NRI Investments & Taxation

Gautam Nayak

Chartered Accountant

Introduction

Till about a decade ago, the subject of investments by and taxation of Non-Resident Indians (NRIs) was a hotly discussed and debated subject, and we had many seminars on the subject. At that time, there were various tax and exchange control concessions available for NRI investment, the rates offered on NRI investments were highly attractive and NRI investments were actively pursued by the Government as a means of shoring up the country’s foreign exchange reserves.

The clock has now turned, and with extremely healthy foreign exchange reserves, NRI monies are no longer welcomed in India with as much enthusiasm as in the past. The present day scenario for NRI investments presents a stark contrast to those heady days of the 1990’s, when NRI investments were actively wooed.

Interest rates in India have fallen drastically over the last decade, reducing the spread available for NRIs investing in India. This has been further aggravated by the fact that the interest rates offered on NRI deposits today are no longer at a substantial premium to the rates offered to domestic investors. Gone are the days when banks would offer 16% to an NRI on NRNR deposits – today he would be lucky to get 7%!

Even the exchange control laws for investments by NRIs put NRIs almost on the same footing as other non-resident foreign citizens or entities. Overseas Corporate Bodies (OCBs – companies owned more than 60% by NRIs) is now a dirty word so far as the regulatory authorities are concerned, and stand on the same footing as other foreign companies. The avenues of investment available have narrowed down to just a few. There have even been attempts to tax the meagre interest currently being paid on NRE and FCNR(B) deposits.   

At the same time, the taxation provisions for residents in general have been significantly liberalised. Dividends and mutual fund income distributions are no longer taxable, long term capital gains on sale of shares and equity oriented units are exempt, short term capital gains on such investments attract only a 10% tax. Viewed in this backdrop, the special tax benefits to NRIs are no longer attractive. 

Yet, NRIs are looking to invest in India. The difference this time around is that they are no longer putting their money in domestic bank deposits, but like other foreign investors, they are focusing on the stock markets, on promoting companies to capitalise on business opportunities in India. Of course, they are also investing in real estate, but not just as planning for their return, but as an investment to earn returns through rentals and capital appreciation.

Concept of Non-Resident Indian

In India, the differing concepts of NRI under income tax laws and NRI under exchange control regulations have been in existence for many years. The complication is aggravated by exemption [section 10(4)(i)]under the Income Tax Act being available to NRIs as defined by FEMA.

While the definition of “person resident in India” under FEMA also now refers to a person residing in India for more than 182 days, the concept of non-resident under FEMA still primarily goes by the test of intention.

For most investment purposes, under FEMA, the concept of NRI includes not only an Indian citizen, but also a foreign citizen of Indian origin, i.e. a person of Indian origin (PIO).

Investment Avenues

The investment avenues in India available today for NRIs are:

1. Bank Deposits – NRE, FCNR(B), NRO

2. Immovable Property

3. Shares – FDI, Portfolio Investment (repatriable, non-repatriable), Non-repatriable investment

4. Derivatives

5. Units of Mutual Funds

6. Company Deposits

7. Debentures & Bonds 

8. Proprietary or Partnership Concerns

9. Loans to residents

NRIs are now not allowed to invest in highly attractive investments, such as Public Provident Fund, Post Office Monthly Income Scheme, 8% Government of India Savings Bonds, National Savings Certificates, etc. 

Yet, even these limited avenues seem attractive to NRIs at times, given the low rates of interest prevalent in their countries of residence, and given the fact that India is now being looked upon as a success story with immense potential.

1. Bank Deposits

a.       Repatriable Deposits

i.         Non-Resident (External) Accounts - (NRE):

Non-Resident (External) accounts (fixed deposits, current, recurring as well as savings accounts) are still one of the most popular NRI investment options. While the deposits are designated in rupees, the principal is fully repatriable. The interest, of course, being a current income, is fully repatriable in any case. The appreciation of the rupee against the US dollar in recent times has ensured that these deposits remain attractive, notwithstanding the fall in interest rates on these deposits over the past few years.

The interest rates on NRE accounts are regulated by RBI, which lays down a cap on such interest. NRE savings accounts can earn a rate of interest not exceeding the six-month LIBOR rate for US Dollars, while NRE fixed deposits for terms of 1 to 3 years can earn interest not exceeding 50 basis points over LIBOR of the corresponding maturity. For fixed deposits exceeding 3 years, the interest rate cannot exceed the applicable rate for 3 years maturity. NRE fixed deposits therefore have to be for a minimum maturity of 1 year.

Accordingly, currently NRE savings accounts earn interest up to 3.71% per annum, while NRE fixed deposits earn interest ranging from 4.38% to 4.60% per annum.

