FOREIGN PORTFOLIO INVESTMENT: OVERVIEW AND TAX EFFECTS IN INDIA

Foreign Portfolio Investment (FPI) entails offshore investors buying into Indian financial assets. All the investments are passively held by the investors. The different types of securities into which such investment is funneled include but are not limited to stocks, bonds, and other financial assets. In India, SEBI (FPI) Regulations, 2019 read with SEBI (Mutual Funds) Regulations, 1996 are the relevant regulations dealing with such funds. Furthermore, the Income-tax Act, 1961 lays down the entire framework for FPI taxation in India. Both these aspects will be covered in the following sections.

FPI funds are growing rapidly, and the net investments made daily (cumulative of all investment routes) are worth hundreds of millions of dollars.

There are three main agents in the chain of an FPI fund, which are briefly discussed below:

• Foreign Portfolio Investor – A person who has been granted certification by the Securities Exchange Board of India (SEBI) authorizing him to buy, sell, or otherwise deal in securities in India. This certificate is issued by a Designated Depository Participant on behalf of SEBI.
• Designated Depository Participant – This entity acts as an intermediary between the Foreign Portfolio Investor and the FPI Fund, acting as a custodian to the investments made by the Foreign Portfolio Investor in the securities operative under the FPI fund.
• Foreign Portfolio Investment fund – Such funds are floated to provide investment options that are beyond the domestic securities network to diversify the investment portfolio. 

The registration granted by the Designated Depository Participants is permanent unless suspended or cancelled by SEBI or surrendered by the FPI voluntarily. FPIs or global custodians (acting on behalf of FPIs) are required to appoint an Indian custodian of securities before making any investments in Indian securities. FPIs are also required to open a foreign currency and rupee-denominated account in India with a bank authorized by the Reserve Bank of India prior to making investments in India. The investments by FPIs are permitted only through stockbrokers registered with SEBI. 

As per the s. 20 of the SEBI (FPI) Regulations 2019, FPIs are permitted to make investments in the following securities (subject to conditions):

• Shares, debentures, and warrants issued by a body corporate; listed or to be listed on a recognized stock exchange in India
• Units of mutual funds
• Units of schemes floated by a Collective Investment Scheme
• Derivatives traded on a recognized stock exchange
• Units of category III Alternative Investment Funds (‘AIFs’), Real Estate Investment Trusts (‘REITs’), and Infrastructure Investment Trusts (‘InvITs’) registered with SEBI
• Listed debt securities of REITs and InvITs
• Indian Depository Receipts
• Dated Government securities/ treasury bills
• Non-convertible debentures/ bonds issued by an Indian company
• Commercial papers issued by an Indian company
• Units of Exchange-Traded Funds
• Security Receipts (SRs) issued by Asset Reconstruction Companies
• Debt instruments issued by banks, eligible for inclusion in regulatory capital
• Credit-enhanced bonds
• Listed non-convertible/ redeemable preference shares or debentures issued in terms of Regulation 6 the revised regulations
• Securitised debt instruments, including any certificate or instrument issued by a special purpose vehicle (SPV) set up for the securitization of the asset(s) with banks, Financial Institutions or NBFCs as originators
• Rupee-denominated bonds or units issued by Infrastructure Debt Funds
• Municipal Bonds
• Any debt securities or other instruments as permitted by the Reserve Bank of India or specified by SEBI for FPIs to invest in from time to time 

The SEBI (FPI) Regulations of 2019 further provide the categorization of FPIs, under which the Foreign Portfolio Investor can apply for registration as per s. 5 of these regulations. The two categories are as follows –

1. Category I is an exhaustive category that includes the following:
   • Government and government-related investors such as central banks, sovereign wealth funds, international or multilateral organizations; entities controlled or at least 75% directly or indirectly owned by such Government and Government related investor(s)
   • Pension funds and university funds
   • Appropriately regulated entities such as insurance or reinsurance entities, banks, asset management companies, Investment Managers (‘IMs’), investment advisors, portfolio managers, broker-dealers, and swap dealers
   • Entities from the Financial Action Task Force (‘FATF’) member countries, or from any country specified by the Central Government by an order or by way of an agreement or treaty with other sovereign Governments, which are: - appropriately regulated funds - unregulated funds whose IM is appropriately regulated and registered as a Category I FPI - university related endowment funds of universities that are in existence for more than five years
   • An entity whose IM is from a FATF member country, and such IM is registered as a Category I FPI; or an entity which is at least 75% owned, directly or indirectly, by another entity, eligible under the heads above and from a FATF member country. 
2. Category II includes registration for investors who are not eligible under Category I, such as:
   • Endowments and foundations
   • Charitable organizations
   • Corporate bodies
   • Family offices Individuals
   • Appropriately regulated entities investing on behalf of their client, subject to prescribed conditions
   • Unregulated funds in the form of limited partnerships and trusts 

FPIs are somewhat restrictive concerning the degree of control exercised by the investor on their investment in them, as the intermediaries have a more significant role than the investors. The intermediaries make most of the decisions relating to acquiring the funds using their expertise and know-how. The investor’s role is limited to fetching short-term returns on such investments. 

