Foreign Institutional Investors Post Budget 2011 Analysis: Insight at a glance

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Budget 2011 snapshots

The Indian Finance Minister Mr. Pranab Mukherjee presented the Union Budget 2011 in the Indian Parliament on February 28, 2011. The budget announcements as they may impact regulations and taxation of FII in India are highlighted hereunder. Industry Overview There has been a marginal growth in the number of FIIs and Sub-accounts registered during the year 2010-11. The FIIs have been net buyers in the Indian equity and debt market activity during 2010-11, however there is a decline of 10.5% in the amount invested in 2010-11. The following table depicts the growth in the FII and their transaction value during the year. Transactions of FIIs Number of FIIs (actual) Number of Sub-accounts (actual) 1. Equity Market Activity (Rs crore) Gross Buy Gross Sell Net 2. Debt Market Activity (Rs crore) Gross Buy Gross Sell Net 3. Total Activity (Rs crore) Gross Buy Gross Sell Net
Source: SEBI Notes: * As on 31 December 2010

Calendar Year 2008-09 1635 5015 2009-10 1713 5378 2010-11* 1718 5503

5,54,585 6,02,292 -47,706 59,993 58,098 1,895 6,14,579 6,60,389 -45,811

7,05,523 5,95,302 1,10,221 1,40,914 1,08,477 32,438 8,46,437 7,03,779 1,42,658

6,03,406 4,90,785 1,12,622 1,54,081 1,29,241 24,839 7,57,487 6,20,026 1,37,461

Key announcements / changes to policy framework and related impact Tax Reforms The introduction of the DTC will result in moderation of rates, simplification of laws and better compliance. The DTC Bill was introduced in Parliament in August, 2010. Presently the Bill is under discussion with the Parliamentary Standing Committee. After receiving the report of the Standing Committee, the Code will be finalised for its enactment during 2011-12. This has been a pioneering effort in participative legislation. The Code is proposed to be effective from April 1, 2012 to allow taxpayers, practitioners and administrators to fully understand the legislation and adjust to the revised procedures. Investment Environment Investment in SEBI Registered Mutual Funds Currently in case of foreign investors, only FIIs and sub-accounts registered with the SEBI, and NRIs are allowed to invest in mutual fund schemes under the RBI Portfolio Investment Scheme. To liberalize the portfolio investment route, it has been decided to permit SEBI registered Mutual Funds to accept subscriptions from foreign investors who meet the KYC requirements for equity schemes. This would

enable Indian Mutual Funds to have direct access to foreign investors and widen the class of foreign investors in Indian equity market.

Way Forward These are broad policy framework and necessary amendments to the SEBI / RBI regulations are expected for allowing foreign investors to invest in mutual funds through the portfolio investments scheme. KYC requirements and forms are prescribed and information regarding the name, address, status, date of incorporation etc. are to be filled in. Further the proof of overseas address, PAN card, list of authorised signatory etc. are to be submitted alongwith the forms. The Budget has not indicated the specific mechanism of taxing the foreign investors in Mutual Funds, and so the normal provisions under section 115A of the Act, should apply unless specified otherwise [as covered under the tax provision for FIIs (section 115AD) or tax provisions applicable to Offshore Fund (section 115AB)]:

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Taxation of the foreign Investor Normal rate of Tax as per section 115A or section 115AB Income Income distributed by the mutual Fund is exempt from tax for the foreign investors Taxation of Capital Gains Short Term capital gains on sale of units of equity oriented funds (subject to STT) 15% 15% 15% 15% Rate of Tax (Corporate) Nil (Non-corporate) Nil Rate of Tax applicable to FII Section 115AD Rate of Tax (Corporate) Nil (Non-corporate) Nil

Short Term capital gains on sale 40% of units of debt oriented funds Long Term capital gains on sale of units of equity oriented funds (subject to STT) Long Term capital gains on sale of units of debt oriented funds Nil