The amendment to withdraw the income tax exemption under section 10(4)(ii) for interest on NRE deposits, which would have further reduced the real rates of return on such deposits, has been rescinded.  This amendment, which was to take effect from 1^st April 2006 (Assessment Year 2006-07), has been withdrawn with effect from the same date, before it came into effect.

This exemption is available to individuals whose status is non-resident under FERA (now replaced by FEMA), and not to individuals who may be non-resident under the Income Tax Act, but not under FEMA. This may give rise at times to interesting situations, where interest for only a part of the year is exempt, while the rest is taxable.

Some banks (particularly foreign banks) had introduced specific products for NRIs, whereby they lent money to NRIs abroad from their overseas branches to invest in NRE accounts in India, to take advantage of the arbitrage opportunity available. This has reduced considerably after the reduction in interest rates on such deposits. These products also had the inherent danger that if the NRI was regarded as carrying on business in India by arbitraging, the interest paid by the NRI to the foreign branch could perhaps have been regarded as interest paid in relation to borrowing for an Indian business, and deemed to accrue or arise in India by virtue of section 9(1)(v)(c). The foreign branch may therefore have been liable to tax in India in respect of such interest on the loan, and the NRI been under an obligation to deduct tax at source on such interest.

NRE deposits/accounts cannot be held jointly with residents. However, a resident Power of Attorney holder can operate or give instructions regarding NRE deposits/accounts.

        ii.    Foreign Currency (Non-Resident) Accounts - [FCNR(B)]:

The capital on FCNR(B) Deposits is also repatriable – the crucial difference from NRE deposits being that such deposits are protected from exchange rate fluctuations, being designated in either USD, GBP, Euro or JPY. Recently, RBI has permitted FCNR(B) deposits to be held in Australian Dollars and Canadian Dollars as well. In a situation where the rupee was depreciating, this feature of denomination in foreign currency made the deposits attractive, but with the recent strengthening of the rupee, this is no longer an attraction.   

FCNR(B) deposits can only be held as term deposits, and not as savings accounts, unlike NRE accounts. Further, they can only be held for terms of 1 year to 5 years. Like NRE deposits, FCNR(B) deposits cannot be held jointly with residents.

The rates on FCNR(B) deposits are also regulated by Reserve Bank of India. The rates of such interest cannot exceed the ceiling rate of LIBOR/SWAP for the respective currency for the corresponding term minus 25 basis points.

The range of interest rates for FCNR(B) deposits for different currencies is currently as under:

The income tax exemption for interest on FCNR(B) deposits under section 10(15)(iv)(fa), like the exemption for interest on NRE deposits, has been retained, after having been withdrawn. Unlike in the case of NRE deposits, the interest exemption is dependant upon the income tax residential status (non-resident or not ordinarily resident) of the depositor, and not his FEMA residential status.

b.       Non-repatriable Deposits:

        Non-Resident (Ordinary) Accounts – (NRO):

These are rupee deposits with banks, which are primarily non-repatriable. They are almost akin to domestic deposits, except that they have restrictions regarding the credits to such accounts. Such accounts can be opened not only by NRIs, but also by other non-residents. Such accounts can be held jointly by NRIs with residents. Such accounts could be in the form of savings, current, recurring or term deposit accounts.

Since the interest rates on such deposits are not regulated under FEMA, the interest rates offered on such deposits are normally the same as on other domestic deposits.

Interest on such deposits is taxable, and suffers tax deduction at source (TDS) at 30% (plus surcharge and education cess) without any minimum limit. Therefore, even interest of Rs.10 suffers TDS of Rs.3. Of course, if the income of the NRI does not justify such high rate of deduction, the NRI has the option of obtaining a certificate for lower rate of deduction of tax at source under section 197 from the Assessing Officer.

2. Immovable Property:

In recent years, investment in immovable property has become a very attractive investment option for NRIs. The reasons for this are manifold – the repatriation of rentals and initial investment, the automatic approvals available for purchase and sale, the relaxation of rental laws in India permitting easier eviction of licensees or tenants, the high rentals that such properties can fetch due to the booming infotech and BPO sectors, the concessional scheme of taxation of rental income for all taxpayers - all these reasons, other than the traditional sentimental reason of wanting to have a house in one’s hometown, have made investment in immovable property in India an alluring proposition for NRIs.

The Foreign Exchange Management (Acquisition and Transfer of Immovable Property in India) Regulations, 2000 draw a distinction between an Indian citizen resident outside India (NRI) and a Person of Indian Origin (PIO) for the purpose of acquisition of immovable property in India. These regulations lay down the circumstances under which properties can be acquired or disposed of in India by NRIs and PIOs without any prior permission.

Under Clause 3 of the Regulations, an NRI is permitted to:

(i)                 acquire any immovable property in India other than agricultural property/plantation/farm house, or

(ii)                transfer any immovable property in India to a person resident in India, or

(iii)             transfer any immovable property other than agricultural/plantation property/farm house to another NRI or PIO, without any prior RBI approval being required.

