More than super-rich tax, the dull equity market is putting FPIs off

There has been a sharp sell-off in the equity market since the Budget presentation, with the Nifty declining 7 per cent.

It is believed that foreign portfolio outflows from the equity market — triggered by the Budget announcement of a hike in the surcharge on income-tax — is behind the sell-off. But this assumption may not be completely right.

For, the surcharge hike impacts not just the equity investments of foreign portfolio investors (FPIs), but their debt investments, too. But foreign investors have been buying Indian debt in recent times. While FPIs net sold ₹23,554-crore worth stocks in July and August, they have net purchased ₹11,371-crore of debt in the same period.

The tax tweak could be partly behind the equity market sell-off, but the weak prospects of the equity market also seem to be playing a role in FPI investment decisions. In the same vein, net inflows into Indian debt, despite the surcharge impact, are due to the superior returns from Gilt instruments this calendar.

The tax incidence

When the Budget introduced a ‘super-rich’ surcharge on individuals, the FPIs also got pulled into its ambit. Most FPIs operate in India through a trust structure, where they pool money from investors and invest that corpus in the market. They enjoy the same tax benefits as individuals enjoy and, hence, were hit by the hike in surcharge.

But this hike in surcharge impacts FPIs’ debt investments, too. “The interest income earned by the FPIs on debt securities is subject to TDS (tax deduction at source) in India at 20 per cent,” says Archit Gupta, CEO of Cleartax. “The TDS shall be enhanced with the surcharge at 25 per cent in case of interest payments above ₹2 crore and up to ₹5 crore. Above ₹5 crore, the TDS shall be enhanced by a surcharge of 37 per cent. The effective rate of TDS would be 25 per cent and 37.4 per cent, respectively.”

Even the capital gains on the sale of bonds by FPIs, be it government or corporate, suffer the same surcharge as capital gains on equity shares sold by them.

“The tax rules do not permit any concession for an FPI purely participating in debt schemes,” says Aravind Srivatsan, partner at Nangia Advisors (Anderson Global). The tax rates are subject to beneficial rates under any applicable tax treaty with a foreign jurisdiction, adds Gupta.

Tepid returns

The opposing stance adopted by FPIs in the debt and equity markets is due to the contrasting performance of the two asset classes.

Ten-year Government of India bond yields are down 90 basis points since the beginning of 2019, with the RBI cutting rates since February. This has resulted in large gains for existing investors in gilts.

Also, India’s 10-year government bonds yield 6.5 per cent, only behind Indonesian bonds’ 7.3 per cent. Many Asian emerging market economies including Thailand, South Korea and Hong Kong offer less than 2 per cent. What’s more, countries including France, Switzerland, Germany and Japan have negative yields on their government securities.

The Indian equity market, on the other hand, has been among the worst performing so far in 2019 ( see chart ).

The pre-election rally in the Nifty 50, which led to it hitting a high of 11,982 on Budget day, appears to have waned once it became apparent that the Centre does not have too many ideas to boost the earnings growth of India Inc.

With fears of a consumption slowdown caused by the liquidity crisis further affecting demand, FPIs appear to be waiting for prices to move lower to reflect the earnings growth prospects.