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India: Analysing foreign portfolio investor taxation in India

Foreign institutional investors (FII) have enjoyed a beneficial tax regime in India since the introduction of section 115AD of the Income-tax Act 1961 (Act), via the Finance Act 1993.

Foreign institutional investors (FII) have enjoyed a beneficial tax regime in India since the introduction of section 115AD of the Income-tax Act 1961 (Act), via the Finance Act 1993. The beneficial regime was introduced following a policy decision that was taken by the government with a view to attracting foreign investment to India. Foreign portfolio investors (FPIs), who replaced FIIs from 2014, have also enjoyed the aforesaid beneficial tax regime since their introduction. The concessional regime has been expanded over the years, and it now covers income from the transfer of shares and other securities, dividends (other than certain specified dividends), and interest. The regime did not include business income, which resulted in litigation as to whether the investment activities of FPIs/FIIs should be considered investment activities (which are eligible for beneficial tax rates) or as business income. With the need to attract foreign investment remaining omnipresent, the government ended this uncertainty in 2014, by amending the Act to provide that any securities that are held by FIIs that have been invested in such securities in accordance with the regulations as stipulated under the Securities and Exchange Board of India Act 1992, would be treated as capital assets.

Long-term capital gains arising from certain listed securities have been exempt from taxation since 2004 when, with a view to simplifying the tax regime on such securities, the securities transaction tax (STT) regime was introduced. The Finance Act 2018 withdrew the exemption. However, any gains that had been accrued up to January 31 2018 were grandfathered, subject to the fulfillment of certain conditions. From April 1 2018, long-term capital gains on listed securities have been subject to tax at the rate of 10%, exclusive of applicable surcharge and cess. However, the negative impacts (if any) of the reintroduction of tax on listed securities after a 14-year period were addressed by providing grandfathering relief to the gains that were accrued up to January 31 2018.

The Finance (No. 2) Act 2019 increased the surcharge for certain categories of taxpayers, including trusts, association of persons (AOPs), body of individuals (BOIs), and artificial juridical persons (AJP) as shown in Table 1.

Table 1
Total incomeSurcharge before 2019Surcharge before 2019Effective tax rate
INR 20 million to INR 50 million 15%15%39%
Above INR 50 million 15%15%42.74%

Accordingly, all FPIs that are structured as AOPs, trusts, and BOIs came under the purview of the aforesaid enhanced surcharge regime. The increased surcharge affected FPIs dealing in both the cash and derivatives markets. The increased surcharge rates were not applicable to all categories, and FPIs structured as companies or limited liability partnerships were not affected.

The increase in tax had a negative effect on the Indian stock markets, as FPIs started selling and withdrawing from the market. Alternatives such as converting to a corporate or LLP structure in order to avoid the enhanced surcharge, were impractical for a variety of reasons. Accordingly, representations were made before the government in order to address the adverse effects of such surcharge on FPIs (structured as AOPs, trusts, and BOIs) that was leading to the exit of foreign investments being made by such entities.

Considering the economic scenario and the various representations, the government announced by way of a press release, the withdrawal of enhanced surcharge on long-term/short-term capital gains arising from transfer of equity shares in a company, units of an equity-oriented fund, or units of a business trust. The press release also mentioned that derivatives were to be treated as capital assets for FPIs, and that gains arising from the transfer of the same were to be treated as capital gains and subjected to a special rate of tax under the Act. Accordingly, any gains for FPIs arising from the transfer of such derivatives (futures and options) shall also be exempted from the levy of enhanced surcharge. However, the press release only covered listed securities that have suffered STT and it does not cover any other securities. The above were subsequently enacted through introduction of Taxation Laws (Amendment) Ordinance, 2019.

India has always made conscious efforts to promote foreign investment in the country. The levy of enhanced surcharge was considered a roadblock by FPIs, and the government has appropriately addressed the issue by announcing the withdrawal of such surcharge.

Dhruva Advisors
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E: mehul.bheda@dhruvaadvisors.com
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