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Extent of tax sops on overseas investment
July, 17th 2007
Almost six months after finance minister P Chidambaram announced in his 07-08 Budget that the government would converge different regulations to allow Indian individuals to invest in overseas securities through local mutual funds, policymakers are now chipping away at norms for launching products.

The financial sector regulators RBI and SEBI are expected to work out a framework for this overseas investment option for local investors but it is clear that certain issues which seem to have escaped the attention of policymakers may need to be addressed. Officials in North Block say that the central bank has flagged off its concerns relating to taxation of investors who buy into stocks of overseas companies.

The issue, it seems, centres around the taxation norms adopted for an individual who invests in stocks of foreign firms and for an individual who also takes an exposure to stocks in the international markets but through the vehicle of mutual funds. Indian tax laws provide for a long-term capital gains tax of 20% to be imposed on an individual if he or she were to invest directly in shares listed abroad. But an individual who invests in an equity-oriented mutual fund scheme does not have to pay long-term capital gains (LTCG) tax if he offloads the units after one year of purchase.

To qualify as an equity oriented fund, the asset management firm has to invest a minimum 65% of the total proceeds in shares of domestic companies. The balance 35% can be invested in other instruments, including shares listed overseas.

What this means is that if UTI MF were to launch an equity-oriented scheme which invests 35% of the proceeds in shares listed overseas, an investor will be spared of paying LTCG. However, if the fund launches a scheme that invests the entire proceeds in shares listed overseas, then the investor will have to pay 10% LTCG, still lower than normal 20% tax paid on long-term capital gains from sale of other assets such as immovable property. So individuals investing through mutual funds enjoy a concessional long-term capital gains tax treatment.

In other words, an investor gets the maximum benefit only if he invests in an equity-oriented mutual fund. Given this scenario, it is therefore not surprising to see UTI or Franklin Templeton launch schemes which aim to invest a good part of the money raised (65 %) in local equities so as not to lose out on the tax advantage.

The issue now being raised is whether a concessional tax treatment ought to be provided to local investors for investing in the stocks of firms located outside the country. Diversification of investment is fine as a choice for investors, but there is no logic in granting concessional tax treatment for investing outside India when the country needs more local investments, says an official.

According to officials, when the tax benefit was given to mutual funds two years ago, the government did not envisage a policy change where it would allow mutual funds to invest in shares listed overseas. The tax policy then was driven by the governments move to encourage more investment in local mutual funds which, it was felt, could in the long run act as a counter balance to foreign portfolio investors. The move has paid off with the assets under management of Indian mutual funds having swelled up in the last couple of years to well over Rs.4,10,000 crore.

A government official said, If the banking regulator feels the concessional capital gains tax treatment for investments made through mutual funds is discriminatory, the government will have to take a policy decision on whether or not to continue the existing tax treatment. Any change can be done only through an amendment in the income-tax law. The government also has the option of taking a re-look at the tax treatment for investors investing through mutual funds while re-writing the IT Act.
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