Planning Points for Foreign Investors

According to the Indian exchange control regulations, a foreign business can have a presence in India in the form of a liaison office, branch office, project office, company, and Limited Liability Partnership (LLP).

The factors to be looked at are as follows:

*It may be noted that conditions provided for availing concessional tax rate is likely to be fulfilled by most Indian companies. Accordingly, at a broad level, the corporate tax rate for an Indian company is reduced to 22%.

Investment via Shares or Loans

A foreign corporation can fund its Indian subsidiary by infusing share capital (FDI) or by extending a loan (External Commercial Borrowing (ECB)). Both FDI and ECBs can be availed by the Indian subsidiary subject to the fulfilment of prescribed exchange control regulations. The critical tax and regulatory implications of FDI/ECBs are:

• Repatriation of capital : Foreign capital invested in India is generally allowed to be repatriated along with capital appreciation, if any, after payment of taxes due on them, provided the investment was made on a repatriable basis. The repatriation is, however, subject to lock-in conditions in certain sectors.
• Return of dividend : The dividend income is freely repatriable. The same would be taxable in the hands of the shareholder.
• Payment of interest on ECBs : Subject to certain conditions, withholding tax on ECBs (wherever allowed) has been reduced from 20% to 5% (with applicable surcharge and cess) for ECBs availed between 1 July 2012 and 1 July 2023.

Further, in case of monies borrowed by the issue of long- term bonds or Rupee Denominated Bonds (RDBs), issued on or after 1 April 2020 but before 1 July 2023, and listed in the stock exchange located in International Financial Service Centers (IFSC), the rate would be 4%. In case such monies are borrowed after 1 July 2023, the rate would be 9%. The concessional rate of 5% would apply on interest on long-term bonds even if the non-resident does not have a PAN in India.

Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs)

The Finance Act (No. 2), 2014 introduced a taxation regime for business trusts - REITs and InvITs. These business trusts give small investors access to large-income-producing real estate and infrastructure assets, much like how mutual funds provide access to stocks. The Securities and Exchange Board of India (SEBI) issued guidelines for regulating such business trusts, and an investor can enter the property market with as little as INR 200,000. Both these models have the following distinctive elements:

• The trust would raise capital by issuing units, which would be listed on recognized stock exchanges in India
• The trust can raise debt from residents as well as non-residents
• Income-bearing assets would be held by the trust by acquiring controlling or another specific interest in an Indian company (Special Purpose Vehicle (SPV)) from the sponsor (promoters of the SPV)

Furthermore, the taxation regime of such business trusts would, among other things, include the following:

• No capital gains tax on the sponsor at the time of exchange of shares of the SPV with the units of the trust.
• Capital gain on transfer of units held for more than 36 months shall be taxable at the rate of 10% on an amount exceeding INR 100,000.
• Capital gains on the disposal of other assets by the trust shall be taxable in the hands of the trust. However, the same would not be taxable in the hands of the unit holders at the time of distribution.
• Dividend, interest, and rental income received by the trust from the SPV is accorded a pass-through status. Accordingly, this dividend, interest, and rental income would not be chargeable to tax in the hands of the trust. However, at the time of distribution of this income to investors of the business trust, taxes would be required to be withheld as per the ITA.
• Distributions made by a business trust shown as repayment of debt in excess of issue price of the unit would be taxable in the hands of the unit holder as income from other sources. Such income would be liable to withholding tax as per the ITA.
• Other income of the trust shall be taxable at the maximum marginal rate (30%).

In addition, certain other reporting compliances like filing of tax returns, etc. would be required to be undertaken by business trusts.

Alternative Investment Funds (AIFs)¹⁵

An AIF is any fund established or incorporated in India in the form of a trust, company, LLP, or a body corporate that is a privately-pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors.

Category I AIFs are those that invest in start-ups or early-stage ventures, social ventures, Small-and Medium-sized Enterprises (SMEs), infrastructure, other sectors or areas that the government or regulators consider as socially or economically desirable and shall include venture capital funds, SME funds, social venture funds, infrastructure funds and such other AIFs as may be specified. AIFs that are generally perceived to have positive spill-over effects on the economy and for which the Board, or government, or other regulators in India might consider providing incentives or concessions shall be included, and such funds that are formed as trusts or companies shall be construed as ‘venture capital company’ or ‘venture capital fund’ as specified in the ITA.

Category III AIFs are those that employ diverse or complex trading strategies and may employ leverage, including through investment in listed or unlisted derivatives. AIFs, such as hedge funds or funds which trade with a view to make short-term returns or such other funds which are open-ended and for which no specific incentives or concessions are given by the government or any other regulator shall be included.

Category II AIFs are those that do not fall in Category I and III and do not undertake leverage or borrowing other than to meet day-to-day operational requirements as permitted in the regulations. AIFs, such as private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other regulator, shall be included.

