Foreign portfolio investors bear the brunt of taxation flip-flops

A senior official at the finance ministry remarked a day after the budget that the most complex part of the Finance Bill proposals are contained in Part I of the first Schedule. Hidden in that part was application of additional slabs of surcharge, subjecting foreign portfolio investors (FPIs ) structured as Association of Persons (AOP), besides individual taxpayers, to higher rate of effective tax.

Progressive taxation is often used mitigate societal ills associated with income inequality. The fact that firms and companies were spared shows that businesses were consciously left out and by that logic, its application to FPIs is an unintended consequence. The government’s reluctance to clarify has merely raised anxiety levels.

FPIs have borne the brunt of India’s taxation flip-flops. The 2018 budget proposal to levy long-term capital gains (LTCG) tax came at a time of slowing growth. With over $430 billion invested in India, FPIs have been growing steadily. FY18 attracted $18 billion after negative net investments in the previous two years. FPIs have generally been inspired with bold decisions on the economic front. This coupled with announcements in the past 18 months to allow FPIs to invest up to 25% in category III alternative investment funds , real estate investment trusts (REITs) and infrastructure investment trusts (InvITs), all three categories structured as AOP, kept up the pace of FPI investments.

Imagine an investor’s anxiety on LTCG tax levy of 14.25%, which was exempt until 2018 and now a tax arbitrage of 5% (on short-term gains) between an FPI structured as a trust and corporate, and that too retrospectively from 1 April 2019?

Options for FPIs to rework their structure is impractical and unwieldy. Firstly, FPIs as a class of investors represent pension funds, investment trusts, hedge funds, asset management companies, university endowments, charitable trusts, sovereign funds, etc., by virtue of the Securities and Exchange Board of India regulations. Secondly, from a business structure standpoint, large investment groups who have dedicated funds are invariably structured as trusts in the US, companies in Luxembourg and partnerships in other jurisdictions.

Besides, regulations in multiple jurisdictions such as the US and the UK consider such portfolio investors as corporations irrespective of their legal form. To apply differential rate of taxation for same class of taxpayers, based on their legal status, sounds irrational, besides discriminatory and against the grain of economic theory.

Budget proposals to enhance the statutory limit of FPI investments up to FDI sectoral norms and permitting FPIs to subscribe to debt instruments of REITs and InvITs are well intended. FPIs shall however weigh such proposals with caution keeping in mind predictability of the tax regime. Even the Laffer Curve economic theory, which is suggestive of incremental increase in tax rates beyond a certain point proving counterproductive to raising tax revenue should compel India to relook at the recent budget proposals.

Mukesh Butani is founder of BMR Legal. The views expressed are personal.