What the tax surcharge means for FPIs

The government in the recent budget proposed an increase in the tax surcharge for foreign entities which are registered as non-corporates. The move spooked investors as the surcharge will impact 40 per cent of the FPIs, as per various industry estimates. Finance minister Nirmala Sitharaman ruled out any possibility of a roll-back last week, sending the market tumbling. Here are the important things one should know about the issue:

What did the finance ministry propose in the Budget?
The government has increased the tax burden on super-rich tax payers in the Union budget for FY20. The government collects a surcharge from the super-rich tax payers with a taxable income of more than Rs 50 lakh a year.

This is over and above the income tax payable by them at a slab of 30 per cent. In the budget, while the government kept the income tax slab unchanged at 30 per cent, it increased the tax surcharge on such super-rich tax payers who earn more than Rs 2 crore a year. While increasing the surcharge, government included all the individuals and association of persons(AOPs) under the purview of the increased surcharge. Many foreign portfolio investors (FPIs) are structured as AOPs, limited liability partnerships and trusts. Hence, they will be subject to the higher tax surcharge if they earn over Rs 2 crore of income a year.


How much has the tax outgo increased?
The increased surcharge will impact the FPIs dealing in both cash and derivatives markets. However, the impact is higher on funds which deal in derivatives since all the income they earn from futures and options (F&O) trades is subject to income tax. For an FPI reporting over ?5 crore of income in India, the effective tax rate in derivatives goes up from 35.88 per cent to 42.74 per cent. If the same entity is earning between ?2 crore and ?5 crore, the effective tax on derivatives goes up from 35.88 per cent to 39 per cent. Even long-term capital gains tax and short-term capital gains tax rates will increase by 3-4 per cent for the entities making over ?2 crore.

What are foreign investors saying?
FPIs feel the government is trying to segregate them based on how they are structured.

Until now, FPIs have only been categorised based on their risk profiles i.e., least risky funds such as sovereign wealth funds have been termed as Category I FPIs while the most risky and unregulated funds are Category III. Compliance requirements of FPIs vary based on such risk profile.

However, the government has now introduced a new division within FPIs — corporates and noncorporates. This division based on structures of FPIs have nothing to do with the quality of money they bring or disclosures they provide.

For instance, a Category III FPI which is owned and controlled by a rich individual overseas can escape the surcharge if it is a corporate entity while a mutual fund or a pension fund may be subject to higher tax since it is structured as a trust or AOP. Also, FPIs structured as trusts or AOPs don’t get any special advantages over the ones that are incorporated as corporates in terms of disclosures or tax rates. Structures of a fund depend on the laws in their home countries.

Why are many FPIs unable to shift from a trust structure to corporates?
The government has been maintaining a stance that FPIs wanting lower tax outgo should convert themselves into corporates. However, it is not possible for the FPIs to convert themselves from trusts to corporates overnight especially in wake of the anti-tax avoidance laws. Some of them may have the option to create a new corporate entity and route all their fresh investments through the entity to avoid higher tax outgo.

But, not all FPIs will be able to undertake such restructuring due to several factors including restrictions in the laws applicable in their home countries.

Also, a single FPI entity set-up invests in multiple markets. Hence, they might not be able to restructure themselves as corporates just for Indian markets, because such an exercise could have repercussions in other markets they are investing in.

Will FPIs exit India due to the tax surcharge?
Investment decisions taken by FPIs consider multiple factors apart from tax. FPIs being subject to the increased surcharge will certainly revisit their strategies in Indian markets since the tax outgo has increased by nearly 7 per cent.

This would shrink their India returns. If the Indian market continues to outperform emerging markets peers, FPIs can absorb the additional tax. However, if India underperforms, the new tax could prompt some investors to turn underweight.