India budget amends key tax rules affecting foreign investors

By Rajesh H. Gandhi & Gaurav Chandak, Deloitte Haskins & Sells LLP, Mumbai Area, India

India’s Union Budget 2020 was presented on 1 February by the Hon’ble Finance Minister, the second budget of the present government.

Given the lower than expected GDP growth in financial year 2019-20, this budget was viewed as crucial for the revival of growth and to provide impetus to the Indian economy.

We have outlined below some of the key tax proposals relevant for foreign investors investing into India.

Abolishment of dividend distribution tax and introduction of classical system of taxing dividends

In India, dividends are currently subject to distribution tax at 15 percent (plus applicable surcharge and cess), resulting in an effective tax rate of approximately 20 percent.

The dividend distribution tax is not eligible for a tax credit in the hands of the shareholder since it is a tax on the company distributing the dividend. This provision was introduced in Finance Act, 2003 with a view to ensure ease in the collection of taxes at a single point.

The budget proposes to remove the dividend distribution tax and replace it with ten percent withholding tax on dividends,

The budget proposes to remove the dividend distribution tax and replace it with ten percent withholding tax on dividends

The proposal acknowledges that the tax should be paid by the recipient shareholder rather than the company. It also states that with the advancement of technology and ease of tracking, the justification for this provision has outlived its utility.

To remove the cascading effect of a withholding tax on dividends, it has been proposed to exempt dividends received by a domestic company from another domestic company provided the first mentioned domestic company pays the dividend one month prior to due date of filing the income tax return.

Further, the budget proposes that no deduction shall be allowed from dividend income except for interest expense incurred in respect of such income subject to a maximum limit of 20 percent of the dividend income.

India’s tax treaties with many countries, including the US, UK, Mauritius, Singapore, Switzerland, Australia, France, Luxembourg, and the Netherlands, set a withholding tax rate between 10 percent to 15 percent depending on the extent of the shareholding.

Investors from these countries will, therefore, benefit from the abolishment of dividend distribution tax.

In fact, foreign direct investment from Mauritius will benefit the most because the rate for dividends there is 5 percent if a Mauritius company holds more than 10 percent of an Indian company. Similarly, the tax rate for Hong Kong investors would be 5 percent.

This provision is expected to provide much needed relief to foreign investors who are facing cascading effects of double taxation due to non-eligibility of credit in their home country.

Concessional withholding tax rate for interest payments

To attract new investment and stimulate the economy, the India budget proposes to extend the period of the concessional withholding tax rate of 5 percent on interest payments to non-resident for specified forms of borrowings from 1 July 2020 to 1 July 2023.

A further reduced withholding rate of four percent has been proposed on interest payments to non-residents in respect of foreign currency borrowings in the form of long term bonds or Rupee Denominated Bond (RDB).

The reduced withholding rate shall be applicable only if long term bonds or RDB are listed on recognised stock exchange located in International Financial Service Center and issued on or after 1 April 2020 but before 1 July 2023.

This is a welcome step as it provides a concessional withholding tax rate to investors for borrowings done by Indian companies.

Withholding tax on interest from government securities

The budget also extends the period for the application of the concessional withholding tax rate on interest payments to foreign portfolio investors (FPI) and qualified financial investors (QFIs) for investment in government securities.

 The period of the concessional withholding tax rate of five percent on interest payment to FPIs and QFIs for investment in government securities and RDB has been proposed to be extended to 1 July 2023 from the existing sunset date of 1 July 2020.

In view of the permission granted by Reserve Bank of India to FPIs and QFIs to invest in municipal bonds, it has been proposed to extend the concessional withholding tax rate of five percent on interest payment to FPIs and QFIs from investment in municipal debt security from 1 April 2020 to 1 July 2023. 

This measure is a welcome step and will attract investment by foreign investors in municipal bonds.

 Exemption for non-residents from filing income tax returns

Under the existing provisions, non-residents are not required to furnish income tax returns if income solely comprises dividend or interest income and the applicable taxes on such income has already been withheld under domestic tax law.The budget proposes to extend this benefit to non-residents whose total income only includes income by way of royalty or fees for technical services and applicable taxes as per domestic tax provisions (as increased by applicable surcharge and cess) has been withheld.

This will provide much needed relief to non-residents who were required to file a return of income in India even though complete tax was withheld at source.

