Taxation on exits of Private Equity fund managers

In a recent move, the government sent notices to major Private Equity (PE) fund managers working in India seeking details of their income and assets abroad.

Through this, the Revenue Department functioning under the Ministry of Finance is seeking to analyse the profit share received by the fund managers on the ‘exit’ of their investments. These ‘exit profits’ are said to reach as high as 30% of a PE fund’s overall exit profit and can amount to hundreds of crores in the case of big funds making big exits. But why should we not be surprised by this move?

This has, in fact, been pending for a while. Why? Investors are first taking capital outside the country and routing it back to India as foreign investment to take advantage of the benefits available to a select few foreign investors based on Double Taxation Avoidance treaties with their home countries. One such treaty that allows for this is the India-Mauritius treaty, which provides capital gains exemption to Mauritius entities who hold Indian shares as any of the following: Foreign Venture Capital Investors, Foreign Institutional Investors, Private Equity or Venture Capital firms. Most of these entities are funds from the United States or European Union nations that invest in India via the Mauritius, Singapore, Cyprus or the Caymans route and were originally meant for domestic domiciled funds. Loose regulations and legal loopholes have made it easy for companies to round-trip money into India through name-plate entities, which leverage the DTAA (Double Tax Avoidance Agreement) while operating from within Indian jurisdiction. Given the prevailing circumstances, the government found it necessary to conduct further investigation into what prima facie appears to be an evasion of revenue.

While PE fund managers using these loopholes are set to face the music, how can this move affect the startups involved?

Startups that are profitable and not considering raising funds externally anytime soon will largely remain unaffected by this move. However, it can stand to hurt companies set up even up to 10-15 years ago who obtained external funding, as PE fund managers can be issued a notice and be subject to scrutiny within a period of 16 years in case of holding assets outside of India.

Additionally, PE fund managers may now be a lot more fastidious with investing in startups, whether via the direct investment route or through Special Purpose Vehicles (SPVs) set up outside India in tax / investor-friendly jurisdictions. This will result in the need for due diligence and vigilance from the startups while closing investment rounds and a holistic understanding of an exit clause placing any tax accountability on them through indemnity, a secondary purchase, compliance, or otherwise. While on the other hand, this could directly result in fiercer competition amongst startups in securing funding from PE fund managers.

Rightful return to the coffer

The last few years have seen the emergence of a plethora of unicorns in the Indian startup space. Taxation of PE Funds will provide a much-needed stimulus to the economy as the profits received by these funds are often astronomical. The 0% tax rates on capital gains due to the DTAA was the primary reason for the country’s exchequer to be deprived of this revenue to date, despite the General Anti-Avoidance Rule (GAAR) which allowed the Department of Revenue to reject the tax treaty benefits if it was found that the primary objective behind this was tax avoidance.

What the future holds

This move could stand to be a game changer for the startup landscape. PE fund managers located in tax havens could face some resistance due to the vigilance of the Revenue department as far as exit profits are concerned in the Indian markets. This could result in them potentially attempting to pass the liability to the startups, or alternatively seek indemnifications from them.

On the bright side, this move could certainly serve to incentivise domestic PE fund managers who can now potentially level the playing field!

(The author is an advocate and Panel Counsel at the Central Board of Indirect Taxes and Customs, or CBIC)