Chapter 12: Taxation – India Specific (Part 3)

12.5 Taxation of Non-Resident Investors in India

Overview

The Indian Alternative Investment Fund (AIF) sector attracts a significant volume of offshore capital from Non-Resident Indians (NRIs), Overseas Citizens of India (OCIs), foreign corporate bodies, and foreign institutional investors. The taxation of these non-resident investors is governed by the interaction of the domestic tax laws of India and international tax treaties. Specifically, their tax liability is computed under the provisions of the Income Tax Act, 1961 (ITA), read alongside the applicable Double Taxation Avoidance Agreement (DTAA) between India and the investor's country of residence.

12.5.1 Double Taxation Avoidance Agreements (DTAA) & Multilateral Instrument (MLI)

To encourage cross-border capital flows and eliminate the burden of paying taxes twice on the same income stream, India has established a robust network of bilateral tax treaties. Non-resident investors are granted a special statutory choice under Section 90(2) of the ITA:

• The provisions of the domestic Income Tax Act, 1961 apply to the investor only to the extent that they are more beneficial than the provisions of the applicable DTAA.
• If a tax treaty offers a lower tax rate or a more favourable exemption on a specific income stream (such as capital gains, interest, or dividends) compared to domestic law, the investor is legally entitled to claim the treaty benefits. This treaty availability is a critical factor that distributors must evaluate and communicate while marketing AIF products to offshore clients.
• The MLI Overlay: In recent years, India's treaty network has been significantly modified by the Multilateral Instrument (MLI) developed by the Organisation for Economic Co-operation and Development (OECD). The MLI operates alongside existing bilateral DTAAs, swiftly modifying them to implement anti-abuse and anti-treaty-shopping measures. Consequently, the tax implications for any offshore investor must be evaluated by reading the specific DTAA in conjunction with the MLI provisions.
• GAAR Override: The application of beneficial treaty provisions is strictly subject to the domestic General Anti-Avoidance Rules (GAAR). If an investment structure is deemed an impermissible avoidance arrangement under GAAR, treaty benefits can be overridden and denied by the Indian tax authorities.

12.5.2 Tax Residency Certificate (TRC) and Form 10F

To prevent treaty abuse and ensure that only bona fide residents of treaty-partner countries claim concessional tax treatments, the Indian tax administration mandates strict documentation:

1. Tax Residency Certificate (TRC): Under the ITA, a non-resident investor is strictly ineligible to claim any relief or benefit under a DTAA unless they obtain a valid TRC issued directly by the tax authorities of their country of residence. This certificate serves as the primary proof of residency and must be renewed on an annual basis.
2. Form 10F: If the TRC issued by the offshore jurisdiction does not explicitly contain all the prescribed details required under the Indian tax laws, the non-resident investor is statutorily required to self-certify and submit a supplementary declaration in Form 10F.
3. Substantiating Documents: The non-resident investor is legally required to maintain and preserve all relevant books of accounts and documents necessary to substantiate the residency claims and information provided in the TRC and Form 10F.

12.5.3 Tax Treatment of Specific Income Streams for Non-Residents

When an Investment Fund (Category I or II AIF) operates under the tax pass-through regime, the income distributed or deemed to be distributed to offshore investors is taxed based on the nature of the underlying income stream.

1. Interest Income

Interest income passed through by the AIF (e.g., interest earned on corporate debt, venture debt, or bonds) is subject to tax in India.

• The tax liability is computed at varying applicable rates depending on the specific legal status of the investor (such as foreign companies, other non-corporate entities, or individuals).
• These domestic rates are subject to any lower capping rates or beneficial clauses provided under the relevant DTAA.

2. Dividend Income

Since domestic investee companies are not required to pay Dividend Distribution Tax (DDT), all dividends distributed by portfolio entities pass through the AIF gross and are taxed directly at the investor level.

• Dividends are fully taxable in the hands of the non-resident shareholders at the applicable domestic tax rates or beneficial treaty rates, whichever is more beneficial.
• Section 57 interest capping: If a non-resident investor has leveraged their investment in the AIF using borrowed funds, they can claim a deduction for the interest expenditure incurred. However, this deduction is strictly capped at a maximum of 20% of the dividend income received from the fund.

3. Capital Gains on Portfolio Securities

The characterisation of gains arising from the sale or transfer of portfolio securities by the AIF follows the same general principles as those applicable to domestic investors. However, the domestic tax rates for non-residents have unique provisions:

• Concessional Rate on Unlisted Securities: The ITA provides a beneficial tax rate for long-term capital gains (LTCG) arising from the transfer of unlisted securities or shares of an Indian company (provided it is not a company in which the public is substantially interested).
• The Non-Indexation Condition: To avail of this lower beneficial tax rate, the non-resident investor must forego two major statutory benefits:
  1. Indexation benefits (adjusting the cost of acquisition for inflation).
  2. Foreign exchange fluctuation benefits (recalculating the gains in foreign currency to hedge against rupee depreciation).

