What’s in the budget for foreign investors, traders?

From proposing steps to blur the distinction between foreign direct investments (FDI) and foreign portfolio investments (FPIs) to tripling capital gains tax on compulsory convertible debentures, the budget’s message to foreign investors has been mixed.

Finance minister Nirmala Sitharaman, in her budget speech on Tuesday, 23 July, said FDI and overseas investment rules will be simplified.

On Wednesday, economic affairs secretary Ajay Seth told The Economic Times that India may move towards a simpler regime for foreign investments by blurring the distinction between foreign direct investments (FDI) and foreign portfolio investments (FPIs).

In the case of FPI, a foreign investor can own up to 10% in a firm, while in the case of FDI, 100% foreign investment is allowed in most sectors.

If an FPI wishes to become an FDI by acquiring “significant beneficial ownership” in a firm, it’s currently not feasible, Seth was quoted as saying in the ET report. Seth suggested that this transition shouldn’t be prohibited and whatever approval process is necessary should be established.

FDI is currently restricted only in strategic and sensitive sectors. Gross FDI inflows into the country peaked in FY22 at $85 billion and have since moderated to $71 billion in FY24.

The government may also tweak norms in the Foreign Exchange Management Act (FEMA) to allow Indian business owners whose share of investments abroad is greater than within the country to step up domestic investments more easily, the ET report said, citing Seth.

Hike in capital gains tax

The budget proposal to hike capital gains tax across asset classes has given foreign investors a rude shock.

Foreign investors will feel the sharpest pinch on FDI in compulsorily convertible debentures (CCDs) as the capital gains tax on this particular segment has jumped more than threefold—from 10% to 35%.

Until now, gains on unlisted CCDs held by foreign firms for over three years were considered long-term capital gains (LTCG) and levied a 10% rate. The budget now proposes to treat these gains as short-term capital gains (STCG), irrespective of the period of holding.

Therefore, capital gains on these debentures will be taxed at the maximum marginal rate, which is 35%. Sitharaman had in her budget proposed to lower the corporate tax rate for foreign companies to 35% from the earlier 40%.

CCDs are commonly used in venture financing and startup funding, where companies need capital but wish to delay equity dilution to future valuation events.

As the name suggests, a compulsorily convertible debenture is a bond instrument that must be converted to equity at a later date, and is popular among companies that seek to raise FDI.

To be sure, such unlisted bonds owned for less than three years were taxed the maximum marginal rate, with the latest amendment also affecting Indian entities though CCDs are largely issued to raise FDI.

Besides the hike in levies on CCDs, foreign investors will also be weighing the impact of the increase in LTCG and STCG tax rates. Sitharaman proposed to raise LTCG from 10% to 12.5%, and STCG from 15% to 20%.

Foreign investors also need to prepare for a change in how taxes are applied to the money they receive from share buybacks.

Previously, the tax on share buybacks was calculated based on the profits that investors had accumulated.

Now, the entire amount received from a share buyback will be treated and taxed as if it were dividend income. This change is likely to increase the total amount of taxes that foreign investors have to pay.

Amendments to Customs Act

The budget has introduced amendments in the Customs Act to make imports easier under free trade agreements (FTAs).

The government has proposed to accept self-certificates to prove the origin of goods. Currently, a certificate of origin is issued to meet the sourcing criteria of imports.

The budget amended Section 28DA of the Customs Act, 1962, substituting ‘certificate’ of origin with ‘proof’ of origin.

Budget documents said that a ‘proof’ of origin can be a certificate or declaration issued in accordance with a trade pact certifying or declaring that the goods fulfill the country of origin criteria and other requirements specified in the said agreement.

“The idea is to align this with FTAs as we now also accept self-certification,” revenue secretary Sanjay Malhotra told ET.

The amendment aims to liberalize compliance with value-addition rules that are woven into FTAs to guard against the misuse of provisions in the trade pact.

The amendment also comes as India is negotiating free trade deals with a host of countries and regions, including the UK and the European Union.

British foreign secretary David Lammy was in India on a two-day visit “to galvanize negotiations for the India-UK FTA”.

New Delhi is also set to resume FTA negotiations with the EU following a pause for the general election.

India had stepped up scrutiny of imports, especially from China, following the June 2020 border clash between Indian and Chinese troops.

It had introduced stiffer rules of origin verification, CAROTAR, after the commerce ministry noticed “re-routing of goods through countries” with which India free trade deals.

The latest easing of rules comes after industry, particularly the electronic sector, sought an easier declaration process.

In FY24, China retained its spot as India’s top import partner with goods inflows rising 3.29% year-on-year to $101.74 billion. India’s overall goods imports during the fiscal were recorded at $675.4 billion.

Axing the angel tax

In a relief for the startup ecosystem in India, Sitharaman also proposed the abolition of the so-called angel tax for all classes of investors.

Angel tax was levied at a steep 30.6% on investments received by an unlisted company that were more than their fair market value.

Ahead of the budget, the commerce ministry had presented a demand from startups to scrap the angel tax.

The angel tax was introduced in 2012 as a step against money laundering.

Under section 56 (2) VII B of the Income Tax Act, if a startup issues shares at a price exceeding fair market value, the difference is taxed as income from other sources.

Startups that relied on angel investment voiced their concerns, stating that unclear valuation methods prevent angel investors from making investments.

Adding to their woes, the Finance Act 2023 had extended angel tax provisions to non-resident investors from April 2024.

The scrapping of the tax should ease the fundraising woes of startups, which have been going through a prolonged funding winter.

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