India’s Union Budget 2023-24 – an overview of important amendments in direct tax laws
The Indian Union Budget made changes to direct tax laws that will affect non-resident taxpayers, as Mehul Bheda and Jagravi Shah of Dhruva Advisors explain.
While the world is currently grappling with a growth slowdown, India is in a bright spot with its growth trajectory looking strong. Against this backdrop, the Finance Minister of India recently tabled the Union Budget for the fiscal year (FY) 2023-24 (Budget 2023) with the aim of steering the Indian economy on a path of growth, all this while setting forth the architecture for Amrit Kaal, a term that Prime Minister Narendra Modi uses for the 25-year road map for India.
This happens to be the current government’s last full Budget before the national elections take place in 2024. This has been yet another year in which the government’s focus was on providing significant impetus to infrastructure spend, digitisation and financial inclusion, amongst other areas. The budget is in line with the vision of the Prime Minister to make India ‘Atmanirbhar’, i.e. self-reliant. The significant increase in capital investment outlay for the third year in a row is aimed to serve as a driver of economic growth and job creation, and as a cushion against global headwinds.
While there is a drive towards self-reliance backed by several efforts in that direction, the government continues to roll out the red carpet for foreign investment in India. Non-residents form a major part of the investment ecosystem in India. Driven by the India growth story, FY 2022 saw a record foreign direct investment (FDI) inflow into India to the tune of approximately $84.8 billion. Even with a slight drop in FDI inflows in FY 2023, India continues to be an attractive destination for foreign investments.
As such, this article captures certain key amendments in direct tax laws, especially amendments impacting non-residents.
Angel tax extended to investments from non-residents
This is one of the most significant and most discussed amendments whereby the applicability of an ‘angel tax’ is extended to non-resident investors. Ever since its introduction in 2012, this provision has been at the centre of many controversies and concerns. In India, tax is typically levied on gains from sales of investments and on dividends earned thereon, i.e., on income and not on the capital receipt at the time of issuance of shares. However, in 2012, a deeming fiction was introduced as an anti-abuse measure to prevent circulation and generation of unaccounted money in the form of share premium. Any consideration received by unlisted companies at the time of issue of shares, which is more than the fair market value (FMV) of such shares was made taxable for the company raising the capital. This provision largely impacted startups raising monies from investors, thus earning the ‘angel tax’ moniker.
Previously, this provision was restricted to consideration received by an unlisted company from Indian resident investors. However, in one of the most impactful changes in the tax laws affecting foreign investments, it is now extended to non-resident investors as well, in an attempt to bring non-resident investors to parity with resident investors. Consequently, consideration received by an unlisted company from non-resident investors above FMV would now be taxable in the hands of the company raising such funds.
There are concerns around valuations. When it comes to raising monies from outside India, the company needs to comply with the Indian exchange control regulations to determine the FMV at which shares can be issued. These regulations prescribe a pricing floor, i.e. a minimum valuation above which a company can raise capital from outside India. This is determined by any internationally accepted pricing methodology.
Ironically, by way of levying the angel tax, the domestic tax laws of India prescribe a pricing cap beyond which any receipts shall be taxed. This is determined by either the net asset value method or the discounted cash flow (DCF) method. In case of start-ups, considering that the valuation is typically a function of investor expectations of how the company shall perform in the future, the DCF method is usually adopted. An interplay of the two laws leaves companies in a conundrum: where the valuations as per the foreign exchange regulations exceed the valuations as per the domestic tax laws, satisfying the requirements of both the laws (without having to pay taxes on such a difference) is an improbability.
While this deeming provision is well-intentioned and attempts to target and tax the tax avoiders, it may come at the cost of bona-fide investments and law-abiding companies. It gives rise to the classic debate of whether such anti-abuse provisions are warranted – whether to catch a few, you must put all under the microscope. Unintended consequences of such amendments may see start-ups opting to externalise their structures, which may allow for more flexibility. Further, while the provisions exempt entities falling under the definition of ‘start-up’ as per Indian laws, the definition is water-tight with many conditions to be fulfilled to be eligible. Therefore, not many entities actually qualify, thus rendering the exemption somewhat ineffective.
Given such difficulties, the industry made representations to the government, and the Ministry of Finance recently announced that it will release modified valuation rules which will allow for five additional methods of valuation in the case of non-residents. Further proposed changes include a safe harbour for 10% variation in value and exemption of certain non-resident investors from the fray. These rules are currently in the drafting stage and are likely to be finalised after considering comments from the public. It will be interesting to see how the government proposes to tackle these issues. Relaxations in the norms will go a long way towards increasing tax certainty and the ease of doing business in India.
Capital gains on transfer of ‘market linked debentures’ and ‘specified mutual funds’
Further, the Budget 2023 has inserted new provisions for taxing market linked debentures (MLD) and specified mutual funds (SMF). MLDs are defined very widely to cover all debt securities with market-linked returns. SMFs are defined to cover mutual funds where less than or equal to 35% of the proceeds are invested in Indian equities.
