Explained: Will tax on the rich hit foreign investments in India?

The government's budget proposal earlier this month to increase taxes on those with annual incomes of more than Rs 2 crore ($292,269) has rattled many foreign portfolio investors(FPIs).

The realisation that the new tax likely applies to the trusts through which many foreign investors put money into Indian financial markets sent stocks plunging last week. Now, their advisors say the investors are threatening to pull funds from India unless rules are amended so that they won't take a tax hit.

Here are some facts about the new tax rules.

What are the new rules?

In her budget, Finance Minister Nirmala Sitharaman proposed a tax increase of 3 per cent for individuals with an annual income of between Rs 2 and 5 crore, and 7 per cent for those earning more than Rs 5 crore.

The additional taxes apply to individuals, and groups of individuals who are an Association of Persons (AoP) or a body of individuals. It takes the tax rate of someone earning Rs 2 crore up to 39 per cent, and for those earning more than Rs 5 crore the rate climbs to at least 42.7 per cent.

The surcharge increases the effective tax rate for most FPIs, set up as Trusts or AOPs, by almost 7 per cent, said Rajesh Gandhi, partner, Deloitte India. "This is a steep increase in the tax rate and is perceived negatively by FPIs." Finance ministry officials said the government was unlikely to withdraw the new rules for foreign investors as it would send the wrong signal to domestic investors, who would still be paying the higher rates.

There is still a possibility of some relief to the FPIs, when the parliament gives final approval to the tax proposals later this month.

Who will be affected?

There are about 9,400 FPIs registered in India, largely from tax domiciles in the United States, Mauritius, Ireland, Luxembourg, Singapore and the United Kingdom, who have invested nearly $50 billion in Indian equity, debt and hybrid instrument markets.

Tax experts say 30-40 per cent of them, registered as trusts, could be affected by the new rules.

Why FPIs register as trusts?

FPIs register as private trusts mainly to navigate cumbersome disclosure rules and other compliance questions. If structured as a corporate fund, they may have to pay a minimum alternate tax of 18.5 per cent. In a trust structure, it is easy for investors to move capital in and out of trusts without paying high taxes, said an auditor at an international tax consultancy.

What is the likely increase in tax burden?

The FPIs registered as trusts will be taxed as AoPs at the new rates. Though they will continue to be charged at the basic tax rate of 15 per cent and 10 per cent on short term and long term capital gains in financial markets, the increase in the overall income tax rates mean their tax bills will go up substantially.

For corporate funds, there is no change in the tax burden on long term or short term capital gains.

Amit Maheshwari, partner at Ashok Maheshwari & Associates, said many countries don’t tax foreign investors on capital gains from listed securities and there is no discrimination against trusts.

"From an investment perspective India could become uncompetitive and expensive," he said.

Will fpis withdraw funds or change structure?

Tax consultants with overseas investors said the majority of investors are unlikely to withdraw their current investments particularly in the debt market though they would continue to lobby for withdrawal of tax rules.

Future investments in India could depend not only on tax rates but on corporate earnings and the fundamentals of the Indian economy compared with other countries.

Large number of FPIs may continue to use trusts and pay higher tax, tax experts said, as their promoters find the structure convenient and always have the option to shift to other markets.

Could it impact sovereign bonds, foreign investment flows? 

The proposed rules could hit India's plans to raise $10-$15 billion through overseas sovereign bonds and its attempts to attract more foreign investment in equities and debt, as many investors may feel reluctant to invest due to uncertainty over tax rates in India.

If the government doesn't announce tax exemptions to proposed overseas sovereign bonds then there will be a negative impact, said Rishabh Shroff, Partner & Co-Head, Private Client Practice, Cyril Amarchand Mangaldas.

Government officials have suggested that they could tax interest payments on sovereign bonds under current rules.

However, the details are still not public.