It is little surprise that time and again successive Indian Governments have aimed to position India as a tax competitive jurisdiction for portfolio investors. Concessional withholding tax rate of 5% on interest income, deeming fiction which characterizes income from transfer of securities as capital gains, short term capital gains tax rate of 30% on unlisted securities, long term capital gains tax rate of 10% on unlisted securities and exemption from minimum alternate tax are few such examples of the tax benefits extended to FPIs. Moreover, FPIs would typically route investments into India through treaty jurisdictions such as Manutius and Singapore, which provide for a capital gains tax exemption on exit, to secure a tax efficient return on investment. However, three recent developments in the India's tax laws, discussed below, now threaten the tax efficacy of an FPI investment in India.
Impending withdrawal of capital gains tax exemption under India's tax treaties
The recent amendments to India-Mauritius tax treaty provide (amongst other things) for the phased withdrawal of capital gains tax exemption. Any transfer of shares of an Indian company acquired by a Mauritian tax resident on or after April 1, 2017 will now be subject to income tax in India as per India's domestic tax law (reduced rate of 7.5% has been provided for two years, subject to a limitation of benefits clause). The amendment to the India-Mauritius tax treaty has resulted in the withdrawal of capital gains tax exemption under India's tax treaty with Singapore, which was co-terminus with the India-Mauritius tax treaty. The domino effect of the amendment to India-Mauritius tax treaty has now culminated into the impending amendment of India's tax treaties with Cyprus and Netherlands.
Additionally, the grandfathering mechanism under the India-Mauritius tax treaty is presently unclear as regards whether the benefit of grandfathering will be extended to convertible instruments that are converted post April 1, 2017 or shares/ securities that are issued post a business reorganization (merger/ demerger) in lieu of shares/ securities that were acquired pre April 1, 2017. Presently, a committee constituted by the Government is looking to iron out the creases in the grandfathering provisions of the India-Mauritius tax treaty.
Given that the impending amendments to India's traditional tax treaties have now foreclosed the possibility for a tax free exit for an FPI, tax treaties such as France, Spain, and Luxembourg (amongst others) may be worth exploring. Under the tax treaties that India has with the aforementioned countries, sale of portfolio investments are exempt from capital gains tax in India (subject to conditions).
Indirect transfer tax rules
India's rules relating to taxation of indirect transfers have garnered attention worldwide. The transfer of a share or interest in a foreign entity becomes taxable in India if such share or interest derives more than fifty per cent of its value from underlying Indian assets.
As such the indirect transfer tax rules contain a carve out where by such transfer is tax exempt if the transferor, at any time in the twelve months preceding the date of transfer, holds less than five per cent of the voting power in the foreign entity and does not have the right of control and management over the foreign entity. The intent behind the introduction so such carve out was to protect portfolio investment from indirect transfer tax rules. However, the 5 per cent threshold is proving too low to provide relief to portfolio investors who may have higher percentage of shareholding in Indian focussed pooling vehicle set up overseas.
The indirect transfer tax rules therefore also make it imperative that the portfolio investor routes investment into the pooling vehicle set up overseas through a favourable treaty jurisdictions which does not permit taxation of indirect transfers. This layering of treaty vehicles adds to the administrative burden and cost of FPI investment into India.
General Anti-Avoidance Rules
General Anti-Avoidance Rules ("GAAR") are all set to come into effect from April 1, 2017. GAAR provisions empower the Indian income tax authorities to re-characterize transactions which are structured to avoid taxes in India. However, GAAR provides certain exceptions to the following transactions/ taxpayers:
- Transactions where tax benefit does not exceed INR 30 million;
- FPI, which is an assessee under the Indian income tax law and does not seek tax treaty benefit, and who has invested in the Indian securities with prior approval of competent authority;
- Non-resident, who has invested in FPIs by way of offshore derivative instrument;
- Income arising to any person from transfer of investments made before April 1, 2017;
- Transactions where tax benefit is obtained prior to April 1, 2017.
Notably, while the exceptions to GAAR purport to offer protection to an FPI and non-resident investor investing in FPI, there still remain open tax issues. For instance, the requirement that an FPI should not avail tax treaty benefits to be exempt from GAAR is onerous since it compels an FPI to elect tax treatment under domestic tax law and pay capital gains tax on exit. On the other hand, if an FPI elects tax treatment under a tax treaty, it will be subject to GAAR, and the subjective scrutiny of the Indian tax officer of the underlying commercial substance of the investment structure. The lingering uncertainty of GAAR will act as a hindrance for an FPI to ascertain the tax cost of its investment in advance.
FPIs have approached the Indian Government (amongst other things) to prevent potential confusion, which may arise from the implementation of GAAR. One of the suggestion include setting out a bright line test or an objective criteria to determine whether an FPI pooling vehicle set up in a favourable treaty jurisdiction meets commercial substance test of GAAR for instance, minimum expenditure, assets, employees requirement in the treaty country. Alternatively, Indian companies looking to raise funds may explore the opportunity of setting up an entity overseas to direct capital inflows into India (though this solution will need tempering in view of place of effective management test, transfer pricing rules, indirect transfer tax rules etc.)
The imposition of Indian capital gains tax could result in potential economic double taxation of the return given that the ultimate investor in the may not be eligible to claim a credit for Indian taxes, paid by the FPI in India, in his home country. FPIs are now in discussions with the Indian Government to seek resolution for these tax issues to ensure that India still remains tax competitive and offers an investible return to investors. Additionally, FPIs are in discussions with SEBI to be allowed the facility of opening multiple demat accounts so that they can co-relate the return on the instruments issued by them to their investors with the underlying sale of the Indian investment under the first in first out rule.
Needless to say, pending resolution of the open tax issues, a taxing terrain lies ahead for FPIs.
1 Annual Report published by the Ministry of Finance, Government of India
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