Budget 2020 is a balancing act

This Union Budget 2020-21 was presented against the backdrop of very weak growth and subdued
animal spirits in the economy. The tax collections for FY20 have been the weakest in a decade. Not
only corporate tax collections have been very weak (partly reflecting tax cut impact), but even the
collections from income tax, GST, etc have slowed dramatically in the year gone by. So the FM had
a difficult task of balancing the imperative of growth revival with keeping the macroeconomic
stability intact. In this regard, the Budget was a fine balancing act. It utilized the fiscal space allowed
under FRBM Act of up to 0.5% of GDP, thus taking the fiscal deficit to 3.8% of GDP for FY21
while resuming fiscal consolidation for next year. Given this, the space for spending for FY21 is
rather limited.
In terms of specific proposals, this year’s budget focused more on opening capital markets and some
changes in tax structure. First with regards to capital markets, FPI limits were relaxed in the
corporate bond segment from 9% of outstanding to 15% of the outstanding is a positive step. Also,
there were some other measures announced to boost capital markets and increase confidence. On the
tax front, government has abolished the Dividend Distribution Tax (DDT) from company level and
will now be taxed in hands of recipients. This would benefit people who have a marginal tax rate
lower that DDT of 22%. However, for the promoters of companies, the tax rate would actually go up
(despite removing 10% tax on 10 Lakh+ dividend). For some promoters, a higher salary would make
more sense than a higher dividend. Additionally, buy-backs become more tax efficient (entails only
20% tax on it). For MNC companies, the foreign promoters in tax-free locations benefit from no
dividend tax.
Further, it has also made significant changes in the income tax structure. While tax rate has been cut
in lower income slabs up to 15 lakh, standard deductions have been taken away in a bid to simplify
the tax structure. As per the finance minister, this will result in INR400Bn of tax revenues being
given up. Further, the step to increase the deposit insurance from INR 0.1mn to INR0.5mn is one
towards protecting the small saver. While affordable housing push continues, there is no meaningful
push given the broader real estate market which came as a disappointment for the markets.
Another positive in this budget has been 100% tax exemption on income on investments (all forms –
dividend, interest, capital gains) by sovereign funds in infrastructure sector to boost the sector and
provide much needed capital to this sector.
Another important announcement was the intent of listing of Life Insurance Corporation of India in
the coming year. This is a marquee jewel of government of India, which while provide government
an avenue of monetizing its wealth. LIC, once listed will be one of the most valued companies, and
will also attract substantial foreign flows and could raise India’s weight in MSCI index post listing.
Also, FM announced complete sell-down of government stake in IDBI Bank. The government is
trying for strategic divestments of entities like Air India, BPCL, Concor, SCI and now IDBI. Success
in few of these may provide a template for further privatization which can improve the capital
efficiency of economy.
The Budget didn't have specific sops for any sector, be it auto or real estate, as widely expected to
create demand in the economy and lift it out of the current slowdown however the budget estimates
looked more realistic than the previous years. The budget has projected a nominal GDP growth of
10% which appears realistic in nature. The fiscal deficit for FY21 has been set at 3.5% of GDP (3.8%
in FY20). Also in the finer print, the government has provided disclosure in the annexure of off-
balance sheet borrowings. This provides much needed transparency that will pay us dividends from
investors in the medium term
At a broader level, the FM articulated with great emphasis the importance of wealth creators in the
economy. The Economic Survey also emphasized that wealth creators are important for overall
progress of the economic and society. And underlying this wealth creation are two fundamental
principles of liberalized markets and trust. Also, there appears to be renewed thrust and emphasis on
privatization which should boost productivity in the long run. This, I think, is the biggest difference
in budget speech this year. Hence, to that extent, one should expect more market opening and wealth
creating measures going ahead.

Foreign portfolio investors (FPIs) structured as trusts and association of persons (AoPs) may fall victim to
the law of unintended consequences once again, thanks to the abolition of the dividend
distribution tax (DDT) in the budget, some experts said.

With dividends to be taxed in the hands of investors, FPIs structured as trusts will have a total liability of
28.5 per cent on account of them. This includes 20 per cent tax on dividends received, 37 per cent
surcharge and 4 per cent educational cess.

Those structured as corporates will only need to pay 20 per cent tax on dividends received. Further, such
an FPI can seek benefits through tax treaties, which could reduce the tax to as low as 10 per cent.

Tax experts said FPIs operating as trusts won’t be able to claim treaty benefits since they don’t fulfil
regulatory requirements in most cases, leaving them with no option but to pay higher tax.

“The move will significantly increase their cost because in many cases, being tax-exempt trusts, they
might not be able to get a credit for the dividend tax,” said Rajesh Gandhi, partner, Deloitte. “In some
cases, it could be a challenge to get the lower tax rate of 10-15 per cent under treaties because most
treaties require that the trust should be a beneficial owner of the dividend income.”

Many FPIs are structured as association of persons, limited liability partnerships and trusts.

In the previous budget, there was an increase in tax surcharge on capital gains made by higher-income
entities, encompassing rich individuals and structures such as AoPs. Overseas investors structured as
corporates were exempt, which meant the budget proposal to levy a surcharge affected 40 per cent of
FPIs, as they were trusts or AoPs.

The government scrapped the enhanced surcharge levied on long- and shortterm capital gains made
from listed companies following backlash from FPIs.

“No, to be honest, I don’t think it was an intent, or we didn’t aim, to touch the FPIs,” finance
minister Nirmala Sitharaman had told ET last year.

But FPIs structured as trusts have to pay surcharge on any other income they make in India apart from
capital gains. Dividends fall into the ‘income from other sources’ category.

“The government’s decision to tax dividends in the hands of investors may bring the corporate versus
non-corporate issue back to the fore,” said Suresh Swamy, partner, PwC. “It may be desirable to equate
surcharge on dividends with capital gains.”

HIGHER DIVIDEND TAXES FOR AIFS TOO

DDT removal will also hurt category III alternative investment funds (AIFs), or hedge funds that invest in
listed companies. Since these funds are structured as trusts too, they are subject to additional tax
surcharge. The effective tax on them will be around 43 per cent.

In this case, category III AIFs are not pass-through entities for taxes. They cannot pass the taxes on to
their investors, but instead, must deduct taxes at the fund level. Being trusts, these AIFs fall in the 30 per
cent tax bracket. An additional surcharge of 37 per cent will be applicable on them if their income exceeds
Rs 5 crore a year, taking the effective tax rate on dividends received to 43 per cent.

“Removing DDT would only make things difficult for category III AIFs since the tax rates applicable on
AIFs structured as trusts is already high,” said Siddharth Shah, partner, Khaitan & Co. Shah added that
the surcharge was a double blow for category III AIFs, which are already facing difficulties due to lack of
passthrough tax status.

Trusts are globally popular structures for pooled investments such as mutual funds or hedge funds. Being
a trust provides a fund house ease in terms of compliance. Corporates, on the other hand, are subjected
to stricter laws globally.