Why new tax surcharge has stunned foreign portfolio investors
The business entities known as Association of Persons have been stunned by new surcharge.
In 2000-01, Indian direct taxes, which include individual income taxes (taxes on salaries, house properties, capital gains, etc) and corporate income taxes accounted for barely 36.31% of total tax collection. This percentage share grew steadily in the subsequent years, to peak at 60.78% in 2009-10. Thereafter, it fell to 49% in 2016-17, recovering to 52% in 2017-18, more or less contributing an equal share as indirect taxes such as GST (goods and services tax) and customs duty. The budget estimates for 2019-20, however, shows the government is hoping the share of direct taxes will go up again the next year, as after several rounds of lowering of GST rates in 2018-19, the actual GST collection will be somewhat subdued.
For 2018-19, the budget estimates for GST was Rs 7.43 lakh crore, but the revised estimate shown in the budget papers last week, for 2018-19 is only Rs 6.43 lakh crore and the budget estimate for 2019-20 shows a small improvement to Rs 6.63 lakh crore. Direct taxes are expected to make up for this drop and then some more. In fact, the budget estimates for total tax collection is 11.7% of GDP in 2019-20, which is a little lower than the revised estimate for 2018-19 at 11.9% of GDP. Out of the 11.7%, direct taxes are now expected to be 6.3% of GDP, while indirect taxes’ contribution will be 5.3%.
Given this context, Finance Minister Nirmala Sitharaman’s moves to bring in more money by way of direct taxes start making sense. The new surcharge announced in the budget kicks in for people with annual income of more than Rs 2 crore at 3% and then for those with income above Rs 5 crore at 7%. All hell broke loose in the bourses after the implications of these new taxes on foreign portfolio investors (FPIs) became clear. Many FPIs in India are not registered as a company or a limited liability firm, but pay their taxes under a taxation construct called Association of Persons (AOP). AOPs are treated as individuals in the eyes of the law, and the new surcharge applies to them. There is, in fact, a suspicion in the markets that the tax was actually targeting the AOPs, as there has been a surge in their numbers in the last few years.
The FPIs can be registered in India as an AOP either through a contract or agreement among the people or funds involved to be treated as an AOP, or they can form a trust, which is also treated as an AOP for taxation purpose. (An AOP is different from a Body of Individuals or BOI, another tax construct, as legal persons or companies can become members of AOPs but not BOIs). The numbers for AOPs between 2013-14 and 2017-18 show a huge spike. According to government data, the number of tax returns filed by AOPs in 2013-14 was 1.01 lakh, and had more than doubled, to 2.07 lakh by 2017-18. The returns filing numbers for trusts that are treated as AOPs also went up from 1.83 lakh in 2013-14 to 2.92 lakh in 2017-18. The number of AOP taxpayers has also gone up from 1.41 lakh to 2.24 lakh, while number of taxpaying trusts has gone up from 2.06 lakh to 2.60 lakh (not every return filer has tax liability, also some tax payers pay tax without filing a return, as tax is deducted at source). For context, one may consider that India had a little more than 8 lakh taxpaying companies in 2017-18.
FPIs registering as AOPs and trusts would be a small number out of the 5 lakhodd entities that are being treated as AOPs for taxation. SEBI data shows a little less than 10,000 registered FPIs operating in India. Senior taxation professional Jairaj Purandare says: “By registering as AOPs, entities could avoid both the minimum alternate tax that companies pay as well as the alternate minimum taxation that is levied on limited liability partnerships.” Purandare, a former chairman of E&Y in India and regional managing partner for PwC, says the finance minister did not mention AOPs in her budget speech and didn’t clarify whether her intent was to tax them, but that the government has not decided to review it may contain a signal.
Rajesh H Gandhi, a partner at Deloitte on taxation, disagrees with Purandare and feels the taxing of AOPs at a higher rate is probably inadvertent. He also feels that FPIs that register in India select a structure that they follow back home. He raises a different question related to FPIs registered as AOPs: “This surcharge came in the middle of the year. Suppose an investor has already exited or an FPI has sold its investments between April and July 2019. Where will that tax liability devolve? Will the current investors have to bear the tax?” This will be unfair to the existing investors. These are questions that need urgent answers.