Why US portfolio investments in India will face a tax burden

Market Realist

Why the Modi government in India holds promise for US investors (Part 4 of 4)

(Continued from Part 3)

U.S. portfolio investments in India

So far in 2014, foreign portfolio investors (or FPIs) have net-bought INR 685.96 billion, ~$11.4 billion, of Indian equities. The U.S. is the largest source of portfolio investment into India, at INR 5.56 trillion , ~$92 billion, or nearly a third of the total foreign holdings in Indian equity, according to depository data.

Popular U.S. exchange-traded funds (or ETFs) investing in India include the WisdomTree India Earnings Fund (EPI), the iShares MSCI India ETF (INDA), and the iShares S&P India Nifty 50 Index Fund (or INDY). Unlike the U.S.-centric funds like the SPDR S&P 500 (or SPY) which invests in the 500 largest U.S. firms like Apple (AAPL), ExxonMobil (or XOM) and General Electric (or GE), these India-centric ETFs invest to make gains from the Indian equity markets. These ETFs have major holdings in companies like Infosys Ltd. (INFY) and HDFC Bank Ltd. (HDB).

Other major FPIs fueling the Indian equity markets include Mauritius, Luxembourg, Singapore, and UK.

Countries with favorable tax treaty can take a sigh of relief

The previous chart shows that portfolio investors based in Singapore and Mauritius enjoy exemptions on capital gains arising out of their investments in India, due to their favorable tax treaty with India. Institutions based in Singapore and Mauritius won’t have to pay tax on derivative trades because of their treaties with India that exempt tax on capital gains.

However, three of the top-five sources for portfolio investments in India, accounting for INR 7.8 trillion, ~$129.5 billion, of investments and including the U.S., Luxembourg, and UK, don’t have a favorable treaty with India on capital gains. These are the countries that will be affected the most by the reclassification of income from all foreign portfolio investment as capital gains.

Capital gain tax on derivatives trading

Derivative trading income, which was generally categorized as business income by FPIs, has been taxed in India, only if the foreign institution had a business connection or a permanent establishment in India. Now, since most fund managers were based abroad with no permanent establishment in India, they didn’t attract any capital gain tax liability on their derivative trading. As a result, derivative trading in India by foreign portfolio investors has been almost tax-free.

With the 2014 budget reclassifying all income from foreign portfolio investment as capital gains, home countries of FPIs who don’t have a favorable tax treaty with India will have to pay a 15% tax on their derivative transactions.

Many foreign portfolio investors who earlier described such trades as business income and paid no tax on these would come under this additional tax burden. However, the proportion of institutional investors that will be affected depends on how many of them were treating portfolio transactions as business income for tax purposes.

 

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