From FY 2019-20 onwards, a special tax regime for Category I and II AIFs has been provided, irrespective of whether they are set up as a trust, company, LLP, or as any other body corporate:

• Any income (other than income from profits and gains of business) of the investment fund will be taxable in the hands of the unitholders and not the investment fund.
• Income from profits and gains of business of the investment fund shall be taxable in the hands of the investment fund only.
• Accumulated losses except business losses as on 31 March 2019 shall be distributed to the unitholders in their investment ratio and shall be allowed to be carried forward in future years. Losses of business shall still be subject to set-off and carried forward to the subsequent years, only at the fund level (i.e. it will not be passed on to the unit holders).
• Any losses, except business loss, shall be distributed to the unit-holders post 1 April 2019 and shall not be eligible to be set-off/carry forward by the investment fund. The unit holder should have held the units for at least a period of 12 months. The share of losses of the unitholders who have held units for a period less than 12 months shall lapse.
• Any income that is not taxable at the fund level and paid to unitholders by the investment fund would be subject to withholding tax at the rate of 10%. According to the Finance Act, 2016, when the unit holder is a non-resident, the withholding tax shall be at the rates in force (depending on the source of income taxable in the hands of unitholders or the price provided under the relevant tax treaty, whichever is lower). However, withholding tax would not be applied if the income is not chargeable to tax under the provisions of the ITA itself.
• Any income of the investment fund would be exempt from TDS requirements. This would be provided by issuing the appropriate notification.
• It is mandatory for the investment fund to file its Return of Income. The investment fund shall also be required to provide the details of various components of income, etc. for the purpose of the scheme to the prescribed income tax authorities and the investors.

This tax pass-through will enhance the ability of these funds to mobilize higher resources and make higher investments in small and medium enterprises, infrastructure and social projects, and provide the much-required private equity to new ventures and start-ups.

Tax incentives to International Financial Services Centers (IFSCs)

To incentivize the growth of IFSCs into world-class financial services hubs, the following tax benefits are provided to IFSC’s:

• Long-term capital gains arising from transactions undertaken in a foreign currency on a recognized stock exchange located in an IFSC (even when the STT is not paid with respect to such transactions) will be exempt from tax¹⁶
• Short-term capital gains arising from an operation undertaken in foreign currency on a recognized stock exchange located in an IFSC (even when STT is not paid with respect to such transactions) will be taxable at a concessional rate of 15% (plus the applicable surcharge and cess)
• In the case of a company, being a unit located in an IFSC and deriving its income solely in convertible foreign exchange, MAT shall be chargeable at the rate of 9%
• The Finance Act, 2018, exempts the transfer of specified bonds or GDRs, RBDs of an Indian company, or derivatives by a non-resident in foreign currency on a recognized stock exchange located in any IFSC. Furthermore, the Finance Act (No. 2), 2019, has also exempted the transfer of any derivatives or such other securities as notified by the Central Government.
• STT/Commodities Transaction Tax (CTT) shall not be levied on the taxable securities transactions/commodities transactions entered into by any person on a recognized stock exchange located in an IFSC where the consideration for such a transaction is paid or payable in foreign currency (applicable from 1 June 2016)
• Any income by way of interest payable by a unit in an IFSC to a non-resident after 1 September 2019 shall be exempt.
• After 1 September 2019, no additional income tax shall be payable by a specified mutual fund out of its income derived from transactions made in a recognized stock exchange located in an IFSC, and where such consideration is paid in convertible foreign exchange.
• In order to incentivize the set up of fund managers of offshore funds in the IFSC, Finance Act 2020 has amended Section 9A for enabling the Central Government to relax/modify the specified conditions, where the fund manager is located in an IFSC and its operations are commenced on or before 31 March 2024.
• In order to boost the undertaking of aircraft or ship leasing activities in IFSCs, an exemption is granted to any royalty or interest income earned by a non-resident from the lease of an aircraft or ship to a unit in an IFSC. The exemption is subject to the fulfilment of certain specified conditions.
• Dividend received by an aircraft leasing unit in an IFSC from a company which is also engaged in aircraft leasing activity shall be exempt.
• Capital gains from the transfer of equity shares of an IFSC entity engaged in aircraft leasing and commencing operations on or before 31 March 2026 shall be exempt, subject to conditions.
• Dividends received from a unit in IFSC shall be taxable at a concessional income tax rate of 10% subject to certain conditions.
• Relocation of a specified offshore fund to an IFSC shall be tax neutral if such transfer takes place before 31 March 2025 subject to certain conditions
• Income derived by non-residents from transactions in offshore derivative instruments entered into with an offshore banking unit of an IFSC shall be exempt subject to fulfilment of conditions by such offshore banking unit
• Income of non-residents from a portfolio of securities, financial products, funds, etc. from an account maintained with an offshore banking unit of an IFSC shall be exempt
• With effect from assessment year 2023-24, an offshore banking unit of a foreign bank in Special Economic Zone (SEZ) will enjoy a tax holiday period of 10 years (100% of its income from specified sources shall be exempt). Furthermore, an IFSC unit can apply for the tonnage tax scheme under the Income Tax Act within three months from the date on which the tax holiday period ends.
• Shares issued by a private company to a Category I or II AIFs located in an IFSC will not be subjected to angel tax provisions under the Income Tax Act .

