Budget impact: Surcharge hike likely to hit global passive funds

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The surcharge on foreign portfolio investors (FPIs), introduced by Finance Minister Nirmala Sitharaman in her maiden Budget last week, may dent the returns of passive funds that invest in India, affecting their ability to mimic the benchmark returns, experts say.

The Budget announced an increase in the taxation of trusts and associations of persons. This will bring global funds that adopt a passive portfolio strategy and are structured as trusts — and which contribute an estimated 20-25 per cent of the FPI money coming into India — in the higher tax bracket. As a result, the net asset values or returns of these funds will be hit, leading them to underperform the benchmarks they track by a wider margin.

“Global index funds and ETFs operating as trusts will get impacted by the higher surcharge and their returns could slip well below their benchmarks,” said Punit Shah, partner, Dhruva Advisors.

Exchange-traded funds (ETF) currently make up $40 billion of the passive money coming into India. Of this, India-dedicated ETFs manage assets of over $11 billion as of May 31, 2019, and will take the maximum hit. Other global and emerging market passive funds will also be affected to the extent of their India investment.

“Some of the large global mutual funds, pension funds, endowments, and university funds are all non-corporates. Of these, several have a sizeable portion invested through passive strategies and all these will get impacted by the increase in surcharge,” said Tejas Desai, partner, tax & regulatory services, EY.

Globally, index funds and ETFs are popular because of the low management fees. Global funds such as BlackRock, Templeton, and Fidelity could have 10-30 per cent of their investment routed through passive strategies, according to experts.

A passive portfolio management aims to mimic the investment holdings of a particular index. Index funds, for instance, are a type of mutual fund with a portfolio constructed to match or track the components of an index such as the Nifty 50. They purchase the stocks in the same proportion as the weight of the stocks in the index. This means these funds are supposed to perform in line with that of their benchmarks, except for a small difference known as the tracking error.

ETFs are similar to index funds, except that they can be bought and sold on the exchanges and are preferred by institutional investors.

The Budget has increased the surcharge on non-corporate entities, including FPIs structured as trusts or associations of persons. The surcharge on FPIs earning more than Rs 2 crore but less than Rs 5 crore has risen to 25 per cent from 15 per cent. The surcharge on income above Rs 5 crore has increased to 37 per cent from 15 per cent. This means that the effective taxation on long-term capital gains for FPIs has risen to a maximum of 14.25 per cent. Tax on short-term capital gains at the highest level has risen to a maximum of 42.74 per cent.

According to experts, there is no basis to tax FPIs organised in different legal forms in their home country on a differential basis. This is especially so, considering several foreign mutual funds and pension funds are organised as non-corporate vehicles overseas as well.

FPI funds that invest in India are either set up as trusts or are in corporate form depending on what is prevalent in the jurisdiction of their establishment. Increasing the surcharge on non-corporate FPIs will hurt those FPI funds that are set up as trusts and thereby inadvertently discriminate against some jurisdictions over others for the same activity,” said Asia Securities Industry & Financial Markets Association, an industry body for FPIs.

The Securities and Exchange Board of India (Sebi) is trying to ascertain the impact of the surcharge on FPIs. The regulator is also trying to determine the number of non-corporate FPIs that operate as trusts and the quantum of investments coming through them. Industry participants are still hopeful that the government will take a final decision on the matter only after studying the overall impact.

In case the government wants to exempt FPIs from the surcharge, it will have to insert a carve-out in the Finance Bill and make changes to Part-II of the First Schedule before it is passed into law, say legal experts. 

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