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Wealthy Indians are increasingly looking to diversify their investments beyond India. The US stock market is a popular option, but there's a hidden danger: inheritance tax. If they inherit US stocks from someone residing in the US, their heirs might owe inheritance tax even if they're not US citizens. The threshold for this tax is surprisingly low, making it a concern for many high net-worth individuals (HNIs).
Business Standard decodes how GIFT City, India's international financial hub, can offer a solution through tax-friendly pooled investment vehicles and access to global markets.
Business Standard decodes how GIFT City, India's international financial hub, can offer a solution through tax-friendly pooled investment vehicles and access to global markets.
The challenge:
Right now, wealthy individuals in India can use a scheme from the Reserve Bank of India (RBI) called the liberalised remittance scheme. This allows them to send up to $250,000 (around Rs 1.87 crore) abroad each year. They can use this money to open bank accounts overseas, invest in stocks, buy listed debt (like bonds), or even purchase properties in other countries.
However, many of these individuals might not be aware that if they have investments or assets in countries like the US, there's a rule there about inheritance tax. If the total value of these assets is more than $60,000 (approximately Rs 45 lakh) when they pass away, their heirs—the people they leave their money and assets to—might have to pay inheritance tax to the US government.
This means that even though they can freely move money abroad during their lifetime, their family members might face unexpected taxes after their death if the value of those overseas assets is high enough. This is something to consider when managing international investments and planning for the future.
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The potential solution:
India's International Financial Services Centres Authority (IFSCA) established GIFT City as a hub for attracting foreign investments. Here, wealthy Indians could set up pooled investment vehicles similar to mutual funds, but specifically designed for outbound investments. This could be a win-win situation:
Investors could avoid US inheritance tax by routing their investments through GIFT City funds.
Indian fund houses could manage this money, keeping it within the Indian financial system.
"Since the estate tax applies only if the inherited assets are in US, the same can be avoided if the investment into the said assets are done through pooled investment vehicles based in an offshore jurisdiction like IFSC, GIFT City, as then the asset is held through the pooled vehicle (including a family investment fund) and the inherited asset is the investment in the pooled vehicle, and also if it invests solely in U.S strategies it won’t be taxed in hands of the non-U.S person as the underlying asset may be US Shares but the company investing will be a foreign entity," said Ketaki Mehta, Partner, Cyril Amarchand Mangaldas.
The tax hurdle
However, there's a catch. Currently, GIFT City funds face a different tax structure compared to regular mutual funds in India. Unlike domestic mutual funds where investors pay tax on gains, GIFT City funds are taxed at the fund level.
"There are two main ways investment funds are taxed: at the fund level or through a pass-through mechanism. Fund-level taxation means the fund itself pays taxes on its income and gains before distributing any returns to investors. Conversely,a pass-through system allows the fund to avoid taxes, passing on all income to investors who then pay taxes based on their individual tax brackets," said Kunal Sharma, Partner, Singhania & Co.
This makes them less attractive for investors for two reasons:
Higher Tax Rate: The tax rate for GIFT City funds could be significantly higher than what investors pay in domestic funds.
"Taxing funds directly reduces their overall returns for investors. This makes them less attractive compared to funds in jurisdictions with pass-through taxation, where investors are taxed directly on their share of the fund's profits. Many investors, particularly those in lower tax brackets or tax-exempt entities, prefer pass-through structures to minimize tax liabilities. Fund-level taxation makes GIFT City funds less appealing to them," said Sharma.
Lower Net Asset Value (NAV): Since the fund is taxed first, the remaining amount available for investors (NAV) is lower. This reduces the overall return, especially for long-term investors who rely on compounding.
"Taxes paid at the fund level reduce the net income available for distribution to investors. This directly impacts their returns, making GIFT City funds less competitive. Moreover, institutional investors often prioritize tax-efficient investments. Fund-level taxation can deter them, leading to reduced capital inflows from these key investor groups," explained Sharma.
What needs to change?
The IFSCA is urging the government to level the playing field. If the tax treatment for GIFT City pooled investments is brought on par with domestic mutual funds, it would offer significant advantages:
Fairer taxation: Investors would pay capital gains tax based on their tax bracket, similar to domestic funds.
Higher returns: The tax burden wouldn't be on the fund itself, leading to a higher NAV and potentially better returns for investors.
Benefits beyond tax
A well-regulated GIFT City fund system would offer additional benefits:
Access to global companies: Funds in GIFT City provide regulated avenues for Indian investors to gain exposure to companies not listed in India, such as Nvidia, Alphabet, Amazon, and Meta.
Reduced Fee outflow: Establishing fund management entities in GIFT City can reduce fees paid to foreign fund managers based in other financial hubs like Singapore or Hong Kong.
Curbing capital outflow: Currently, many HNIs use the Reserve Bank of India's liberalised remittance scheme to invest overseas. A robust GIFT City system could retain this money within India.
Boosting Indian fund management: Indian fund houses could manage these investments, instead of foreign fund managers based in Singapore or Hong Kong.
Government's dilemma
The government might be hesitant to favor the wealthy. They might prefer to promote broad-based mutual funds accessible to a wider range of investors, rather than catering exclusively to HNIs. Additionally, allowing tax benefits for GIFT City funds could be seen as encouraging capital flight, where wealthy individuals move their money out of the country.
The key lies in finding a balance. By creating a fair and attractive tax structure for GIFT City funds, the government can attract wealthy investors without promoting excessive capital outflow. Regulators and the government may consider establishing tax parity for retail schemes in GIFT City, similar to the tax treatment of 'specified funds' like category-3 funds.A potential model could involve deducting taxes at the fund level upon distribution or redemption, which could streamline the investment process for a wider base of retail investors.
Case Studies: Successful Tax Strategies
•Luxembourg: Pass-through taxation and a network of tax treaties make it a preferred domicile for European funds.
•Singapore: Tax incentives and pass-through taxation for funds attract numerous asset management companies (AMCs) and fund houses, boosting investor confidence.
"For GIFT City to achieve its full potential, adopting a pass-through taxation model similar to successful global financial hubs is crucial. This will enhance its appeal, attract more funds, and contribute to its growth as a leading international financial services center," said Sharma.
