FPIs stare at higher tax on debt investment

Mar 30, 2024

FPIs stare at higher tax on debt investment

Foreign portfolio investors (FPIs), who are enjoying a concessional tax rate of 5% on the interest income of rupee-denominated bonds, could be staring at a higher tax outgo after June 30, 2023.

FPIs enjoy a lower TDS rate or withholding tax of 5% on the overall interest earned on such bonds issued by Indian firms and government securities since 2013 under Section 194LD of the Income Tax Act.

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It was widely expected that this sunset period would get extended by another three years or at least a year. However, no announcement to this effect was made in this year’s Budget, which would mean that the tax rate is now likely to go up to 20% plus applicable surcharge and education cess. This could accelerate selling in such bonds before June from FPIs who do not want to pay higher tax.

“Since the extension has not been announced, investors will suffer taxation at 10-20% on interest which will be priced into the net yield of the investment. In the context of hardening bond yields globally, the impact of this change might negatively impact investments,” said Subramaniam Krishnan, partner, private equity tax, EY India.

Let us say an FPI invests into a 1,000-rupee bond with a coupon rate of 10% per annum. If Rs 100 is the interest received, the 5% withholding tax reduces the income to Rs 95. Deducting the hedging cost of, say, 4% per annum on the principal, the FPI gets back Rs 55. If the tax deducted increases to 20%, this income reduces to Rs 40, which is lower by 27%.

“This will significantly impact FPI debt investments as there is no grandfathering of existing investments, which is otherwise provided for in Section 194LC in respect of monies borrowed by Indian companies or business trusts in foreign currency from a source outside India and by way of issue of any long-term bond,” said Suresh Swamy, partner, Price Waterhouse & Co.

“FPIs may now have to resort to tax treaties for availing of the lower rate, if any, provided therein. Alternatively, they will need to explore investing through the IFSC fund which has a lower rate of 10% plus applicable surcharge and education cess. The additional benefit of coming through IFSC is that the rate is codified in the domestic law and FPIs will not be required to satisfy treaty conditions to avail this rate,” said Swamy.

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Experts believe the lower tax rate is a significant contributor in making India’s debt market attractive to overseas investors. The concessional rate has also helped reduce borrowing costs for the government and firms and boosted offshore lending in G-Secs and corporate debt.

“FPI flows in debt have been muted in the past few years, so the impact to that extent will be limited. Having said that, not extending the sunset clause will discourage long-term flows by FPIs into the country’s debt market,” said Ajay Manglunia, managing director and head of the investment grade group at JM Financial.

FPIs were net sellers of debt papers worth $1.5 billion in CY22, in addition to $16.5 billion sold in equities. The previous year, they were net buyers in Indian debt to the tune of $3 billion. In the past five years, however, FPIs have cumulatively net sold in excess of $10 billion of Indian debt.

Overseas investors in the corporate debt market generally invest for longer tenures and look for tax certainty vis-a-vis expected income to be earned during the period.