Mixed bag for private equity funds

The Budget has been a mixed bag for the Private Equity (PE) and Venture Capital (VC) industry, giving away some welcome tax reforms for VC Funds, poignant retrospective amendments reversing Vodafone ruling and uncertainty created by introduction of aggressive General Anti-Avoidance Rules (‘GAAR').

Some of the major amendments impacting PE and VC industry are:

Taxability of Venture Capital Fund

The VCF has been simplified providing the much-needed certainty. Earlier, domestic VCFs were exempt from tax only in respect of investment in companies engaged in nine specified sectors. The sectoral restriction is now proposed to be removed, that is, pass through status is proposed to be restored to VCFs irrespective of sectors in which the companies operate. Such income would be taxable in the hands of investor upon accrual of income to the VCF as against distribution of income as it exists today.

The exemption from applicability of withholding provisions on income credited or paid by VCF to investors is proposed to be withdrawn.

Removal of exemption of applicability of withholding tax obligations could raise issue of double taxation on certain types of income.

Having regard to the certainty in taxation of VCFs provided by this amendment, the unified structure wherein the domestic VCFs act as a master fund to the domestic and foreign investors would become more popular vis-à-vis co-investment structure wherein the overseas investors make investments parallelly with domestic VCFs.

Taxability of overseas transfer

The Bill proposes to retrospectively amend the deeming fiction to provide for taxation of overseas transfer of shares or interest of an overseas entity deriving substantial value from Indian assets (directly or indirectly). Further, the Bill proposes to specify certain transactions which would be subject to withholding tax obligations irrespective of the fact whether or not such transactions are taxable in India.

The proposed amendments are audacious and if enacted, would impact numerous cross-border transactions involving overseas transfers. Given the retrospective amendment, it may re-open the settled cases too which were hoping to rely on the Supreme Court decision in Vodafone case.

Offshore private equity funds, which either wholly or substantially focus on India investments, would most certainly be impacted as any overseas exit by the Fund or the investors of the Fund would become taxable in India, subject to tax treaty benefits.

Introduction of GAAR

One of the key amendments proposed is the introduction of GAAR from April 1, 2012 highlighting the Government's strong commitment to curb unacceptable tax avoidance practices. The GAAR provisions would override the tax treaty provisions in cases where GAAR is invoked.

Further, no grandfathering has been provided for any investments made prior to April 1, 2012. Wide powers have been granted to Tax Authorities when GAAR is invoked for an “impermissible avoidance arrangement” which include disregarding or re-characterising steps or the transactions or the accommodating party etc.

Certain factors which were taken into account in the Vodafone ruling (for example, period of holding, payment of taxes, providing an exit route, and so on) have been treated to be not relevant in determining commercial substance.

Further, the Budget has also clarified that obtaining a TRC in an offshore jurisdiction is a requisite; it is not sufficient for claiming treaty benefits. The above amendments would lead to a high level of uncertainty on existing investments, transactions and structures from jurisdictions such as Mauritius, Cyprus, etc and could impose additional burden of proof on the tax payers.

The retrospective nature of amendments have provided the unwelcome uncertainty in the tax laws in India for private equity players.

(The author is Partner, Tax, KPMG in India.)

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