TAX EFFECTS ON FOREIGN PORTFOLIO INVESTMENTS

FPI taxation in India - From a tax perspective, as per the Income-tax Act, 1961 (the Act) income earned by FPIs can be broadly categorized into gains from the transfer of securities, interest, and dividend income. Income arising from the transfer of securities will be characterized as ‘capital gains’, whereas dividends and interest income are characterized as ‘income from other sources’. The tax rates applicable to an FPI are summarised below: 

Note: With effect from FY 2018-19, in terms of FPI taxation in India, the exemption for long-term capital gains (LTCG) on the sale of listed shares was done away with. 10% tax on such gains was introduced, and more importantly, it was specified that gains up to 31 January 2018 would be grandfathered.

Tax discharge: Usually, any payments made to a non-resident are subject to TDS. However, there is no TDS on capital gains earned by FPIs. Tax on such income earned by the FPIs is to be discharged by advance tax before the repatriation of such income before the specified due dates. Any other income earned by the FPIs would be subject to TDS at specified rates.

In furtherance of FPI taxation in India, the FPIs are mandated to file an annual ITR with the Indian revenue authorities, in which they must report their India-sourced income.

Exemption from Minimum Alternate Tax (‘MAT’) provisions: As per the Act, Companies are chargeable to tax based on income computed under the regular tax provisions or on book profits (i.e., MAT) at the rate of 18.5%, whichever is higher. However, the Act specifies that the MAT provisions do not apply to foreign companies unless they have a permanent establishment (‘PE’) in India, or they are required to be registered in India under the prevailing Company Law provisions.

Consequentially, MAT provisions do not apply to FPIs not having PE in India.

RULES AND TREATY ASPECTS OPERATIVE IN CERTAIN SITUATIONS

Beneficial ownership: This concept is based on the principle of ‘substance over form’ and was introduced to identify the actual owner of the income or asset, who has the ultimate right of enjoyment over it. It must be interpreted in the context of DTAAs if the need arises while dealing with FPIs.

General Anti-Avoidance Rules (‘GAAR’): These sets of rules (which are in effect from 1 April 2017) help in invalidating an arrangement that a taxpayer has entered to obtain undue tax benefits on his income. It overrides benefits availed under any tax treaty. However, the exemption is given from the applicability of GAAR in the following cases of a Foreign Portfolio Investment –

• An FPI assessed as per the provisions of the Act.
• An FPI that has not claimed benefits under any DTAA.
• An FPI that has invested in listed/ unlisted securities with the prior permission of the relevant authority and in accordance with the SEBI regulations.
• In case a non-resident investor has invested in an FPI directly/ indirectly through an offshore derivative instrument or otherwise.

Multilateral Convention to Implement Tax Treaty-Related Measures to Prevent Base Erosion and Profit Shifting (‘MLI’): As the name suggests, MLI is a multilateral treaty that enables jurisdictions to easily make amendments to their tax treaties for implementation of measures designed to address multinational tax avoidance and resolve tax disputes more effectively. The MLI adopted numerous measures to prevent Treaty abuse, improve dispute resolution, and so on. Upon coming into effect, the MLI applies with respect to taxes withheld at source and all other taxes. MLI does not function as a protocol and needs to be read in connection with the existing treaties for precise interpretation.

With India being one of the countries becoming signatories to the MLI (it being one of the countries as top destinations attracting FPI money), the investors will now have to relook at their structures and strategies, especially if they are claiming any benefits under the tax treaties.

Indirect transfer: When shares of a foreign company or interest in any entity incorporated or registered outside India are/ is transferred and in case such shares or interest derive their substantial value from assets located in India directly or indirectly, then such a transfer is commonly referred to as ‘Indirect Transfer’

The share or interest mentioned above would be regarded as deriving substantial value from assets located in India if, on a specified date, the fair market value of such assets exceeds INR 100 million AND represents at least 50% of the fair market value of total assets owned by the foreign company/entity.

There was an amendment in the tax provisions introduced by the Finance Act, 2017,wherein Category I FPI was exempted from indirect transfer provisions laid out in the Act.