I. What the Tax Surcharge means for FPIs (Source - The Economic Times)

• FPIs being subject to increased surcharge will revisit their strategies in Indian markets.

The government in the recent budget proposed an increase in the tax surcharge for foreign entities which are registered as non-corporates. The move spooked investors as the surcharge will impact 40 per cent of the FPIs, as per various industry estimates. Finance minister Nirmala Sitharaman ruled out any possibility of a roll back last week, sending the market tumbling.

Here are the important things one should know about the issue:

What did the finance ministry propose in the Budget?

The government has increased the tax burden on super rich tax payers in the Union budget for FY20. The government collects a surcharge from the super rich tax payers with a taxable income of more than Rs 50 lakh a year.

This is over and above the income tax payable by them at a slab of 30%. In the budget, while the government kept the income tax slab unchanged at 30%, it increased the tax surcharge on such super rich tax payers who earn more than Rs.2crore a year. While increasing the surcharge, government included all the individuals and association of persons(AOPs) under the purview of the increased surcharge. Many foreign portfolio investors (FPIs) are structured as AOPs, limited liability partnerships and trusts. Hence, they will be subject to the higher tax surcharge if they earn over Rs. 2 crore of income a year.

How much has the tax outgo increased?

The increased surcharge will impact the FPIs dealing in both cash and derivatives markets. However, the impact is higher on funds which deal in derivatives since all the income they earn from futures and options (F&O) trades is subject to income tax. For an FPI reporting over Rs. 5 crore of income in India, the effective tax rate in derivatives goes up from 35.88% to 42.74%. If the same entity is earning between Rs.2 crore and Rs.5 crore, the effective tax on derivatives goes up from 35.88% to 39%. Even long term capital gains tax and short term capital gains tax rates will increase by 3-4% for the entities making over Rs.2 crore.

What are foreign investors saying?

FPIs feel the government is trying to segregate them based on how they are structured.

Until now, FPIs have only been categorised based on their risk profiles i.e., least risky funds such as sovereign wealth funds have been termed as Category I FPIs while the most risky and unregulated funds are Category III. Compliance requirements of FPIs vary based on such risk profile.

However, the government has now introduced a new division within FPIs — corporates and non-corporates.

This division based on structures of FPIs have nothing to do with the quality of money they bring or disclosures they provide.

For instance, a Category III FPI which is owned and controlled by a rich individual overseas can escape the surcharge if it is a corporate entity while a mutual fund or a pension fund may be subject to higher tax since it is structured as a trust or AOP. Also, FPIs structured as trusts or AOPs do not get any special advantages over the ones that are incorporated as corporates in terms of disclosures or tax rates. Structures of a fund depend on the laws in their home countries.

Why are many FPIs unable to shift from a trust structure to corporates?

The government has been maintaining a stance that FPIs wanting lower tax outgo should convert themselves into corporates. However, it is not possible for the FPIs to convert themselves from trusts to corporates overnight especially in wake of the anti-tax avoidance laws. Some of them may have the option to create a new corporate entity and route all their fresh investments through the entity to avoid higher tax outgo.

But, not all FPIs will be able to undertake such restructuring due to several factors including restrictions in the laws applicable in their home countries.

Also, a single FPI entity setup invests in multiple markets. Hence, they might not be able to restructure themselves as corporates just for Indian markets, because such an exercise could have repercussions in other markets they are investing in.

Will FPIs exit India due to the tax surcharge?

Investment decisions taken by FPIs consider multiple factors apart from tax. FPIs being subject to the increased surcharge will certainly revisit their strategies in Indian markets since the tax outgo has increased by nearly 7%.

This would shrink their India returns. If the Indian market continues to outperform emerging markets peers, FPIs can absorb the additional tax. However, if India underperforms, the new tax could prompt some investors to turn underweight.

II. Smart ways to reform the startup ecosystem (Source - Live mint)

• Here’s what India needs to do to keep pace with the changing demands of the startup sector

Startup Reforms:

Union Budget 2019-20 had some bright spots. The enduring issue of angel tax for startups has been resolved to a large extent, perhaps completely. There are encouraging plans to get India skilled in the realm of artificial intelligence (AI), Internet of Things (IoT) and virtual reality (VR). And the critical gap in research to achieve the well intentioned goals in the emerging fields of AI and IoT would hopefully be addressed by the setting up of a National Research Foundation, which was another major announcement in the budget speech.

