Concessional tax rate on debt puts foreign funds on sticky wicket

Even as the clamour for abolishing tax on long-term capital gains for equity investment is growing, overseas investors are staring at a higher tax outgo on their investments in Indian debt. Foreign portfolio investors (FPIs) pay a concessional tax rate of 5 per cent on interest they earn on rupee denominated bonds issued by Indian firms and government securities. This is provided for under section 194LD of the I-T Act, often referred to as the withholding tax. The catch — the concession is applicable only till June 30, 2020, and interest to be paid after this date would be taxed at 20 per cent or higher.

The government had introduced the lower tax rates in 2013 after a wobble in the rupee led to a flight of foreign money. These were applicable on interest payable till May 31, 2015. Record FPI inflows in the debt segment in 2014 prompted the Centre to extend these concessions twice in subsequent years.

Experts believe the lower tax rate is a significant contributor in making India’s debt market attractive to overseas investors. The concessional rate has also helped in reducing borrowing costs for the government and firms.

“Investors will be in for a big disappointment if the timeframe for the lower withholding tax rates is not extended,” said Ajay Manglunia, MD and head (institutional fixed income), JM Financial. “FPIs may look to book profits and/or not invest further after maturity of their investments. It could also impact borrowing costs for corporates at a time when it has become increasingly difficult to borrow domestically.” 

FPIs have been net sellers of debt papers worth $1.5 billion in 2020, against net purchases of $1.7 billion in equities. Last year, they were net purchasers in Indian debt to the tune of $3.5 billion, far lower than the net investment of $14.2 billion in equities. 

According to Tushar Sachade, partner at PwC India, FPI in Indian debt has grown significantly over the past few years. Investors in the corporate debt market generally invest for longer tenures and look for certainty on tax consequences vis-a-vis income expected to be earned during the period. 
 

“Failure to extend the sunset clause beyond June 2020 may result in higher tax incidence for investors, prompting them to evaluate other investment opportunities and increasing borrowing costs for corporates,” Sachade said.

Industry players, in fact, have lobbied with the government to ensure the lower tax rate of 5 per cent is made applicable without any sunset clause.

A decision to discontinue the lower rate should be taken only after providing sufficient notice to investors to avoid any disruption in FPI flows, according to experts. According to Rajesh Gandhi, partner at Deloitte India, tax deducted at source for foreign investors could increase to 15 per cent, 20 per cent or 40 per cent, depending on the type of debt and treaty availability if concessional rates are not extended. 

Say, an FPI invests in a Rs 1,000 bond with coupon rate of 10 per cent  per annum. If Rs 100 is the interest received, the 5 per cent withholding tax reduces the income Rs 95. Deducting the hedging cost of, say, 5 per cent per annum, the FPI gets back Rs 45. If tax deducted, however, increases to 20 per cent, this income reduces to Rs 30, which is down by 33 per cent.