It appears that the chance to revamp the country’s income-tax regime has just past us by. For domestic private equity funds, it is almost a case of “the grass seemed greener on the other side, but its still grass!” The implications for offshore private equity funds are largely in line with the Direct Taxes Code Bill, 2009 (Original DTC Bill).
So, what is in it for private equity investors?
Domestic private equity funds – sector-specific tax pass through reinstated
What appeared to be a welcome relief for venture capital companies (VCC)/ venture capital funds (VCF) the Original DTC Bill, has been withdrawn under the Direct Taxes Code Bill, 2010 (New Bill). The Original Bill conferred tax pass-through status to VCC/VCF, with respect to investments across all sectors. However, the new Bill has restricted the tax pass-through status to investments in specified sectors. In short, the present law on this aspect has been reinstated.
Investment in specified sectors
The nine sectors, investment in which currently ensure tax pass-through status to VCC/VCF, include, amongst others, nanotechnology, information technology relating to hardware and software development, building and operating composite hotel cum convention centre (with seating capacity of more than three thousand), development of infrastructure facility, etc. The term ‘infrastructure facility’ has been defined; notable exclusions from the definition are development of power projects, SEZ, etc.
Investment in other sectors
In respect of such income, the taxation would be as that applicable to a regular trust (traditionally domestic private equity funds have been set up as trusts).
Key difference is as follows:
• If a VCF invests in a specified sector, income from such investment would be taxed only in the hands of investors, and more importantly, only when such income is actually distributed to the investors.
• Income from investments in other sectors would be taxable in the hands of the investors on accrual basis.
Taxation of income from other sources
The taxation of VCF’s income from other sources (such as interest on fixed deposits) has not been dealt with. The taxation of such income would also be as that applicable to a regular trust.
Withholding of tax on distributions
There seems to be no clarity as to whether VCFs would need to withhold tax on payment to investors, even where a VCF is treated as a pass through vehicle. This, however, does not seem to be the intention.
Taxation of trusts – fewer anomalies?
Trust taxation provisions have been simplified under the New Bill. Differential tax regime applicable for determinate and indeterminate trusts has been removed. Hence, the possibility of VCFs being regarded as indeterminate trusts (or discretionary trusts), and consequently, being subject to tax at the maximum rate (of 30%) on all incomes, does not seem to exist any longer. The provision relating to taxation of the entire income of a trust at the maximum rate, if the trust has any business income, has also been dropped. These changes in taxation of trusts would certainly reduce the need for the myriad complex tax positions currently adopted by VCFs.
The New Bill provides a definition for the term ‘private discretionary trusts’; this term was used under the Original DTC Bill exclusively in the context of wealth-tax provisions. While the references of the term have been deleted under the wealth-tax provisions in the New Bill, the definition has been retained without any provision referring to the term. This appears to be an error, and does not seem to be a means of retaining the concept of indeterminate or discretionary trusts.
Capital Gains on exit
The imposition of a tax rate of 30% (vis-à-vis the existing rate of 20%) on long term capital gains on sale of unlisted shares is a major shift from the current tax regime, albeit indexation benefit has been retained. Investments in unlisted companies constitute a major portion of private equity investments; this provision could possibly result in private equity funds having to re-calibrate the IRR promised to investors.
Tax exemption on long term capital gains will continue with respect to sale of equity shares through the stock exchange.
Offshore private equity funds – risks galore
Offshore fund will be eligible to claim the benefits available under a favourable tax treaty, except where General Anti-Avoidance Rules (GAAR) or Controlled Foreign Corporation (CFC) Rules are invoked.
The New Bill has introduced the concept of place of effective management as a test of residential status of companies. If regarded as a tax resident of India, the entire income of a foreign company could be subject to India tax. Appropriate documentation should be maintained to demonstrate that the offshore funds are not effectively managed in India.
Sweeping powers are sought to be provided to the tax officers to declare an arrangement as impermissible (and hence, taxable in India), if it has been entered into with the objective of obtaining tax benefits and if it lacks commercial justification.
CFC Rules would have an impact on overseas holding companies set-up by Indian companies and individuals. Profits of CFC attributable to the resident tax payer would have immediate Indian tax implication, even if the resident tax payer does not receive any income from the CFC.
If a foreign subsidiary of an Indian company qualifies as a tax resident of India as well as a CFC, it could result in tax implications for the foreign company itself as well as its Indian shareholder. Appropriate clarification on this aspect in the Code would mitigate undue hardships for tax payers.
Level playing field between domestic and offshore funds
Time and again, concerns have been raised on inequality in tax implications for domestic funds vis à vis offshore funds, since offshore funds typically invest in India through tax favourable jurisdictions resulting in lower or no tax liability at all. This seems to have been partially taken into consideration by the Finance Minister by the introduction of specific provisions on GAAR and CFC Rules.