Exit challenges faced by PE funds

Private equity (PE) investors invested in Indian businesses in the past are mulling various exit mechanisms for profitable returns with low tax-risks.

The lukewarm response to initial public offers of unlisted companies has forced PE funds to look for alternative exit routes, which inter alia include buyback of shares, capital reduction or secondary sale of shares either to the promoters or other investors. Vaibhav Gupta and Tusha Goyal , who are chartered accountants, discuss the taxability of these options in conversation with Grant Thornton.

Will tax on share buyback deter companies from using it as a preferred exit route?

Buyback of shares was always liable for capital gains tax in the hands of the seller unless the seller claimed treaty benefits to pay no tax. Finance Act 2013 makes the company undertaking the buyback liable to pay the tax on gains, thus negating the tax exemption on capital gains under the tax treaties.

When making new investments, companies and PE funds factor the tax on buyback as part of the transaction cost.

However, the tax would have a bearing on the current investments made through Mauritius or Singapore where buyback was considered a tax-neutral exit option. It may lead to negotiations between the company and the exiting PE fund on who would bear the increased transaction cost.

How would capital reduction be different from buyback of shares?

Capital reduction through court approval attracts dividend distribution tax to the extent of accumulated profits distributed. Any additional distribution would be liable for capital gains in the hands of the investor and thus eligible for treaty benefits, if any.

What are the tax consequences for purchase of shares by promoters?

Where promoters buy out the PE investor, the transaction would be treated as secondary sale of shares, with the promoters liable for tax withholding on gains.

Lately, tax authorities are invoking transfer pricing provisions on various capital transactions between associated enterprises. Would transfer pricing be attracted in the options discussed above?

PE funds holding more than 26 per cent stake in any company would be treated as associate enterprise. Any transaction between the company and the PE fund should be at arm’s length under the Indian transfer pricing regime.

What are the challenges faced by investors in secondary sale of shares?

For investments routed through jurisdictions such as Mauritius or Singapore, having a favourable capital gains tax-treaty clause with India, gains on the secondary sale of shares would not attract tax liability in India if the shareholder produces a valid Tax Residency Certificate and other prescribed documents.

However, tax authorities have constantly challenged the treaty benefit to the exiting investor, thus forcing PE investors to look for means of protecting themselves from litigation.

For transactions between two non-residents, tax authorities generally go after the buyer first for non-compliance of withholding norms. What safeguards are available against such action?

Non-resident investors are wary about the extent of withholding required when buying shares of Indian companies from a non-resident in a secondary deal.

The buyers protect against future tax demands through measures such as taking an indemnity from the seller, drawing an insurance policy against future tax demands, or retaining the tax amount in escrow till the seller obtains Advance Ruling or there is finality on the ultimate tax liability.

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