Despite weak macroeconomic trends due to various internal and external factors, India witnessed a sharp increase of 16% in foreign direct investment (FDI) in 2019. Structural reforms undertaken by the government, including a reduction in the corporate tax rate and the effective implementation of the insolvency and bankruptcy code resulted in a notable improvement in India’s ranking in the World Bank’s ease of doing business table, and undoubtedly contributed to the increase in FDI in India.
In an attempt to further boost FDI, the government in the 2020 budget has proposed further major structural reforms. One proposal is to abolish the dividend distribution tax (DDT) that a company declaring a dividend is required to pay at a rate of 20.35%. The dividend is not at present subsequently taxable in the hands of the recipient. With effect from 1 April 2020 however, companies will not be required to pay DDT, and the recipients will be taxed directly on their dividends. This will result in greater yields for foreign investors as well as benefiting those foreign investors who are liable to pay no, or a lower rate of tax on dividend income. This will lead to transparency in the repatriation of profits by a company to its foreign shareholders as tax payments in respect of DDT will no longer be an issue for foreign holding companies. However, this could have an adverse impact on infrastructure investment trusts (InvITs).
As India aims to become a US$5 trillion economy by 2024-25, infrastructure is one sector that will require significant investment. Acknowledging its importance to economic growth the government in the budget has announced special exemptions to make investments in the infrastructure sector more attractive to foreign investors. It is proposed that sovereign wealth funds will be granted 100% tax exemption on interest, dividends and capital gains from investments in the infrastructure sector that have a minimum lock-in period of three years. The budget also proposes extending the concessionary corporate tax rate of 15% to new companies in the power sector. These reforms will certainly stimulate growth in the infrastructure sector in the near term. Interestingly, this exemption is not offered to private sector investors, something that would have attracted more FDI in the infrastructure sector. Perhaps, the government should offer similar tax concessions to private investors in the infrastructure sector provided they meet the prescribed minimum thresholds and lock-in requirements.
The budget also proposes a uniform tax treatment for both listed and unlisted InvITs. This is helpful as the Securities and Exchange Board of India has already permitted private placement of units of InvITs. With such uniform tax treatment, InvITs will no longer have to list solely to gain tax advantages over an unlisted status. This will provide flexibility and cost savings to issuers as unlisted InvITs face fewer compliance requirements and a less onerous governance burden.
After a long wait, the government has finally indicated that it will take steps to encourage external commercial borrowing and FDI in the education sector. Despite the fact that FDI in the education sector is already permitted up to 100% under the automatic route, there has been little FDI in the formal education sector compared to the overall growth of FDI in India. This is largely because a formal education institute in India can only be set up as a non-profit entity and therefore does not attract much interest from financial investors. To incentivize foreign investors, the government may perhaps consider relaxing the mandatory requirement to carry out business through a non-profit entity and allowing foreign investors to repatriate a portion of their profits. The government has given no details of the nature and extent of the reforms and only after a formal announcement has been made can the proposals be evaluated.
The budget certainly ticked some boxes but there were omissions as well. Against expectation, the budget did not increase the FDI limit for insurance companies to 74% from the existing 49% to allow entry for the foreign players who would introduce new technologies, sophisticated insurance products and efficiency. Such innovations can only benefit the Indian economy. Industry experts were also expecting removal of the long-term capital gains tax on equity mutual funds to boost private consumption but were disappointed.
These reforms, designed to build confidence will certainly brighten the prospects for FDI. They should go far to create a sustainable investment environment, encouraging both GDP and economic growth and boosting the aim of becoming a US$5 trillion economy by 2024-25.
Navin Syiem is a partner and Nitin Gera is a managing associate at L&L Partners. The views of the authors are personal.
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