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    FPIs operating as trusts pushed into a corner

    Synopsis

    Tax experts said FPIs operating as trusts won’t be able to claim treaty benefits.

    DDT removal will also hurt category III alternative investment funds (AIFs), or hedge funds that invest in listed companies.
    Foreign portfolio investors (FPIs) structured as trusts and association of persons (AoPs) may fall victim to the law of unintended consequences once again, thanks to the abolition of the dividend distribution tax (DDT) in the budget, some experts said.

    With dividends to be taxed in the hands of investors, FPIs structured as trusts will have a total liability of 28.5 per cent on account of them. This includes 20 per cent tax on dividends received, 37 per cent surcharge and 4 per cent educational cess.

    Those structured as corporates will only need to pay 20 per cent tax on dividends received. Further, such an FPI can seek benefits through tax treaties, which could reduce the tax to as low as 10 per cent.

    Tax experts said FPIs operating as trusts won’t be able to claim treaty benefits since they don’t fulfil regulatory requirements in most cases, leaving them with no option but to pay higher tax.

    FPI snip 6

    “The move will significantly increase their cost because in many cases, being tax-exempt trusts, they might not be able to get a credit for the dividend tax,” said Rajesh Gandhi, partner, Deloitte. “In some cases, it could be a challenge to get the lower tax rate of 10-15 per cent under treaties because most treaties require that the trust should be a beneficial owner of the dividend income.”

    Many FPIs are structured as association of persons, limited liability partnerships and trusts.

    In the previous budget, there was an increase in tax surcharge on capital gains made by higher-income entities, encompassing rich individuals and structures such as AoPs. Overseas investors structured as corporates were exempt, which meant the budget proposal to levy a surcharge affected 40 per cent of FPIs, as they were trusts or AoPs.

    The government scrapped the enhanced surcharge levied on long- and shortterm capital gains made from listed companies following backlash from FPIs.

    “No, to be honest, I don’t think it was an intent, or we didn’t aim, to touch the FPIs,” finance minister Nirmala Sitharaman had told ET last year.

    But FPIs structured as trusts have to pay surcharge on any other income they make in India apart from capital gains. Dividends fall into the ‘income from other sources’ category.

    “The government’s decision to tax dividends in the hands of investors may bring the corporate versus non-corporate issue back to the fore,” said Suresh Swamy, partner, PwC. “It may be desirable to equate surcharge on dividends with capital gains.”

    HIGHER DIVIDEND TAXES FOR AIFS TOO
    DDT removal will also hurt category III alternative investment funds (AIFs), or hedge funds that invest in listed companies. Since these funds are structured as trusts too, they are subject to additional tax surcharge. The effective tax on them will be around 43 per cent.

    In this case, category III AIFs are not pass-through entities for taxes. They cannot pass the taxes on to their investors, but instead, must deduct taxes at the fund level. Being trusts, these AIFs fall in the 30 per cent tax bracket. An additional surcharge of 37 per cent will be applicable on them if their income exceeds Rs 5 crore a year, taking the effective tax rate on dividends received to 43 per cent.

    “Removing DDT would only make things difficult for category III AIFs since the tax rates applicable on AIFs structured as trusts is already high,” said Siddharth Shah, partner, Khaitan & Co. Shah added that the surcharge was a double blow for category III AIFs, which are already facing difficulties due to lack of passthrough tax status.

    Trusts are globally popular structures for pooled investments such as mutual funds or hedge funds. Being a trust provides a fund house ease in terms of compliance. Corporates, on the other hand, are subjected to stricter laws globally.
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