Dampener for private equity

When P. Chidambaram took over as the current Finance Minister, he promised clarity on tax laws, stability in tax regime, non-adversarial tax administration, fair mechanism for dispute resolution, and an independent judiciary. However, little did the private equity industry anticipate that he was on his way to fulfil Mark Twain’s observation “Better a broken promise than none at all”.

As the Minister declared in a press release in January, the General Anti-Avoidance Rules (GAAR) are on way to becoming reality after being deferred to financial year 2015-16. He has also accepted Shome Committee recommendations, including invoking GAAR only when the main purpose of the arrangement is to obtain tax benefit, giving the assessee an opportunity to prove why GAAR should not be triggered, an approving panel with independent members and so on. However, some of the other announcements in the press release such as grandfathering earlier investments, exemption for foreign institutional investors from GAAR and so on have not emerged in the Budget. Also, industry has to wait and watch to find out how future guidelines will determine the situations in which GAAR would be invoked.

One proposal that sent shockwaves across the private equity industry was that Tax Residency Certificate (or TRC) would be necessary, but not sufficient for claiming treaty benefits. Private equity investors are worried whether this effectively means immediate backdoor entry for GAAR. The Finance Minister himself confessed later that the proposal was ambiguously drafted and put out another release clarifying that TRC shall still be a valid proof of residence without any questions from authorities, and Circular 789 will remain in force for Mauritius.

Distribution tax of 20 per cent is introduced on buyback of shares of domestic unlisted companies. This proposal seems pursuant to the Authority for Advance Rulings’ decision in the case of Otis Elevators, where buyback was struck down as being in lieu of dividends. However, instead of dealing with this head-on by invoking GAAR, the Finance Minister has smartly moved the tax to the company undertaking the buyback, leaving no room for argument for claim of treaty benefits. Also, the provision is not happily worded as the tax can be levied irrespective of whether or not the company has accumulated profits. Further, indexation benefits available to the investor, as also his cost of acquisition from a previous subscriber would not be available as the tax is computed on the difference between consideration and amount infused into the company.

The Budget was a major setback for domestic private equity funds as well. Pass-thru benefit was anticipated for all categories of Alternative Investment Funds (AIF) and, at the least, Category-1 AIF. However, the Finance Minister has further restricted the pass thru to the sub-category of venture capital funds within Category-1 AIF. This means that others such as infrastructure fund, SME fund and so on cannot benefit from pass-thru treatment and would face complex trust taxation provisions.

It was a relatively good budget for the mutual fund industry as taxation of securitisation trusts has been exempted. However, other classes of investors (such as insurance companies) may not benefit as they could face a higher effective tax rate. Further, reduction of Securities Transaction Tax for mutual funds is a welcome move to attract investors. However, the increase in distribution tax on all debt mutual funds to 25 per cent would reduce their arbitrage vis-à-vis fixed deposits.

The Budget remains silent on taxation of indirect transfers, leading to lack of clarity and interpretational issues on the taxation of international transactions.

The Budget was also expected to clear the air on applicability of Minimum Alternate Tax to foreign companies, availability of 10 per cent capital gains tax on sale of shares of private limited companies by non-residents, taxation of Qualified Foreign Investors, reduction in withholding tax on interest on corporate bonds for Foreign Institutional Investors and so on. None of that came through, nor was there any roadmap for the Direct Taxes Code.

Welcome announcements include simplifying the registration process and KYC norms for foreign portfolio investors. Also, a committee is being set up to clearly distinguish and define a strategic investment as FDI and a portfolio investment as FII. SME (small and medium enterprises) listing without need for an IPO would open up capital raising opportunities for this segment. Also, steps have been announced to create an active corporate bond market, including introduction of a dedicated debt segment by stock exchanges, and direct trading by insurance companies, provident and pension funds in the debt segment.

Overall, the Budget proved a dampener for the private equity industry as far as tax proposals are concerned, and little has been done to move towards a stable and certain tax regime for them.

(Tushar Sachade Partner-Tax contributed to the article.)