Under Clause 4 of the Regulations, a PIO is permitted to:

(i)           purchase any immovable property in India other than agricultural land/farm house/plantation property through inward remittances or funds held in non-resident accounts;

(ii)          receive a gift of immovable property in India other than agricultural land/farm house/plantation property from a resident, an NRI or a PIO;

(iii)              inherit immovable property in India from a non-resident, who acquired it in accordance with relevant exchange control regulations or from a resident;

(iv)              sell any immovable property in India, other than agricultural land/farm house/plantation property, to a resident;

(v)                gift or sell agricultural land/farm house/plantation property in India to an Indian citizen resident in India;

(vi)              gift residential or commercial property in India to a person resident in India or to an NRI or to a PIO without prior RBI approval.

As can be seen from the above, an NRI has a much wider leeway in acquiring or transferring immovable properties without prior RBI permission. While only the specific modes of transfers are permitted for different types of properties in the case of PIOs, in the case of NRIs, all types of transfers are permitted for most types of properties. It is mainly in the case of agricultural/plantation/farm house properties that there are significant restrictions for NRIs as well.

These provisions relating to NRIs/PIOs can be tabulated as under:

No documents are required to be filed with Reserve Bank of India (RBI) by an NRI/PIO on purchase, inheritance or receipt of gift of the property, if it is covered by the above. Any number of permitted properties can be acquired by the NRI/PIO.

So far as transfer of property is concerned, if the proposed transfer is not covered under the automatic approval route, an application can be made to RBI seeking specific prior approval, under the proviso to clause 8 of the Regulations.

The property can be acquired out of rupee funds or out of balances in NRE/FCNR(B) accounts or out of inward remittances. It is however necessary that the entire consideration for the property is paid in India, and no part of the consideration should be paid outside India.

Residential property can also be acquired through housing loans taken from banks in India against the security of NRE/FCNR(B) deposits, or be financed by rupee loans from a bank, or housing finance company in India. Such loans can be repaid out of inward remittances, from NRE/FCNR(B)/NRO accounts or out of rental income derived from letting out the property.

The property can be let out by the NRI/PIO, and the entire rental income, being a current account transaction, can be remitted outside India, net of taxes payable on such income. Rental income would be liable to tax in India, and would be subject to TDS under section 195 at the rate of 30% (plus surcharge and education cess) of such income. However, the effective tax rate on such income would not exceed 21% (plus surcharge and education cess), since 30% of the rental income (or the municipal taxes and 30% of the rent less municipal taxes) would qualify for a deduction under section 24(a). In most cases, it would therefore be advisable for the NRI to make an application to the assessing Officer for a certificate for lower rate of TDS under section 197(1). 

Under Clause 6(b) of the FEMA (Acquisition and Transfer of Property in India) Regulations, an NRI/PIO, who has acquired a property in convertible foreign exchange (out of inward remittances, or out of NRE or FCNR(B) accounts) in accordance with exchange control regulations, is permitted to repatriate sales proceeds of the property not exceeding the original investment in terms of the relevant foreign currency. For this purpose, if the property was acquired through a rupee loan, which was repaid through inward remittances or from NRE/FCNR(B) accounts, such repayment would be regarded as acquisition of the property in foreign exchange.

Such repatriation is however restricted in the case of residential properties, to not more than two such properties. In the case of commercial properties, there is no restriction on the number of such properties for repatriation.

There is no lock-in period for the sale of the immovable property, to qualify for repatriation of the sales proceeds. In fact, even if the NRI/PIO has booked a flat or entered into an agreement for purchase of a property, and the transaction is cancelled, the refund of the advance payment and the interest can be remitted, provided the original advance was paid in foreign exchange [AP (Dir) Series Circular No.46 dated November 12, 2002].  

There is also one more avenue for repatriation of sales proceeds of immovable properties. Under Clause 4(3) of the Foreign Exchange Management (Remittance of Assets) Regulations, 2000, an NRI/PIO is permitted to remit an amount not exceeding US $ 1,000,000 per calendar year out of sales proceeds of assets, provided that if the immovable property was acquired otherwise than by inheritance or settlement, it should have been held for at least 10 years. The remittance is subject to documentary evidence in support of acquisition of the assets and tax clearance/NOC from income tax authorities for the remittance. If the property has been held for less than 10 years, the sales proceeds can be deposited in an NRO account for the balance period to complete 10 years, and can then be repatriated.

