They say when it rains, it pours. No, I’m not talking about the deluge which takes down Mumbai every other day during the monsoons. I’m talking about the series of challenges that have hit India’s capital market in the last few months.
An economic slowdown, a frail fiscal profile, corporate bankruptcies, credit defaults, a visibly stressed NBFC sector – it’s a long list. And just when the market was hoping for a lifeline from the government in the form of an economic stimulus, it got the exact opposite. A tax jolt. A surcharge hit that has super-charged the bears on Dalal Street. So what exactly is this FPI tax tangle that is causing angst among asset managers from Mumbai to New York?
Higher Surcharge = Higher Capital Gains Tax
The budget proposal of a hike in surcharge rates has had a spillover effect on two classes of investors – Foreign Portfolio Investors (FPIs) and Category 3 AIFs or Alternative Investment Funds. This is because the government took a view that surcharge will be applicable not just on individuals but to all trusts which are incorporated & structured as an AOP or Association of Persons. This effectively means that the capital gains paid by an FPI will now have to include the higher rate of surcharge. Thus Long Term Capital Gains Tax for FPIs now stands at 14.2 percent vs 11.9 percent earlier and short term capital gains tax goes up to 21.4 percent from 17.9 percent. Asset managers who run these funds are obviously not amused.
“This is a back-handed way of increasing the Capital Gains tax on foreign investors,” argues Nandita Parker, representative of the FPI industry body AMRI. “This will impact 50 percent of the FPIs investing in India and will surely sour sentiment,” she added.
Now let’s look at the other class of investors who have been hit – Category III AIFs.
Higher Surcharge: AIFs Take A Hit
Category III AIFs include hedge funds, which undertake sophisticated trades using a combination of long-short strategies across cash stocks & derivatives. Since trading is a daily activity, these funds pay tax at the fund level on the business income which the fund generates. Till now that rate was approximately at the peak corporate tax rate of close to 35 percent. Now with the surcharge going up to 37 percent from 15 percent for those earning above Rs 5 crore, Category III funds will have to pay tax at the maximum marginal rate of 42.7 percent on the trading gains they make. This is making many of them question the AIF model and its business viability itself.
“Both mutual funds and Category 3 funds like us deal with the same underlying equity securities. Then why should MFs pay 10 percent tax when we are being charged a near 43 percent tax rate? The tax policy has become highly discriminatory,” says Vaibhav Sanghvi, Co-CEO, Avendus Alternate Strategies.
The ‘Trust’ Factor
At the core of the debate is the government’s sudden decision to crack down on trusts – a vehicle long favoured by foreign investors to pool assets and invest in markets around the world. It’s very clear from the post-budget North Block conversations, that the higher tax liability on FPIs & AIFs is not a drafting ‘error’ or ‘omission’. It is certainly not an unintentional fallout of the move to hike income tax surcharge. The tax increase seems to be something that the government has thought through.
In an interview to CNBC-TV18, Akhilesh Ranjan, member of the Central Board of Direct Taxes, said, “We are wanting to find out as why is it and what makes FPIs to come in through this (trust) route. Trusts are normally associated with a degree of opacity in the functioning and I am sure the FPIs are not doing that. So we are trying to see why exactly and what is exactly is the problem.”
So the question then arises – were FPIs using trusts to reduce their tax liability? Are trusts being misused? There are no clear answers. But there surely is hectic debate around this question.
Can ‘Trusts’ Be Trusted?
According to Sudhir Kapadia, head of tax at EY, trusts have been the preferred route for a lot of foreign investors as they are operationally efficient vehicles. “Many FPIs form trusts as global parent investor firms have a preference for these structures. Movement of capital from the trust to its beneficiaries is quite smooth and seamless. The burden of disclosure and compliance is not too onerous," adds Kapadia.
Karma Capital’s Nandita Parker, who represents the FPI association, raises a tough question, “Why attack the trust structure when the NIIF itself is set up as a trust?”
An important factor that determines a trust’s tax liability is whether that trust is determinate (beneficiaries have a fixed holding or stake in the trust) or indeterminate (the beneficiaries ownership or holding is not fixed). “If a trust is determinate in its form, then tax is paid by the beneficiaries and these vehicles won’t be impacted by the higher tax hit. However indeterminate trusts, where ownership is not defined, will now have to pay tax at the maximum marginal rate of 42.7 percent and it’s these type of funds that will be hit the most,” explains Girish Vanvari, Founder of Transaction Square.
While industry members don’t see trusts as a tax evasion or tax abuse vehicle, the government has decided to question the route. One can argue that the timing perhaps is not the best given the fragile state of the capital market.The jury is out on whether trusts really lead to a tax arbitrage or tax leakage, and whether they need to be streamlined from a regulatory perspective. The answer to this very important question will perhaps determine the shape of tax policy, and even FPI flows in the capital market in the days to come.