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Tax implication may discourage foreign banks

Tax implication may discourage foreign banks
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First Published: Sun, Jan 23 2011. 07 30 PM IST
Updated: Sun, Jan 23 2011. 07 30 PM IST
Mumbai: There may not be too many takers among foreign banks that have a presence in the country for the Reserve Bank of India (RBI) proposal to convert their branches into wholly owned subsidiaries due to tax implications they may face in the event of any stake dilution by the parent in the next eight years.
According to tax experts, though foreign banks setting up a wholly owned subsidiary in India can avail of a one-time exemption from paying capital gains tax under the current tax laws, it locks the parent for a period of eight years from diluting the stake in the subsidiary. Doing so would trigger a liability in the form of capital gains tax.
This would mean that the parent bank can neither dilute its holding in the local subsidiary for eight years nor tap the Indian capital markets to mobilize funds during the lock-in period.
“The transfer has to take place at a fair market value. Consequentially, there will be a tax liability of around 21% to the parent, assuming that the business is more than three years old (in India), while there will be no income generated from the transfer,” said Sudhir Kapadia, tax market leader, Ernst and Young India Pvt. Ltd.
“Although there is a one-time exemption for such a transfer under Section 47 (iv) of the income tax act, it prohibits the parent from stake dilution for eight years, failing which the tax liability will get triggered,” Kapadia said.
Under the current tax laws, the branch of a foreign bank in India is treated as a foreign company. If a foreign bank has to set up a wholly owned subsidiary (WoS) for local incorporation, it will have to acquire the business of the branches, requiring the parent pay capital gains tax for the transaction. Mint could not independently verify this tax provision.
“Even though the transfer of business is taking place within the group, under the existing tax laws, this will be treated as any other third-party transaction,” Kapadia said.
Referring to the tax implication, included in a discussion paper on further opening up India’s banking sector to foreign players released on Friday, the central bank had said that foreign banks may approach the appropriate authority for suitable clarifications on the matter. The discussion paper has sought comments till 7 March.
A senior official with one of the largest foreign banks in India said his bank will seek more clarity from the regulator and the Indian Banks’ Association grouping on these issues prior to finalizing the subsidiary plan.
“The tax implications arising from the conversion of a branch into a WoS, has not been addressed in this paper. This may be a cause for some uncertainty in interpretation and needs to be resolved,” the official, who wished not to be named, told Mint.
Banks are also concerned about the lack of clarity on the fate of their existing non-banking finance company (NBFC) operations, as the regulator, in the discussion paper, also made it clear that it did not favour locally incorporated banks run NBFC operations. The RBI discussion paper stressed the need for both existing and new foreign banks to locally incorporate their operations instead of the branch model. This would mean that foreign banks will either have to eventually exit their NBFC business or seek special approval of the regulator to retain such business. Presently, many foreign banks such as Citibank have NBFCs in the country, which largely cater to business such as personal finance and brokerage services.
The RBI said it would “incentivize” such subsidiaries by a “less restrictive” branch expansion policy and permission to raise rupee resources in the form of non-equity capital but despite these perks, foreign lenders are still wary about the cost impact they may have to incur on converting branches into wholly owned subsidiaries.
Presently, there are 34 foreign banks in India and collectively they have at least 310 branches, which works out to be around 0.43% of the 71,998-strong branch network across the nation. As of 31 March, 2010, the share of foreign banks in the total assets of the banking system stood at 7.65%, according to RBI data.
Traditionally, foreign banks operating in India have focused on trade finance, wealth management, mergers and acquisition (M&A) advisory, besides funding to big companies, which do not require a large branch network. Except for a few lenders, participation in retail banking services has been limited.
Analysts said even though local incorporation will be a costly affair for foreign banks, those having long term plans could benefit from such a move.
“Overall, local incorporation will be a more expensive exercise but for foreign banks that have longer-term plans in India, it may become less of a factor,” said Aditi Thapliyal, analyst, banking and financial services, with UK-based investment bank, Execution Noble and Co Ltd.
“On the other hand, they will also have to fulfil an onerous 40% priority sector requirement, with one-fourth of this being lent to the agriculture sector over a five-year transition phase and also perhaps exit existing NBFC businesses,” Thapliyal said.
Sanjiv Bhasin, general manager and chief executive officer, DBS India, said: “Existing foreign banks will now have to go back to the drawing board. Though national benefits have not been given, the benefits on priority sector indicate that national benefits may come after the priority sector targets have been met.”
A Citibank official statement welcomed the discussion paper and said the bank will continue to work with RBI and the government as the guidelines get finalized.
In the discussion paper, RBI also said that though the central bank will be more liberal in its branch licensing policy, it is difficult to award “full national treatment” to foreign banks.
“Allowing full national treatment could lead to unintended consequences for the banking sector. However, they would be placed in a much better position than the foreign bank branches operating in India but less than that of domestic banks,” RBI said.
Under a 1997 World Trade Organization (WTO) agreement, RBI needs to give 12 new branch licences to foreign banks every year, including those given to new entrants and existing players, but the Indian regulator has all along been allowing foreign banks to open more branches, going beyond its commitment, but not as many as the foreign banks want.
RBI had laid out a road map in 2005 for foreign banks in India, encouraging them to set up local subsidiaries. None has so far approached the regulator to incorporate locally.
Standard Chartered started its Indian operations by opening its first branch in Kolkata in April 1858, a year after the first war of independence in which sepoys of the British East India Co.’s army rebelled against the colonial rulers. HSBC’s origins can be traced back to October 1853, when Mercantile Bank of India, London and China was founded in Mumbai. It was acquired by HSBC in 1959. Citibank is 108 years old IN INDIA?.
Among other foreign banks, Deutsche Bank AG, 30 years old in India, is present in 12 centres through 13 branches. Barclays Bank Plc, which launched its India operations in November 2006, has seven branches.
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First Published: Sun, Jan 23 2011. 07 30 PM IST