4. Share Buybacks (Section 10(34A))

• When an Indian portfolio company buys back its shares from the AIF, the buyback tax is collected directly from the company under Section 115QA.
• Therefore, any gains arising from such a buyback of shares are completely exempt from income tax in the hands of the non-resident investors under Section 10(34A) of the ITA.

5. Conversion of Debentures and Preference Shares

• The physical conversion of convertible debentures or preference shares of an Indian investee company into equity shares is not regarded as a taxable transfer.
• No capital gains tax is triggered at the fund level or the investor level at the time of conversion. Tax liability is deferred until the resulting equity shares are ultimately sold.

6. Share of Profits from LLP Portfolio Entities

• If the AIF invests in an investee entity structured as a Limited Liability Partnership (LLP), the profit share of a partner is fully exempt from tax under the ITA.
• Consequently, when these LLP profits are passed through the AIF, they remain completely exempt from tax in the hands of the offshore investors.

7. Acquisitions Below Fair Market Value (Section 56(2)(x))

• If a non-resident investor or the AIF acquires any property (including securities like equity shares, preference shares, or debentures) at a price lower than its Fair Market Value (FMV) computed under prescribed tax rules, Section 56(2)(x) is triggered.
• If the difference between the FMV and the purchase consideration exceeds INR 50,000, the entire differential amount is taxed as "Income from Other Sources" in the hands of the non-resident recipient.

12.5.4 Indirect Transfer Provisions

Under the general provisions of the ITA, if a non-resident transfers shares or interest in an offshore entity, and that offshore entity derives its value substantially (directly or indirectly) from assets located in India, the transaction is subject to the Indirect Transfer Tax in India.

To prevent this rule from causing double-taxation friction for offshore fund structures, the Central Board of Direct Taxes (CBDT) issued a critical clarification:

• The indirect transfer provisions shall not apply in respect of income accruing or arising to a non-resident on account of the transfer of shares or interest held in an offshore feeder fund through which the investment in the Indian AIF is routed.
• This exemption is valid provided that:
  1. The income arises from or in consequence of the transfer of shares or securities held in India by the AIF.
  2. The proceeds of redemption or buy-back received by the non-resident from the feeder fund do not exceed their pro-rata share of the total consideration realised by the AIF from the underlying transfer of Indian shares or securities.

12.6 General Anti-Avoidance Rules (GAAR)

The General Anti-Avoidance Rules (GAAR) are a set of sweeping anti-tax-avoidance provisions contained in Chapter X-A of the ITA, which officially came into effect on 1 April 2017.

The Core Purpose of GAAR

The primary objective of GAAR is to empower the Indian Income Tax Department to look through complex, artificial, or aggressive tax structures and deny tax benefits to arrangements that have been set up solely for the purpose of tax avoidance or tax evasion, and which lack genuine commercial substance.

Defining an "Impermissible Avoidance Arrangement"

Under Chapter X-A, an arrangement can be declared an "Impermissible Avoidance Arrangement" if its main purpose is to obtain a tax benefit, and it satisfies at least one of the following four statutory tests:

1. The Arm's Length Test: It creates rights or obligations that are not ordinarily created between persons dealing at arm's-length.
2. The Abuse of Law Test: It directly or indirectly results in the misuse or abuse of the provisions of the Income Tax Act.
3. The Commercial Substance Test: It lacks commercial substance or is deemed to lack commercial substance, in whole or in part.
4. The Bona Fide Purpose Test: It is entered into, or carried out, by means or in a manner that is not ordinarily employed for bona fide purposes.

Illustrative Powers of Tax Authorities under GAAR

If an arrangement is determined to be an impermissible avoidance arrangement, the tax authorities are granted expansive powers to reallocate income, re-characterise transactions, or disregard structures. These powers include:

• Disregarding or combining any individual step of the arrangement or any party involved.
• Re-characterising any step, transaction, or financial instrument (e.g., treating debt as equity or business income as capital gains).
• Disregarding or treating any accommodating party and any other party to the arrangement as one and the same person.
• Ignoring the entire arrangement for the purposes of computing tax liability.

Implication for AIF Structuring: To mitigate the risk of scrutiny under GAAR, AIF sponsors must ensure that their pooling vehicles, feeder funds, and investment routes (such as parallel or unified structures) are backed by genuine commercial substance and have a clear business purpose beyond tax optimization.

12.7 Goods and Services Tax (GST)

Alternative Investment Funds in India are subject to the indirect tax regime governed by the Goods and Services Tax (GST) Act, 2017.

GST on Management Fees

• The relationship between the AIF (the trust or pooling vehicle) and the Investment Manager (the Asset Management Company) is classified as a service transaction.
• The Management Fee paid by the AIF to the investment manager for managing its portfolio is subject to GST.
• This tax is payable on the management fee amount, and is typically charged in addition to the base fee agreed upon in the investment management agreement.

Impact on Fund Cash Flows and Distributions

• GST represents a direct statutory outflow for the fund.
• Under the standard Distribution Waterfall of an AIF, GST and other taxes or statutory levies are categorized as Priority 1 payments.
• Consequently, these indirect tax expenses must be cleared from the fund's cash realisations before any net proceeds are allocated to investors or before calculating the manager's performance incentives (carry).

