India budget: an international perspective

Global

On 28 February 2015, the Finance Minister for India announced the country’s budget for 2015-2016. There had been high expectations for this budget, which have largely been met, with measures aimed at facilitating foreign investment, cracking down on black market activity and building on India’s economic growth.

The budget comes against a strong outlook for India; inflation has declined over the last year and GDP has climbed to 7.4%, compared with 6.9% in 2013-2014, making India the fastest growing large economy in the world.  In recent months the Government has announced a number of initiatives to build on this growth, including the ‘Make in India’ programme, designed to transform India into a global manufacturing hub.  Investment is also planned for the infrastructure sector, with spending allocated to India’s roads, railways and ports.  The Government is running a fiscal deficit of 3.9% to provide for these initiatives, confident they will provide returns in terms of growth and investment.

Therefore, while the budget and accompanying Finance Bill do not contain any major policy changes or extensive reforms, they do set out a number of measures, particularly in relation to the tax regime, which are designed to support and strengthen the Government’s economic initiatives and encourage foreign investment.

We set out below some of the key highlights of the budget from an international investment perspective.

KEY HIGHLIGHTS

Amendments to the rules on the indirect transfer of Indian assets: dealing with Vodafone

Foreign investors have had serious concerns in recent years about the rules on the transfer of a foreign company’s assets which derive ‘substantial value’ from underlying Indian assets (indirect transfers).  Ambiguous amendments to the legislation in 2012, following the landmark Supreme Court Vodafone v Union of India decision, created uncertainty as to how the rules were to be interpreted in order to determine the tax implications in India of foreign transfers.  The amendments proposed in the Finance Bill will provide welcome clarification for foreign investors.

The existing indirect transfer rules are contained in the Income Tax Act 1961 (the “IT Act”), as amended in 2012 following Vodafone.  In that case, the court held that the offshore transfer of shares in a Cayman Islands company did not result in the transfer of a capital asset situated in India, meaning capital gains from the transfer could not be subject to Indian tax and there was no obligation on Vodafone to deduct tax at source.  The IT Act was amended in light of this case, to provide that where a foreign asset derives substantial value, directly or indirectly, from assets located in India, the asset will be deemed to be situated in India, bringing capital gains earned on the transfer within the jurisdiction of the Indian tax authorities.

Following recommendations from a Government-appointed Expert Committee, the Finance Bill now provides much needed guidance on this test, including: (i) defining the meaning of “substantial” as where the value of Indian assets exceeds INR 100 million and represents at least 50% of the value of all the assets owned by the foreign entity; (ii) calculating capital gains tax as only applying to such part of income as is reasonably attributable to the Indian assets; and (iii) providing exemptions from the rules for small shareholders and indirect transfers taking place in the context of a merger or demerger of two or more foreign companies.  When adopted, the amendments will be retrospective in effect.

Amendments to the rules on the residential status of a company for tax purposes

Under the IT Act, a company is currently considered resident in India for tax purposes if the control and management of its affairs is situated “wholly” in India.  The Finance Bill proposes to amend this provision so that a company is resident if its “place of effective management” (POEM) “at any time in [the relevant] year” is in India, which may have serious tax implications for foreign companies with even a limited presence in India.

It is proposed that guidelines be produced to explain the ‘POEM’ concept, which is defined in the Finance Bill as “a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance made”.  It is also imperative that the lawmakers address the risk presented to foreign companies by the current “at any time”  language in the amendment, which would deem a foreign company resident in India even where its POEM is in India for just one day during the financial year.  Any foreign companies that conduct even a small amount of decision-making in India could, as the amendment is currently drafted, potentially be exposed to tax liability in India.

Presence of a fund manager in India will not necessarily create a nexus between India and the offshore fund for tax purposes

Under the current tax regime, where a non-resident has a “business connection” in India, any income earned by the non-resident through or from this connection is deemed to be sourced in India. As a result, offshore investment funds have located their fund managers outside of India lest they become liable to tax in India purely because of their fund managers’ presence in the country.  The Finance Bill proposes changes to this regime which aim to encourage fund management activities in India.  