Determination of profit attribution to PE to be covered under safe harbour rules and advance pricing agreements

There has been considerable ambiguity regarding attribution of profits to a permanent establishment under the existing provisions. This has created significant litigation and also added to uncertainty for investors.

To ensure certainty and reduce litigation, the budget proposes to incorporate attribution of profits to permanent establishments within the ambit of safe harbour rules and advance pricing agreement provisions.

To ensure certainty and reduce litigation, the budget proposes to incorporate attribution of profits to permanent establishments within the ambit of safe harbour rules and advance pricing agreement provisions.

Indirect transfer provision

The indirect transfer provisions require India focused funds to pay capital gains tax on indirect transfers by their offshore investors owning more than 5 percent ownership in their funds outside India.

In 2014 regulations, category I FPIs such as sovereign funds and category II FPIs such as regulated funds were exempt from the indirect share transfer tax. Category III foreign portfolio investors were not exempt. SEBI merged category II and category III when they revised FPI regulations in September 2019.

Category II FPIs will now be subject to the indirect transfer provisions. The original intent was perhaps to tax only unregulated funds falling under Category III. However, now the tax will apply even to well-regulated foreign funds as the budget explicitly states that only
Category I FPIs will be exempt.

One option would have been to carve out and tax unregulated entities under Category II and exempt the others. The saving grace is that there is a grandfathering benefit for Category II funds registered before September 2019.

Sovereign wealth funds

To promote investment by sovereign wealth funds (SWFs) in Indian Infrastructure facilities the India budget proposes to provide a tax exemption to such investors on income in respect of such infrastructure facilities.

The proposal would exempt dividends, interest, and long term capital gains arising from investments in a company or enterprise carrying on the business of developing, operating or maintaining such infrastructure facility.

The exemption is available to the following investors:

A wholly-owned subsidiary of Abu Dhabi Investment Authority which is a resident of United Arab Emirates (UAE) and which makes investment out of the fund owned by the government of UA  or sovereign wealth funds which satisfy the following conditions:

• It is wholly owned and controlled, directly or indirectly, by the government of a foreign country;
• It is set up and regulated under the law of the foreign country;
• Its earnings are credited either to the account of the government of the foreign country or to any other account designated by that government such that no portion of the earnings inures any benefit to any private person;
• Its asset vest in the government of the foreign country upon dissolution;
• It does not undertake any commercial activity whether within or outside India; and
• It is notified by the central government in the Official Gazette for this purpose

Reduced rate of tax for power generation companies

The Taxation Law Amendment Act (2019) prescribed a reduced rate of tax of 15 percent (subject to fulfillment of certain prescribed conditions) for domestic companies engaged in the manufacture of an article or thing.

In view of the representations received, the budget has proposed to also provide companies engaged in the generation of electricity an option to claim the benefit of a 15 percent tax rate provided no exemptions are being claimed.

Safe harbour for offshore fund managers

The Union Budget of 2019 had relaxed the special tax regime for offshore funds by providing exemption to offshore funds from creating a “business connection” under domestic tax provisions merely based on the presence of a fund manager in India.

This exemption was subject to the fulfillment of certain conditions. One of the conditions to avail this exemption was that the aggregate participation or investment in the fund directly or indirectly by persons resident in India should not exceed five percent of the corpus of the fund.

This condition was viewed as an impediment as fund managers are required to invest in the fund during the initial years in order to attract investment and build their reputation.

The budget has relaxed this condition by excluding the contribution made by the eligible fund manager for the first three years up to INR 250 million (approx. US$ 3.5 million).

Another condition for claiming exemption under the special tax regime was that an eligible fund must have in the year of establishment of fund, monthly average corpus of not less than  INR 1 billion (approx. US$ 14.5 million) at the end of six months from the end of incorporation or at the end of the previous year whichever is later.

This resulted in discrimination between funds on the basis of their date of incorporation as the fund incorporated at the start of the financial year had 18 months to achieve this condition.

To remove this anomaly, the budget has proposed to prescribe a uniform timeline of twelve months for the fulfillment of monthly average corpus fund of INR 1 billion (approx.
USD 14.5 million).

This measure will provide clarity to fund managers who may now consider shifting their base to India.

Taxpayer’s charter

To outline a taxpayer’s rights with the objective to enhance the efficiency of the delivery system of the tax department, it has been proposed to introduce a Taxpayer Charter which India’s tax administration body has been mandated to adopt.