12.8 Stamp Duty and Local Taxes

Stamp duty is a vital transaction tax applicable to the securities issued and traded by Alternative Investment Funds in India.

The Amended Stamp Duty Framework

To centralize and uniformize the collection of stamp duty across the country, major amendments were introduced to the Indian Stamp Act, 1899 via the Finance Act, 2019, which officially came into effect on 1 July 2020.

Role of Registrars and Share Transfer Agents (RTAs)

• The Central Government has notified and authorized Registrars and Share Transfer Agents (RTAs) to act as central collecting agents for stamp duty.
• Under the guidelines issued by the Securities and Exchange Board of India (SEBI), RTAs are mandated to collect stamp duty on:
  1. The issue of AIF units to investors at the time of drawdowns or closings.
  2. The transfer of units between investors (such as secondary transfers).
  3. The sale of units.
• The collected stamp duty is then remitted by the RTAs to the respective state governments, simplifying transaction compliance for AIFs.

12.9 Foreign Account Tax Compliance Act (FATCA) and Common Reporting Standard (CRS)

In an era of globalized capital, AIFs must adhere to international tax information-sharing frameworks to combat tax evasion and ensure tax transparency.

1. Foreign Account Tax Compliance Act (FATCA)

• Background: FATCA was introduced in the United States Internal Revenue Code in 2010 to address tax evasion by U.S. taxpayers who conceal assets and income in offshore accounts.
• The India-US Agreement: India signed an Inter-Governmental Agreement (IGA) with the United States on 9 July 2015 (which became effective on 31 August 2015) to exchange financial account information.
• Compliance Duty: Under this agreement, Indian financial institutions—including registered Alternative Investment Funds—are legally required to identify and report financial accounts held directly or indirectly by specified U.S. persons.

2. Common Reporting Standard (CRS)

• Background: To expand automatic tax information exchange globally, the G20 countries commissioned the OECD to develop a global standard. This resulted in the creation of the Common Reporting Standard (CRS).
• India's Signatory Status: India is a signatory to the multilateral agreement and began exchanging financial account information under CRS from June 3, 2015.

3. Operational Impact on AIFs and Investors

• Due Diligence Prerequisite: To comply with both FATCA and CRS, AIFs are statutorily required to carry out detailed customer due diligence and collect self-certification forms from all prospective investors at the time of onboarding.
• Mandatory Investor Disclosures: The fund's ability to satisfy its international reporting obligations depends entirely on each investor providing accurate and timely information, tax documentation, and waivers.
• Scope of Information: Investors must disclose information concerning:
  • Their tax residency status.
  • Their Taxpayer Identification Number (TIN).
  • Details regarding the direct or indirect beneficial owners (Controlling Persons) of the investing entity.

Key Terms & Definitions

1. Multilateral Instrument (MLI): A multilateral treaty developed by the OECD that allows countries to swiftly modify their existing bilateral tax treaties to implement measures to prevent base erosion and profit shifting.
2. Tax Residency Certificate (TRC): A certificate issued by the tax authorities of a country confirming that the taxpayer is a tax resident of that country, which is a mandatory prerequisite to claim DTAA benefits in India.
3. Form 10F: A mandatory self-declaration form required to be furnished by a non-resident investor in India if their TRC does not contain all the information prescribed under the ITA.
4. Impermissible Avoidance Arrangement: An arrangement whose main purpose is to obtain a tax benefit, and which violates arm's length principles, misuses tax laws, lacks commercial substance, or is carried out in a non-bona fide manner.
5. Common Reporting Standard (CRS): A global standard developed by the OECD for the automatic exchange of financial account information between signatory countries to prevent tax evasion.
6. Form DI: The mandatory reporting form filed with the RBI by an AIF within 30 days of making downstream investments that are classified as indirect foreign investments.

Key Takeaways & Exam-Relevant Tips

• Treatment of LTCG for Non-Residents: Non-residents enjoy a beneficial tax rate on LTCG from unlisted Indian shares under the ITA, but they must forego indexation and foreign currency fluctuation benefits to claim it.
• GAAR Implementation Date: GAAR came into effect on 1 April 2017. Any structure lacking commercial substance can be re-characterised or ignored by tax authorities under these rules.
• Indirect Transfer Exemption: Indirect transfer rules do not apply to transfers of interest in offshore feeder funds, provided the income arises from AIF Indian transactions and the redemption is on a pro-rata basis (does not exceed the non-resident's pro-rata share of fund realisations).
• Stamp Duty Collection Agent: Since 1 July 2020, stamp duty on the issue, sale, or transfer of AIF units is collected centrally by RTAs acting as collecting agents.
• FATCA & CRS Signing Dates:
  • India signed the FATCA agreement with the US on 9 July 2015 (effective 31 August 2015).
  • India became a signatory to exchange information under CRS on June 3, 2015.
• Form 64D and 64C Timelines (From Part 1): Always remember that Form 64D must be submitted to the Tax Department by June 15, and Form 64C must be issued to investors by June 30 of the following financial year.