The Finance Bill proposes that fund management activity carried out through an “eligible fund manager”, in the ordinary course of its business for an offshore fund, shall not render the fund manager a business connection of that fund.  The application of this provision will be subject to the fulfilment of several conditions, such as (i) the fund not being a person resident in India; (ii) the fund being a resident of a country or a specified territory with which India has entered a tax treaty; and (iii) the aggregate Indian participation in the fund (direct and indirect) not exceeding 5% of the corpus of the fund.  In view of the extent and the rigid nature of the conditions, it is possible that the amendment will not achieve its goal of incentivising funds to relocate their managers to India.

Implementation of tax avoidance rules postponed

The Finance Act 2013 introduced general anti-avoidance rules (GAAR) which were due to come into force on 1 April 2015.  However, the Finance Bill now proposes to defer the implementation of the GAAR by two years, allaying for the time-being the concerns of both Indian and international taxpayers that the implementation of the GAAR would create red tape for business activity in India.

When implemented, the GAAR will apply only to investments made on or after 1 April 2017.  The two-year delay also provides an opportunity for the Government to produce guidance on the scope and implementation of the GAAR, in order to minimise disruption to businesses in 2017.

Reduction in non-resident tax rates for royalty income and fees for technical services

Where non-residents receive royalty income or fees for technical services from a Government or Indian entity, they are currently subject to a tax rate of 25%, pursuant to the Finance Act 2013.  It is now proposed to reduce this rate to its pre-2013 level of 10%, which should lessen the tax burden on SMEs and encourage collaboration between foreign and Indian companies, strengthening the Government’s ‘Make in India’ programme.

Opening up the foreign investment route and simplifying the tax regime for Alternative Investment Funds

The Finance Bill proposes to allow foreign investment in Alternative Investment Funds (AIFs) to all categories of funds and to remove the distinction between different types of foreign investment.  Composite investment caps will be introduced for Foreign Portfolio Investment (FPI) and Foreign Direct Investment (FDI), stimulating FPI in Indian companies, which was previously capped at 24%.  It is also proposed to grant tax ‘pass through’ status to income (except business income) earned by AIFs registered as Category I (investing in infrastructure or other socially/economically desirable sectors) or Category II (private equity or debt funds not falling under Categories I or III) funds.  The proposals should encourage foreign investment in Indian AIFs and help investors to avoid double taxation. 

Foreign investment in AIFs is currently only automatically permitted where AIFs are established as companies.  If a foreign investor wishes to invest in an AIF set up as a trust (which is a far more common structure in India), approval must first be obtained from the Government or the Reserve Bank of India via a lengthy process.  The regulations for the precise changes to the permissions are yet to be finalised, however it is anticipated that this move, together with the removal of the FPI/FDI distinction, will prompt an in-flow of foreign investment in Indian AIFs. 

The pass-through tax status for AIFs is currently only available in respect of venture capital funds and companies falling under Category I.  The proposals in the Finance Bill would extend this tax exemption to the income (other than business income) of all Category I and II funds, the tax liability instead being allocated among investors as if the investors had invested in the portfolio company directly.  On distribution of the income, the funds would apply a withholding tax of 10% for which the investors could claim a credit.  Tax would still be payable at the fund level for business income, however there would be no withholding tax on distribution and investors would not pay any tax on receipt of this income from the fund.   These proposals aim to create a single tier of taxation for Category I and II AIFs, reducing uncertainty for investors and funds alike.

Concessional tax rate for interest payable to Foreign Portfolio Investors

A concessional 5% withholding tax rate is currently available on interest payments made to foreign portfolio investors (FPIs) in respect of Government securities and corporate bonds.  Although the rate was due to expire on 1 June 2015, it has now been extended until 30 June 2017.  The move is expected to increase FPI interest in these types of investments, providing a welcome boost to the Government’s ‘Make in India’ programme. 