Introduction of withholding tax on e-commerce transactions

To widen the tax base, the budget proposes to introduce withholding tax provisions for e-commerce transactions.

According to the proposed provisions, tax at the rate of one percent shall be withheld by e-commerce operators for sale of goods or provision of services facilitated by it through a digital or electronic facility or platform.

According to the proposed provisions, tax at the rate of one percent shall be withheld by e-commerce operators for sale of goods or provision of services facilitated by it through a digital or electronic facility or platform.

According to the new levy, an e-commerce operator is required to withhold tax at the time of credit of the amount to the account of e-commerce participant, irrespective of the mode of payment.

An e-commerce operator has been defined to mean any person who owns, operates or manages digital or electronic facility or platform for electronic commerce and is a person responsible for paying to the e-commerce participant.

Similarly, e-commerce participant is defined to mean a person resident in India selling goods or providing services or both, including digital products, through a digital or electronic facility or platform for electronic commerce. Also, electronic commerce is defined to mean the supply of goods or services or both, including digital products, over a digital or electronic network.

Any payment made by a purchaser of goods or recipient of services to the e-commerce participant shall be deemed to be payment by the e-commerce operator to the e-commerce participant and shall be included in the gross amount of consideration on which taxes shall be withheld.

E-commerce participants being individuals, and other specified categories of taxpayers are excluded from this levy if the gross amount of sales or services of e-commerce participants through the e-commerce operators does not exceed INR 0.5 million (approx. USD 7,500) and specified identification number is furnished to the e-commerce operator.

The withholding tax levy increases to five percent in the absence of the furnishing of the specified identification number.

It has been clarified that the transactions subjected to withholding under the newly introduced withholding tax provisions on e-commerce shall be exempt from any other existing withholding tax provisions in order to avoid double taxation.

Further, existing withholding tax provisions shall be applicable to any amount received by e-commerce operators for hosting advertisements or for providing any services which are not connected with sale of goods or provision of services.

This provision aims to widen the tax net by capturing data in respect of individuals or entities not appropriately reflecting their income.

Levy of taxes collected at source (TCS) on sale of goods

Presently, taxes were required to be collected at source from the buyer on the sale of specified goods. The budget proposes to expand the scope of TCS provisions to provide that TCS shall be collected by seller of goods at the rate of 0.1 percent on the consideration received from a buyer in excess of INR five million in a financial year.

The TCS rate increases to five percent in the absence of furnishing of the specified identification number. The TCS provision shall be applicable only in case of those sellers whose total sales, gross receipts or turnover from the business carried on by it exceed INR 100 million (approx. US$ 1.5 million) during the financial year immediately preceding the financial year.

Further TCS shall not be collected, if the seller is liable to collect TCS under other provision of section 206C or the buyer is liable to withhold tax under any provision of the domestic tax law Act and has deducted such amount.

The government is empowered under the new TCS provisions to notify such classes of persons who shall not be responsible to collect TCS. These provisions shall come into force from 1 April 2020.

Deferring applicability of significant economic presence

Pursuant to BEPS Action Plan 1 on Digital Economy, India’s Finance Act, 2018, introduced provisions relating to ‘significant economic presence’ as a nexus to tax profits from specified operations in India. However, the provision did not specify the thresholds where the provisions will apply.

In view of the ongoing discussions in the G20-OECD project under which a report is expected by December 2020, it is proposed to defer the applicability of ‘significant economic presence’ provisions till 31 March 2021 by deleting the existing provision.

It has been proposed that a new provision will come into effect from 1 April 2021.

This was an expected proposal considering the prevailing discussions on this issue in OCED.

New nexus on basis of data collected from India

In the backdrop of the ongoing discussions in international tax forums, the budget proposes to amend the source rules to widen the tax base.

As per the proposed nexus rules, revenue arising from targeted advertisements to Indian customers, revenue from the sale of data collected from India or revenue arising from the sale of goods and services using data collected from India shall be brought to tax as per domestic tax provisions.

The new nexus rules are proposed to be applicable from 1 April 2020.

Considering the discussions underway on OECD Pillar Two approach, the applicability of this provision will be overridden by tax treaties

Thin capitalisation rules relaxed for interest payment to permanent establishment of non-resident banks

The domestic tax law prescribed thin capitalization rules pursuant to Base Erosion Profit Shifting (BEPS) Action Plan 4 whereby interest payment in excess of 30% of EBIDTA was not allowed as deduction. Financial institutions were not excluded from the scope of this provision.

