The government last year had made efforts on both tax and regulatory fronts to boost the PE/VC industry. It provided tax pass-through status to domestic funds and clarified income classification and offered incentives for startups.
It also issued much-awaited clarifications on General Anti-Avoidance Rules (GAAR) and guidelines on the concept of Place of Effective Management (POEM).
Given the pro-investment and development approach of the government, much was expected from the Budget 2017. It was hoped that the budget would take measures to make it easier to do business in India, including for managing offshore funds from India and attracting more capital by domestic funds.
The budget was also expected to provide more exemptions to startups at initial stages, announce steps to rationalise taxation on transactions and M&As, and smoothen the overall process.
Some of the key tax highlights of the Budget 2017 impacting PE/VCs as well as M&A deals are discussed hereunder:
Incentives for Startups
Extension of tax holiday period
The Budget 2017 proposes to extend the period for claiming tax deduction by providing that the startups could claim deduction of profits for any three consecutive years out of seven years from the date of incorporation as compared to five years prescribed earlier.
Carry forward of losses by startups
As per the extant provisions, the losses of a closely held company (including a private company) are not allowed to be carried forward if there is a change in the shareholding of the company by more than 49%.
The Budget 2017 proposes to provide that the startups would be eligible to carry forward the losses even if there is a change in shareholding by more than 49% provided that (i) all the shareholders at the time of incurrence of losses continue to hold those shares and (ii) the concerned losses have been incurred within seven years from the date of incorporation. Thus, additional shares which are bought by the existing shareholders post the incurrence of the loss are not expected to be locked in.
Major boost for affordable housing sector
The Budget 2017 proposes to include the affordable housing sector within the definition of infrastructure sector, thereby providing a much need boost for channelization of investments in this segment. Specifically, this would make debt investments in affordable housing more flexible and cheaper.
Taxation of foreign portfolio investors (FPIs)
The Budget 2017 proposes to provide exemption to non-resident investors in Category I and Category II FPIs from the indirect transfer provisions. This exemption would provide much-needed clarity to FPIs and investors in FPIs specifically, in light of the recent amendments to the tax treaties withdrawing exemption on capital gains.
Incentives for debt investments in India
Extension of concessional withholding tax rate of 5%
The Budget 2017 proposes to extend the concessional withholding tax rate of 5% applicable to interest income earned by foreign investors from external commercial borrowings (ECBs) or by FPIs from investments in rupee-denominated bonds—popularly known as masala bonds—of an Indian company from June 30, 2017 to June 30, 2020.
Further, the Budget 2017 has proposed to extend the same benefit to foreign investors on interest accrued on the offshore masala bonds. This extension would undoubtedly provide certainty on taxation of interest income from India in the hands of foreign investors and help boost foreign debt flow in the infrastructure (including affordable housing) and real estate sectors and also to Indian companies in distress for refinancing high domestic debt cost.
In addition to the above, the Budget 2017 also proposes to provide exemption from capital gains under the domestic tax law on transfer of masala bonds (being NCDs, offshore masala bonds) between non-residents.
Introduction of thin-capitalization rules for related parties
The budget proposes to insert new provisions to provide that interest expenses claimed by an entity to its associated enterprises shall be restricted to 30% of its EBITDA or interest paid or payable to related parties, whichever is less. The interest which is not allowed as deduction shall be allowed to be carried forward for subsequent eight assessment years and allowed as deduction to the extent of maximum allowable interest expenditure.
This appears to be an indirect introduction of thin capitalization norms under the domestic tax laws in relation to debt transaction between related parties. It would impact investee companies wherein foreign investors are predominant lenders as well.
Reforms in M&A transactions
Conversion of preference shares into equity
As per the extant provisions, conversion of preference shares into equity shares was not specifically exempt. This resulted in ambiguity on the taxability on the conversion of preference shares into equity, unlike conversion of debentures into equity.
The Budget 2017 has proposed to provide an exemption on conversion of preference shares into equity shares. Further, the cost of acquisition of preference shares shall be treated as cost of resultant equity shares and period of holding of preference shares shall also be counted towards the period of holding of resultant equity shares. This is contrary to conversion of debentures into equity shares where there is no clarity on the continuation of the period of holding.
This is a significant clarification providing clarity and relief to the investment community at large which was long outstanding. Further, this would also clarify the ambiguity in the language of recently amended tax treaties in relation to the applicability of the grandfathering provisions.
Deemed gift provisions
The Budget 2017 proposes to rationalize the deemed gift provisions under section 56 to provide for exemption for transactions of merger and demerger approved by the National Company Law Tribunal. It is to be noted that the amendment does not provide any clarity with respect to such transactions prior to April 1, 2017
Imputation of fair market value (FMV) as sale consideration in respect of transfer of unlisted shares
The Budget 2017 proposes to impute FMV (to be prescribed) as sale consideration where the consideration of unquoted shares is less than the FMV. This amendment is onerous as it is akin to back door entry of transfer pricing provisions and defies the long accepted principle that the price bargained for in a commercial transaction between unrelated parties should be accepted as the sale consideration thereby giving discretion to the Income Tax Authorities to impute FMV as sale consideration.
The Budget has provided much needed clarity in certain cases as well as extended / provided incentives for investments in debt/startups by PE/VC funds. These amendments would also help boost critical sub-sectors like affordable housing as well as provide impetus to startups (especially, in consumer business and tech space) backed by PE/VC.
Anil Talreja is partner, Yashesh Ashar is senior manager and Ankit Panchal is deputy manager at Deloitte Haskins & Sells, LLP.
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