Sales proceeds of immovable property located in India would invariably be liable to capital gains tax in India, being income accruing or arising in India. Further, there would not be relief available under tax treaties, since most Double Taxation Avoidance Agreements (DTAAs) provide for such income being taxable in the country in which the property is located. The manner of computation and taxation of capital gains on sale of immovable property by an NRI/PIO would be the same as that arising on sale of such property by a resident – long term capital gains would be computed with cost indexation, and would be taxed at 20% (plus SC and EC), while short term capital gains would be taxed at the slab rates of tax. Further, payment of sales proceeds to an NRI/PIO would be subject to deduction of tax at source under section 195 on the capital gains – at 20% (plus SC and EC) on the long term capital gains, and at 30% (plus SC and EC) on the short-term capital gains.

An NRI/PIO can of course claim the benefit of exemption under sections 54, 54EC and 54F in respect of long term capital gains on sale of immovable property in India. Further, there appears to be no bar under sections 54 or 54F on the exemption being claimed in respect of long term capital gains arising on sale of property in India, for the amount spent on purchase of a residential house outside India within the specified time period.

3.        Shares:

There are 4 different routes by which an NRI/PIO can invest in shares of an Indian company. Some of these permit investment on a repatriation basis, while others can be only on a non-repatriable basis. All investments on a repatriable basis have to be acquired through inward remittances, or from funds from NRE/FCNR(B) account, while non-repatriable investments can also be acquired from NRO funds. In all these cases, irrespective of whether the investment is on a repatriable or non-repatriable basis, the dividends are fully repatriable, being a current account transaction. Dividends are also exempt from income tax under section 10(34). However, in effect, tax is paid on the dividends by way of dividend distribution tax, for which tax credit would not be available in the NRI/PIO’s country of residence, in most cases.

A.       Portfolio Investment:

NRIs/PIOs can purchase and sell shares or convertible debentures of an Indian company through a registered share broker on a recognised stock exchange under the Portfolio Investment Scheme, as per Schedule 3 to the Foreign Exchange Management (Transfer or Issue of Security by A Person Resident Outside India) Regulations, 2000. Such purchase of shares and convertible debentures can be on a repatriation basis or on a non-repatriation basis. In case of acquisition of shares on a repatriation basis, the purchase has to be out of inward remittances or from NRE/FCNR account.

Since such transactions have to take place on a recognised stock exchange, obviously such transactions can only be in listed shares or convertible debentures. Such purchase and sale is permitted only on delivery basis, and therefore purchase and sale of the shares on the same day is not permitted. There is however no lock-in period, and the shares can be sold as soon as the shares are credited to the demat account.

There is a limit of 5% of the paid-up value of the shares (or convertible debentures, as the case may be) of the company for investment by each NRI, and an overall limit of 10% of the paid-up value of the shares of the company for all NRIs put together. This 10% limit can be increased to 24% through a special resolution of the company.

All the transactions of an NRI have to be routed through a particular designated branch only. Since co-ordination between the bank and the broker is often difficult, most NRIs either route their transactions through the bank branch with whom the broker has tied up or route their orders through the broker whom the bank branch has arrangements with. Many brokers also offer Portfolio Management Services to NRIs/PIOs, where they manage the portfolios for the NRIs/PIOs, generally on a discretionary basis. All the paperwork is then taken care of by the brokers concerned.

Since such transactions are routed through the stock exchange, they would be subject to Securities Transaction tax with effect from 1^st October 2004. The long term capital gains arising on sale of the equity shares after 30^th September 2004 is exempt under section 10(38), while short term capital gains is subject to tax at 10% (plus SC and EC).

B.  Non-Repatriable Investment:

Under Schedule 4 to the FEMA (Transfer or Issue of Security by A Person Resident Outside India) Regulations, 2000, an NRI/PIO is permitted to acquire shares/ convertible debentures of an Indian company through a public issue, a private placement or a rights issue on a non-repatriation basis. This investment is not subject to the 10% (or 24% limit), which applies to Portfolio Investment Scheme.

Since such transactions are not on the stock exchange, the investment could be in an unlisted company or private company. However, the investee company should not be engaged in the business of chit funds, nidhis, agricultural plantations, real estate business (other than development of townships, construction of residential/commercial premises, roads, bridges, etc), construction of farm houses or dealing in Transferable Development Rights.

The sales proceeds of such investments would have to be credited to NRO account, since the investment would be on a non-repatriable basis. NRIs/PIOs are permitted to sell such investments on a recognised stock exchange through a registered broker, gift them to a resident or gift or sell them to another NRI/PIO.

In case NRIs/PIOs desired to sell such investments to a resident (other than through a stock exchange), they earlier required prior approval of RBI in accordance with clause 10B of the Regulations. However, vide AP (Dir Series) Circular No.16 dated 4^th October 2004, RBI has granted general permission to non-residents to sell shares to residents through private sale, provided the sale meets with the pricing guidelines and other conditions laid down in the circular. The non-resident also has to submit Form FC-TRS to the Authorised Dealer regarding such sale, along with various documents. This circular does not apply to shares of a company engaged in the financial services sector.  

