Overview Budget 2011 proposes relatively limited changes in the taxing framework for the Financial Services industry.

Though, on the face of it, it may appear that the Budget could have done more for the Financial Services industry, on balance, it seems to be a fairly good budget as it has targeted an annual growth rate of approximately 8.6 percent, and has put much more emphasis on the infrastructure sector, which is closely inter-twined with the Financial Services industry. This would help the Financial Services industry leverage off the various initiatives taken by the Government for benefitting the infrastructure sector. Key budget proposals Policy announcements Fiscal Consolidation As part of the Government's initiative towards fiscal consolidation, the Government is in the process of setting-up an independent Debt Management Office in the Finance Ministry. Currently, a middle office is already operational. As a next step, the Government proposes to introduce a new Bill in Parliament, in the next financial year, to be called the Public Debt Management Agency of India Bill, which will help the Government achieve its objective of having an independent Debt Management cell. Foreign investment in Indian Mutual Fund schemes Currently, only Securities and Exchange Board of India ("SEBI") registered FIIs / sub-accounts and NRIs are allowed to invest in mutual fund schemes that are launched by Indian mutual fund houses. The Government seems keen to liberalise portfolio investment from foreign investors, into investment schemes floated by Indian mutual fund houses. To this effect, the Government has decided to allow foreign investors who meet the KYC requirements prescribed by SEBI, to invest in equity schemes of Indian mutual fund houses. This should help enable Indian mutual funds to have direct access to foreign investors and widen the class of foreign investors that access the Indian equity markets. Budget 2011 does not specify whether this new investment window will be open to all categories of foreign investors or to a select category of foreign investors, and we will need to wait and see what corresponding changes are brought about by the Reserve Bank of India ("RBI") and SEBI to the Indian exchange control regulations and securities laws in this regard. Currently, foreign corporates and foreign individuals that (i) have a sound financial track record, (ii) are of particular size, and (iii) whose monies are professionally managed by foreign investment managers, are allowed to invest in Indian mutual fund schemes through the FII-subaccount route. It will be interesting to see whether the new investment window spoken about by the Finance Minister will allow other categories of foreign investors (who do not qualify for registration with SEBI as foreign corporate sub-accounts or foreign individual sub-accounts), to invest directly into equity schemes of Indian mutual fund houses. Foreign Institutional Investors ("FII") Currently, FIIs / sub-accounts are allowed to invest in 'listed' or 'to be listed' corporate bonds that are issued by Indian corporates that engage in the infrastructure sector, up to an aggregate limit of USD 5 billion. This is subject to the corporate bonds, inter-alia, having a residual maturity of over five years. To enhance the flow of funds to the infrastructure sector, the Finance Minister has proposed to increase the overall limit available to FIIs to invest in

Contacts
Bobby Parikh Bobby.Parikh@bmradvisors.com +91 22 30217010 Shefali Goradia Shefali.Goradia@bmradvisors.com +91 22 30217170 Ajay Mehra Ajay.Mehra@bmradvisors.com +91 22 30217030

such corporate bonds to be issued by Indian infrastructure companies by USD 20 billion; thereby increasing the investment limit from the existing cap of USD 5 billion to USD 25 billion. Thus, the overall cap now available to FIIs to invest in 'listed' or 'to be listed' corporate bonds to be issued by all Indian companies is increased from the existing limit of USD 20 billion to USD 40 billion. We have tabulated these limits below: Existing caps (US$) 5 billion Proposed caps (US$) 25 billion

Russell Gaitonde Russell.Gaitonde@bmradvisors.com +91 22 30217045

FII investment caps Corporate Debt in Infrastructure Sector (as is defined in the ECB policy) having a residual maturity of over five years All other Corporate Debt Total

