Why FIIs going away from India? Will Tax load loose FIIs forever?

It is safe to say that Foreign Institutional Investors (FIIs) are not only moving out of India, but they are also being driven out. This is particularly true because the Indian government has been doing everything in its power to restrict FIIs from pouring in their investments into the country. In this article, we will consider a very important issue that concerns real effective exchange rate capital gain taxes, which have had detrimental effects on the Indian capital market, driving FIIs away from India.

Do you know that a major blocker for foreign investors seeking to invest in India is the fact that they suffer from double taxation? Let's discuss it in detail.

 

Capital Gains Tax In India: A Legal Murderer of Investors

Before analysing it too much, we need to quickly know what capital gains tax is and how it operates in India.

Every time an investor purchases a share, bond, mutual fund, or any asset and subsequently sells it for a profit, that profit earned from the sale is taxed as capital gains. In India, this tax is broken down into two classifications:

1. Short Term Capital Gains (STCG): When an asset is disposed of in less than a year of acquisition, the profits earned on sale of the asset are taxed at 20 percent.

2. LongTerm Capital Gains (LTCG): People profiting from an asset that is held for more than a year will be taxed at 12.5%.

Both Indian and foreign investors have to pay this tax. But for foreign investors, this causes issues of double taxation since they need to pay in India first and then pay again in their country without any relief set off. Let us discuss this in detail.

 

Detailed Video

 

Points regarding Capital Gains Tax by Samir Arora

Samir Arora has serious concerns over the capital gains tax system in India, and has been very vocal about it. The founder and Chief Investment Officer of Helios Capital believes that it has disheartened the sentiment of foreign investors and is one of the major causes in the persistent FII exodus from the Indian stock markets.

For the last five months, FIIs have been exiting the Indian equity markets. Within a handful of months, they have exited their positions in stocks worth over Rs.1 trillion.

 

Why Are FIIs Exiting India?

As per Samir Arora, three main causes explain the FII exodus:

1. India is the Only Country Taxing FIIs

Out of a worryingly near 200 nations, India is one of the very few that charge capital gains tax on Foreign Institutional Investors. Most other nations use tax-free investment options to woo foreign funding. India, on the other hand, expects FIIs to pay tax here, claiming setoff benefits would happen in their home country, which never materialises.

2. No Tax Set Off Benefit

In India, tax setoff is a complicated procedure where an investor may receive an investment claim for taxes paid in their base country while filing returns in the target investing nation. With the Indian system of capital gains tax, Foreign Investment Institutions are never able to take advantage of this provision.

 

Example: 

A US-based investor puts in Rs.100 crore into India and makes a profit of Rs.20 crore.

India’s charge will be 15% of capital gains, so that’s Rs.3 crore.

Then the US will tax it at 20%, which is Rs.4 crore.

The foreign investor is required to pay taxes amounting to Rs.7 crore because Indian taxes do not allow for setoff.

Further investments into India are seemingly unaffordable due to the drop in profits above a certain benchmark.

 

3. Forex Risk

When FIIs want to withdraw their earnings, they have to first change the profits made in India to their domestic currency.

A depreciation in the Indian Rupee further reduces an investor's net returns.

They pay capital gains tax in India, but when the currency depreciates, their profit decreases even further. Finally, they pay taxes in their domestic country.

These issues combined give higher urgency for foreign investors to withdraw capital from India.

 

 

Impact of Taxation on FII Investments

Before 2017, India had some favourable tax treaties with Singapore and Mauritius, greatly benefiting FIIs regarding capital gains taxes that were largely changed after 2017 when India started imposing capital gains tax on FIIs, making it difficult for foreign investors to obtain any tax benefits and worsening the returns for these investors.

 

How Much Tax Revenue Does India Earn from This?

Samir Arora contends that while capital gains tax will bring $10 to 11 billion in FY 202223, because of shifts in economic market conditions, this is not a sustainable figure.

Regardless of India collecting $20 billion over the next few years (which is around $34 billion per year), Arora questions if this collection justifies the cost incurred due to the foregone hundreds of billions of FII investment opportunities.

 

How the Private Equity Investment is Affected By the Capital Gains Tax

Foreign Institutional Investors (FIIs) do not only invest in public equities, but they also facilitate exits into India for foreign private equity (PE) investors.

A foreign firm comes into India, grows the business, and ultimately sells their interest to Foreign Institutional Investors.

The exorbitant capital gains tax makes it less appealing for FIIs to acquire these interests, which constrains the exit options for the PE investors.

A policy such as this could be raising a few billion in tax revenue, but is most likely costing somewhere between $100 billion–$200 billion in FII investments every year due to the policies.

 

What Steps Should India Take?

Samir Arora recommends that India either eliminate capital gains tax on FIIs or implement some type of systematic tax claim arrangement to avoid taxing the same transaction twice. Unlike the tax which is likely to yield additional revenue in the short run, it is likely to undermine the economy and stock market in the long run.

 

What Should Retail Investors Do?

From the perspective of retail investors, the next 6 months should be dedicated to focusing on conserving capital rather than indulging in risky investments.

As per the analysis of Arora, the following are the most critical aspects to observe:

1. Press conferences by Donald Trump - Policies formulated by the US are relevant to the Indian stock market.

2. Market Sentiment - Having an idea about the stock market is very important for investing.

He proposes keeping an eye on the market during May and June in case you want to make major financial changes.

 

Conclusion

The capital gains tax regime here discourages FIIs from investing in India, forcing flight from the market. Forex risk, coupled with the lack of tax set-off benefits, further increase the burden on potential gains. The tax does collect revenues, but might have cost billions of lost investments to India. Therefore, any reforms to attract FIIs will need to consider a tax regime that is more favorable to investors.

So what do you think? Would it make sense for India to remove the capital gains tax to boost foreign investor confidence? Or will the government maintain the status quo?

Disclaimer: Not a buy or sell recommendation. No investment or trading advice is given. This blog is provided solely for informative purposes and should not be considered investment advice. Always conduct research and talk with a financial advisor before investing.