Debt investors face a tax maze in India

With a lower than estimated rate of growth of gross domestic product, and the economy in the midst of a downturn, the Union Budget due to be presented on February 1 is an important juncture in India’s vision of becoming a $5 trillion economy by 2024-25.


While debt is an important source of funds for the Indian economy, investors — especially foreign investors — have to navigate through various complexities associated with the taxation of debt investments.


Multiple tax rates


First, the applicable tax rates. Depending on the type of instrument and the route under which investment is made, interest income is taxed at varying tax rates. For domestic investors, there is no concessional tax rate for interest income, which is taxed as per applicable rates. For foreign investors, interest is taxed at 5 per cent for (i) investment by a foreign portfolio investor (FPI) in rupee bonds (subject to certain conditions); and (ii) foreign currency external commercial borrowing (ECB) and masala bonds (subject to certain conditions).


Interest on foreign currency convertible bonds (FCCBs) is taxable at 10 per cent. Interest received by FPIs and interest on foreign currency debt is taxable at 20 per cent. Lastly, interest income is taxed at 40 per cent for foreign companies investing under the foreign direct investment (FDI) route.


The above rates are subject to the beneficial rate, if any, provided under a tax treaty. The beneficial tax rate under a treaty is generally subject to the “beneficial ownership” test. However, the term “beneficial owner” has not been defined under the treaty or the domestic tax law and the lack of clarity in this regard has been used to deny treaty benefits in some cases.


While interest income is taxable for the investor, the deductibility of the interest expenditure is subject to the quasi thin capitalisation rules in section 94B of the Income-tax Act, 1961 (ITA).


Challenges faced by debt AIFs


Private debt funds are typically set up in the form of Category II alternative investment funds (AIFs). Such AIFs have been accorded a tax pass-through status for income other than business income, and such income is taxed directly in the hands of investors, as per the applicable tax rates. Business income is taxed at the AIF level at the maximum marginal rate (42.74 per cent).


While the tax office has provided clarifications in respect of taxability of income arising from transfer of unlisted shares and listed shares/securities, there is no certainty of the taxability of income earned by debt AIFs. The pass-through status of debt AIFs has also been questioned by the tax office in a few cases and hence investors are cautious about investing in such AIFs.


Taxation of debt mutual funds


On the other hand, income distributed by a debt mutual fund to individuals is subject to a distribution tax of 29.12 per cent, and exempt in the hands of the individual. This creates a significant arbitrage between debt AIFs and debt mutual funds.



Timing of taxation of interest


Another irregularity is the timing of taxability of interest income. The ITA provides that interest should be taxable when it accrues to the investor. Judicial precedents have held that interest accrues only on specified dates when it becomes due, and not on a day-to-day basis. However, the Income Computation and Disclosure Standard (ICDS) IV provides that interest shall accrue on a time basis, and premium on debt securities is to be considered as accruing over the period of maturity of such securities.



Clarifications required


Some changes that are key to increase debt investment flows in India are: (a) Providing a single rate of taxation for interest income on debt securities and providing a concessional rate for domestic investors; (b) extending the sunset clause for the concessional rate of 5 per cent for FPIs and ECBs; and (c) clarifying the nature of income for debt AIFs and removing the arbitrage for debt mutual funds.


An increase in debt investments is likely to help economic growth in India. The Budget may be a good place start in rationalising the tax provisions relating to debt investments, allaying the fears of investors and boosting debt investments in India.   



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