30% Nil

30% Nil

30% Nil

20%/10%

20%/10%

10%

10%

The rate of tax will be increased by applicable surcharge and cess. Further there may be requirements to withhold tax on capital gains arising on sale of units by the foreign investors if purchase of mutual funds were treated as normal investment. Increase in FII limit for investment in Corporate Bonds To enhance the flow of funds to the infrastructure sector, the FII limit for investment in corporate bonds, with residual maturity of over five years issued by companies in infrastructure sector, is being raised by an additional limit of US Dollar
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20 billion taking the limit to US Dollar 25 billion. This will raise the total limit available to the FIIs for investment in corporate bonds to US Dollar 40 billion. FIIs allowed to invest in bonds of unlisted infrastructure SPVs Since most of the infrastructure companies are organised in the form of SPVs, FIIs would also be permitted to invest in unlisted bonds with a minimum lock-in period of three years. However, the FIIs will be allowed to trade amongst themselves during the lock-in period.

Way Forward Since it is an unlisted security, necessary amendments are expected in the SEBI / RBI regulations. Whether the FII would require approval from the Reserve Bank of India for the pricing of the Bonds before making such investment may be clarified when the regulations are amended. The withholding tax on interest payments on unlisted infrastructure bonds should be at the rate of 20% plus surcharge and cess, and could be on accrual basis. Black Money The generation and circulation of black money is an area of serious concern. To deal with this problem effectively, Government has put into operation a five-fold strategy which consists of Joining the global crusade against black money; Creating an appropriate legislative framework; Setting up institutions for dealing with illicit

funds; Developing systems for implementation; and Imparting skills to the manpower for effective action. During the year, India has concluded discussions for 11 TIEAs and 13 new DTAAs along with revision of provisions of 10 existing DTAAs. To effectively handle the increase in tax information exchange and transfer pricing issues, Foreign Tax Division of CBDT has been strengthened. A dedicated Cell for exchange of information is being set up to work on this agenda. The Ministry of Finance has commissioned a study on unaccounted income and wealth held within and outside India. It would suggest methods to tax and repatriate this illicit money.

Way Forward Non-cooperative jurisdictions / areas to be notified.

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Proposed Tax Amendments Surcharge on Income Tax The existing surcharge of 7.5% on a domestic company is proposed to be reduced to 5%. In case of companies other than domestic companies, the existing surcharge of 2.5% is proposed to be reduced to 2%. Toolbox of counter measures in respect of transactions with persons located in a notified jurisdictional area In order to discourage transactions by resident taxpayers with persons located in any country or jurisdiction which does not effectively exchange information with India, anti-avoidance measures have been proposed in the Act. It is proposed to insert a new section 94A in the Act to specifically deal with transactions undertaken with persons located in such country or area. The proposed section provides 1) An enabling power to the Central Government to notify any country or territory outside India, having regard to the lack of effective exchange of information by it with India, as a notified jurisdictional area; 2) That if an assessee enters into a transaction, where one of the parties to the transaction is a person located in a notified jurisdictional area, then all the parties to the transaction shall be deemed to be associated enterprises and the transaction shall be deemed to be an international transaction and accordingly, transfer pricing regulations shall apply to such
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transactions; 3) That no deduction in respect of any payment made to any financial institution shall be allowed unless the assesse furnishes an authorization, in the prescribed form, authorizing the Board or any other income-tax authority on its behalf, to seek relevant information from the said financial institution; 4) That no deduction in respect of any other expenditure or allowance (including depreciation) arising from the transaction with a person located in a notified jurisdictional area shall be allowed under any provision of the Act unless the assesse maintains such other documents and furnishes the information as may be prescribed; 5) That if any sum is received from a person located in the notified jurisdictional area, then, the onus is on the assesse to satisfactory explain the source of such money in the hands of such person or in the hands of the beneficial owner, and in case of his failure to do so, the amount shall be deemed to be the income of the assesse; 6) That any payment made to a person located in the notified jurisdictional area shall be liable to deduction of tax at the higher of the rates specified in the relevant provision of the Act or rate or rates in force or a rate of 30%. Our Observation: This should have implications for FIIs even if it is transacting through the recognized stock exchange in debt securities and block shares (other than normal equity transactions) as the counter party is known. The local custodians,

