6 minute read 8 Jun 2020
Measures in Budget to encourage long-term investments

Tax exemption for sovereign wealth funds to boost Infra investments in India

By Gaurav Karnik

EY India Real Estate National Leader and Tax Partner

Advising real estate private equity funds and developers on acquisitions and asset monetization.

6 minute read 8 Jun 2020
Related topics Tax Tax planning

To fund its infrastructure development plans, the government introduced an income tax exemption for investments by Sovereign Wealth Funds and Pension Funds.

Given the state of the economy, there were widespread expectations that the Government of India would announce significant steps in the Union Budget FY21 to kickstart demand. While it abstained from introducing big measures, it rolled out a few far-reaching steps to ease the fiscal deficit targets, including the announcement of large expenditure proposals in the agriculture and infrastructure sectors.

To fund its infrastructure development plans, the government, in a welcome move, introduced an income tax exemption for investments by Sovereign Wealth Funds and Pension Funds. As per the proposal, income in the nature of dividend, interest and capital gains arising from investments made by Sovereign Wealth Funds and Pension Funds in specified infrastructure activities shall be exempt from income tax. This includes investments made in units of all types of Infrastructure Investment Trusts (InvITs), debt or shares of companies engaged in specified infrastructure activities (such as road, ports, airports, bridges, water treatment and sewage) and units of Category 1 and Category 2 Alternate Investment Funds (AIF), which have invested 100% of their funds in companies engaged in the infrastructure activities outlined earlier. The exemption is subject to the fact that the investments are made after 1 April 2020 and before 31 March 2024 and held for a period of three years. The government has also provided that they will have the powers to include other sectors for the income tax exemption as they deem fit in the future.

This initiative is extremely encouraging as it will help attract long-term investors demand the highest standards of corporate governance. These investors have invested in large infrastructure projects globally as well as in India in the past and will continue to do so. The exemption is broadly based on the US income tax exemption provided to Sovereign Wealth Funds (commonly known as section 892) and one hopes that the government would look to interpret and apply the exemption in a liberal manner, keeping in mind the class of investors and the objective of attracting large-scale investments in the infrastructure sector.

Currently, SWFs have been defined to include:

  • Wholly-owned subsidiary of Abu Dhabi Investment Authority, which is a tax resident of the UAE and makes investments out of funds owned by the Government of the UAE.
  • Any other Sovereign Wealth Fund which satisfy the following conditions:
    • It is wholly owned and controlled, directly or indirectly, by the government of a foreign country.
    • It is set up and regulated under the law of such foreign country.
    • The earnings of the said fund are credited either to the account of the government of that foreign country or to any other account designated by that government so that no portion of the earnings inures any benefit to any private person.
    • The asset of the said fund vests in the government of such foreign country upon dissolution.
    • It does not undertake any commercial activity whether within or outside India.
    • It is specified by the central government, by notification in the official gazette, for this purpose.
  •  Pension funds which are:
    • Created or established under the laws of a foreign country, including under the law of province, state or a local body.
    • Not liable to tax in the foreign country.
    • Satisfy other such conditions as may be prescribed.
    • Specified by the central government, by notification in the official gazette, for this purpose.

The provisions also provide for a claw back provision to tax income which has been exempt in the earlier years. The provision triggers in the year of breach of any of the conditions relevant to exemption claimed in earlier years. The Central Board of Direct Tax is also authorized to issue guidelines in relation to the interpretation and implementation of the above provision. These guidelines need to be approved by the central government and laid before both Houses of the Parliament. They shall be binding on the tax authority as well as the specified person.

While on one hand the above exemption seeks to attract long-term institutional investors, on the other, budget announced in February 2020 sought to remove the exemption from income tax on dividends in the hands of unit holders of business trusts. This includes Infrastructure Investment Trusts/Real Estate Investment Trusts (InvITs/REITs) which could have led to the long-term investors potentially moving away from investing in the business trusts, which is at a nascent stage in India. Globally, such vehicles and their investors are subject to a single layer of taxation based on the rationale that the tax in the structure should be equal to the tax, had the asset was owned directly by the investor rather than through the structure.

The introduction of a blanket tax on dividends declared by a business trust at the unit-holder level, created two levels of taxation which could have jeopardized any fund raise through an InvIT/REIT by infrastructure and real estate companies. Simultaneously, it would have sent a negative signal to global and local investors, creating a perception of an uncertain policy regime in India – having introduced a dividend exemption and then removing it. The objective of a business trust, unlike a company, is to ensure that annuity income is distributed to investors and 90% of its net distributable cash surplus is distributed to its unit holders. To enable this, a tax exemption on dividends was accorded to the business trust, subject to conditions.

Keeping the above perspective in mind and in deference to the representations made by several stakeholders, the amended the Finance Bill, 2020 during final enactment has provided that as long as special purpose vehicle (SPV) from which dividend income is received by REIT/InvITs by way of distribution has not opted to be governed by lower rate of corporate tax of 22%, unit holders of REITs/InvITs will not be required to pay tax on dividend income distributed by the said REIT/InvIT. Besides this, there shall be no withholding obligation on distribution of such dividend income to their unit holders.

However, if the SPV opts for the lower corporate tax rate of 22% then dividends paid by the SPV would be taxable in the hands of the unit holders of the REITs/ InvITs. Accordingly, issuers of REITs/ InvITs would need to plan for alternate scenarios while finalizing their plans.

In conclusion, the government’s move to provide Sovereign Wealth Fund and Pension Fund income tax exemption for specified infrastructure investments along with dividend exemption for unit holders of InvITs/REITs, signaled its intent to welcome long-term patient investors to invest in sectors which have significant backward and forward linkages with the economy. This may help in boosting the country’s Gross Domestic Product and in generating employment opportunities.

Summary

The income tax exemption signals the government’s intent to welcome long-term investors to invest in sectors which have significant backward and forward linkages with the economy.

About this article

By Gaurav Karnik

EY India Real Estate National Leader and Tax Partner

Advising real estate private equity funds and developers on acquisitions and asset monetization.

Related topics Tax Tax planning