With some recent amendments made to the country’s foreign exchange and taxation laws, foreign private equity funds have reasons to cheer.

In March this year, the Reserve Bank of India (RBI) permitted foreign venture capital investors or FVCIs to invest in portfolio companies also by purchasing securities from third parties, that is, from some existing shareholders of these companies.

Till then, FVCIs were permitted to invest only through initial public offers or private placements made by portfolio companies; purchase from any third-party was not permitted.

A recent tax amendment brought further good news to foreign private equity investors, including FVCIs. It brought them on a par with foreign institutional investors in respect of long-term capital gains on unlisted securities by prescribing the same rate of 10 per cent for both.

INDIAN SITUATION

While foreign private equity investors, in general, have reason to be happy with these amendments, their Indian counterparts, however, may be worried; this is because of other recent amendments made to taxation and securities laws.

Recently, the Securities and Exchange Board of India notified the SEBI (AIF) Regulations, which govern the investment funds set up in India.

These regulations have divided the funds into three broad categories, namely, Category I, II and III. Category I covers those funds that will primarily invest in start-ups or early ventures and are eligible for incentives or concessions provided by SEBI or the government or other regulators in India.

Category II and III will have to be those which do not get any specific incentives or concessions.

As per the SEBI regulations, a venture capital fund will fall under Category I; a private equity fund under Category II, while funds employing diverse or complex strategies such as hedge funds under Category III.

These regulations could result in a domestic private equity fund (that is not a venture capital fund) losing certain tax benefits, which otherwise were available to it so far.

For example, it appears that one of the important benefits, called ‘tax pass through’ benefit will not be available to a private equity fund, though it will continue to be available to a venture capital fund.

A ‘tax pass through’ benefit is one where the income received from a portfolio company is not taxed in the hands of the fund, but in the hands of the actual investor who had initially invested in the fund.

A private equity fund would now stand to lose this benefit, since the SEBI regulations provide that a private equity fund cannot be one which derives any incentive or concession.

Also interestingly, unlike earlier, when the ‘tax pass through’ benefit was available only in nine sectors, it has now been extended to all sectors barring two — ‘non-banking financial activities’ and ‘gold financing’.

Therefore, in a way, it can be said that a private equity fund could suffer a double loss, one that of losing the ‘tax pass through’ benefit and the other of the enlargement of this benefit to almost all the sectors.

NO I-T CONCESSION

The story does not end here. If the same logic is extended, that is, a private equity fund cannot be a fund which can get concessions or incentives, then it could also lose all other concessions or incentives that it could otherwise have got.

Take for example, the benefit of non-applicability of the newly inserted Section 56 (viib) and proviso in Section 68 of the Income Tax Act.

Broadly, Section 56 (viib) provides that a privately-held company will have to pay tax as ‘income earned from other sources’ if it issues shares to a person resident in India at a consideration higher than the actual fair market value of those shares.

Interestingly, Section 56 (viib) provides an exemption in cases where the consideration for the issue of shares is received from a venture capital fund.

It is quite possible that a company may not be able to take this exemption if it receives the consideration from a private equity fund.

Similarly, under Section 68, a certain provision of that Section will not apply if an amount in a company’s records is standing to the credit of a venture capital fund, which could again be denied if, instead of a venture capital fund, the amount is standing to the credit of a private equity fund.

For the reasons described above, unless further clarity or amendments are extended to applicable provisions of law, it is certain that a private equity fund registered under SEBI (AIF) Regulations will have to let go all concessions or incentives which it got so far.

It will have no option but to bite the bullet.

(The author is a Partner with J. Sagar Associates. The views are personal.)

(This article was published on July 22, 2012)
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