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Budget 2014: Impact On Asset Managers!

Published on Mon, Jul 21,2014 | 17:46, Updated at Mon, Jul 21 at 17:46Source : Moneycontrol.com 

By: Tejesh Chitlangi, Partner, IC Legal

The proposals contained in the recent Union Budget 2014-15 (“Budget”) have received a mixed response from the Indian asset management industry. One set of proposals dealing with pass through status for Real Estate Investment Trusts (“REITs”) and Infrastructure Investment Trusts (“InvITs”), mitigation of Permanent Establishment (“PE”) exposure of Foreign Portfolio Investors (“FPIs”) despite their fund managers housed in India, categorisation of profits made by FPIs as capital gains etc. have been well received by the industry. On the other hand, the proposals pertaining to increase in long term capital gains tax rate and holding period for units of non-equity mutual fund schemes, non-extension of tax pass through to AIFs (other than the pass through currently available for Category I AIF-VCF), non extension of PE mitigation measures to the foreign private equity funds (a proposal only announced for FPIs) etc. have been a few key areas of concern.

To discuss some of the big positives - First, the tax pass through status is proposed to be extended to REITs and InvITs, which have long been considered as potential game changers in India’s real estate and infrastructure sectors. The Consultation paper along with draft SEBI (REIT) Regulations, 2013 was published by SEBI on October 10, 2013, however the tax ambiguity didn’t allow the final regulations to see the light of day. With the requisite tax clarifications proposed in the Budget, the final regulations are likely to be soon notified by SEBI. It is relevant to note that SEBI post Budget (on July 17, 2014) has also published the draft regulations for InvITs. The Memorandum to the Finance (No. 2) Bill, 2014 (“Finance Bill”) which explains the substance of the main provisions of the Finance Bill, lays down in detail the taxation regime for REITs and InvITs. Such REITs and InvITs are contemplated as “business trusts”, which may raise capital by issuing units listed on a stock exchange and can also raise debt from resident and non-resident investors. Income bearing assets would be held by such trusts by acquiring controlling or other specific interest in an Indian special purpose vehicle (“SPV”), which holds the underlying assets.

Some of the proposed key features are as follows – (a) The listed units of the business trust when traded on a stock exchange would be accorded similar tax treatment as is applicable with respect to the equity shares of a company (i.e. payment of STT, long term capital gains tax exempt and short term capital gains tax payable at the rate of 15%); (b) Interest income received by the business trust from SPV to be accorded pass through treatment, i.e. not taxable in the hands of the business trust and no withholding tax at the SPV level (however, distribution of such interest income by the business trust to non-resident unitholders to attract withholding tax at the rate of 5% and to resident unitholders to attract withholding tax at the rate of 10%; and then taxable in the hands of unitholders at regular rates); (c) Dividend received by the business trust and further distributed to the unitholders, both exempt from tax (subject to dividend distribution tax at the level of SPV); (d) The capital gains income on disposal of assets by the business trust taxable in the hands of the business trust at applicable rates and tax free in the hands of unitholders on distribution. Any other income of the business trust to be taxable at the maximum marginal rate. The proposals would take effect from October 1, 2014. Prior to this, the final regulations on REITs and InvITs are likely to be notified by SEBI with necessary modifications.
 
Second, the long time debate on capital gains versus business income characterisation of the income earned by FPIs is being put to rest as the Income Tax Act, 1961 (“ITA”) is proposed to be amended to provide that any security held by FPI (including erstwhile FIIs) in accordance with the SEBI regulations would be treated as capital asset only. Consequently any income arising from transfer of such security by the FPI would be in the nature of capital gains. Also, currently as a general practise, the fund managers of such FPIs are housed outside India. This is to showcase that the investment decisions are not being taken from India and therefore the FPI does not have a permanent establishment (PE) in India, which would otherwise subject such FPI’s income to be taxed in India at maximum rates. What has now been proposed is that such fund managers may be housed in India and the same will not result in such FPI having a PE in India. This would of course be subject to the requirements of any overseas jurisdiction. For instance, if the overseas laws require an investment manager to be located in the same jurisdiction as that of the fund, then the same would have to be complied with. In such cases, Indian advisory companies may continue to enter into the requisite advisory agreements with such offshore managers, as has currently been the case too.   

