Section 196D – TDS on Income of Foreign Institutional Investors (FIIs) from Securities

Introduction to Section 196D

Section 196D of the Income Tax Act, 1961, specifically addresses the deduction of Tax Deducted at Source (TDS) on income received by Foreign Institutional Investors (FIIs) from securities. This section is a crucial part of India's tax framework for regulating foreign investment in its capital markets, ensuring that tax is collected at the source on income accruing to these entities.

Key Provisions of Section 196D

1. Applicability:

Section 196D applies to any income payable to a non-resident or a Foreign Institutional Investor (FII) in respect of securities.

• A Foreign Institutional Investor (FII) is a specific category of investor defined under Indian regulations, primarily involved in investing in Indian securities markets. With the introduction of the SEBI (Foreign Portfolio Investors) Regulations, 2014, the term 'Foreign Portfolio Investor' (FPI) largely replaced 'FII', but for tax purposes, the reference to FIIs in some sections like 196D continues to apply to the broader category of foreign portfolio investors.

2. Who is the Deductor?

The person responsible for paying such income to the FII (e.g., Indian companies paying dividends or interest, brokers facilitating transactions, or mutual funds distributing income) is liable to deduct TDS.

3. Who is the Deductee?

A Foreign Institutional Investor (FII) (or a Foreign Portfolio Investor, as applicable) receiving income from securities.

4. Income Covered:

Section 196D covers two primary types of income:

• Income by way of interest from securities.
• Income by way of capital gains arising from the transfer of such securities. This is a significant point as it explicitly brings capital gains of FIIs under the TDS net, unlike some other sections which might only cover interest or dividends.

It's important to note that dividends paid by Indian companies were previously subject to Dividend Distribution Tax (DDT) and not TDS under most circumstances. However, with the abolition of DDT and the shift to shareholder-level taxation of dividends from April 1, 2020, dividends received by FIIs would now generally be subject to TDS, often covered under Section 194 or Section 195, but the specific tax treatment for FIIs under their special regime (e.g., Section 115AD) must also be considered.

5. TDS Rate:

The TDS rates under Section 196D are as follows:

• On interest income: 5%
• On capital gains from transfer of such securities:
  • Short-Term Capital Gains (STCG): 30% (if such STCG arises from the transfer of equity shares or units of an equity-oriented mutual fund on which Securities Transaction Tax (STT) is not paid)
  • Long-Term Capital Gains (LTCG): 10% (if such LTCG arises from the transfer of equity shares or units of an equity-oriented mutual fund on which STT is not paid)
  • For other capital gains (e.g., from debt securities, or where STT is paid on equity shares/equity-oriented mutual funds as per Section 115AD), the rates specified under Section 115AD apply, and TDS would be under Section 195. Specifically:
    • STCG on listed equity shares/units of equity-oriented mutual funds where STT is paid is taxable at 15%.
    • LTCG on listed equity shares/units of equity-oriented mutual funds where STT is paid (exceeding Rs. 1 lakh) is taxable at 10% without indexation.
    • Other LTCG (non-equity mutual funds, debt, etc.) is taxable at 10% without indexation or 20% with indexation, whichever is more beneficial.

It is crucial for the deductor to correctly identify the nature of income and whether STT is paid to apply the correct TDS rate.

• These rates are subject to any beneficial provisions of a Double Taxation Avoidance Agreement (DTAA). FIIs often operate from jurisdictions with which India has DTAAs, which may offer lower tax rates on interest or capital gains. If an FII wishes to claim DTAA benefits, they must provide the necessary documentation, including a Tax Residency Certificate (TRC), Form 10F (if required), and a declaration that they are the beneficial owner of the income.

6. When TDS is Deducted:

TDS is to be deducted at the time of credit of such income to the account of the payee or at the time of payment thereof in cash or by the issue of a cheque or draft or by any other mode, whichever is earlier.

7. No Surcharge or Cess for TDS Calculation:

One of the significant features of Section 196D, similar to other sections for certain non-resident incomes (196A, 196B, 196C), is that the rates specified are inclusive of surcharge and cess at the TDS stage. This means that when deducting tax at source under Section 196D, the deductor applies the straight 5% for interest or the applicable capital gains rate without adding surcharge and cess on top. The final tax liability for the FII will be determined at the time of assessment.

8. No Threshold Limit:

There is no specified threshold limit under Section 196D. TDS is deductible on all payments of the specified income, regardless of the amount.

9. Exemption if PAN Not Furnished:

Unlike some other TDS sections, Section 206AA (higher TDS if PAN not provided) generally does not apply to payments covered under Section 196D, provided the FII furnishes specific information as prescribed. This exemption is crucial to facilitate ease of doing business for large institutional investors.

Significance for Foreign Investment in India

Section 196D is pivotal in regulating the taxation of income for FIIs (now largely FPIs) investing in Indian capital markets. It provides a clear framework for TDS on their interest and capital gains income, ensuring tax collection at the source. For both the paying entities in India and the FIIs themselves, understanding and complying with this section, along with the special tax regime under Section 115AD and applicable DTAAs, is essential for smooth and compliant investment operations.