15 billion 20 billion

15 billion 40 billion

Recognising that most of the infrastructure companies are organised in the form of Special Purpose Vehicles ("SPVs"), Budget 2011 proposes to allow FIIs to also invest in 'unlisted bonds' of such SPVs, with a minimum lock-in period of three years. The FIIs will be allowed to trade among themselves in these 'unlisted bonds' during the lock-in period. At this stage, it is unclear whether any quantitative restrictions will apply and how the debt limits will be allocated to the various FIIs. Hence, one will need to wait until SEBI issues its directional circulars in this regard. Banks Close on the heels of the discussion paper that was issued by the RBI in August 2010, on entry of new banks in the private sector, the RBI has proposed some amendments to the Banking Regulation Act, 1949. The Finance Minister has reiterated his commitment to bring about suitable legislative amendments in this regard, in the current session of Parliament. He has also indicated that the RBI is planning to issue the guidelines for new bank licenses before the end of the current financial year ("FY") (ie before March 31, 2011). The Government proposes to provide INR 60 billion to Public Sector Banks for FY 2011-12 to enable them maintain a minimum Tier I Capital to Risk Weighted Assets ratio of 8 percent. As part of an initiative to financially strengthen Regional Rural Banks, the Government proposes to recapitalize Regional Rural Banks by INR 5 billion to enable them maintain a minimum Capital to Risk Weighted Assets ratio of 9 percent as on March 31, 2012. Financial inclusion In last year's budget, the Government had advised banks to provide banking facilities to habitations having a population of over 2,000 by March 2012. The banks identified about 73,000 such habitations for providing banking facilities using appropriate technologies. A multimedia campaign, 'Swabhimaan', has been launched to inform, educate and motivate people to open bank accounts. During FY 2010-11, banks are expected to cover 20,000 villages, while the remaining villages are expected to be covered during FY 2011-12, thus achieving what the Government sought to do last year. In last year's budget, the Government had announced a co-contributory pension scheme called 'Swavalamban'. Workers in the unorganised sector have welcomed the scheme. Over 400,000 applications have already been received. On the basis of the feedback received, the Government proposes to relax the exit norms for participants in this pension scheme, whereby a subscriber under 'Swavalamban' will be allowed to exit (i) at the age of 50 years instead of 60 years, or (ii) a minimum tenure of 20 years, whichever is later. The Government also proposes to extend the benefit of Government contribution from three years to five years for all subscribers of 'Swavalamban' who enrol during FY 2010-11 and FY 2011-12. The Government anticipates that an estimated 2 million beneficiaries will join the scheme by March 2012. Under the on-going Indira Gandhi National Old Age Pension Scheme for Below The Poverty Line beneficiaries, the eligibility for pension is proposed to be reduced from the present age of 65 years to 60 years. Further, for those who are 80 years and above, the Government has increased the monthly pension slightly. Microfinance sector Budget 2011 recognises the critical role played by Micro Finance Institutions ("MFIs") in financial inclusion, and recognises that creation of a dedicated fund for providing equity to smaller MFIs would help them maintain growth and achieve scale and efficiency in operations.