The wish list of the asset management industry from the Budget was pretty long. However, some expectations remained unfulfilled and to add to that, there were a few negative surprises in store. Some of the pertinent ones are discussed below:  

First, in case of non-equity mutual fund schemes (i.e. other than equity oriented funds/schemes having more than 65% of funds invested in equity shares, as defined under the ITA), the long term capital gains tax rate applicable on transfer of units as well as required holding period to classify such gains as long term, have been proposed to be increased. From the current long term capital gain tax rate of 10% and holding period of 12 months, the proposal is to increase the same to 20% and 36 months, respectively. The reasoning behind the same is that direct investments in banks and other debt instruments attract a higher rate of tax and hence there is a possibility of tax arbitrage.

Some key concerns with the said proposal are as follows: (a) Since the mutual fund assets under management (AUM) under non equity schemes, particularly FMPs are currently at a peak, hence mass erosion of mutual fund AUM is likely in case the proposal is implemented in the manner it’s currently proposed; (b) Issuers of corporate bonds, CPs and CDs will have to pay/incur a higher coupon/borrowing rate to their investors/lenders, since a chunk of the market is captured by mutual funds as lenders and such investments by mutual funds will substantially reduce in view of the lower inflows in their debt schemes. The borrowing rates for corporates will rise, absence of large mutual fund lenders will put pressure on the banking system and also negatively impact the corporates who may not be in a position to avail further bank funding; (c) The Budget proposes such amendments to take effect from 1st April, 2015 and to apply in relation to the assessment year 2015-16 and subsequent years. This contradictory wording has created confusion and there are several clarifications floating around, some suggesting that the tax will be retrospectively imposed, some suggesting that redemptions prior to budget would not be taxed as per new proposed law and a few also suggesting that the proposal would be implemented for the assessment year 2016-17 onwards. The final clarity is still awaited and the things would be clear on passing of the Finance Act, 2014.

In the interest of investors, mutual fund industry, corporate borrowers and banking system, this contentious proposal needs to be diluted, both from the perspective of holding period as well as the tax rate. While the equity schemes of the mutual funds will be more heavily promoted by the fund houses to counter the reduction in the AUM as a result of redemptions and reduced interest in debt schemes (coupled with a boost from the increase in tax exemption limit under Section 80C of ITA which may benefit the equity schemes), the fate of debt schemes look rather bleak. Whilst on one hand, the Government intends to promote the mutual fund industry in the interest of investors and the markets, but on the other hand is proposing such draconian measures which will hurt all the stakeholders alike. Similarly, the longtime intent has been to strengthen the corporate debt markets and increase liquidity, whereas such contradictory proposal will hurt debt markets the most.
 
Second, no tax pass through treatment has been accorded to alternative investment funds (AIFs) (except the existing tax pass through available to Category I AIFs-VCF). The tax pass through status could ensure that the income is exempt at the fund level and only taxable in the hands of the investors, and hence there is a single layer of taxation. In order to achieve tax pass through status for AIFs (other than VCFs), the industry relies on principles of trust taxation (as vast majority of the funds are set up as trusts). Relying on income tax laws and rulings, an interpretation is drawn that if a trust qualifies to be a determinate and non-discretionary trust (if the beneficiaries and their shares are identified in the trust deed) then a tax pass through status can be achieved. This often results into ambiguity as different views are possible in this regard. Hence, the fund industry needed a clear tax pass through status for all the AIFs registered with SEBI, which unfortunately has got missed out.

Third, with respect to FPIs, it has been proposed that the income earned by them would be in nature of capital gains and having the fund manager/s based in India would not expose the FPI to PE risk in India. A similar proposal has not been made for the offshore private equity funds which too are forced to house their fund managers outside India for the fear of fund otherwise facing potential adverse tax implications in India. Such similar clarification could otherwise have been conducive for investments by offshore private equity funds in India.

There were lot of (over)expectations with the Budget, but the proposals have been a mixed bag for the asset management industry. The Finance Minister has recently been heard saying that “This is not the end of the journey, this is just the beginning”. One therefore needs to wait and watch. A recent message doing the rounds reads as follows - “Watch your finger closely. The ink you got on your nail after voting might still be there on your finger tip!! Your nail itself doesn’t grow so fast, and you expect development to happen in such a quick time? Keep calm and trust Modi.” This seems to be the best option and ‘mantra’ for the moment.

 
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