How FPIs are avoiding taxes on gains from non-convertible debentures

Capital gains tax is no longer exempt even for investors coming via Mauritius, hence FPIs are now classifying it as interest income to save on taxes.

Foreign portfolio investors (FPIs) are nowadays categorising the gains from non-convertible debentures (NCDs) as interest income to benefit from tax arbitrage, a stark contrast to the earlier practice of showing such income as capital gains.

Currently, the interest income of FPIs is subjected to five per cent withholding tax, against 15-20 per cent tax on capital gains, depending on the treaty.

The amended Double Tax Avoidance Agreements (DTAAs) with several countries, especially Mauritius and Singapore, are the reason behind this shift, experts say.

Earlier, capital gains were a more viable option for FPIs, as they could claim benefits under the treaties.

Although a withholding tax of 15-20 per cent was applicable on the capital gains, FPIs obtained relief under the DTAA where capital gains were exempt.

However, capital gains tax is no longer exempt even for investors coming via Mauritius, hence FPIs are now classifying it as interest income to save on taxes.

“Ever since the DTAA has been amended, there is a visible shift in how FPIs are structuring income from NCDs.

"Unlike in the case of shares or rupee-denominated loans, there are a few loopholes in the taxation structure of NCDs, which is helping the foreign funds to minimise their tax outgo,” said a source.

The government brought an amendment to the Income Tax Act in 2013, allowing a concessional withholding tax rate of five per cent to foreign investors, provided certain conditions are met.

One important condition is that the concessional rate is applicable only if the interest on the NCD is not more than 500 basis points (bps) over the base rate of State Bank of India (SBI).

For instance, the current base rate of SBI is 8.65 per cent.

Hence, to qualify for the concessional tax rate, the interest income derived cannot be more than 13.65 per cent.

If more, a withholding tax of 20 per cent would be applicable.

These days, FPIs buy instruments with an interest rate fixed below 13.65 per cent to get the concessional tax rate.

Over and above the rate, they also include a clause in their NCD agreements, which says the company will have to pay a premium, calculated on the basis of its share price performance at the time of redemption.

Although the premium is linked to the performance of the company’s share, it can be categorised as interest income due to loophole in the rules.

“The characterisation of premium payable over NCD at time of redemption as interest or premium is a long-standing tax issue and it will be better if the tax department provides certainty by issuing detailed guidance.

"This will, in turn, help the foreign investors and also the Indian companies to structure their NCD more efficiently,” said Amit Singhania, partner, Shradul Amarchand Mangaldas.

NCDs are debt instruments with a fixed tenure. However, unlike convertible debentures, these instruments cannot be converted into equity.

The government has taken steps to open up the NCD market in the past few years through various measures, including tax sops.

Last year, the Securities and Exchange Board of India had allowed FPIs to participate even in unlisted NCDs.

Photograph: Mukesh Gupta/Reuters