Traders work on the trading floor of the Motilal Oswal Financial Services Ltd. office in Mumbai, India. (Photographer: Vivek Prakash/Bloomberg)

Budget 2017: Tax Reform For Financial Services

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Given the recent developments in the Indian economy, the upcoming Union Budget will certainly be critical and important in determining the future outlook of the economy. The financial services industry has been one of the key drivers of growth due to its strong cause and effect relationship with the economy. While the Indian economy had regained some lost ground over the last 2-3 years, recent developments around the world and the demonetisation exercise have raised concerns.

The last few budgets have made certain positive clarifications and amendments to the Income Tax Act, 1961. The government has also constituted several committees to provide recommendations on issues related to direct taxation. This clearly establishes the positive intent of the government to push reforms and accelerate economic growth.

Several provisions of the Act still require fine tuning, especially those with respect to the financial services sector.

Several new provisions may be required to be inserted to set the right tone. This article seeks to highlight certain critical budget expectations from the financial services industry.

Foreign Portfolio Investors: Seeking Reassurance

There has been intense speculation that the coming budget could make changes in the capital gains regime for investments in stocks or shares.

At the National Institute of Securities Markets campus outside Mumbai on December 24, 2016, Prime Minister Narendra Modi said the “contribution of tax from those who make money on the markets has been low.” (Image: Government of India)
At the National Institute of Securities Markets campus outside Mumbai on December 24, 2016, Prime Minister Narendra Modi said the “contribution of tax from those who make money on the markets has been low.” (Image: Government of India)

While the finance minister has clarified that the government does not intend to impose long-term capital gains tax in the stock market, certain other changes could be expected:

  • Increase in existing holding period to 2-3 years, from the current 1 year, for availing the long-term capital gains tax exemption.
  • Increase in short-term capital gains tax rate, which is currently at 15 percent.

If these changes are made, they would come soon after the government renegotiated tax treaties with Mauritius, Singapore, and Cyprus withdrawing the capital gains tax exemption. This could have an impact on institutional investors.

Also Read: Will Foreign Portfolio Investors Abandon Mauritius And Singapore In Favour Of Netherlands?

The ghost of indirect transfer provisions resurfaced following a recent clarification issued by the Central Board of Direct Taxes. This has again elevated foreign investors' fears. The provisions in their present form could have an adverse impact on the foreign investment flow into India. The rules, as 'clarified',  are expected to result in double taxation of the income stream for offshore investors of India-focussed funds, and slice into their profit.

The foreign investor community is expecting the budget to liberalise the indirect transfer provisions, in line with the declared intent to welcome foreign capital into India.

Treatment Of Alternative Investment Funds

Alternative Investment Funds (AIF) have invested more than $103 billion in Indian companies between 2001 and 2015. These funds include, inter alia, venture capital funds, private equity funds, debt funds, infrastructure funds and social venture funds. These investments were made in over 3,100 companies across 12 major sectors, as noted in the report filed by the Securities and Exchange Board of India instituted panel led by NR Narayana Murthy.

The size of this investment makes the growth of the AIF route vital to the development of the Indian economy. While several positive measures have been taken in the recent past by the government on the tax and regulatory front, a few more changes are essential for the development of the AIF space.

The budget is expected to draw upon several recommendations made by the Murthy panel. Some of the key positive amendments could include:

  • Extension of the tax pass-through status to Category-III AIFs.
  • Extension of pass-through tax status to net losses incurred by the AIF (i.e. losses incurred by the AIF should be available for set-off to its investors).
  • Clarification that the income earned by the AIF should not be regarded as ‘business income’ for tax purposes.

NBFCs Seek Parity With Banks

Non-banking finance companies form an integral part of the financial fabric and are key contributors to the Indian economy. Like banks, NBFCs have a prominent role to play in rural India by providing financing for the acquisition of trucks, buses, and tractors. This, in turn, results in greater jobs and opportunities.

The last budget, aimed at bringing parity between banks and NBFCs in the application of the direct tax regime. It allowed NBFCs to claim a deduction under the provisions created for bad and doubtful debts. However, certain key areas remained unaddressed.

The Act currently recognises the principle of taxing income on sticky advances in the year in which they are received by banks, housing finance companies, and other financial institutions. This benefit is not currently available to NBFCs.

This has led to protracted litigation where several courts have taken contradictory views. Moreover, the introduction of the Income Computation and Disclosure Standards is expected to create a larger debate given that the same requires recognition of interest on a ‘time basis’.

NBFCs have long sought this parity, which if granted would come as a major relief, especially given the increase in bad loans over the last few years.

Next, an exemption from the requirement to deduct tax on the interest portion of the installment paid to NBFCs could facilitate in reducing overhead and compliance costs, and bring them at par with banks.

Promoting India-Based Fund Managers

In 2015, the Indian government took a commendable step by introducing a regime to promote India as a fund manager jurisdiction, and to encourage offshore funds to appoint India-based fund managers. The tax regime provides that an offshore fund that appoints an India-based fund manager will neither be considered as a resident of India nor be considered as having a business connection/permanent establishment in India.

In order to qualify for the above tax benefit, there are several onerous conditions that need to be satisfied by the off-shore fund as well as the India-based fund manager.

These conditions have deterred several fund managers from relocating to India. It is expected that the onerous conditions would be relaxed and the regime is brought in line with international best practices, as was originally intended.

Other measures such as deferral of the Income Computation and Disclosure Standards, clarity on taxation of masala bonds could bring in more certainty and clarity on the tax front.

Over the years, India has diversified its financial sector, which has undergone rapid expansion. It has seen strong growth of existing financial services firms as well as new entities entering the market. A favourable tax regime that offers certainty can bolster overall economic development.

Punit Shah is partner at Dhruva Advisors, with special focus on banking, financial services and private equity sector. The views expressed in this article are entirely the personal views of the author and are not that of Dhruva Advisors. The opinion expressed herein should not be construed as legal or professional advice.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.

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