Tax Implications of Foreign Portfolio Investors

Ankita Tiwari

10 May, 2023

Foreign Portfolio Investment is a form of investment in foreign countries. It is at an emerging stage in India and the Indian Government is continuously involved in creating favorable tax implications for Foreign Portfolio Investors (FPIs). Income earned by FPIs can be categorized either into gains from the transfer of securities or interest and dividend income. Income from the transfer of securities will be treated as capital gains, whereas interest or dividend income will be treated as income from other sources. The Income Tax Act of 1961 has separate provisions for the levy of tax on FPIs. If you’re an FPI, then you must understand the tax implications of FPIs. Let’s discuss the tax implications of various incomes on FPIs.

Tax Implications of different incomes of FPI

Long-term Capital Gains (LTCG)

On and from 1^st April 2018, LTCG on the transfer of equity shares, units of equity-oriented funds or units of a business trust are taxable at the rate of 10% if the amount exceeds INR 1 lakh. This shall be in cases where the Securities Transaction Tax (STT) is already paid. Before 1^st April 2018, for computing LTCG, the cost of acquisition was taken to be higher of :

1. The actual cost; or
2. The fair market value of the asset as of 31^st January 2018 or consideration received from the transfer of capital asset; or
3. the gains or losses from the transfer of securities are determined based on the ‘First-In and First-Out’ method.

However, 1^st April 2018 marked the end of the exemption for LTCG on the sale of listed shares and gains up to 31^st January 2018 were permitted to be grandfathered.

Short-term Capital Gains (STCG)

STCG on the transfer of securities such as equity shares or units of equity-oriented mutual funds is 15% when STT has been paid. However, STCGs that are not subject to STT attract a 30% tax rate. Such STCGs include off-market transactions relating to equity shares, bonds, debentures, or derivatives.

How the taxes are discharged by FPIs?

Generally, any payments to a non-resident attracts withholding taxes however, there is no withholding tax on income from capital gains earned by FPIs. Tax on income from capital gains is discharged in the form of advance tax paid before the repatriation of the income or before the specified due dates, whichever is earlier. Any other form of income earned by FPIs is subject to withholding tax at specified rates. In addition to the payment of taxes, the FPIs are required to file an income tax return annually for reporting their Indian sources of income. FPIs are recognized by way of PAN submitted at the time of registration of the FPI. PAN is also necessary for opening bank and securities accounts in India for investing in Indian domestic capital markets.

Exemption from Minimum Alternate Tax (MAT)

One of the tax implications of FPIs is that MAT provisions do not apply to them. Generally, companies are chargeable to tax based on normal tax provisions or book profits i.e. MAT at the rate of 18.5%, whichever is higher. However, as per the Income Tax Act of 1961^[1], MAT provisions do not apply to foreign companies unless they have a permanent establishment in India or are registered in India as per the prevailing company law provisions.

General Anti-Avoidance Rules (GAAR) and their tax implication on FPI

Where a tax treaty is operational, the ‘substance over form principle is applied to identify the actual owner of an income or asset. If the need arises, it can be interpreted in the context of Double Taxation Avoidance Agreements (DTAAs). GAAR is a set of rules based on which an arrangement entered into by a taxpayer to obtain undue tax benefits on his income is invalidated. It is an overriding provision however, exemptions are available from applicability of GAAR in the following cases of foreign portfolio investments:

1. When an FPI is assessed as per the provisions of the Income Tax Act;
2. When an FPI has not claimed benefits under a DTAA;
3. When an FPI has invested in listed or unlisted securities with the permission of relevant authority and as per the SEBI regulations.
4. When a non-resident investor has invested in FPI either directly or indirectly via offshore derivative instrument or otherwise.

Multilateral Instrument to Implement Tax Treaty-Related Measures to Prevent Base Erosion and Profits Shifting by FPIs (MLI on BEPS)

MLI is a treaty entered into by multiple jurisdictions. It makes an amendment to tax treaties easy and addresses multinational tax avoidance and tax disputes effectively. MLI is applied on taxes withheld at source and on all other taxes. It is to be read in connection with the existing treaties for apt interpretation. As India is a signatory to the MLI so it becomes one of the top destinations for FPIs to invest. The FPIs can claim any benefit under the tax treaties as per the structures and strategies prescribed in the MLI.

Further, if the shares of a foreign company or interest in a foreign entity are transferred and such shares or interest derive substantial value from an asset located in India either directly or indirectly, resulting in what is called an ‘Indirect Transfer’. In such cases, the shares or interests are considered to derive substantial value from assets located in India if the fair market value of such asset is more than INR 100 million on a specified date and represents at least 50% of the fair market value of total assets owned by the foreign company or entity. The tax implications of FPI relating to the indirect transfer is that the Finance Act 2017 introduced an amendment in the tax provisions exempting Category I FPI from indirect transfer provisions.

Conclusion

At present, the regulatory framework, including its tax implications, is dynamic as foreign portfolio investment is still at an emerging stage. However, the Indian government is making continuous efforts to construct a framework that allows FPIs to make holistic contributions to the Indian financial markets.

Read our Article: Foreign Portfolio Investors can Invest in Alternate Investment Funds