The Modi-led Government has taken policy measures in 2015 budget, that are bold, decisive and pragmatic- clearly, a major step in the right direction for achieving a projected 8.5% growth rate in 2015-16 and leaping towards the hallowed two digit growth rate in the near future.
A slew of regulatory and fiscal measures proposed in the Budget seek to improve India’s investment and business environment. Major reliefs include phased reduction in corporate tax rates, deferral of General Anti Avoidance Rules (GAAR) and grandfathering of existing structures, pass-through status for alternate investment funds, extension of lower withholding tax rate for interest on non-convertible debentures (NCDs), and relief against minimum alternative tax (MAT) for foreign portfolio investors (FPIs) and more clarity on taxation of overseas indirect transfers. The proposal to mitigate permanent establishment (PE) risk for offshore funds (primarily hedge funds) is laudable, though the fine print leaves ambiguity on whether such relief can be claimed in reality by private equity funds, including those sponsored by India based fund managers. The Government has laid the groundwork for implementation of a pan India goods and services tax (GST) by 2016, which will truly be a game changer and will reduce the overall burden of consumption taxes including excise, service tax and value added tax.
India’s corporate tax rate of 30% (excluding surcharge and education cess) is one of the highest in the Asia-Pacific region. The Finance Minister has proposed to reduce the tax rate to 25% from 2016 over a period of four years in a move to enhance competitiveness and encourage global investors to ‘Make in India’. This has been coupled with the move to reduce the rates of withholding taxes for royalties and fees technical services provided by non-residents to 10% which would incentivize foreign companies to set up manufacturing bases in India.
A major change has been proposed to the definition of corporate residency for tax purposes. Today, a company incorporated in India or a foreign company which is ‘wholly’ controlled and managed from India is considered a resident and taxed on global income. The Budget proposes to change the definition of resident of India to cover any company if it has its place of effective management in India. Thus, the definition moves away from an objective test to a subjective test. This is likely to result in an enormous amount of litigation, especially in cases where Indian companies have subsidiaries abroad or are globalizing their businesses, as also in cases of private client and carry structures of fund managers structured through offshore companies.
The GAAR provisions which were set to trigger next month will now be deferred to April 1, 2017. Further, all investments prior to April 1, 2017 would be grandfathered, thereby providing significant relief to private equity and strategic investors using popular investment structures including Mauritius and Singapore based structures. The ambiguities replete in the GAAR provisions have always stuck out as a sore thumb and it is expected that additional clarity will be provided before GAAR is finally implemented.
The retroactive tax on overseas M&A with underlying Indian assets introduced back in 2012 adversely impacted many cross border deals. This tax has been severely criticised by the global investor community because of the uncertainty in its application. The Budget proposes to rationalise the provisions by limiting the tax incidence to transactions where the underlying assets in India constitute at least 50% of the global enterprise value. Further, sellers that do not control the overseas target and hold less than 5% in the company will not be subject to this tax. Of course, it would have been more prudent to have removed these provisions in entirety considering that it goes against global tax practices, which the Finance Minister assured, will be followed in India as a policy measure.
A long-standing demand of the fund industry has been addressed with the Budget proposing pass-through status for Category I and Category II alternative investment funds which inter alia include onshore venture capital, infrastructure, private equity and debt funds. Investment income earned by the fund would be taxable at level of the investor or unit holder instead of the fund while business income will be taxed at the maximum marginal rate at the fund level. With pass-through status, there is more flexibility in structuring the fund – for instance as a company. However the imposition of withholding tax of 10% in respect of distributions of non-business income by the fund to its investors will act as a dampener since they apply even to exempt income such as dividends / capital gains on listed shares. Overseas investors may also mitigate tax incidence by taking advantage of tax treaty relief as in the case of investments from Mauritius, Singapore and Netherlands.
The presence of fund managers or investment advisors in India may, in certain scenarios, be viewed as a Permanent Establishment (PE) of the offshore fund, thereby exposing the fund to additional tax liability. The Budget proposes to mitigate this risk by clarifying that an India based fund manager or investment advisor shall not be treated as a PE as long as the offshore fund is broad-based with over 95% investors being non resident, each investor?s holding in the fund is capped at 10%, specific limits on the quantum of investment in any entity and other criteria is satisfied. While this proposal can definitely boost India’s fund management industry, it appears that the relief can effectively only be availed by FPIs or hedge funds and may end up excluding private equity or venture capital funds. It is important to extend this relief to private equity funds as well considering the investment of around USD 100 billion made by private equity funds into India over the last decade. Another criterion for the relief is that the fund manager cannot be employed by an entity connected with the fund, which is not optimal since funds sponsored by India based fund managers may not be protected against PE risks.
The Budget offers limited relief to FPIs by proposing that MAT should not apply in relation to capital gains from securities transactions. In light of various judicial decisions, it would be helpful if the MAT exemption is widened to cover all overseas investors including private equity investors claiming capital gains tax exemption under a treaty (e.g.: those based in Mauritius or Singapore) as long as there is no PE in India. Further, the specific provision of a MAT exemption to just FPIs would, as a reverse corollary, open the doors for the tax department to impose MAT on other foreign entities earning exempt income (either under domestic law or due to treaty benefits).
In a significant boost to debt markets, the lower 5% withholding tax rate (reduced from 20%) on interest coupon on NCDs issued to FPIs will extend till June 2017. This will facilitate substantial debt investment into the country.
The framework for Real Estate Investment Trusts and Infrastructure Investment Trusts has been an area which has seen significant changes. Since their introduction, there has been a lack of interest due to absence of clarity around the tax incidence on setting up of such vehicles. While pass through status to REIT investors in relation to interest income earned by the REIT from the SPV was earlier provided, it is now proposed to be extended to rental income earned in respect of property directly held by the REIT. Sponsors of REITs who acquired units through swap of SPV shares can now benefit from capital gains tax relief applicable upon sale of listed units on the stock exchange, though no MAT relief has been provided.
A number of measures have been introduced to counter tax evasion and black money including stringent reporting of offshore assets and prosecution for failure to comply. Taking a cue from countries like Singapore, the Government proposes to make tax evasion a predicate offence for money laundering which will give more teeth to regulatory authorities.
Regulatory changes introduced by the Budget, including shifting of power to regulate most capital account transactions to the Central Government clearly show the Government?s intention to simplify cross-border transactions. Also, bold initiatives have been introduced to bolster the BFSI sector. Extending the much needed SARFAESI benefits to large NBFCs and introduction of a comprehensive bankruptcy code are measures that will have a significant impact. The Government has also announced various initiatives to facilitate simpler regulatory approval processes.
While proposing sweeping reforms in the 2015 Budget, the Modi-led Government seems to be committed towards reducing overall tax compliance costs, removing uncertainty, ensuring a stable and non-adversarial environment, boosting investor confidence and fostering a favourable business and investment regime. While it is a great way to bring India back on the global investment radar, some of the fine print in the Budget may act as an irritant. There have of course been missed opportunities such as bringing clarity on tax treaty entitlement, exemption from MAT to SEZ units and on deductions for CSR spends, which, it is hoped, will be addressed in the future.
About the author
This article is written by Nishith M. Desai