This circular also gives general permission for private sale of shares of Indian companies by resident to non-residents, including NRIs/PIOs, subject to the pricing guidelines and conditions and procedure laid down. NRIs can therefore purchase shares of Indian companies from residents under this route as well, either on a non-repatriable basis.

If such shares are sold on a recognised stock exchange, the long term gains on sale of the shares would be exempt from tax under section 10(38), while the short term capital gains would be taxable at 10% under section 111A.

Where such shares are sold outside the stock exchange, the manner of taxation of long term capital gains on sale of such shares would depend upon the type of funds from which the shares were acquired.

If the shares were acquired in foreign exchange, the capital gains would be computed in terms of the foreign exchange in which they were acquired, in terms of the first proviso to section 48. No cost indexation benefit would be available. If such shares are listed but sold off the stock exchange, the long term capital gains would be taxed at 10% in accordance with the proviso to section 112(1). If the shares are unlisted, the long term capital gains would be taxed at 20% (plus SC and EC). In both cases, the short term capital gains would be taxed at the slab rates of tax.

If the shares were acquired out of rupee funds, the long term capital gains would be computed with indexation of cost, and be taxable in the same manner as for a resident – for listed shares sold off market, long term capital gains tax at lower of 20% (plus SC & EC) of gains or 10% (plus SC & EC) of gains without cost indexation. 

C.  Foreign Direct Investment (FDI):

NRIs/PIOs can also make strategic investments in Indian companies by subscription to shares on a repatriable basis under the Foreign Direct Investment route, outlined in Schedule I of the FEMA (Transfer or Issue of security by a Person Resident Outside India) Regulations, 2000, in the same manner as other foreign investors. For purposes of FDI, NRIs/PIOs are treated like any other foreign investor.

These investments are subject to the negative list in Annexure A and to the sectoral caps in Annexure B of that Schedule.

The investee company has to intimate RBI about receipt of the application money within 30 days of receipt giving details stipulated in Clause 9(1)(A), and to file Form FC-GPR with RBI within 30 days of allotment of the shares, along with the certification stipulated in Clause 9(1)(B) of the Schedule.

The sale of such shares is permitted in the same manner as the sale of shares acquired as non-repatriable investments. AP (Dir Series) Circular No.16 dated 4^th October 2004 has granted general approval for sale at prevailing market price on the stock exchange, and has permitted private sale subject to pricing guidelines and other conditions.

Since this circular has also permitted transfer of shares from residents to non-residents, NRIs/PIOs can also acquire shares on a repatriable basis on the basis of this circular under the FDI route. Such acquisition is subject to the activities of the investee company being under the automatic approval route, compliance with sectoral caps, the pricing guidelines laid down in the circular and filing of various documents with the authorised dealer.  

The taxability of the capital gains arising on sale of these shares will also be in the same manner as that arising in case of shares acquired as non-repatriable investments, discussed in Part B above.

D. Shares in Public Sector Enterprises:

Under Clause 2(1)(iii) of Schedule 5 to the FEMA (Transfer or Issue of security by a Person Resident Outside India) Regulations, 2000, an NRI/PIO can purchase shares in public sector enterprises being divested by the Government of India on a repatriable basis.

Such purchase has to be in accordance with the terms and conditions stipulated in the notice inviting the bids. Since the regulations do not specify that it applies only to divestment by way of strategic or private sale by the Government, even divestment through a public offer by the Government would fall under this clause.

The company wise limits do not apply to such investments.

The taxation of gains arising on sale of these shares is the same as that of gains arising on sale of the earlier two categories of share investment.

4.        Derivatives

NRIs/PIOs are permitted to invest in exchange traded derivative contracts approved by SEBI, under clause 5(7) of the FEMA (Transfer or Issue of security by a Person Resident Outside India) Regulations, 2000. This approval is however subject to the limitations that such investment can only be out of rupee funds held in India (and therefore not out of inward remittances or balances in NRE/FCNR accounts), is subject to limits prescribed by SEBI and is on a non-repatriable basis.

Effectively, therefore, with rupee funds, an NRI/PIO can carry on transactions in financial derivatives on the stock exchanges, and remit the profit arising on such transactions, since the profit on such transactions would be a current account transaction.  

5.        Units of Mutual funds:

Under Schedule 5 of the FEMA (Transfer or Issue of security by a Person Resident Outside India) Regulations, 2000, an NRI/PIO is allowed to purchase units of domestic mutual funds without any limits on a repatriation basis [Clause 2(1)(i)]. Under Clause 2(1)(ii) of the same Schedule, he is also permitted to acquire such units on a non-repatriation basis, along with units of a money market mutual fund, without any limit. Indirectly, this indicates that an NRI/PIO cannot acquire units of a money market mutual fund on a repatriable basis.

