US inheritance taxes threaten HNI investors: can GIFT City be a solution?

Wealthy Indians are increasingly trying to diversify their investments outside India. The US stock market is a popular option, but there is a hidden danger: inheritance taxes. If they inherit U.S. stock from someone living in the U.S., their heirs may owe estate taxes even if they are not U.S. citizens. The threshold for this tax is surprisingly low, making it a concern for many high-net-worth individuals (HNIs).

Business Standard decodes how GIFT City, India’s global financial hub, can provide a solution through tax-efficient joint investment vehicles and access to global markets.

The challenge:

Currently, wealthy individuals in India can avail of a Reserve Bank of India (RBI) scheme called the liberalized cash transfer scheme. This allows them to send up to $250,000 (about Rs 1.87 crore) abroad every year. They can use this money to open foreign bank accounts, invest in stocks, buy listed debt (such as bonds) or even buy property in other countries.

However, many of these individuals may not be aware that if they have investments or assets in countries like the US, there is a rule there about inheritance taxes. If the total value of these assets at their death exceeds $60,000 (approximately Rs 45 lakh), their heirs – the people to whom they leave their money and assets – may have to pay inheritance taxes to the US government.

This means that while they can freely move money abroad during their lifetime, their relatives could face unexpected taxes after their death if the value of those foreign assets is high enough. This is something to consider when managing international investments and planning for the future.

The possible solution:

India’s International Financial Services Centers Authority (IFSCA) has established GIFT City as a hub for attracting foreign investment. Here, wealthy Indians could set up pooled investment vehicles, similar to mutual funds, but specifically designed for outbound investments. This can be a win-win situation:

Investors could avoid U.S. estate taxes by routing their investments through GIFT City funds.

Indian fund houses could manage this money and keep it within the Indian financial system.

“Since the inheritance tax is applicable only if the inherited assets are located in the US, the same can be avoided if the investment in the said assets is made through pooled investment vehicles based in an offshore jurisdiction like IFSC, GIFT City as the asset will then is held through the pooled vehicle (including a family investment fund) and the inherited wealth is the investment in the pooled vehicle, and even if it invests exclusively in US strategies, it will not be taxed in the hands of the non-US person if the underlying asset It may be US stocks, but the company investing will be a foreign entity,” said Ketaki Mehta, partner of Cyril Amarchand Mangaldas.

The tax obstacle

However, there is a catch. Currently, GIFT City funds face a different tax structure than regular mutual funds in India. Unlike domestic mutual funds where investors pay taxes on gains, GIFT City funds are taxed at the fund level.

‘There are two main ways in which investment funds are taxed: at fund level or through a pass-through mechanism. Fund-level taxation means that the fund itself pays tax on its income and profits before distributing any returns to investors. The system allows the fund to avoid taxes and pass on all income to investors, who then pay tax based on their individual tax slabs,” said Kunal Sharma, Partner, Singhania & Co.

This makes them less attractive to investors for two reasons:

Higher tax rate: The tax rate for GIFT City funds can be significantly higher than what investors pay to domestic funds.

“Taxing funds directly reduces their overall returns to investors. This makes them less attractive compared to funds in pass-through tax jurisdictions, where investors are taxed directly on their share of the fund’s profits. Many investors, especially those in lower tax brackets or tax-exempt entities, prefer pass-through structures to minimize tax liabilities. Taxes at fund level make GIFT City funds less attractive to them,” said Sharma.

Lower net asset value (NAV): Because the fund is taxed first, the remaining amount available to investors (NAV) is lower. This reduces overall returns, especially for long-term investors who rely on compounding.

“Taxes paid at the fund level reduce the net income available for distribution to investors. This has a direct impact on their returns, making the GIFT City funds less competitive. Moreover, institutional investors often prefer tax-efficient investments. Taxes at fund level can deter them, thereby reducing capital inflows from these important investor groups,” Sharma explains.

What needs to change?

The IFSCA urges the government to level the playing field. Aligning the tax treatment for GIFT City pooled investments with domestic investment funds would provide significant benefits:

Fairer taxes: Investors would pay capital gains tax based on their tax bracket, similar to domestic funds.

Higher efficiency: The tax burden would not be on the fund itself, which would lead to a higher net asset value and possibly a better return for investors.

Benefits beyond tax

A well-regulated GIFT City fund system would provide additional benefits:

Access to global companies: Funds in GIFT City offer Indian investors regulated opportunities to gain exposure to companies not listed in India, such as Nvidia, Alphabet, Amazon and Meta.

Reduced outflow of reimbursements: Establishing fund management entities in GIFT City can reduce the fees paid to foreign fund managers based in other financial centers such as Singapore or Hong Kong.

Reducing capital outflow: Currently, many HNIs are taking advantage of the Reserve Bank of India’s liberalized remittance program to invest abroad. A robust GIFT City system could hold this money within India.

Boosting Indian fund management: Indian fund houses could manage these investments, instead of foreign fund managers in Singapore or Hong Kong.

The government’s dilemma

The government might be reluctant to favor the rich. They may prefer to promote broad-based mutual funds that are accessible to a wider range of investors, rather than focusing solely on HNIs. Furthermore, allowing tax breaks for GIFT City funds could be seen as encouraging capital flight, where wealthy individuals move their money out of the country.

The key lies in finding a balance. By creating a fair and attractive tax structure for GIFT City funds, the government can attract wealthy investors without promoting excessive capital outflows. Regulators and the government could consider introducing tax parity for retail schemes in GIFT City, similar to the tax treatment of ‘specified funds’ such as Category 3 funds. A potential model could involve tax deductions at the fund level upon distribution or redemption, which could streamline the investment process for a broader base of retail investors.

Case studies: successful tax strategies

•Luxembourg: Pass-through taxation and a network of tax treaties make it a favorite location for European funds.

•Singapore: Tax incentives and pass-through funds are attracting numerous asset managers (AMCs) and fund houses, boosting investor confidence.

“For GIFT City to realize its full potential, it is critical to adopt a pass-through tax model similar to successful global financial centers. This will increase its attractiveness, attract more funds and contribute to the growth as a leading international financial services center.” Sharma said.

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