While all of these are of course steps in the right direction, India needs to do more to keep pace with the changing economic demands of the startup sector. A few other issues faced by startups need urgent attention. The government has been trying to address some of them, such as funding, tax on employee stock option plan (ESOP), intellectual property rights (IPR), and the official definition of accredited investors, but much more needs to be done.

With regard to funding, the government has established a Rs.10,000 crore Fund of Funds for Startups (FFS) to extend funding support to innovation driven startups. While it is a great initiative which began in 2016 under the aegis of the Startup India initiative, it is moving at a snail’s pace.

FFS is monitored by the Department for Promotion of Industry and Internal Trade (DPIIT) and operated by the Small Industries Development Bank of India (Sidbi) uses a network of registered Alternative Investment Funds (AIFs) to finally invest in DPIITrecognized startups. As per the latest numbers released by the government, there are 19,351 such startups and 49 AIFs. Sidbi has committed Rs. 3,123.20 crore to these 49 AIFs, but only Rs. 483.46 crore has been drawn from FFS, so far, which is a fraction of the proposed Rs. 10,000 crore. Also, these AIFs have invested only in 247 startups till date.

The government is looking to sweeten the deal for startups on Esops. The DPIIT has begun discussions with the finance ministry on taxing shares granted by startups under Esop only at the time of sale. At present, Esops are taxed as income when employees exercise their options and convert them to shares. The finance ministry is examining the matter when it looks at proposals for the next budget. The government already has a special carve out in the tax regime for recognized startups, which could be useful in making specific changes to their stock option framework. This should help in making it easier to attract great talent through grant of Esops by startups.

Taxing matters

On the angel tax front, the government’s move to remove it as an impediment to angel investments is a good start, but more needs to be done to make it progressive.

Life is a stage

Most of our discussions around innovation focus on startup ecosystem and incentivising startups. This approach is like pushing a string. It will go only so far. We need to take a more holistic approach of building and incentivising innovation ecosystems.

Undoubtedly, and encouraged by the thinking and doing of the government, we need a more comprehensive approach to creating self sustaining clusters of innovation economies, rather than just restrict our focus to startup ecosystems. This is a natural corollary to the proposed innovation and smart city zones.

An effective innovation ecosystem is successful when it builds collaboration and desired capacity. Here are some of the measures that can help us achieve that.

• Taxation for accredited Investors


• CSR for incubators and innovation ecosystem building


• Incubator stakeholder training


• Monitoring of incubators


• Deployment of FFS effectively

Corporate Innovation

In the spirit of impacting the entire innovation ecosystem, it is important to help spur the demand for startup products and innovation through demand from corporations. Corporate innovation is perhaps the biggest priority to build an innovation ecosystem. Corporations create demand for the products and services of startups, and without that demand startups cannot reach their full potential. It is happening to some extent, mainly through programmes in multinational companies, but it is at a very small level.

While the government can create policy frameworks to develop a sustainable innovation economy, we need to unlock the potential for the government to be a consumer of startup products and services.

Conclusion:

The government should evolve and implement effective procurement policies for purchasing through startups; grant goods and services incentives to startups; government “challenge grants" to seek innovative solutions from startups or cluster of startups; incentivise startups to use India Stack as an innovation platform.

Several countries around the world have developed great startup programmes and funded them generously. But most of these programmes have yielded mediocre to disappointing results because the right people were not leading and implementing them.

India has a real shot to emerge as a world leader in innovation over the next few decades. Dreams of a “New India" will materialize only when backed by adequate and effective policy measures.

Hope you enjoyed reading this edition.

Disclaimer:

The views of the authors/publishers should not be construed as advice. Investors must make their own investment decisions based on their specific investment objectives and financial positions and using qualified advisors as may be necessary. Opinions expressed in various articles are not necessarily those of Wealthmax Enterprises Management Private Limited(WEMPL) or any of its directors, officers, employees and personnel. Consequently, WEMPL or any of its directors, officers, employees and personnel do not accept any responsibility for the editorial content or its accuracy, completeness or reliability and hereby disclaim any liability with regard to the same. Stock picks and mutual fund snapshots are not exhaustive and should not be construed as recommendations.