Previously, gains on transfer of these instruments, if qualifying as long-term capital assets, were taxed at a lower rate. However, now the gains on redemption and transfer of MLDs and SMFs shall be taxed as short-term capital gains taxable at applicable tax rates. Henceforth, regardless of the period of holding, the gains on redemption and transfer of MLDs and SMFs would be taxed as short-term capital gains. Thereby the concessional rate of 10% in respect of long-term capital gains will no longer be available. Further, while the SMFs acquired before April 1 2023 stand grandfathered, in the case of MLDs, the amendment will become applicable even in respect of MLDs purchased prior to April 1 2023.
This amendment was brought in to bring MLDs and debt mutual funds into parity with fixed income instruments. As a result of this amendment, investors will enjoy lower post-tax returns on investments in MLDs and SMFs going forward. This will take away the attractiveness of such instruments and is likely to have a significant impact not only on the investor community but also on the issuer companies.
Further, the term ‘specified mutual fund’ is not clearly defined. Interesting questions may arise on what could be categorised as an SMF – whether foreign funds investing in foreign equities or fund of funds also stand covered. Some clarity in this regard may be useful to investors.
Investments in REIT and InvIT
The next set of amendments pertain to real estate investment trusts (REITs) and infrastructure investment trusts (InvITs) (collectively referred to as ‘business trusts’ or ‘BTs’). These are investment vehicles which have been introduced in India for increasing investment in the real estate and infrastructure sectors.
These business trusts raise money from unit holders and in turn invest money in special purpose vehicles (SPVs) through equity or debt instruments. The SPVs utilise the funds for conducting their real estate/infrastructure business. Out of the cashflows generated by the SPVs via their business, the SPVs gradually repay the loan to the BTs, including interest thereon. The BTs distribute this cash to their unit holders. Thus, repayment of debt is nothing but a return of principal advanced by the BT to the SPVs. As regards the BTs and its unit holders, this payment represents a partial return of the capital invested by the unit holders, which the BTs had, in turn, invested by way of loans into the SPVs. This payment was therefore neither taxable as income for the unit holders nor for the BTs.
By way of Budget 2023, this ‘repayment of debt’ shall now be taxed as income in the hands of unit holders. Thus, the unit holders will need to include distribution in the nature of repayment of debt as income in their return of income and pay tax as per applicable rates. However, only the ‘specified sum’ received by the unit holder shall be taxed; a formula has been laid down for computing the specified sum. In essence, only such sum that is received in excess of the issue price shall be taxed under this provision.
Further, non-resident investors would also have to analyse the implications under the applicable tax treaty. Most treaties either provide for taxing any other item of income as per the domestic tax laws or in the state in which the income arises.
Changes in personal taxation
A plethora of changes have also been introduced as regards personal taxation. Currently, there are two different tax regimes (the old tax regime and the new tax regime) for taxing the income of individuals in India. Individuals have been given the option to choose between these two tax regimes. The income slabs and the corresponding tax rates vary based on whether the taxpayer has chosen the old or the new tax regime to compute their tax liability.
The new tax regime has lower tax rates compared to the old tax regime. However, individuals opting for the new tax regime are not allowed certain exemptions and deductions that are available in the old regime. To encourage and incentivise taxpayers to gravitate towards the more simplified new regime, Budget 2023 revised the slab rates and enhanced the rebate whereby no tax is payable on income up to 0.7 million Indian Rupees (INR) per annum. It is proposed to make the new tax regime the default regime (with an option to avail the benefit of the old tax regime).
In addition, the standard deduction for the salaried class and pensioners is proposed to be extended to the new tax regime. In a welcome and much awaited move, it is proposed to reduce the highest surcharge rate from 37% to 25% for a taxpayer opting for the new tax regime, thereby bringing down the maximum tax rate from 42.74% to 39%.
Further, as per current tax laws, the income from long-term capital gains on sale of residential property or other capital assets is exempt from tax, in the hands of an individual provided the taxpayer reinvests the gains in purchasing or constructing a residential house within a specified time limit. Earlier, there was no cap on the exemption that could be availed for capital gains arising from the sale of house property or other assets. However, Budget 2023 has capped the exemption, whereby the cost of the new residential property for the purpose of the exemption is capped at INR 100 million with effect from FY 2023-24. Accordingly, the amount exceeding INR 100 million shall not be considered.
To illustrate, if the capital gain arising from the sale of a residential house is INR 120 million, and this capital gain is reinvested in another residential house worth INR 120 million, then the cost of the new house for the purpose of claiming the exemption will be restricted to INR 100 million. Thus, the taxpayer will have to pay tax on the balance gain of INR 20 million (INR 120 million minus INR 100 million). For capital gains arising from the sale of other capital assets, there is a concept of proportionate deduction. Thus, where the cost of the new residential house, while exceeding INR 100 million, is less than the net consideration of the original asset, the exemption on capital gains shall work out to be even less than INR 100 million.
