FPIs cannot avail benefits of lower tax on bonds

The budget has been silent on the continuation of Section 194LD and that means FPIs have to pay higher tax on debt instruments. Foreign Portfolio Investors (FPIs) have greatly enjoyed the conveniences from the concessions provided under Section 194LD of the Income Tax Act since 2013 wherein they are charged tax at just 5% of the returns on debt instruments.

Things have changed post this budget as the extension of Section 194LD has not been taken up in this Union Budget. The sunset period was expected to be prolonged by another three years or at least for another year. However, the Budget did not make any announcement regarding its extension. This means; the withholding tax on debt is going to shoot up from 5% to 20% plus applicable surcharge and education cess.

This could lead to a bond selling spree by FPIs at an accelerated rate. Most of the FPIs have been loath to pay the higher tax as they have been used to the Indian pampering of foreign investors for just too long. Experts have warned that it could have a negative impact on investments into India, with concomitant impact on the fiscal deficit too. But, we have to wait and watch.

Here is the mathematics of it. If an FPI purchases a Rs1000 bond with coupon rate of 10%, they receive Rs100 interest. Under the old tax regime, 5% withholding tax would be imposed on this income, along with the 4% annualized hedging cost on principal. This means the FPI received net interest of Rs55. Now, under the new tax rule, the interest received falls 27% to Rs40.

FPIs may have to explore investing through IFSC which provide lower rates of 10% + surcharge and education cess, or resort to tax treaties for lower rates.