To this end, the Government has announced that during the course of the year it will create a 'India Microfinance Equity Fund' with SIDBI, with a corpus of INR 1 billion, to focus on such initiatives. The Government also proposes to create a 'Women's Self Help Group's Development Fund', with a corpus of INR 5 billion, which will help empower women and promote Women Self Help Groups. The Malegam Committee that was set-up by the RBI to look into the issues relating to the micro finance sector in India has submitted its report to the RBI. The Government has indicated that it is considering putting in place an appropriate regulatory framework to protect the interests of the small borrowers in India. Infrastructure financing To attract foreign investment in infrastructure financing, the Government proposes to create Special Vehicles in the form of notified infrastructure debt funds, which will focus on providing financial assistance to the Indian infrastructure sector. The notified infrastructure debt funds will be given tax-exempt status and the investors in these funds will be taxed at concessional rates. The Government has updated that the India Infrastructure Finance Company Ltd ("IIFCL"), which it set-up to provide long-term financial assistance to infrastructure projects is expected to achieve a cumulative disbursement target of INR 200 billion by March 31, 2011 and INR 250 billion by March 31, 2012. The take out financing scheme that was announced by the Government during Budget 2009 has also been implemented and seven projects have been sanctioned with a debt of INR 15 billion, with an additional INR 50 billion to be sanctioned during FY 2011-12. In order to give a boost to infrastructure development in railways, ports, housing and highway development, the Government proposes to allow various Government undertakings to issue tax-free bonds of INR 300 billion during FY 2011-12. This will include Indian Railway Finance Corporation INR 100 billion, National Highway Authority of India INR 100 billion, HUDCO INR 50 billion and Ports INR 50 billion. Rural Infrastructure Development Fund The Rural Infrastructure Development Fund, which is popular among State Governments, is an important instrument for routing bank funds for financing rural infrastructure projects. The Government has pledged its commitment to support this Fund and has proposed to raise the corpus of the Fund by INR 20 billion, from the existing corpus of INR 160 billion to INR 180 billion. The additional allocation of INR 20 billion is to be used for creation of warehousing facilities in rural India. Micro, Small and Medium Enterprises The Government has recognised that Micro and Small enterprises play a critical role in furthering the objective of equitable and inclusive growth. The Government now proposes to provide INR 50 billion to SIDBI, to refinance incremental lending by banks to such enterprises, out of the shortfall of banks on priority sector lending targets. The Government has also recognised the economic stress that handloom weavers are facing in India, because of which the weavers are unable to repay their debts owed to handloom weaver co-operative societies. This has made the handloom weaver co-operative societies in India financially unviable. The Government now proposes to provide INR 30 billion to NABARD, in a phased manner, to help bail out these co-operative societies. This initiative of the Government is expected to benefit 15,000 co-operative societies and about 300,000 handloom weavers. The details of the scheme are to be worked out by the Ministry of Textiles in consultation with the Planning Commission. Housing sector To stimulate growth in the housing sector, the Government proposes to liberalize the extant scheme of interest subvention of 1 percent on housing loans by extending it to housing loan up to INR 1.5 million (presently INR 1 million) where the cost of the house does not exceed INR 2.5 million (presently INR 2 million). Recognizing the increase in prices of residential properties in urban areas, the Government propose to raise the existing housing loan limit for dwelling units under priority sector lending from INR 2 million to INR 2.5 million.

To provide housing finance to targeted groups in rural areas at competitive rates, the Government proposes to enhance the provision under the Rural Housing Fund to INR 30 billion from the existing INR 20 billion. The Government has announced creation of a Mortgage Risk Guarantee Fund, to address the issue of credit enablement of Economically Weaker Sections ('EWS') and Low Income Group ('LIG') households. The proposed fund is expected to guarantee housing loans taken by EWS and LIG households and enhance their credit worthiness. To prevent frauds in loan cases involving multiple lending from different banks on the same immovable property, the Government has facilitated setting up of a Central Electronic Registry under the SARFAESI Act, 2002. The Registry is expected to be operational by March 31, 2011. Financial Sector legislative initiatives and sectoral reforms In last year's budget, the Government had announced that a Financial Sector Legislative Reforms Commission ("Commission") would be established to rewrite and streamline the financial sector laws, rules and regulations and bring them in harmony with the requirements of a modern financial sector. The Government has now updated that the Commission is expected to complete its work in 24 months. The Government has indicated that it is committed to financial sector reform and proposes to move the following legislations in Parliament, that are relevant to the Indian financial sector: The Insurance Laws (Amendment) Bill, 2008 The Life Insurance Corporation (Amendment) Bill, 2009 The revised Pension Fund Regulatory and Development Authority Bill (first introduced in 2005) The Banking Laws Amendment Bill, 2011 The Bill on Factoring and Assignment of Receivables The State Bank of India (Subsidiary Banks Laws) Amendment Bill, 2009 The Bill to amend the Recovery of Debts due to Banks and Financial Institutions ('RDBFI') Act, 1993, and SARFAESI Act, 2002