There is no other restriction as to the type of scheme that an NRI/PIO can invest in – equity, income, g-sec, balanced, etc., all are permissible. Though an NRI/PIO is not permitted to trade in derivatives on a repatriable basis, he can invest in a mutual fund scheme which deals in derivatives on a repatriable basis.

Permission has also been granted to NRIs/PIOs for tender of such units to the mutual fund for repurchase or redemption under clause 4 of the Schedule. 

The income distribution by the mutual fund in respect of mutual fund units would be fully repatriable, irrespective of whether the units are acquired on repatriable basis or non-repatriable basis, being a current account transaction.

Units of mutual funds, being neither shares nor debentures, would not be eligible for computation of capital gains in terms of the foreign currency in which they were acquired, under the first proviso to section 48.

In case of equity oriented mutual funds, the long term capital gains arising on sale of the units after 30^th September 2004 would be exempt from tax under section 10(38), since the transaction would be subject to Securities Transaction Tax, while the short term capital gains on transfer of such units would attract tax at 10% (plus SC and EC). 

In case of other mutual fund schemes, the long term capital gains would be subject to tax at the lower of 20% (plus SC and EC) of the capital gains, or 10% of the gains computed without cost indexation under section 112.

The language of section 112 indicates one interesting difference in the computation of long term capital gains tax under section 112 of a non-resident from that of a resident. It appears that, in case a non-resident has other income less than the basic exemption, the unutilised portion of the basic exemption is not available for reducing the taxable capital gains, and the entire long term capital gains will be taxed at 20%, and not just the excess. This is on account of the fact that the proviso found to clause (a) of section 112(1) is not to be found in clause (c), which deals both with non-residents and foreign companies. A similar problem also seems to exist under section 111A in respect of short term capital gains.

An interesting question arises as to whether one can then take recourse to the slab rates of tax in such cases, by falling back on section 4(1) read with Part I of the First Schedule of the respective Finance Act. This does seem doubtful, particularly when specific rates of tax have been prescribed under the respective sections for such specific types of income.

The income distribution by the mutual funds would not be taxable in the hands of the NRI/PIO unit holder under section 10(35), having already suffered distribution tax under section 115R.

6.        Government Securities & PSU Bonds:

Clauses 2(1)(i) and 2(1)(ii) of Schedule 5 to the FEMA(Transfer or Issue of security by a Person Resident Outside India) Regulations, 2000 permit an NRI to invest on repatriation basis without any limit in government dated securities (other than bearer securities) or treasury bills or bonds issued by a Public Sector Undertaking (PSU) in India. Bond of PSUs owned either by Central Government or State Government can be acquired. Government Securities and Treasury Bills can also be acquired on non-repatriation basis.

Government Securities or Treasury Bills would give a yield to maturity of about 7% currently. There is very little retail trade in government securities, except perhaps for sale by Primary Dealers through a few public sector banks. There are also very few PSU bonds currently available in the market, since these issues have reduced in recent times, and are generally not frequently traded.

7.        Company Deposits & Non-Convertible Debentures:

With effect from 24^th April 2004, a company cannot accept deposits from NRIs/PIOs on repatriation basis, which it could do earlier under clause 7(1) read with Schedule 6 to the Foreign Exchange Management (Deposit) Regulations, 2000. It can only renew such old deposits accepted on repatriation basis.

However, a company can accept such deposits on a non-repatriation basis from NRIs/PIOs, subject to the conditions specified in Schedule 7 to those Regulations. Even a partnership firm or proprietary concern can accept such deposits. While a company can accept such deposits under private arrangement or under a public deposit scheme, partnership firms and proprietary concerns can accept such deposits only under a public deposit scheme.

The rate of interest on such deposits is subject to the ceiling applicable for NBFCs or under the Companies (Acceptance of Deposits) Rules, 1975 for other entities. Currently, such rates are the NRE deposit rates for NBFCs, and 12.5% for other entities respectively.

The deposits can only be made from NRO account, and cannot be made out of inward remittances or from NRE/FCNR(B) accounts. The maximum tenure of such deposits can be 3 years.

Under Clause 5(1) of the Foreign Exchange Management (Borrowing and lending in Rupees) Regulations, an Indian company can issue Non-convertible Debentures (NCDs) to NRIs/PIOs on repatriation or non-repatriation basis through a public offer. The interest on such NCDs cannot exceed 300 basis points over State Bank of India’s Prime Lending Rate (currently 10.25%), and the maturity has to be beyond 3 years.

There have hardly been any Indian companies which have issued such NCDs in the recent past.

8.        Proprietary & Partnership Concerns:

An NRI/PIO can invest in the capital of a partnership firm or proprietary concern in India under clause 4 of the Foreign Exchange Management (Investment in Firm or Proprietary Concern in India) Regulations, 2000 on a non-repatriable basis.