Other Tax Incentives

The Indian government offers various types of tax incentives to accelerate economic growth and extend various direct and indirect incentives to the business community. Some incentives available under the ITA are as follows:

• India has robust tax treaties with many countries. Taxpayers have the option of availing benefits under a tax treaty to the extent it is more beneficial vis-a-vis the provisions of the ITA (subject to documentation requirements).
• The rate of withholding tax on interest on ECBs has been reduced from 20% to 5% subject to certain conditions.
• Profit and investment-linked incentives:
  • For units located in Special Economic Zones (SEZs): 100% income tax exemption on export income for the first five years, 50% for the next five years, and 50% on the re-invested export profit for the next five years. However, no exemption will be allowed to non-filers of income tax return with effect from FY 2023-24.
  • For SEZ developers: Income tax exemption on income for a block of 10 years in 15 years where the development of an SEZ has begun on or before 31 March 2017
• Investment-linked incentives are available for specified activities/sectors, such as:
  • Infrastructure
  • Oil and gas
  • Research and development activities
  • Activities in specified geographical areas
  • Cold storage, warehousing facilities for agriculture produce and sugar
  • Hotels, hospitals, and slum redevelopment or rehabilitation with certain restrictions.

However, the company will be liable to pay tax under the provisions of MAT wherever profit- and investment linked incentives are available.

• Accelerated depreciation at the rate of 20% is available on new plant or machinery acquired and installed by an undertaking engaged in the manufacture of any article.
• In the case of additional wages paid to new employees across all sectors, the taxpayer will enjoy an additional tax deduction of 30% of the salary paid for a period of three years, subject to certain conditions.
• 100% deduction will be allowed for business income earned by an eligible start-up for a period of three consecutive years. The start-up should be engaged in a business that involves innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property and should hold a certificate of eligible business from the Inter-Ministerial Board of Certification notified by the Central Government. The turnover of the business should not exceed INR 1 billion in any year in which deduction is claimed.
• The taxpayer will have the option of claiming this deduction for three consecutive years from a period of ten years starting from the year of incorporation of the start-up¹⁷. The start-up should not be formed by splitting up or reconstructing a business already in existence. It should also not be formed by using second- hand plant and machinery exceeding 20% of the total value of plant and machinery.

Other Recent Developments

The Indian government offers various types of tax incentives to accelerate economic growth and extend various direct and indirect incentives to the business community. Some incentives available under the ITA are as follows:

• With effect from 1 April 2023, the tax rate on income in the nature of royalty and FTS earned by non-residents has been increased from 10% to 20% as per the ITA.
• As a result of this amendment, the gap between rates of tax on income under the ITA and under most tax treaties has widened. As a result, many non-residents would prefer to avail the tax rates as per tax treaties wherever the same are beneficial.
• To avail tax treaty benefits, a non-resident is required to have a Tax Residency Certificate (TRC) and a self-declaration in Form 10F for information which is not available in the TRC. However, the Indian tax authorities have now mandated e-filing of Form 10F along with Tax Residency Certificate (TRC) on the income tax website except in certain cases where all the prescribed information is mentioned in the TRC.
• Temporary relief has been granted until 30 September 2023 for non-residents that do not have a PAN in India and are not required to have a PAN in India. Such non-residents can continue to provide Form 10F in physical form until the aforesaid date.
• These changes entail additional compliance to be undertaken by the non-resident: Profit and investment-linked incentives:
  • Obtaining PAN in India.
  • Obtaining a Digital Signature Certificate in India.
  • Filing of income tax returns (once treaty benefit is availed, filing of tax returns in India is mandatory) and undertaking transfer pricing compliances, if applicable.
• Another critical amendment under the Indian tax laws pertains to treatment of capital gains from the sale of Market Linked Debentures (MLD) or units of Specified Mutual Funds (where investment in equity shares of domestic companies is less than 35%). With effect from 1 April 2023, any capital gains from the sale of MLD or units of a Specified Mutual Funds shall be treated as short term capital gains. Units of Specified Mutual Fund acquired prior to 1 April 2023 are grandfathered.

• 6.Could be under the automatic or government approval route involving post-facto intimation or prior approval, respectively
• 7. Only for few sectors, where FDI is permitted under the approval route
• 8. Excluding surcharge and Health and education cess
• 9. MAT is designed to ensure that no company with substantial accounting income can avoid tax liability by using exclusions, deductions, and incentives available under the Income Tax Act
• 10. The Taxation Laws (Amendment) Act, 2019, Income Tax Department, https://www.incometaxindia.gov.in/Pages/acts/taxation-laws-amendment-act-2019.aspx, as accessed on 16 July 2023
• 11. AMT is similar to MAT and applies to non-corporate bodies only if they are claiming incentive-linked or profit-linked deductions
• 12. Excluding surcharge and Health and education cess.
• 13. Transfer of listed equity shares/unit of an equity-oriented fund which attracts STT and transfer of unlisted shares (without benefit of indexation and foreign currency fluctuation)
• 14. Other cases
• 15. This income would be taxable in India based on whether or not the non-resident has a residence or place of business in India or has rendered services in India
• 16. This amendment has been applicable from 1 April 2016
• 17. Section 80-IAC of Income Tax Act, 1961