Direct tax proposals Notified Infrastructure Debt Funds To attract foreign investment in infrastructure financing, the Government proposes to create Special Vehicles in the form of Infrastructure Debt Funds, which will focus on providing financial assistance to the Indian infrastructure sector. Budget 2011 proposes to grant a beneficial tax regime for such funds as well as the foreign investors in the funds. We have highlighted below the key tax issues associated with the Funds and the foreign investors in the Funds: Taxation at the Fund level The Funds are to be set-up in accordance with prescribed guidelines and are to be notified by the Central Government in the Official Gazette. The Funds are to enjoy tax-exempt status. They are required to file annual tax returns with the Indian Revenue authorities. The Funds are required to withhold tax at the concessional tax rate of 5 percent (as opposed to the current tax rate of 20 percent), while making interest payments to the foreign investors in the funds. Taxation at the foreign investor level Foreign investors in the funds would be taxable at the concessional tax rate of 5 percent on interest received from the funds. If such interest is the only source of income that is earned by a foreign investor, on which adequate tax has been withheld at source, then the foreign investor need not file a tax return in India reporting the interest income to tax. They would be entitled to tax treaty benefits, if any. Open issues The proposed tax law, which is to become effective from June 1, 2011, is silent on how the prescribed guidelines are to work in the context of the Infrastructure Funds. The tax law is also silent on whether the foreign investors in the Funds will be able to earn income in the form of

any other source from such Funds (eg profit on redemption of units to be issued by the Funds, which could arise in case of a Growth option). In such a situation, the concessional tax rate of 5 percent that has been prescribed above, may not apply to the foreign investors and they may be liable to tax on such income as normal capital gains or business profits. Correspondingly, the Funds would need to withhold tax at source at the applicable tax rates, while making the payments to the foreign investors. However, foreign investors should continue to be eligible for tax treaty benefits, if any. Mutual Funds Budget 2011 proposes to increase the distribution tax that is payable by Indian mutual funds on the income they distribute to the unit holders in their non-equity oriented investment schemes. This is to be made effective from June 1, 2011. We have tabulated the existing and proposed tax rates: Type of mutual fund schemes Money Market Mutual Funds or Liquid Funds - Payable to Individuals or HUFs Money Market Mutual Funds or Liquid Funds - Payable to all other categories of investors Other non-equity oriented investment schemes - Payable to Individuals or HUFs Other non-equity oriented investment schemes - Payable to all other categories of investors Existing tax rate 25% Proposed tax rate 25%

25%

30%

12.5%

12.5%

20%

30%

Housing expenditure Budget 2011 proposes a tax deduction for capital expenditure (other than expenditure incurred on land, goodwill and financial instrument) incurred by a taxpayer on or after April 1, 2011 for developing and building a housing project under a scheme for affordable housing framed by the Central Government or the State Government, as the case may be, and notified by the CBDT in accordance with the guidelines as may be prescribed by the Government. Contributions to the New Pension Scheme Currently, contributions made by an employee as well as by the employer to the New Pension System ("NPS") account, on behalf of the employee, are allowed as a tax deduction for the employee subject to overall limit of INR 100,000. Budget 2011 proposes that the employer's contribution to NPS shall be excluded from the overall limit of INR 100,000 of permissible deductions. Additionally, under the current tax law, contributions made by an employer to the NPS are not allowed as tax-deductible expenditure. Budget 2011 proposes that such employer's contribution to NPS would be allowed as a tax-deductible expenditure subject to an overall limit of 10 percent of the salary of the employee. Subscriptions to Long-term infrastructure bonds Under the current tax law, an additional tax deduction of INR 20,000 (over and above the overall limit of INR 100,000) is allowed in computing total income of an individual or a HUF if the sum is paid or deposited during the FY 2010-11 in long-term infrastructure bonds as are notified by the Central Government. Budget 2011 proposes to extend this benefit for one more year and continue granting the additional tax deduction of INR 20,000 for investments in such notified long-term infrastructure bonds during FY 2011-12. Liaison Offices ("LO") Filing of tax returns Non-residents operating in India through LOs (eg foreign banks that set-up LOs in India) typically do not file tax returns in India on the basis that they are not permitted to carry out any commercial activity and hence do not earn any income in India. With an objective to seek regular information, Budget 2011 proposes that every non-resident taxpayer that has a LO in India must file an Annual Information Statement with respect to the activities being undertaken by the LO. Such statement must be filed with the jurisdictional Assessing Officer, in the prescribed form and with the prescribed details within sixty days from the end of the FY concerned. This amendment is proposed to be made effective from June 1, 2011.