Curbing black money dealings

The Finance Minister has announced measures aimed at addressing the black money or ‘parallel economy’ issue in India, whereby income/assets are undisclosed and taxes evaded, and large transactions for the purchase of immoveable property are made in cash.  A Bill for a comprehensive new law will be introduced during Parliament’s current session, addressing in particular the concealment of assets abroad.  Transactions in cash involving loans, deposits or advances above INR 20,000 in respect of immoveable property will also be prohibited.  Such measures will allow foreign investors to invest in comfort and reap the rewards India can offer, in a business climate free from corruption and risks of proceeds of crime. 

Concessional tax rate for Global Depository Receipts

In 2014 the Government extended the Global Depository Receipts (GDRs) scheme; they may now be issued against securities (rather than just shares) of listed and unlisted companies and may be a source of investment for both residents and non-residents.  The tax implications of this liberalised scheme have thus far been unclear, but it is now proposed that a concessional 10% tax rate should apply for long term capital gains on the transfer of GDRs between both resident and non-resident investors.  The greater clarity and certainty this proposal brings will be a comfort to foreign investors considering GDRs as an investment option.

Tax treatment of interest received by foreign banks

An area which has been the subject of much scrutiny in the Indian courts is the tax treatment of interest payments made by the Indian branches of foreign banks to their head offices.  It has been held that a branch is eligible to claim a deduction from the interest payment on the basis that the head office and the branch are part of the same entity.  In order to provide clarity, it is now proposed that the interest payment be subject to withholding tax, in line with a circular issued by the Central Board of Direct Taxes stating that an Indian branch of a foreign entity is to be treated as a separate entity for tax purposes.  The clarification should now provide certainty for foreign banks with branches located in India. 

No change in corporation tax rate for foreign companies

Although the Government has announced a plan to reduce the basic tax rate for domestic companies from 30% to 25% over the next four years, the rate for foreign companies is unchanged at 40%. 

Preferential tax regime for business trusts extended to sponsors

Most investors in Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (IINVITs) (collectively, business trusts) currently benefit from a preferential tax regime in relation to gains earned on the sale of units in such trusts.  As of April 2015, this regime will be extended to the sponsors of business trusts, levelling the playing field for investors in real estate and infrastructure. 

Most investors in business trusts enjoy a tax exemption for gains on the sale of units held for more than 36 months and pay 15% for gains on units held for a shorter term.  Sponsors of business trusts will now also benefit from this concessional regime.  

The Finance Bill also proposes to grant pass-through status to REITs in respect of rental income arising from real estate assets directly held by REITs, placing the tax liability in the hands of the investors.  However, it is arguable that this proposal does not go far enough because SPVs in fact hold many of the relevant assets in India, in respect of which rental income will still be taxable.  It therefore remains to be seen how advantageous the pass-through will be in practice.

Minimum Alternate Tax exemption for foreign institutional investors

The income earned by foreign institutional investors on securities transactions is treated as capital gains under Indian tax law.  The Finance Bill proposes to exempt such capital gains (except short term gains) from minimum alternate tax (MAT), with a view to encouraging investment from foreign investors. 

The existing provisions of the IT Act provide that if the income tax payable by a company (including foreign companies) is less than 18.5% of its book profits (which are defined to include long term capital gains), the book profits are deemed to be the company’s total income and MAT is applied at 18.5%.  The proposed amendment will remove the application of these provisions to foreign institutional investors.  However, foreign institutional investors will still be liable to pay MAT on forms of income other than capital gains, such as interest income, and private equity funds and foreign companies will still be subject to MAT liability generally.

CONCLUSION

Overall, the budget is a significant step in the right direction for India’s economy.  While not packed with headline-grabbing policy reforms, the measures proposed will certainly lay the foundations for investment and growth over the next few years.  Although it remains to be seen how some aspects of the budget will be interpreted and applied in practice, the budget as a whole sends a clear message to the international investment community that India is open for business.