Deciphering India's tax landscape: An insight for foreign investors

Characterization of income on transfer of Indian investments  
 

Understanding the taxation of gains from the transfer of Indian securities is indeed crucial for foreign investors. In India, these gains can be categorized as either “capital gains” or “business income,” depending on various factors, such as the investor's intent, holding period, frequency of transactions, and the type of security involved.

Characterization of gains arising from transfer of Indian securities has been a vexed issue. To provide clarity on this matter, Indian tax laws stipulate certain rules. For instance, listed shares or securities held for a period exceeding 12 months immediately preceding the date of transfer are deemed to be treated as “capital gains,” unless the investor explicitly treats them as “business income.” Similarly, for unlisted shares, they are also treated as “capital gains” unless certain conditions are met, such as if the transaction is not genuine or if the transfer is made along with the control and management of the underlying business.

In the case of Foreign Portfolio Investors (FPIs), the tax laws stipulate that all securities held by FPIs are treated as capital assets. As a result, any gain or loss arising from the transfer of these securities is classified as capital gains or losses for tax purposes. This means that regardless of the intent or strategy behind the investment, gains or losses from the sale of securities by FPIs will be treated as capital gains or losses.

Income arising from Capital Gains

• Capital gains in India are computed using the First-In-First-Out method and categorized as either long-term or short-term based on type of security and holding period. The following table outlines the holding period for the classification of gains as short-term or long-term:
   

*Specified Mutual Fund is defined as a mutual fund wherein < 35% of total proceeds are invested in the equity shares of domestic companies. The equity shareholding of the Mutual Fund is to be computed using the annual average of the daily closing figures.

• The tax rates applicable to capital gains from the transfer of Indian securities vary based on the classification of the asset as mentioned above. Long-term gains (LTCG) are subject to a tax rate of either 10%* (for non-residents as well as residents) or 20%* (primarily for residents), depending on nature of security and the availability of a cost step-up benefit in certain cases. Conversely, short-term capital gains (STCG) arising from on-market transfers of the listed shares, units of equity oriented mutual funds and units of business trust (REIT/InvIT) are taxed at 15%*, while any other STCG is taxed at 30%* for non-corporates or 40%* for corporates.
• The Indian tax law provides for computation of capital gains by reducing cost of acquisition from full value of consideration received on transfer of securities. Expenses related to purchasing securities can be added to the cost, while expenses in connection with transfer, such as brokerage, custody fees, bank charges and other transaction charges are deductible when computing capital gains. However, Securities Transaction Tax (STT) paid during the purchase or sale of securities is not considered part of the purchase cost, nor is it deductible when calculating capital gains.
• Further, foreign investors may also invest in American Depository Receipts or Global Depository Receipts with an Indian security as underlying. Transfer of depository receipts is not taxable in India. However, where these depository receipts are converted into the underlying Indian securities, any subsequent sale of the underlying Indian security is taxable in India.
• In managing capital gains and losses, investors have the flexibility to offset Short-term Capital Losses (STCL) against STCG, as well as LTCGs. However, long-term Capital Losses (LTCL) can only be offset against LTCG. Additionally, losses incurred from one type of security can be set off against gains from another type of security as long as they share the same classification as capital assets. For example, losses from short-term equity (taxable at 15%) can be offset against gains from short-term derivatives (taxable at 30%). Furthermore, any unused STCL and LTCL losses can be carried forward for up to eight years. However, for corporate taxpayers, gains can only be set off against losses from a prior year if at least 51% of the investors (by voting power) remain unchanged.
• In addition to the above, foreign investors may also be subject to indirect share transfer provisions under certain circumstances. These provisions aim to tax gains derived from the transfer of shares or interest in a foreign entity that derives its value substantially (>50%) from assets located in India. Exemption is provided to non-residents holding less than 5% share/interest in the foreign entity. Further, investors in a Category I FPIs are specifically exempted from the applicability of indirect transfer provisions. Moreover, if non-resident investors hold interests indirectly ( through an entity outside India) in a Category I or Category II Alternative Investment Fund (AIF), and the redemption of such interests occurs due to the transfer of shares or securities held in India by such AIF, resulting in taxable income in India, the non-resident investor is exempt from the indirect transfer provisions.
• The Indian tax laws include provisions regarding “bonus stripping,” where any short-term capital loss incurred by a taxpayer through purchase or sale transactions of a security close to the record date of a bonus issue is disallowed. Instead, this loss is added to the cost of the bonus shares or units received. Additionally, the laws encompass deemed income provisions if investors acquire securities without consideration or at a value lower than the fair market value (FMV) of such securities.

