Foreign bond investors face a bill of up to $8 billion in new and retrospective taxes; potentially reversing Modi's previous efforts to attract overseas investment into fixed income markets.
India's government had promised a more predictable, less aggressive tax regime, notably after the new government led by Modi came into power last May.
So foreign portfolio investors said they were shocked by local tax authorities’ move from March to levy minimum alternate tax (MAT) on their earnings.
Announced in 1997, MAT was levied only on India-based manufacturing companies who maintain Indian balance sheets while foreign investors were exempted.
Finance Minister Arun Jaitley’s speech around MAT in the February budget, which sought to remove uncertainty around the treatment of the tax on foreign investors, ironically created more ambiguity.
“The rules on MAT in India could do with further clarification in the first place,” Patrick Pang, head of fixed income and compliance, Asia Securities Industry & Financial Markets Association (Asifma) told FinanceAsia. “It has now become a big problem”
In the speech Jaitley sought to rationalise the MAT provisions for foreign investors, saying that profits made from capital gains — earnings made on stocks — will not be subject to the tax. Also the bill will be enforced from the next financial year (April 2015) onwards.
The clumsy wording of Jaitley’s speech made it open to interpretation, market experts warned.
Tax authorities now assume that investors are liable for MAT on other forms of earnings, including interest income from debt securities.
“Going forward, it [the ambiguity about MAT] could impact bonds,” Mumbai-based Keyur Shah, a tax and regulatory services partner at Ernst & Young, known as EY, told FinanceAsia, adding that although the government has cut withholding tax levied on fixed income products from a range of 20% to 5% on June 1, 2013, MAT effectively increases the total tax levied on these instruments back to a range of 18.5% to 21%.
Shah said the the government is making concessions with one hand and taking them away with the other, adding this "...does not make sense.”
Moreover, since MAT’s capital gains exemption only goes into effect from April 2015, tax authorities have assumed investors still need to pay tax on profits generated in previous years - as many as seven years, according to India's tax code.
This effectively turns MAT into a retroactive tax - a worrying development for foreign institutional investors, as the net asset value of funds needs to be negatively adjusted for historical transactions, warned industry experts in a meeting with India’s capital markets regulator Securities and Exchange Board of India (Sebi) on March 30.
Funds will also take a hit for taxes on gains earned and distributed to earlier investors, the capital markets experts said, adding that this goes against the government policy of providing a stable and predictable taxing environment.
“What we want is clarification that MAT is exempted for foreign investors and that it is not only exempted from April 1 for capital gains that are subject to securities transaction tax, but also from a retrospective aspect,” said Asifma’s Pang.
Central Board of Direct Taxes (CBDT) have issued notices to 90 foreign funds and several foreign private equity firms over the past few weeks to pay MAT on book profits for financial years — ending March 31 — 2011-12 and 2010-11.
Local media reports suggested tax authorities could collect $8 billion in MAT under this interpretation, although industry experts can't substantiate the figure.
Dwindling appetite
There is concern that the list of 90 foreign investors liable for a retroactive MAT may grow into the thousands.
Currently, the tax rate on short-term capital gains from equity and equity-linked products stands at 15%. Long-term capital gains are not taxed.
The tax department wants to levy 20% MAT on book profit for the previous years. If MAT is levied, the foreign investors would have to pay 20% tax even on their long-term capital gains.
Sean Chang, head of Asian debt investment at Baring Asset Management told FinanceAsia that the organisation is bullish on India’s market, especially after the new government led by Modi came into power.
But the recent MAT issue could affect investor appetite for Indian credit, he said.
In the short-term, the changes [to MAT] may affect the market "because investors will take some time to digest the information and whether that will influence market flows,” said Chang. “When there is any tax involved, we have to take into account how that will affect one’s overall total return. Such policies will influence our investment decisions.”
The participation of foreign investors in local debt investments and the daily trading of Indian corporate bonds have dwindled in the wake of all the lobbying done to address foreign investors’ concern with the treatment of MAT, local fixed income experts said.
Since the beginning of the year, monthly FPI net debt investments have plummeted from Rs207.69 billion ($3.3 billion) in January to a mere Rs63.26 billion in March, according to data from the Central Depository Services (India) Limited.
Futhermore, daily trades of corporate bonds have declined from a monthly peak of Rs61.01 on March 27 to Rs38.54 billion on March 30, according to data from Sebi.
"One of the reasons could be the sensitivity around MAT on interest income earned," said Mumbai-based Anand Rengarajan, head of investor services, India at Deutsche Bank. "For India's debt market to remain attractive, clarity on this matter should be made at the earliest, if not this may have an impact on investments into India. "