Indirect tax proposals The basis of levying service tax on purchase or sale of foreign exchange has been changed with effect from April 1, 2011. Service tax would now apply at 0.1 percent of 'value' determined as under: For a currency exchange from / to INR, amount equal to the difference between the buying rate or the selling rate, as the case may be, and the RBI reference rate for that currency for that day, multiplied by the total units of currency. In case where the RBI reference rate for a currency is not available, amount equal to 1 percent of the gross amount of INR provided or received, by the person changing the money. In case where neither of the currencies exchanged is INR, amount equal to 1 percent of the lesser of the two amounts the person changing the money would have received by converting any of the two currencies into INR on that day at the reference rate provided by the RBI. The option of paying service tax on an amount charged as 'fee' for such purchase or sale of foreign exchange appears to have been withdrawn.

The scope of exempt services has been specifically amended to cover 'trading'. Thus, all proprietary trading activities would now be specifically treated as exempt services triggering (specifically) denial of input credits relatable and attributable to such trading activities. The amendment seems to be clarificatory, and its retroactive application needs to be examined. Service providers providing taxable and exempt services (which now also includes trading) and classifying their (taxable) services under 'banking and other financial services' ("BOFS") have faced challenges on determining the proportion of credits that are eligible. An option that has always been provided under the regulations is to maintain separate records for inputs and input services used for taxable services and exempt services, else proportionate reversals (based on ratio of exempt turnover) apply. A specific provision has been added to the effect that such service providers would be eligible to only 50 percent CENVAT credit available to them. The manner in which this would operate is that the service provider would avail eligible credits, and then be required to "pay" back (or reverse) 50 percent of the credit. This scheme applies by default and other options (of proportionate reversal) are not available to such service providers. The provision would be effective from April 1, 2011. Similar provision has been inserted for insurers providing 'life insurance' related services and services of 'management of ULIPs'. For these services, a cap of 20 percent (instead of 50 percent above) has been prescribed. In other words, 80 percent of the credit would have to be reversed / paid back. Again, this scheme applies by default and other options (of proportionate reversal) are not available to such service providers. The provision would be effective from April 1, 2011. The scope of life insurance services has been expanded to cover all services in relation to management of investments for policy holders. Service providers have been allowed an option to pay tax at standard rate on premium not invested or to pay composition rate of tax of 1.5 percent of gross premium. BMR comments Budget 2011 has largely remained focussed on macro-economic issues and development of the infrastructure sector in India. It has not covered many of the fiscal measures that could have provided additional support to the Financial Services industry. Notably, proposals relating to equal tax treatment for NBFCs vis--vis Banks, alignment of accounting and tax treatment of loan provisioning by Banks, restoration of tax exemption to venture capital funds for investments across all sectors, clarity on characterisation of securities trading income, clarity on certain tax issues on payment to overseas offices, etc did not find mention in the Budget. However, on balance, the Budget does provide a positive signal as the Finance Minister has shown his resolution to push through key policy level and regulatory reforms, which are critical for the development and growth of our financial services sector.
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