The Rationale for Roll Back of Surcharge on FPIs The government has already set up an aggressive disinvestment target for the FY 2019-20 and for that to materialize it needs buoyant equity markets

During her Budget 2019 speech on July 5, Finance Minister Nirmala Sitharaman had announced an increase in the surcharge levied on individuals earning more than rupees 2 crores a year. She proposed a hike in the surcharge for the super-rich (non-corporate) from 15 per cent to 25 per cent for incomes between Rs 2 crore and Rs 5 crore, and from 15 per cent to 37 per cent for incomes above Rs 5 crore a year. This increased surcharge would be applicable on FPIs that are structured as trusts or association of persons, since those are treated similarly to individuals for income tax purposes. The move had hit nearly 40 per cent of the FPIs. According to reports, about 2,000 FPIs operate as trusts and not companies due to several advantages related to flexibility and tax-efficient repatriation.

India's Market

The recent move has unnerved the FPIs in India, data suggests that foreign investors turned net sellers in the equity markets in July, withdrawing more than Rs 11,000 crore (nearly $2 billion) from the markets which is the highest pullout in any particular month in 2019. This is also the highest ever outflow since October 2018 when foreign investors pulled out Rs 27,622 crore from India's equity markets and a little over Rs 10,000 crore from the debt markets.

Interest of FPIs

The increased surcharged has greater ramifications for FPI's investments in India because the higher surcharge makes Indian equity markets less attractive from a returns perspective in the eyes of an FPI. FPIs are set up as trusts or limited partnerships in their home jurisdictions. However, the definition of a partnership firm under Indian tax law refers to the Indian Partnership Act, which does not recognize foreign partnerships or limited partnerships. In their initial response the government had asked the FPI to restructure themselves as corporate entities to avoid the higher surcharge, but this is a long cumbersome process and in some cases it's not the interest of the FPIs to adopt such route to route to lower taxes.

In most cases, it will not be possible for the FPI to convert from a trust to a company because the company structure will not allow the FPI to operate as an open-ended fund in the home country. Existing laws in their home countries in most cases do not allow funds to operate as corporations, although from a taxation point of view they can be treated as corporations.

Section 9 (1)

Even in the cases where an FPI intends to morph into a corporate identity, there is a long cumbersome process. To facilitate this transition, amendments would be required to provisions in the IT laws, which would need the approval of the parliament. In specific terms amendments would be needed in Section 47 of the IT act to enable specific exemptions for entities restructuring into corporations, in addition, separate immunity from the General Anti Avoidance Rules, and ring-fencing from the Section 9(1) provision applicable on indirect transfers would also be required.

Given the intricacies in the whole process, the government needs to make some tweaks, as the rollback of the surcharge is not on the table at this point. The government has swung into action with the intervention from the highest level, PMO, top officials from the finance ministry and top bureaucracy is at work to provide relief for the FPI. FPI pullout has led to severe wealth destruction in the Indian equity markets, as per estimates, Indian companies have lost approximately Rs 13 Trillion in market cap since this controversial step was announced.

Government's Move

The government which is already on the back-foot due to a faltering economy with several sectors of the economy especially auto and finance in deep trouble can ill afford such mass FPI exodus from the Indian equity markets. The government has already set up an aggressive disinvestment target for the FY 2019-20 and for that to materialize it needs buoyant equity markets.

Unconfirmed media reports have indicated that a decision in this regard is in the offing and could be announced shortly, as a reaction to the news Indian equity markets have rallied for two consecutive days. We believe that if the government follows through with positive steps to address the concerns of the FPI it would be a welcome and much-needed boost that the Indian equity markets urgently need at this point.