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What Is PE Industry Expecting From Union Budget 2016?

There has been a constant debate on classification of income into capital gains and business income, which has consequently led to numerous litigation

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The time finally seems right for private sector investment to take off in the next few quarters with an aim to drive GDP growth and employment. In the last decade, the private equity and venture capital industry has provided vital risk capital to businesses and effectively bridged the gap between the public market and banks. Over the years, the Indian private equity ecosystem has evolved and taken the shape of an industry itself. However at the same time, it is riddled with many issues due to lack of clarity around regulations and policies which need to be streamlined. There are few areas where the government can bring about appropriate clarifications to set this agenda.

There has been a constant debate on classification of income into capital gains and business income, which has consequently led to numerous litigations. Recently, the Alternative Investment Policy Advisory Committee appointed by the Securities and Exchange Board of India (SEBI) under the Chairmanship of N. R. Narayan Murthy recommended that income earned by an Alternative Investment Fund (AIF) should be classified as capital gains. Also, the Easwar Committee set-up for simplification of income tax has also recommended an objective criteria to be set whereby if shares are owned for more than 12 months, then such gains shall be considered as long-term capital gains, unless they are classified as stock-in-trade in the books.

Through the Finance Act, 2015, the government introduced safe harbour rules to incentivise fund managers of offshore funds to be based in India. However, the benefits under the new safe harbour rules are available only upon satisfying certain stringent conditions such as investor diversification, investment related diversification, control or management of any business in India or from India, remuneration of a fund manager being at arm's length, annual reporting requirement, etc. Due to these conditions, measures failed to take off and could not be implemented by the fund industry. Therefore, in the Budget 2016, it should be clarified that FPIs, FIIs or FVCIs should be treated as an 'eligible investment fund'; direct and indirect members should be considered for ascertaining the number of members in a fund; participation interest of a single investor to be increased from 10 per cent to 49 per cent; and activities undertaken by a fund in connection with its investment in the investee company will not result in the fund controlling and managing any business in India or from India.

Funds invest not only through direct equity but also through hybrid instruments like convertible debentures or preference shares. As far as convertible debt is concerned, tax laws provide an exemption on conversion of such debt into equity. However, a similar exemption is not explicitly available on conversion of preference shares. In order to avoid potential litigations and bring about clarity, an explicit exemption can be extended even to convertible preference shares. At the same time, it will be ideal to grandfather the holding period of hybrid instruments to equity shares upon conversion to bring about parity in investment in equity vis-à-vis hybrid instruments.

Tax laws provide a concessional tax rate of 10 per cent on long-term capital gains earned from the transfer of unlisted securities in the hands of non-residents. However, currently the way unlisted securities are defined in the Act, it leaves room for doubt whether it includes the shares of private limited companies or not. Given that a significant portion of investment by funds in India is in equity shares of private companies, it should be clarified that the beneficial rate of 10 per cent shall be available on long-term capital gains derived from the transfer of shares of all unlisted companies.

Several funds are organised through a multilayer structure and pooling takes place in different jurisdictions. The genesis of bringing the indirect transfer provision in statute was to cover strategic transactions, which are taking place outside India but derive substantial value from India and hence should pay capital gains tax in India. However, current provisions have led to unintended consequence, especially, for the fund industry where these provisions need to be tested at each level. It will be better if once tax laws are applied on direct transfer of shares of Indian company then subsequent distribution should not be covered by indirect transfer provisions.

Any distribution of income by an AIF to its investors, other than income taxable under 'business income', is subject to withholding tax at the rate of 10 per cent. This results in cash trap issues at the investor level on income which is exempted/not subjected to tax in India as the investors might then need to seek a refund for taxes withheld in their own income tax returns, which could take years. Accordingly, the government should either consider to drop the withholding tax provisions and let the investors pay taxes directly on the income as per the applicable law or make suitable amendments to avoid unnecessary withholding tax on income which is exempt in the hands of investors under the domestic laws or the relevant tax treaty.

Funds have to incur management fees and operating expenses for their day to day operations. These expenses cannot be specifically identified with any particular investment and therefore currently cannot be claimed as expenses or loaded into the cost of investments and therefore this goes against the very concept of 'pass through' status. Therefore, clarity is essential so that these expenses can be claimed against the investments.

Currently, if debt is raised from a foreign portfolio investor, it is eligible for a lower withholding tax of 5 per cent; however, this benefit is available only until 31 May 2017. Indian companies need long-term resources to build infrastructure; hence the tenure of debt is normally long-term in nature. To help ensure predictability of returns, investors might prefer to have clarity of availability of a lower withholding tax rate for five - seven years, if not more and therefore instead of providing an extension only towards the end of the expiry of the benefit, it may be better if this is extended as a one-time measure for atleast five years, so that both the companies and investors can plan their affairs.

Providing the above clarifications shall not result in a real loss of revenue for the government in comparison to the benefit of a certainly in tax treatment and avoiding of litigations.

With inputs from Nikhil Thakkar - Associate Director, Tax, KPMG in India

Disclaimer: The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG International or KPMG in India.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.

Tags assigned to this article:
Budget 2016-17 private equity sebi tax policy

Alok Mundra

The author is Partner, Tax, KPMG in India

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