India: India Budget Analysis 2018-19

Earlier today, the Indian Finance Minister ("FM") announced the Budget for financial year ("FY") 2018-19 ("Budget"). This Budget is expected to be the last of this Government prior to elections which are expected to happen over the next twelve months, and the focus was around ensuring that the rural economy was adequately benefitted.

Although the last twelve months have seen a significant increase in investments from Foreign Portfolio Investors ("FPI") and Foreign Direct Investment ("FDI"), the Budget largely focuses on the domestic audience. Reforms are proposed in the health and rural sector with emphasis on generating higher income for farmers. On the tax and regulatory front, the Budget proposals have been minimal, especially for the global investor community. The biggest blow has been for the Indian capital markets with introduction of a long term capital gains ("LTCG") tax at the rate of 10% on listed equities, which were earlier exempt.

The Budget proposes a 10% tax on transfer of listed equity shares, units of an equity oriented mutual fund and units of a business trust, where such gains exceed INR 100,000 (approx. USD 1500), with effect from April 1, 2018. The Budget also proposes to introduce limited grandfathering in respect of protecting gains realized on a mark to market basis up to January 31, 2018; an increase in share value post this date would be brought within the tax net. This is in line with the Government's intent not to introduce taxes with retrospective effect and to protect any exodus from the Indian markets.

The most significant impact will be on foreign portfolio investments. The first blow to FPIs were the amendments to the Double Tax Avoidance Agreements ("Tax Treaties") with Mauritius and Singapore, last year, which gave India the right to tax capital gains from sale of shares. The introduction of a tax on LTCG is the second blow which will result in higher tax costs for FPIs as the treaty benefits earlier available should also no longer be available. This will be a deterrent for foreign investors and could potentially result in a movement of trading activity away from India to other offshore jurisdictions such as Singapore which offer better tax rates and sophisticated financial products.

On a more positive note, the Budget proposes to reduce corporate tax rates to 25% for Indian companies whose turnover is less than INR 2.5 billion (approx. USD 40 million). This is in line with the earlier proposals of the FM and should enhance competitiveness and encourage global investors to 'Make in India'. The exemption is broad enough to cover 99% of all tax-paying companies. It is important that in an era of tax competition where countries have been lowering corporate tax rates, India does not get left behind. While the move to reduce corporate tax rates is welcome, it would have been ideal if the corporate tax rates for large companies were also reduced to make them more competitive in the global marketplace.

Over the last couple of years, the Government has enacted several provisions in line with the Base Erosion and Profit Shifting Action Plan ("BEPS Action Plan") by the Organization for Economic Cooperation and Development ("OECD"). This year, the Budget proposes to expand the scope of the 'business connection' test (the equivalent of permanent establishment) through two sets of changes. Firstly, the scope of 'dependent agent' has been widened to include persons who habitually play the principal role leading to conclusion of contracts by non-residents. This is in line with the expansion of the concept of Permanent Establishment ("PE") under the Multilateral Instrument ("MLI"). Secondly, to tax new business models in the digital space, the Budget proposes to include a 'significant economic presence test' ("SEP Test"). Under the SEP Test, download of data or software, or solicitation of business activities through digital means in India could lead to non-residents coming within the tax net. Interestingly enough, the OECD in the BEPS Action Plan has not yet endorsed such an approach on the basis of economic presence. The result of these changes would effectively mean that companies would be extremely reluctant to undertake transactions with Indian entities other than through treaty countries, given the expanded scope of the provisions. The possibility of substantial litigation going forward also cannot be ruled out.

The justification of the Government to expand the scope of the provisions has been that going forward, these tests would be included in tax treaties resulting in the domestic law becoming favourable to the taxpayer. However, it is relevant to note that even the MLI provisions today do not provide for the SEP Test that India has introduced. In an era of technology and digital access, this move of the Government runs contrary to their stance of increasing digitization in India.

One area where the Government seems to have proactive has been in the context of bankruptcy and insolvency laws, which have always been a pain point for investors and creditors. While 2017 witnessed a large number of cases being referred to bankruptcy courts (NCLT), concerns have been raised on the fact that tax law has not yet caught up with the changes. The Budget proposes to promote the restructuring plans by introducing tax incentives such as the ability to carry forward losses despite change in ownership and Minimum Alternate Tax ("MAT") relief to the extent of unabsorbed depreciation and carried forward loss where a company has been admitted into the bankruptcy process. These proposals should further increase interest amongst investors in distressed assets.

In its continuous endeavour to build a robust financial services centre in the country, the Government has proposed incentives for financial services operating through International Financial Services Centers ("IFSCs"). Importantly, in addition to the tax reforms, the FM in his speech has proposed to establish a unified authority to regulate this space.

Another interesting takeaway from the FM's speech was the policy for hybrid instruments that will be put in place, especially for the start-up community and venture capitalists. A robust framework for investments through hybrid instruments will be vital in developing a sophisticated market to attract foreign investment.

The Start Up Action Plan introduced by the Government has garnered an overwhelming response from the start-up community. A key cause of concern for the start-up community has been the inefficient tax incentives associated with the Action Plan. Over the years, the Government has rationalized these measures. In this Budget, the FM has proposed to bring the definition of start-up in line with that provided by the Department of Industrial Policy and Promotion ("DIPP"). Additionally, considering that the tax incentives were not fully being utilized, the FM has proposed to extend the tax exemption for another 2 years i.e. till March 31, 2021.

Other budget proposals include introduction of a new scheme for assessments. The proposed scheme eliminates interactions between the tax officer and the taxpayer through an e-assessment model which will result in greater transparency and efficiency. The effort seems to in line with the dual aim of 'ease of doing business' and promoting the digital economy.

All in all, the Budget seems rather lacklustre for global investor community as their long standing demands such as clarity over indirect transfer tax, General Anti-Avoidance Rules ("GAAR") and reforms for start-up investments have remained unfulfilled.

We have provided below a more comprehensive analysis and further insights on the 2018 Budget proposals. Hope you enjoy reading it. Join us for an interactive Webinar on Tuesday, February 6, 2018 (India time) for insights on India's 2018 Budget.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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