Portfolio Adviser • Portfolio Adviser November 2024 • Macro matters

While India’s growing economy presents an exciting opportunity for stockpickers, foreign investors may not be aware that a percentage of their return is subject to local capital gains tax, writes Christian Mayes

India’s growth shows no signs of abating, with the International Monetary Fund (IMF) predicting its economy will become the third-largest in the world by 2027.

The Indian stockmarket has gone from strength to strength over the past few years and has challenged China’s traditional dominance in emerging market portfolio exposure. However, foreign investors may not know that a percentage of their returns are subject to Indian capital gains tax.

Typically, mutual funds adhere to the tax rules in the area they’re domiciled in. Most investors in listed equities and bonds in India, including foreign investors, are subject to long-term and short-term capital gains tax. This was first introduced in 2016 after the Bharatiya Janata Party (BJP) came to power, brought in by then-minister of finance and corporate affairs Arun Jaitley.

Rates were set at 15% for long-term capital gains, defined as securities held for over a year, and 20% for short-term capital gains.

Local capital gains tax was further hiked following the general election earlier this year, with 12.5% taken on long-term gains and 20% for short-term.

This presents an issue for mutual funds – how do funds handle, report and accrue the added tax, and can it lead to disadvantages for investors?

Gaurav Narain, adviser to the India Capital Growth fund, says local capital gains tax rules have three main impacts on fund houses. First, the net asset value (NAV) does not reflect absolute performance, he explains, as funds are required to make a full provision for realised and unrealised capital gains tax while computing the NAV.

“Second, for foreign investors, there are many countries that do not levy a capital gains tax. This would put India at a disadvantage when it comes to allocation of funds as it impacts relative returns.

“Third, more operational and tax advisory resource may be required to compute a daily NAV that accurately provides for Indian capital gains tax.” “No market in the world taxes foreigners going into their market,” says Chikara Investments portfolio manager Andrew Draycott.

“Normally, you pay your own tax when you bring that money home on your own capital gains. That’s why in the UK, for example, we have ISAs and Sipps, and we wrap everything up.

“But the common denominator is that the majority of countries want you to have capital deployed to their markets and the competition for capital is obviously intense, because most people want to enjoy all the benefits of foreign money coming into the market.

“If you take Asia, there is no precedent for capital gains tax being lumped on to foreign investors.”

He adds that as the Indian market’s performance has been particularly strong in the past three years, the impact has become much more noticeable when comparing active investors versus the benchmark.

“MSCI India is our benchmark. They don’t reflect at any point in the process that capital gains tax has to be paid by both foreign and domestic investors.

“The second point to note is that if you’re a local mutual fund, you don’t charge your investors capital gains tax. The investor itself, the unitholder, pays their own capital gains tax at the end. Once they’ve taken that equity out, they crystallise at their own tax-filing level.

“One of the things that is a bug bear for me is the fact that domestic funds are reporting these exponential returns, but they’re not factoring in any capital gains tax.”

Draycott has managed the Chikara Indian Subcontinent fund since launch in 2018. As a daily-dealing fund, it accrues capital gains tax on a daily basis. Equity is audited on a single-stock basis by a local custodian, and gains are reflected relative to the capital gains rate.

“If you take the headline benchmark since we started in 2018, relative to an ETF which is effectively a mirror image of the benchmark, the slippage is 26% in six years. These are real differences that are not widely appreciated by the foreign investment community.”

India Capital Growth’s Narain adds that the result is the NAV reflects post-tax performance, while the benchmark reflects pre-tax performance, creating an illusion of underperformance.

Chikara’s Draycott argues that the tax, coupled with China’s recent resurgence, has led to foreign flows into the Indian market drying up this year.

“Between 2021 and 2024, foreign institutional investors have deployed $19bn (£14.7bn) up until the beginning of October into the Indian equity market. Domestic investors have deployed $108bn, so five times the foreign input [Jefferies as at Sept 2024].

“Since the beginning of October, when China became flavour of the month and this fiscal bazooka came through, the foreign investors have actually sold down the majority of their $11bn that’s gone in this year.”

He adds: “My sense is that foreign investors have been reluctant buyers of India since Covid and have got the market earnings completely wrong, but now that they are underweight, they are doubling down on the Indian valuation rhetoric and doubling up on their ‘China is cheap’ mantra.

“The government hiked capital gains tax in the budget, which I think has deterred foreign money more. But on the flip side, if the China rally falters, then foreign money will run a risk of material underperformance from the Indian index, particularly if the Diwali festive period is strong, and the Chinese 30% of benchmark falls.

“We haven’t seen overseas investors so underweight India throughout the life cycle of the fund, and to be honest, that excites me.”

Though capital gains tax can cause issues for foreign investors, India remains one of the world’s fastest-growing economies, with the IMF predicting a 6.1% growth rate over the next five years.

“Indian equity markets are also thriving, reaching all-time highs this year,” Pauline Ng, co-manager of JPMorgan Asia Growth & Income, says.

“Despite some volatility during the general elections, stocks have consistently outperformed their emerging market peers. Since the pandemic low during March 2020, the blue chip NSE Nifty 50 has surged over 200%, with the total market cap around $5trn.

“Our top Indian holdings – HDFC Bank, Reliance Industries, and Mahindra & Mahindra – are well positioned to benefit from India’s economic growth, fuelled by digitalisation and urbanisation. While valuations may appear elevated, strong fundamentals support sustained growth, and we’re optimistic about the long-term outlook.”