brokers, depositories, FIIs etc who are in receipt of any sum from a Person from such notified jurisdiction may also have implications unless they can satisfactorily explain the source of funds. Infrastructure Debt Fund In order to augment long-term, low cost funds from abroad for the infrastructure sector, it is proposed to facilitate the setting up of dedicated debt funds. Income of such infrastructure debt fund should be exempt from tax. Interest received by a non-resident investor from such notified Infrastructure debt fund shall be taxable at the rate of 5% plus surcharge and cess on the gross amount of income, as per section 115A of the Act. Withholding of tax should also be at the rate of 5% plus surcharge and cess. Our observation: Section 115AD of the Act has not been amended to tax income from debt funds at concessional rates of 5% if the FIIs are permitted to invest in the debt funds under the Portfolio Investment Scheme. Collection of information on requests received from tax authorities outside India It is proposed to facilitate prompt collection of information on requests received from tax authorities outside India in relation to an agreement for exchange of information under section 90 or section 90A of the Act.

The new sub-section 131(2) has been inserted for the purpose of conferring authority on the tax officer to make an enquiry or investigation. Further, section 131(3) has been amended to empower the authority to impound and retain any books of account and other documents produced before Income-tax authority in any proceeding under the Act. Extension of time limit for assessments in case of exchange of information It is proposed to exclude the time taken in obtaining information from the tax authorities in jurisdictions situated outside India, under an agreement referred to in section 90 or section 90A, from the statutory time limit prescribed for completion of assessment or reassessment. Reporting of activities of liaison offices A non-resident does not file a return of income with regard to its liaison office on the ground that no business activity is allowed to be carried out in India. It is proposed to seek regular information from non-residents regarding the activities of their liaison offices in India. The non-residents as per new section 285 is required to file the annual information, within 60 days from the end of the financial year, in the prescribed form and providing prescribed details by non-residents as regards their liaison offices.

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Tax Rate Card for Foreign Institutional Investors (FIIs)

The below rates are subject to enactment of the Finance Bill 2011. The rates are for the financial year 2011-2012. There has been no change in the tax rates applicable to the FIIs. 1. Capital Gains Capital Gains Corporate1 Total Income upto `10mn Sale of equity shares, units of equity oriented fund (STT paid) Short-term capital gains Long-term capital gains Sale of equity shares, units of equity oriented fund (Non- STT paid) Short-term capital gains Long-term capital gains 2. Other Income Nature of Income Corporate11 Total Income upto `10mn Dividends / Income from units3 Interest from and in respect of securities Business Income Exempt 20.60% 41.20% Total Income exceeding `10mn Exempt 21.012% 42.024% Non-Corporate2 Total Income
The tax rates for Corporate assessee are inclusive of surcharge @ 2.0% [AY 2010-11, surcharge @ 2.5%] (where income exceeds `10mn) and cess @ 3% 2 The tax rates for Non-Corporate assessee are inclusive of cess @ 3% 3 The Dividends / income from units will be exempt provided the Indian Company declaring the dividend pays DDT on the dividends declared
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Non-Corporate2 Total Income

Total Income exceeding `10mn 15.759% Exempt

15.45% Exempt

15.45% Exempt

30.90% 10.30%

31.518% 10.506%

30.90% 10.30%

Exempt 20.60% 30.90%

3. Securities Transaction Tax (STT) No change proposed in rate of STT. STT leviable on the value of taxable securities transaction are as under: Taxable Securities Transaction Purchase / Sale of equity shares, units of equity oriented fund (delivery based) Sale of equity shares, units of equity oriented fund (non-delivery based) Sale of an options in securities Sale of an option in securities where option is exercised Sale of futures in securities Sale of unit of an equity oriented fund to the Mutual Fund Payable by Purchaser /Seller Seller Seller Purchaser Seller Seller Rates 0.125% 0.025% 0.017% 0.125% 0.017% 0.25%

