Withholding taxes bite NRIs in Indian FCNR leverage schemes
Unexpected withholding tax liabilities on loans used to leverage Indian FCNR deposits are eroding the narrow returns for non-resident investors in the US and Singapore.
Indian banks pushing leveraged Foreign Currency Non-Resident (FCNR) deposits are exposing non-resident investors to hidden tax costs that can wipe out the thin margins of these products.
These deposit schemes have become a popular tool for lenders to raise foreign capital. Under the structure, an NRI invests an initial amount, such as $1 million, and borrows between $9 million and $19 million to amplify their position. The investment's appeal relies entirely on a narrow spread of 50 to 80 basis points between the deposit yield and the lending rate.
A 10 percent withholding tax levied on the interest paid to banks outside the investor's home jurisdiction directly attacks this margin. For example, the tax pushes an effective borrowing cost of 6 percent up to 6.6 percent, significantly diminishing the expected return on the total deposit.
The tax exposure depends heavily on which branch of an Indian bank handles the loan. "If a Singapore resident individual obtains leverage from the Singapore branch of an Indian bank, to invest in FCNR deposits, the interest paid to that branch is not subject to Singapore withholding tax," said Eunice Hooi, director, head of tax & transfer pricing at InCorp Global. "However, if the borrowing is from the GIFT City branch of the same Indian bank, the interest paid is subject to Singapore withholding tax."
Hooi noted that while the domestic withholding tax rate is 15 percent, this can generally be reduced to 10 percent if the conditions under the India-Singapore DTAA are satisfied. Even at the lower rate, the added cost undermines the leveraged returns.
US-based NRIs face a completely separate set of complications. While FCNR interest is tax-free in India, it remains fully taxable in the US. Investors whose income exceeds certain thresholds also face an additional 3.8 percent net investment income tax (NIIT). Furthermore, compliance burdens such as FBAR and Form 8938 filings for foreign assets are frequently overlooked by participants.
Several large and mid-sized state-owned Indian lenders have actively used their GIFT City branches to extend this leverage. To protect their own net returns, some banks have inserted clauses into their loan documents that explicitly transfer the withholding tax burden onto the borrower.
The underlying borrowing costs are also facing scrutiny from market participants. "Banks understandably would add a sizeable mark-up over the basic fixed rate, with different divisions of a bank like the treasury, products group, and private banking adding their spreads," a senior banker noted. This layering of fees occurs even though a baseline five-year floating rate in the US money market can currently be converted to a fixed rate slightly above 5 percent.