It is now proposed to exclude permanent establishments of non-resident banks from the application of the thin capitalization rules. However, this benefit has not been extended to other financial institutions such as non-banking financial institutions, insurance companies etc.

Amending domestic tax provisions to align with MLI

 The provisions of the MLI have entered into force for India on 1 October 2019 and its provisions will be applicable on double tax avoidance treaties that India has entered into from 1 April 2020.

Article 6 of the MLI aims to eliminate double taxation without providing any opportunities for double non-taxation or reduced taxation through tax evasion or tax avoidance.

Existing provisions of section 90 and section 90A of the Act empowers the government to enter into an agreement with foreign countries, specified territories and specified associations situated in specified foreign jurisdictions to avoid double taxation.

However, the aspect of double non-taxation or reduced taxation remains unaddressed by the domestic tax provisions.

As MLI will become operative in India shortly, the budget proposes to amend the domestic tax provisions so as to not only provide for avoidance of double taxation but also curb practices aimed at double non-taxation, reduced taxation through tax evasion or avoidance strategies, treaty-shopping arrangements aimed at the indirect benefit of third jurisdiction residents.

New rules for income determination of non-residents

It is proposed to empower the Central Board of Direct Taxes (India’s tax administration body) to make new rules prescribing the manner and procedure for determining the income of a non-resident arising out of operations carried out in India from 1 April 2020.

It is also proposed that India’s tax administration body will make rules prescribing the manner and procedure by which income shall be arrived at in case of transaction or activities of a non-resident. This provision will come into effect from 1 April 2021.

While this is an expression of intent, the applicability of these rules should be overridden by tax treaties.

Rationalization of tax rates

Individuals and other specified persons are subject to tax at slab rates. It is proposed to rationalize and reduce the tax slabs for individuals who do not avail any exemption.

Employer contribution to pension plan

As an additional measure to widen tax base, the amount of contribution by employers to specified pension plans has been restricted to INR 750,000 (approx. USD 12,000).

Employer contributions in excess of this amount will be treated as taxable in the hands of the employee. Amount received on withdrawal will continue to be exempt from tax.

This measure is likely to impact high salary individuals.

Employee stock options by eligible startups

Stock options are treated as taxable at the time of exercise. To provide relief to employees and to facilitate the attraction of talent, it is proposed to defer taxation of stock options by five years or sale of shares or where the employee ceases to be the employee of the eligible start-up.

This measure will help start-ups to attract and retain talent at low cost.

Digitization of audit and appellate proceedings

The electronic audit proceedings introduced in 2019 to promote faceless interactions with tax authorities have been extended to cover other situations of audits by tax authorities.

In addition to electronic audit proceedings, it is now proposed to extend this to penalty and first level appellate proceedings in order to ensure faceless appellate proceedings.

Stay of demand before second level appellate tribunal

It is also proposed that a grant of stay of 180 days by the second level appellate tribunal in any proceedings against the order of first-level appellate authorities is available only if twenty percent of the amount of tax, interest, fee, penalties has been deposited or security of any equivalent amount is furnished by the taxpayer.

A second level appellate tribunal may grant a further stay if the delay in disposing of the appeal is not attributable to the taxpayer subject to a total period of stay not exceeding 365 days and the taxpayer depositing twenty percent of the amount of tax, interest, fee, penalty or furnishes an equivalent amount of security.

Tax dispute resolution scheme

It has been proposed that a new amnesty scheme will be introduced for settlement of long-standing tax disputes.

Under this scheme (yet to be notified), a taxpayer will be required to pay only the amount of disputed tax and will get a complete waiver of interest and penalty provided the tax is paid by 31 March 2020 or 30 June (with additional levy).

The scheme will remain open till 30 June 2020. 

Conclusion

 Overall, the intent of the government is to widen the tax base, increase compliance, reduce litigation and curb harassment of taxpayers.

The budget (Finance Bill) will now be placed before both Houses of the Parliament and once passed (after incorporating any other changes) it will be sent to the President of India for signature.

Once signed, all amendments proposed in the Finance Bill will become law.

Arpita Sonee, Assistant Manager at Deloitte Haskins & Sells LLP, contributed to this article.