Since early days of economic liberalisation, foreign institutional investors (FIIs) have always been an important class of investors in the Indian capital markets. Over the years, India has seen heightened investment activity, which has contributed to the growth and vibrancy of capital markets. Given its importance, among other things, India has a specific concessional tax regime for FIIs (which has been in place since 1993). Under the regime, the income earned by FIIs from transactions in Indian securities is classified as capital gains and subjected to lower tax rates. Capital gains earned by FIIs are not subject to withholding taxes in India. Interest income earned by FIIs from government securities or specified corporate debt securities is taxed at rates that are currently as low as five percent.
However, there are grey areas in the tax laws that have emerged in the recent past and hence the need to provide FIIs with tax certainty. Two specific areas on which FIIs need tax certainty are (i) the tax status of entities constituted as foreign business trusts (BTs) in their home country, and (ii) taxability of offshore reorganisations involving BTs (that are implemented in the home country for non-tax reasons).
Tax certainty is a significant concern for FIIs, especially in the case of mutual fund FIIs that have a wide investor-base and which keeps changing on a daily basis - the entry and exit prices being determined on the basis of a daily net asset value (NAV) of the units of the fund. Taxation of such FIIs in their home country usually takes place at an investor level, so called transparent entities. Hence, it becomes imperative for such FIIs to have certainty in the countries in which they implement investments. A lack of it unfairly shifts the tax burden to a new class of investors, and negatively impacts the NAV of the fund.
The first issue
Typically, US mutual fund FIIs maybe organised as either corporations or business trusts [for example, Massachusetts Business Trusts (MBTs) or Delaware Statutory Trusts (DSTs)]. Under US tax laws, MBTs and DSTs, though not constituted as 'corporations', elect to be taxed (in the US) as 'corporations'. The questions that then arise are (i) whether such MBTs and DSTs should be complying with filing requirements in India and reporting their Indian sourced income as ‘trusts’ (ie based on their legal form) or as 'corporations' (ie based on how they elect to be taxed in the US)?, and (ii) whether such MBTs and DSTs should pay taxes (in India) at the tax rates that are applicable to ‘trusts’ or '’corporations’?
Indian tax law requires a tax payer to comply with filing requirements based on its legal form. India does not generally allow a tax payer that is constituted in one legal form (say a partnership) to file its return based on some other legal form (say a company). Even so, the Indian government should consider allowing such MBTs and DSTs to be treated as ‘corporations’ for Indian tax purposes, so as to ensure that they are adopting consistent tax positions in India vis-à-vis the tax position that they adopt in their home country.
The second issue
FIIs often need to reorganise themselves in their home jurisdiction to address regulatory issues, such as migrating a fund from one US state to another for better governance purposes such as converting an MBT to a DST, or converting an MBT / DST into a corporate structure. Such internal fund reorganisations do not result in a change in the assets, investors, directors / trustees, or fund manager of the predecessor fund and the successor fund, and are treated as ‘tax neutral’ in the home country.
India treats all such types of (offshore) reorganisations that involve transfer of Indian assets, as being taxable. India exempts certain types of overseas reorganisations (especially involving a merger between two foreign companies), subject to satisfaction of certain conditions.
However, aside from this, other types of overseas reorganisations do not qualify for exemptions. This results in capital gains tax leakage for the predecessor fund.
Further, Indian securities held by the predecessor fund for over a year lose their status as long-term capital assets in the hands of the successor fund; any accumulated capital losses that lie with the predecessor fund are not available to the successor fund upon such reorganisation. There are compliance issues relating to filing the tax returns for the predecessor fund and representation issues before the Indian Revenue after the predecessor fund ceases to exist.
To deal with the aforesaid problems, the Indian government should consider granting ‘tax neutral’ status to all types of overseas reorganisations involving non-corporate entities and suitably amend the Indian tax law to (i) allow continuity of the period of holding, original cost of acquisition and carry-forward of losses to the successor fund, and (ii) allow for filing of the Indian tax return and representation by the successor fund.
The Indian government has implemented tangible steps over the last few years to address key pain points faced by FIIs. The most recent example is the minimum alternate tax (MAT) controversy that has resulted in an amendment to the Indian tax law to clarify that the MAT provisions were never intended to apply to foreign companies (including FIIs), especially if they do not have a PE in India. Another example is the fund manager guidelines to encourage offshore funds to station fund managers in India with tax neutral status, subject to conditions. Timely addressing such tax issues will go a long way in increasing investor confidence and building the government’s investor-friendly reputation, thereby encouraging more FIIs to invest in India.