In the backdrop of slow global growth, turbulent financial markets and volatile exchange rates, one may say that expectations from the Union Budget 2016 were overall low. Amid a need to maintain fiscal discipline and with limited avenues to mobilise additional resources (except by increasing taxes), aspects like no substantial increase in service tax, no change in the structure of taxation for listed securities and no change in extension in holding period for an asset to qualify as long-term capital asset, all are signs of relief and indicators of a stable regime.
Having said that, the alternative fund industry, being the source of risk capital for Indian entrepreneurs, had significant expectations from the Budget. They were hoping that the government will significantly accept the recommendations of the Alternative Investment Policy Advisory Committee (AIPAC) formed by the Securities and Exchange Board of India (SEBI) under the chairmanship of NR Narayana Murthy. In fact, the report had a chapter dedicated to tax reforms required for the alternative funds industry.
While many of those recommendations could have been accepted, the Budget proposals fell short of expectations in this regard. However, some proposals relevant to the alternative fund industry made their way and are summarized below:
Withholding tax on distributions by Alternative Investment Funds (AIF): It is proposed that distribution of income by AIFs to non-resident investors shall not be subject to 10 per cent withholding tax provided such non-resident investor is eligible for tax treaty benefits. This proposal will be warmly welcomed by the AIFs, specifically, the fund managers based in India, who were looking to raise capital from offshore investors, to capitalise on the recent FDI liberalisation allowing 100 per cent FDI in AIFs under the automatic route. However, it would have helped if the government had taken distributions to exempt resident investors or distributions of exempt income to residents out of 10 per cent tax withholding.
Applicable long-term capital gains tax rate to foreign funds: The issue of applicability of reduced rate of 10 per cent tax on long-term capital gains arising on transfer of unlisted securities for non-residents is proposed to be resolved. It is proposed that such rate shall be available on long-term capital gains derived on transfer of unlisted securities or shares of company in which public is not substantially interested. While taxation of gains arising to most of the foreign funds would be protected under the applicable tax treaty, this amendment should help foreign funds in tax indemnity related discussions on exits.
Reduction in holding period: In another welcome move, the finance minister said that the holding period of securities of unlisted companies to be treated as long-term capital asset is proposed to be reduced from three to two years. However, enabling provisions to enact such amendment in the law seems to have been missed out.
Safe harbor rules largely unchanged: Allowing onshore asset management of offshore pool of capital has been a key demand of the alternative fund industry for more than three years. If enacted, the amendment will help the government not only in restricting export of intellectual capital but also raise additional revenues by way of income-tax on fund management fees. While two small amendments have been made (explained below), a lot was expected about investment diversification, investor diversification and provisions relating to arm’s length management fees. One hopes that these will be dealt through a separate notification for which the law provides for – though this needs some sense of urgency.
(i) Safe harbor rules were applicable to an eligible investment fund resident of a country / specified association, with which India has entered into a double taxation avoidance agreement. This section is proposed to be amended to also include a country which may be notified by the government. Here also instead of a country to be notified, what the industry expects is that the fund could be set up or established or incorporated in the countries with which India has a tax treaty.
(ii) Currently, an eligible investment fund is not permitted to carry on or control and manage, directly or indirectly, any business in India or from India. This condition is now proposed to be restricted to controlling any business in India and not from India.
Place of Effective Management (POEM) effective from April 1, 2016: In order to provide clarity for implementation of the POEM-based residency test and also to address concerns of the stakeholders, it is proposed to defer the applicability of such rule by a year. However, it is expected that the government will soon finalise the detailed guidelines relating to determination of POEM for effective implementation.
MAT on foreign companies: With a view to provide certainty in taxation of foreign companies, it is proposed that MAT provisions shall not apply to foreign companies if it is from a treaty country and does not have a permanent establishment in India or it is not from a treaty country and is not required to register under the Companies Act.
New asset classes: Probably the last hurdle from tax standpoint for REIT/ InvIT, is proposed to be cleared in this Budget. Once enacted, dividend received by an REIT / InvIT from wholly owned special purpose vehicles (SPV) shall not be taxable in the hands of the trust nor will it be subject to dividend distribution tax (DDT) in the hands of the SPV.
Similarly, a new taxation regime for securitisation trusts and its investors has been provided. Amongst others, tax pass-through status has been provided to income of securitisation trust and income from securitisation trust would be taxable in the hands of investors. Further, 100 per cent FDI is proposed to be allowed under the automatic route in asset reconstruction companies. For foreign portfolio investors regulated by SEBI, it is proposed that they shall also be allowed to invest 100 per cent of security receipts issued by the securitisation trust. Both provisions should help fund managers focusing on these asset classes in short to medium term.
Other important amendments include introduction of the Organization for Economic Cooperation and Development’s (OECD) recommendation on certain action plan of Base Erosion and Profit Shifting (BEPS) project, tax incentives for units located in International Financial Services Center, systematic phase out of tax incentives currently available under the tax laws and replacing it with tax incentive for startups and entities generating employment.
The industry still craves for clarity around characterisation of gains of an AIF to be treated as ‘capital gain’, extension of tax pass-through to all categories of AIFs and allowing retirement and pension funds invest in AIFs – though the circular issued yesterday should address one of the concerns in this regard (regarding characterization).
One would hope the government issues the necessary guidance to provide certainty on the above issues, as these are a must for better development of the alternative fund industry.
Vikram Bohra is partner and Devang Ambavi is associate director manager, Financial Services Tax and Regulatory Services, PwC India.