4. Income Distribution Tax (IDT) rates for Mutual Funds Income distributed By equity oriented funds By a money market mutual fund or liquid fund By a debt fund other than a money market mutual fund or a liquid fund Individual / HUF Any other person Individual / HUF Any other person Recipient Rate of IDT * Nil 27.0375% 32.445% 13.51875% 21.63%

* The tax rates for both Individual / HUF and Corporate assessee are inclusive of surcharge @ 5.0% (AY 2010-11 @ 7.5%) and cess @ 3%.

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International Tax Tax Treaty roundup

India - Mexico The 2007 treaty between India and Mexico entered into force on 1 February 2010 and will apply in India as from 1 April 2011 and in Mexico as from 1 January 2011. Once in effect, a withholding tax rate of 10% will apply to dividends (although India does not currently levy withholding tax on dividends), interest or royalties. India - Switzerland When in effect, the protocol signed on 30 August 2010 to the existing treaty, provides that interest paid to a resident of the other contracting state that is engaged in the operation of ships or aircraft in international traffic will be taxable only in the residence state to the extent the interest is paid on funds connected with those activities. India - Mozambique On September 30, 2010, India and Mozambique signed a DTAA for support of economic co-operation: one regarding mineral resources, the other small and medium sized enterprises. This treaty has not come into force. India - Finland The treaty signed on 15 January 2010, applies in India with effect from 1 April 2011; provides for a withholding tax of 10% on dividends, interest, royalties and fees for technical services. India - Luxembourg The 2008 treaty applies as from 1 April 2010 in India (1 January 2010 for Luxembourg) and provides for a 10% withholding tax rate on dividends, interest and royalties. India-Myanmar The 2008 treaty applies as from 1 April 2010 and provides for 5% withholding tax rate on dividends and 10% rate on interest and royalties. India-Norway On 2 February 2011, an agreement for the avoidance of double taxation and prevention of fiscal evasion with respect to taxes on income and on capital was signed between India and Norway. This will replace the existing Convention signed between the two countries on the same subject on December 31, 1986. In the Article concerning Residence, the new DTAA allows the place of effective management of an entity to be determined through Mutual Agreement Procedure in case it cannot be determined otherwise. A provision for insurance PE has been inserted in the new agreement. The new DTAA provide for lesser rate of taxation of dividend and interest in the source country. It provides for 10% rate as against 15% or 25% in existing DTAA. The new DTAA has an article on Limitation of Benefit. The new DTAA has an article on exchange of Information, which specifically provide for exchange of banking information and information without domestic interest.

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Tax Information Exchange Agreement India has entered into TIEA with 10 countries, which are: Argentina, Bahamas, Bermuda, British Virgin Islands, Cayman Islands, Isle of Man, British Island of Jersey, Marshal Islands, Monaco, and Saint Kitts and Nevis. Cabinet Approval, we understand, has been granted in case of 8 of them.

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Glossary
Abbreviation Act CBDT Cess DDT DTAA DTC FII IDT KYC PAN PE Mn NRI RBI SEBI SPV STT TIEA Long Form The Income-tax Act 1961 Central Board of Direct Taxes Education cess Divident Distribution tax Double Tax Avoidance Agreement Direct Tax Code Foreign Institutional Investor Income Distribution Tax Know Your Client Permanent Account Number Permanent Establishment Million Non Resident Indian Reserve Bank of India Securities and Exchange Board of India Special Purpose Vehicle Securities Transaction Tax Tax Information Exchange Agreement

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