The private equity and venture capital industry has more often than not been fraught with tax uncertainties ever since its advent into India. The provisions of the Indian Income Tax Act, 1961 (“Act”) provide a special regime for taxation of onshore funds. At the same time, there was not much jurisprudence with respect to taxation of offshore funds. Since then there have been a number of amendments to the Act, and a number of judicial decisions on different matters affecting taxation of PE and VC funds. Further, India’s Foreign Direct Investment (“FDI”) policy also regulates investments made by offshore Funds in various sectors in India. The FDI policy has been evolving on a continuous basis and giving rise to a number of interpretational issues affecting FDI investments into India.
Some cross border contemporaneous tax and regulatory issues which affect the fund industry are discussed in the subsequent paragraphs:
Substance Issues: An important issue which has been plaguing foreign VC / PE Funds is the requirement of substance in their offshore (often) Mauritius structures, and the moot question which comes up for debate often is “how much is good enough? India is on the anvil of implementing a General Anti Avoidance Rule (“GAAR”) with effect from April 2015, which may seek to tax gains made by Funds from exit of their India investments in the event of lack of substance at the offshore fund level. The new legislation provides for grandfathering of investments made prior to August 30, 2010 such that income arising from transfer of such investments would not be subject to GAAR. Otherwise, GAAR would apply to all exits made after April 2015.
Meanwhile, Mauritius, in an effort to combat use of Mauritius entities as conduits for investment into other jurisdictions, has also released its own substance rules. These rules are basic in nature (example, requirement to maintain office in Mauritius, employ staff in Mauritius, hold assets in Mauritius, etc), and only one condition out of six needs to be satisfied in order to be eligible for issuance of a TRC. In fact, if one group entity satisfies any of the six conditions, they will be deemed to have been satisfied for all group entities based in Mauritius. It will be interesting to see how these rules will tie in with the Indian GAAR.
Given the above, Fund managers have been considering alternate jurisdictions like Singapore for new Funds, or even migrating existing funds to alternate jurisdictions which could provide more certainty on taxation. Fund migration through setting up Alternate Investment Vehicles can be a challenging exercise since it involves an interplay of local corporate laws of both the jurisdictions alongwith the Indian tax laws.
At the same time, an amendment to the Act provides for a 10% tax rate on sale of shares of Indian companies by a non resident investor. Gains arising from sale of shares on the stock exchange is also exempt in India. Thus, PE / VC Funds may evaluate the practicality of the case while determining the extent to which substance can be built into the offshore structure, given the associated tax risk with the change in tax rates.
Permanent Establishment issues: One of the most critical issues for the offshore PE/VC funds is whether or not the offshore Fund establishes a PE in India. Offshore Funds typically operate on an investment advisory model whereby an Indian Advisor provides non binding investment advice to an offshore Manager which in turn manages the offshore Fund. The Indian Government, in the recent past, had given an indication that they may be willing to issue a circular which would exempt activities of Indian Fund Managers / Advisors from constituting a PE of the offshore Fund in India. While such a circular is still awaited, it would give a much needed impetus to the PE / VC Industry. It would be useful if the Government would issue a Circular exempting Offshore Funds from creation of a PE in India. This would also be a fairly dynamic move on the part of the Indian Government and would project India as an attractive jurisdiction for location of fund managers.
The Cyprus controversy: India has been taking exchange of information with its treaty partners very seriously. The India Cyprus tax treaty has been used often in the recent past due to the favorable capital gains tax exemption and the concession on the withholding tax on interest afforded by the treaty. It scores well over other treaties with jurisdictions like Mauritius, Singapore and Luxembourg due to the combination of a capital gains tax treatment combined with the reduced income tax rate of 10% on interest income earned in India (the rate under the Indian domestic law for non residents can be as high as 40%!). Cyprus’ entry into the EU also gave investors the comfort and helped them in deciding to invest through Cyprus into India. As a result, Real estate and PE funds investing in debt instruments have preferred to invest from Cyprus.
There has however been increased heat over the India-Cyprus tax treaty in the recent past primarily due to two reasons - (a) declaration of Cyrus as a non-compliant jurisdiction for transparency & exchange of information by the OECD and (b) non-cooperation by the Cyprus Government with the Department of Revenue in India on exchange of information. As a response, India’s action of notifying Cyprus as a non-jurisdictional area was a significant step for compliance with international transparency standards on exchange of information. The implications of such a notification are far reaching, including deemed transfer pricing applicability, denial of tax deductions for payments made to a Cyprus resident (subject to certain conditions), increased withholding tax burden for payments made to a Cyprus resident, and so on.
In response to this, a new re-negotiated treaty with Cyprus is expected to be finalised soon which should address India’s concerns over lack of exchange of information. It also remains to be seen whether the new treaty will provide a Limitation on benefits provision to curtail the capital gains tax exemption, and also whether the tax rate on interest income will also be the subject matter of renegotiation. The re-negotiated treaty should however not be effective immediately, and a time gap would ideally be provided in order to give investors time to re-arrange their structure and investments.
Recent media reports have suggested that India has also been in talks with Switzerland to improve exchange of information. While Switzerland has not yet been notified as a non-compliant territory, it definitely remains on India’s watch list.
New Foreign Portfolio Investor regime: The Securities and Exchange Board of India (“SEBI”) recently introduced a new category of investors known as “Foreign Portfolio Investors” or “FPI”. The new FPI regime seeks to subsume the existing Foreign Institutional Investor (“FII”) and the Qualified Foreign Investor regime. The existing tax framework has also been changed accordingly to give FPIs the status of FIIs and thus provide for a uniform basis of taxation for all categories of FPIs.
Reserve Bank of India (“RBI”) clarification on put and call options: PE and VC investors generally negotiate for an assured return on their investments with promoters of portfolio companies. The assured return is typically documented in the form of put and call options in the investment agreement. RBI has in the past frowned upon such arrangements with a logic that such options practically result in reclassification of equity into debt. Recently the RBI reviewed its policy on put and call options and has provided investors with flexibility to exit based on a “Return on Equity” formula. The catch however is that the investors cannot be provided an assured return, while they may be allowed to exit based on the “return on equity” formula. This policy creates serious issues for investors, since it is possible that providing an assured return on equity could give rise to the investment not being compliant with FDI policy. At the same time, it is questionable whether the “return on equity” formula is the right approach for valuation purposes. Till the time RBI does not come out with suitable clarifications on the new law, this is bound to impact PE and VC investment in India.
Equity share warrants: Under the existing law, investment by way of equity share warrants requires prior approval of the Foreign Investment Promotion Board. Share warrants are an important instrument since it also assists a foreign PE / VC Fund to lock in the price at which investments may be made at the time of exercise of the warrants, and thus provide flexibility for making such investments. It may be good if such investment is brought under the automatic route albeit subject to certain criteria like forfeiture of allotment price paid, minimum period for exercise of the warrants, etc.
Exit on the SME Exchange: A PE / VC investor may exit its shares invested in a small and medium enterprise on BSE’s SME Exchange. The SEBI Regulations provide for listing of securities of small and medium enterprises subject to certain conditions which are less onerous than for companies seeking to list on the main exchange. Provisions regarding migration to the main exchange are also incorporated in the SEBI Regulations. These regulations provide flexibility to PE / VC investors to exit on the stock exchange and also claim exemption of capital gains tax earned from such exit.
To sum up, while India is gearing up its securities and regulatory laws and aiming at providing investors with a more secure and regulated environment, it will be increasingly important for Fund Managers to recognize and deal with a changing tax environment to ensure that they are able to provide investors with a better return on their capital rather than combating tax litigation at different levels.