Other incomes
 

• Income from securities, including dividends and interest, held by foreign investors is typically subject to tax at a rate of 20%*. However, resident Indian entities and individuals are taxed on such income at their applicable rates. For individuals and non-corporates, this rate is usually 30%*. For corporates, the tax rate varies depending on the regime opted by such entities, ranging from 22%* to 30%*.
• Business income and any other income, including interest received on income tax refunds, earned by both residents and non-residents are taxable as regular income at the maximum applicable rate, determined by the investor’s category.

Taxability on investment in Alternative Investment Funds (AIFs)
 

AIFs are categorized into three groups: Category I, Category II, and Category III. Category I and Category II AIFs benefit from a special tax regime, wherein they are granted pass-through status. This means that any income, excluding business income, earned by these AIFs is directly taxable in the hands of the investors at the applicable rates (as mentioned above).

Conversely, Category III AIFs established in India are not covered by any special tax regime and are subject to complex trust taxation provisions. Typically, Category III AIFs are taxed at the trust level, and the income distributed by these AIFs to their investors is exempt from tax in the hands of the investors.

Category III AIFs operating in the International Financial Services Centre (IFSC) enjoy certain tax exemptions and lower tax rates. These exemptions include exemption from capital gains on securities other than shares of Indian companies and a reduced tax rate of 10%* on dividend and interest income, among others.

Moreover, the Fund Management Entity (FME) of such AIFs in IFSC also enjoy a 10-year tax holiday. Additionally, such entities are also not liable to the Goods and Services Tax (GST) on their income.

Withholding tax
 

Indian entities are required to withhold taxes at applicable rates (as mentioned above, subject to lower rates available under the tax treaties) while making payment to non-residents. However, no taxes are required to be withheld on capital gains earned by FPIs.

Tax payments and annual income tax return
 

Indian advance tax obligations mandate timely tax payments in four installments during each financial year as follows as per prescribed due dates, failing which a minimal penal interest of 1% per month is levied. Any taxes not paid by the end of the financial year can be paid subsequently, along with applicable interest. Also, Indian tax return filing deadlines applicable to foreign non-corporate and corporate investors is July 31 and October 31 of the relevant assessment year respectively, considering the investor is not subject to transfer pricing provisions.

Benefits under a tax treaty
 

In case an investor belongs to a jurisdiction wherein a tax treaty has been signed by India, the Indian tax law allows such taxpayers to avail beneficial provisions/ rate as prescribed in the tax treaty, provided the investor fulfils the criteria’s mentioned therein and is eligible to claim treaty benefits. However, it is pertinent to note that tax benefits available in the tax treaty can be denied by Indian tax authorities if provisions of the General Anti-Avoidance Rule (GAAR) or Multilateral Instrument (MLI) are attracted. Investors from jurisdictions such as Mauritius, Singapore, France, Netherlands, Ireland, Denmark, and few other EU countries enjoy capital gains exemption on transfer of all securities other than equity shares, while residents of certain countries, such as France, Netherlands, Denmark, among others, enjoy complete capital gains exemption, even on sale of equity shares subject to conditions. Investors from Mauritius and Singapore enjoy tax exemption on sale of equity shares only with respect to shares purchased before 1 April 2017.

Conclusion
 

In conclusion, India offers promising investment opportunities for foreign investors, but success hinges on a comprehensive understanding of the tax landscape. The Government has tried to provide a light touch tax and regulatory environment for offshore funds investing in India without a local presence. The Government has also taken several steps to make the GIFT City a hub not just for financial markets but also for banks, insurance, leasing and support services companies. Tax environment is also sought to be modernized by several steps to digitize tax compliance and administration.

By adhering to the regulations, strategically managing capital gains and losses, and leveraging exemptions where applicable, foreign investors can optimize their investment strategies. Effective tax planning and compliance are essential for unlocking the full potential of investments in the dynamic Indian market.

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