Changes in tax on royalty and fees for technical services
The tax rate applicable on income by way of royalty and fees for technical services earned by non-residents or foreign companies is increased from 10% to 20% with effect from April 1 2023. Corresponding withholding tax rates also stand adjusted to reflect this change in the tax rate. Because of this amendment, given the higher withholding under the domestic tax laws, payers may prefer to avail benefits under the tax treaties that provide for a lower tax rate. In such cases, treaty provisions will have to be complied with. Further, in cases where the tax treaties do not provide for a lower rate benefit, this amendment will push up the cost of doing business. Payments to non-residents are often grossed up for withholding tax, hence, there will be an impact on the resident payer whose costs will go up because of the incremental tax outflow.
Impact on foreign outward remittances
The Reserve Bank of India introduced the Liberalised Remittance Scheme (LRS) to permit Indian residents to freely remit a certain amount of money to another country for expenditure (such as for relatives, medical treatment, education, gifts, and so on) and investments. To deepen the tax net and keep a check on the LRS transactions, the finance minister introduced provisions for collecting tax at source (TCS) at the time of remitting money under LRS in 2020. Now, it has been proposed to increase the rate of TCS on remittances under LRS (other than for education and medical treatment) from 5% to 20% without any threshold limit with effect from July 1 2023. Overseas use of international credit cards is also included in the overall limit under LRS now. However, the government has issued a clarification that payments on international cards up to INR 0.7 million per annum will be excluded from the LRS limits and will not attract any TCS.
Like the withholding tax provisions, the taxpayer is eligible to receive credit of TCS against their tax liability while filing their income tax return. Thus, there is no overall increase in tax cost due to TCS. However, there would be a temporary cash flow mismatch until the taxpayer receives a refund on account of the TCS. This may in turn impact the remittances done by residents outside India under LRS, thus, though this amendment does not directly impact taxability of non-residents, it does impact their transactions with residents.
Miscellaneous amendments impacting non-residents in general
Previously, gifts made by residents to non-residents were kept outside the tax net. In 2019, non-residents receiving monetary gifts exceeding INR 0.05 million from non-relatives were made taxable in India. However, gifts made to a resident but not ordinarily resident (RNOR, as defined ) were not included in its ambit.
A person is considered as resident in India for a financial year if he or she satisfies one of the following two conditions:
He or she stays in India for 182 days or more during the financial year; or
ii. He or she stays in India for at least 365 days during the four years preceding that year AND at least 60 days in that year.
However, if he or she leaves India as a crew member of an Indian ship or for the purpose of employment outside India during the year, 60 days in the above condition will be substituted with 182 days.
Further, in cases where he or she is a citizen of India or a person of Indian origin, being outside India, and he or she visits India, 60 days in the above condition is substituted with 182 days. In such a case, if his or her total income other than foreign income is more than INR 0.15 million during the year, 60 days is substituted with 120 days.
He or she will be considered as RNOR for the year if he or she satisfies one of the two conditions for a resident, and also:
If he or she has been a non-resident in nine out of ten financial years preceding the year;
If he or she has been in India for a period of 729 days or less during the past seven financial years; or
If he or she is a citizen of India or a person of Indian origin, being outside India, and he or she visits India, and his or her total income other than foreign income is more than INR 0.15 million during the year, and he or she stays in India for at least 365 days during the four years preceding the year and for at least 120 days but less than 182 days in the financial year.
Further, a citizen of India who is not a resident by way of any other criteria, if his or her total income other than foreign income is more than INR 0.15 million, and if he or she is not liable to tax in any other country, shall be deemed to be RNOR.
Plugging the gap
Now, Budget 2023 has plugged this gap and, accordingly, monetary gifts received by an RNOR from Indian non-relative residents over INR 0.05 million shall be taxable in India.
Further, previously non-residents were subjected to withholding taxes of 20% plus applicable surcharge and education cess at the time of distribution of income from mutual funds, without any provision to claim treaty benefits. Now, in a welcome Budget 2023 change, a non-resident can furnish the Tax Residency Certificate and benefit from favourable treaty rates at the time of tax deduction. Further, the benefit of lower deduction/nil deduction certificates is proposed to be extended to withholding tax on dividends, interest and rental income payable by a business trust to non-resident unit holders.
In addition, there are changes brought about to further increase the attractiveness of the International Finance Services Centre (IFSC), an initiative aimed at encouraging foreign capital to participate in India’s growth story. These amendments include a reduction in the tax rate of dividends received by a non-resident from an IFSC unit from 20% to 10%, and a withholding tax of 9% on interest income payable by an Indian company/business trust to non-residents on long-term/rupee denominated bonds issued on or after July 1 2023 and listed only on IFSC stock exchange.
Overall, the government seems to have performed a fine balancing act. While the tax landscape has not changed much, there have been a few unanticipated changes which are likely to have long-bearing implications. Meanwhile, there have been a few changes which will have the impact of rationalising the provisions and easing the norms. To summarise, Budget 2023 did not see many major changes but mostly minor tweaks. In the long run, especially when it comes to non-residents, tax certainty is imperative and not too much change is a good form of reform. Regulatory stability is perennially of paramount importance when it comes to investing and staying invested in a foreign jurisdiction, and would go a long way towards ensuring that the red carpet laid down by India for foreign investors stays in place.