What needs to be kept in mind is that it is only the capital which is non-repatriable. The interest, remuneration or profit accruing to the partner/proprietor from such investment, being a current account transaction, is fully repatriable. If one desires repatriation of the interest, remuneration or profit, it is advisable to transfer the amount to the NRO or NRE account of the NRI partner, and not leave the amount lying to the credit of the partner’s current or capital account, as that may amount to reinvestment in capital of the firm. 

Some areas of operation are prohibited for such partnership firms/proprietary concerns. They should not be engaged in agricultural or plantation activity, real estate business (dealing in land and immovable property) or in print media.

In case of a proprietary concern, care needs to be taken to ensure that the NRI does not become a resident by virtue of carrying on business in India. Also, one needs to be careful to ensure that under DTAAs, the tie-breaker test does not result in the NRI being treated as an Indian resident for the purposes of the DTAA.

In case of a proprietary concern as well, if one desires remittance of the profit, it is advisable to credit it to the NRO/NRE account of the proprietor, and not leave it in the capital account of the business.

9.        Commercial Paper:

Investment by an NRI in Commercial Paper issued by an Indian company is permissible under clause 8(2) of the Foreign Exchange Management (Deposit) Regulations, 2000. Such investment can only be on a non-repatriable basis, and can only be in Commercial Paper which is non-transferable.

Commercial Paper can be issued for maturities from 7 days to 1 year, and in denomination of Rs.5 lakhs. There is no maximum yield on Commercial Paper prescribed under the Non-Banking Companies (Acceptance of Deposits through Commercial Paper) Directions, 1989. The current yield on commercial paper is in the range of 5.5 to 6% p.a.

Tax would be deducted at source on maturity of Commercial Paper on the amount of discount at 30% (plus SC & EC) under section 195, since such discount would not be regarded as “interest”, in view of the CBDT Circular No.647 dated 22^nd March, 1993 clarifying that such discount is not to be treated as interest for the purposes of TDS.

Some Tax Issues

Having considered the various possible investments that NRIs can make in India, one also needs to consider the impact of some recent tax changes and developments on various types of investments.

Concept of NOR:

The concept of “Resident but Not Ordinarily Resident” (NOR) contained in explanation 6 to section 6(1) has been amended with effect from Assessment Year 2004-05, whereby a person has to be non-resident for 9 out of the past 10 previous years, or to be present in India for 729 days or less during the past 7 years, to qualify for the NOR status. Earlier, as the law was then generally understood, a person had to be non-resident for only 2 out of the past 10 previous years, and to be present in India for 729 days or less to qualify as NOR. 

This has had an impact on returning NRIs, as many NRIs who have been out of India for only 3 to 5 years may now not qualify for the NOR status on their return to India. Such persons would have to take care that they plan their return to India towards the early part of the financial year, so that their overseas earning is not taxed in India in the year of return. Such persons would also not have the tax advantage of earning income on assets retained abroad, without payment of taxes in India. Many such returning NRIs may instead now find it profitable to invest in taxable savings bonds, etc. in India, instead of earning meagre interest abroad. 

Forex Computation of Capital Gains:

Under the first proviso to section 48, for a non-resident, capital gains (both long term as well as short term) arising on transfer of shares or debentures of an Indian company acquired in foreign exchange, is to be computed in terms of the foreign currency in which the shares or debentures were acquired, and the resultant gain or loss is to be converted into Indian rupees. No cost indexation is available for such gains or losses.

With the appreciation of the Indian rupee in the last couple of years, the application of this provision often proves disadvantageous to non-residents, as losses in terms of rupees are offset by the gains that the rupee has made against the foreign currency.

The question that arises is whether a non-resident can opt out of such computation of capital gains in forex terms? The language of the section seems fairly clear, that such computation is mandatory.      

However, if one looks at the intention behind such amendment, as clarified in paragraphs 10.1 to 10.3 of CBDT Circular No.554 dated 13^th February 1990, the purpose was to compensate the non-resident for the lower earning in foreign currency on account of the fall in the value of the Indian rupee. It may perhaps be possible for a non-resident to claim that this was a benefit which was given to compensate for possible losses, and that claim of such a benefit cannot be mandatory in a case where the non-resident chooses not to claim it, being disadvantageous to him.   

Chapter XII-A:

Chapter XIIA, consisting of sections 115C to section 115J, of the Income Tax Act, 1961, was the one part of the Act granting benefits exclusively to NRIs and PIOs. As mentioned in the beginning of this paper, the significance of these benefits has been considerably whittled down due to the various changes made relating to taxation of dividends, mutual fund incomes and capital gains, whereby such incomes are either totally exempt or taxable at nominal rates in the hands of the recipient.

The Chapter can however still be used to pay lower rates of tax on interest income arising out of bonds or government securities or company deposits. In most cases, perhaps this interest too would fall within the ambit of section 115A(1)(a)(ii), and be taxed even otherwise at 20%.

