18 September 2019 - Article
India's 2017-18 Budget is mostly populist with a big focus on infrastructure and rural development. While some proposals seek to improve ease of doing business in India, certain key areas of difficulty and uncertainty will continue to bother global investors. They will be impacted by the Budget as well as other recent developments including the amendment of India's tax treaties with Singapore, Mauritius and Cyprus, and onset of new anti-avoidance rules. The following are 10 important takeaways for MNCs, funds, global entrepreneurs and investors.
1. The Budget provides further stimulus for India's shift from a cash to digital economy. The number of India's internet users are likely to double to 600 million in 2020. More than half of this will be located in rural areas where over 70% of India's 1.2 billion population resides. Global investors are betting on a fintech boom in India. The Government is also trying to create an environment for startups to flourish. The Budget proposes to expand some of the tax incentives provided last year including a lower corporate tax rate of 25% and a 3 year tax holiday within a block of 7 years. However, so far, many startups have faced difficulties in claiming such reliefs.
2. Singapore and Mauritius structures have contributed to almost 50% of India's foreign direct investment. This will be impacted by amendments to India's tax treaties with Singapore and Mauritius, which remove the capital gains tax (CGT) exemption for transfer of shares after April 1, 2017. A two year transition period has been provided within which new investments will be subject to half the CGT upon exit. Investments after April 1, 2019 will be subject to full CGT. Investments prior to April 1, 2017 will be grandfathered. Companies claiming the exemption have to fulfil various expenditure and ‘substance criteria'. Several investors are expediting their Indian investments or considering appropriate restructuring before the April 1, 2017 deadline. Where investments in India are captive- such as outsourcing hubs or wholly owned entities- MNCs have explored limited liability partnerships (as opposed to corporate) structures since they are more tax efficient and operationally less cumbersome.
3. The Budget has finally confirmed the tax exempt status of conversions of convertible preference shares (CCPS) into equity shares. Most private equity and venture capital (PE/VC) investors prefer to invest into CCPS issued by Indian companies. There is need for clarity on whether the tax exemption under the Singapore and Mauritius treaties covers CCPS investments prior to April 1, 2017 even if they convert into equity shares after this date.
4. Debt investments, both convertible and non-convertible, continue to be popular because of the tax efficiency and relative ease of repatriating capital. Regulatory constraints have also been liberalized over a period of time. The Budget has extended the lower 5% interest withholding tax rate to certain types of debt investments made until 2020. These bonds, which include external commercial borrowings and rupee denominated ‘masala bonds', are long term and subject to certain conditions including ceiling on interest payouts. For most debt investments, the Indian withholding tax on interest can range between 20% to 40% and investors usually claim relief under a tax treaty. Singapore is at a relative disadvantage since the treaty with India reduces the interest withholding tax rate to 10% as opposed to 7.5% which is offered in India's new treaty with Mauritius. The Budget also introduces a thin capitalization rule that limits the ability of certain Indian companies to deduct interest payouts beyond 30%, with the balance deductible over a period of 8 years.
5. India's tax on overseas share transfers with underlying Indian securities poses a big challenge to M&As, group reorganizations, share redemptions and similar transactions involving overseas companies. Some relief has been provided for certain categories of foreign portfolio investors, while PE/VC funds and other overseas entities are mostly excluded. Investors are inclined to secure appropriate treaty based relief to shield against the tax exposure on indirect share transfers.
6. The Budget provides further relief to certain categories of overseas funds to promote fund management out of India without incurring tax risks. However, the safe harbour is very narrow and excludes most overseas PE/VC funds which still have an incentive to beef up activities and substance in countries like Singapore, Mauritius, etc.
7. While some guidance was recently provided in relation to residence of companies based on ‘place of effective management' (POEM), there is still much uncertainty. Overseas companies risk being taxed in India as residents based on POEM due to presence of directors and decision making in India. Business groups are now determined to employ key decision makers overseas so that the companies are not viewed as being controlled from India. Singapore has emerged as a key platform for Indian companies to globalize, thanks to the ease of doing business, proximity and ability to depute senior business leaders. This is also visible from the increasing interest of Indian entrepreneurs in setting up family offices in Singapore.
8. India's new (and much feared) general anti-avoidance rules (GAAR) will be implemented from April 1, 2017. GAAR will override India's tax treaties and could potentially disregard several conventional structures for lack of substance. Going forward, structures have to be commercially justified and care has to be taken at each step of implementation.
9. The Budget also proposes to tax transfer of assets (beyond shares) to companies, partnerships and trusts as income of the recipient, if the consideration is below fair market value. Some fear that transfer of assets into trusts- a common succession planning strategy- could now result in taxation for the trustee. There is need for clarity that such a provision only covers abusive cases and excludes legitimate transactions.
10. Indian tax authorities have been given additional powers to clarify the meaning of tax treaty terms that are un-defined. There is some unease about possible misuse of such unilateral definitions to the extent they are inconsistent with the international understanding, since it can lead to a denial of treaty relief in certain cases.