Financial services – Tax developments in 2021 and expectations of the Union budget 2022
The world has been on turmoil since the start of the pandemic, but the Indian government has made efforts to prioritize not only the well-being of individuals, but also to keep the country’s economic growth on track. With many citizens now vaccinated and amid concerns over Wave 3, the economy is preparing to receive the 2022 Union budget in around two months.
As stakeholders outline their expectations for the next budget, it is worth reflecting on the recent fiscal changes the economy has witnessed in the financial services arena.
Tax developments in 2021
Developments of the International Financial Services Center (‘IFSC’)
Not so long ago, India introduced the concept of IFSC with the aim that it would one day be seen as a financial hub and be on par with financial centers like Hong Kong, Singapore and London. To demonstrate its commitment, numerous policy initiatives and tax reforms have been taken to promote the IFSC.
In September 2020, the government introduced sweeping changes in the tax treatment of Class III Alternative Investment Funds (“AIFs”) based on the IFSC, in which income on the transfer of securities is exempt (at the except for shares of an Indian company) in the hands of these AIFs. In addition, income from securities is taxable at the preferential tax rate of 10 percent in the hands of such AIFs over the 20 percent rate prescribed for foreign portfolio investors (“REITs”).
From the point of view of unitholders, income from Category III AIFs to IFSCs and from the sale of units of such AIFs are tax exempt.
In order to facilitate fund pooling activities in India and incentivize existing offshore funds to move to the IFSC, the government has made tax changes to ensure that no adverse tax consequences occur on investors. offshore fund or on the offshore fund due to the relocation of the offshore fund to the IFSC.
The investment division of IFSC’s offshore banking unit enjoys tax benefits similar to the tax benefits granted to Category III AIF for investments made in India under the REIT route.
The government tried to attract the aircraft leasing activity that was historically conducted from Ireland to the IFSC. Aircraft rental companies operating out of the IFSC may claim exemption from tax on business income (including capital gains resulting from the sale of aircraft) for a consecutive period of 10 years out of a 15-year block.
In addition, rents relating to the rental of aircraft (including interest in the case of a finance lease) received by a non-resident entity of the IFSC aircraft rental unit (established no later than March 31, 2024) are fully exempt from income tax.
Other developments impacting foreign investors
Besides the IFSC, another area that has remained a priority in 2021 is the tax exemption granted to sovereign wealth funds (“SWF”) and pension funds (“PF”) for investments in infrastructure companies. The government relaxed some of the onerous conditions as SWFs / PFs were given operational flexibility to invest through holding companies, AIFs and non-bank financial company infrastructure.
Finally, the government has allowed REITs to avail themselves of the benefits of the tax treaty for withholding tax on dividends.
Expectations of the 2022 budget
With the above being said, there are expectations of foreign investors to resolve some of the issues.
Streamline the withholding tax process on dividends for REITs
There is a lack of clarity among Indian companies as to what kind of documentation to obtain from REITs to allow lower withholding tax on dividends, as the benefits of the tax treaty come with endorsements. In practice, each company requests a different set of information and documents from REITs to extend the benefits of the tax treaty with respect to withholding tax on dividends. To this end, the industry expects that if a standard set of documents can be prescribed by the government, it will result in reduced administrative efforts at both ends.
5 percent tax rate on commercial trust interest by REITs
Another issue requiring clarification concerns the taxation of interest earned by REITs on securities issued by commercial trusts. The 2021 budget led to the taxation of commercial trust interest at the rate of 20 percent instead of 5 percent [this was an unintended consequence due to amendment to the definition of the term ‘securities’ under Securities Contract (Regulations) Act, 1956]. From a regulatory perspective, REITs have recently been allowed to subscribe to debt securities issued by commercial trusts.
This positive regulatory amendment must be accompanied by a clarification on the applicability of the preferential tax rate of 5 percent on the interest generated by these debt instruments.
While a lot has been done on the IFSC front, the government should stay the course and make the IFSC even more attractive to investors.
SWF / PF
On the SWFs and public funds front, the government is expected to further ease the conditions, including granting transfer status to the national holding company created for investments in infrastructure companies and clarifying the calculation of the investment limit at AIF level.
In conclusion, the fiscal and regulatory incentives put in place by the Government have met with a very positive response from the actors concerned. The IFSC has led to the establishment of activities such as aircraft leasing, pooling of funds, banking, etc. which were previously carried out abroad, in India. In addition, investments in infrastructure companies are recovering given the tax exemptions granted to sovereign wealth funds and public funds. It would be interesting to see what all of the industry’s expectations are taken into account by the Minister of Finance in the next budget.
The views expressed in this article are the personal opinion of Sunil Badala, Partner and Head of Financial Services, Taxation, KPMG India.