It is perhaps time that this Chapter was weeded out from the Income Tax Act altogether as a measure of real simplification and rationalisation.

Impact of Double Taxation Avoidance Agreements:

Very often, when computing the tax liability of NRIs, one tends to overlook the provisions of the tax treaty of the country of residence of the NRI, and focus just on the domestic tax law provisions.

Double Taxation Avoidance Agreements often provide a reduced tax rate for certain types of income in the source state. For example, by virtue of Article 11 of the Indo US Tax Treaty, the tax chargeable on interest arising in India to a resident of the USA cannot exceed 15% of the gross interest. Similarly, the Indo UAE Tax Treaty provides for a tax rate on gross interest of 12.5%, while the Indo Oman Tax Treaty provides for a similar rate of 10%.  

Benefit of Indo UAE DTAA:

The Double Taxation Avoidance Agreement between India and the United Arab Emirates (UAE) has been dogged by controversy as to its applicability to individuals residing in UAE, ever since its inception. At the heart of the controversy is the issue of whether an individual can be said to be a resident of the UAE and take advantage of the provisions of the tax treaty, given the fact that individuals are not subject to tax in the UAE at all, and given the fact that a person has to be resident in the UAE under the tax laws of that state in order to qualify as a resident of the UAE for the purposes of the tax treaty.

The first advance ruling in Mohsinally Alimohamed Rafik’s case, 213 ITR 317, held that individuals residing in the UAE, though not taxable in the UAE, were eligible to claim the tax benefits under the treaty. An opposite view was then taken in the advance ruling in the case of Cyril Eugene Pereira, 239 ITR 650. The Supreme Court, in the case of Azadi Bachao Andolan 263 ITR 706, disagreed with the view taken in Cyril Pereira’s case, and one therefore thought that this signalled the end of the controversy. Unfortunately, the issue has again erupted due to the recent advance ruling in the case of Abdul Razak A. Meman 276 ITR 306, where the Authority for Advance Rulings has again held that individuals residing in the UAE cannot take advantage of the Indo-UAE tax treaty in the absence of any tax law in the UAE applicable to such individuals.

If the treaty benefit is not available, NRIs residing in the UAE will be liable to tax in India in respect of their Indian investments on the short term capital gains arising on sale of shares, and will be liable to pay tax on interest income at slab rates instead of at 12.5% prescribed under the treaty. Fortunately, so far as interest is concerned, the AAR (in Meman’s case) has held that such individuals could claim the benefit of taxation at 12.5% of the gross interest under the tax treaty, relying on the CBDT Circular No.734 dated 24^th January 1996 [217 ITR (St.) 74].

Tax Impact in Country of Residence:

In choosing investments, many NRIs tend to opt for investments where their post-tax return is highest, by considering only the impact of Indian tax. Very often, they tend to ignore the impact of tax in their country of residence. This could however significantly impact the rate of return on their investments.

Take a situation where an NRI resident of the USA invests in an NRE Fixed Deposit earning 4.5%. Since the interest is exempt in India, the post-tax rate of return is 4.5% (ignoring exchange fluctuations). However, being a resident of the USA, his worldwide income, including such interest, would be taxable in the USA. Such interest is not exempt in the USA, and if he pays a tax of 40% on such interest in the USA, the post-tax return would drop significantly to just 2.70%, making the investment perhaps not worthwhile.

However, if the same NRI were a resident of the UK, though such interest would also be taxable in the UK, the Indo UK Tax Treaty has a tax sparing clause in paragraphs 3(a) and 4(a) of Article 24 – Elimination of Double Taxation. This provides that for the purposes of tax credit, the term “Indian tax payable” shall include any tax which would have been payable as Indian tax but for an exemption granted under section 10(4) or section 10(15)(iv), besides other sections. Effectively therefore, the UK resident would get credit against UK tax for the Indian tax that he would otherwise have paid in respect of such NRE interest. Assuming that the tax rates in the UK is 40%, while the tax rate on such interest would have been 30%, the NRI pays only 10% tax on such interest in the UK, and no tax at all on such interest in India. His effective post-tax rate of return is therefore 4.05%. This benefit under the Indo UK Tax Treaty is however available only for a period of 10 consecutive fiscal years.

There are tax sparing clauses also in India’s tax treaties with Oman, Qatar and the UAE, but since most of these countries do not have income tax at all for individuals, this clause is not of much significance.

Conclusion

Given the limited investment avenues for NRIs in India and the reducing attractiveness of such instruments, most NRIs appear to be gravitating towards investments in immovable property, investment in shares, or investment in businesses in India, which today still yield decent returns. From favoured investors, NRIs are now regarded as less desirable investors. One hopes that the day will not be far off when NRIs will be neither favoured investors nor less desired investors, but on par with Indian investors.

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