Budget and private equity: A missed opportunity?

By Bijal Ajinkya and Rohit Jayaraman, Khaitan & Co
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India’s recent general elections gave the country its first single party government in 30 years with the Bharatiya Janata Party (BJP) obtaining a simple majority in the Lok Sabha. The overwhelming mandate coupled with the economically reformist outlook promised by the BJP and the new prime minister, Narendra Modi, during the election campaign had led to expectations in the business community, including the private equity (PE) industry, of sweeping economic and fiscal reforms being introduced in the 2014-15 budget. The proposals in the budget passed into law as the Finance (No. 2) Act, 2014 (Finance Act), however, turned out to be a mixed bag for the PE industry.

Bijal Ajinkya
Bijal Ajinkya

Alternative investment funds

From a fund manager’s perspective, the biggest expectation from the budget was in terms of obtaining clarity on the taxation of alternative investment funds (AIFs) set up as trusts and registered with the Securities and Exchange Board of India (SEBI) under the SEBI (AIF) Regulations, 2012. The Income Tax Act, 1961 (ITA), currently provides pass-through status for only one sub-category of category I AIFs, namely venture capital funds. The taxation of other sub-categories of category I AIFs, as well as category II and category III AIFs, is governed by the general principles of trust taxation. This position has led to considerable ambiguity and the industry expectation was that the budget would at least extend pass-through status to other sub-categories of category I AIFs.

However, the budget was silent on this point and the ambiguity was further compounded by a circular on AIF taxation issued by the Central Board of Direct Taxes on 28 July 2014. The circular states that the trustees of AIFs which are not considered to be determinate (i.e. whose trust deeds do not specify the names and beneficial interests of the investors) would be required to pay tax at the maximum marginal rate (MMR) on the entire income of the AIF as a “representative assessee”. The circular further stated the trustees of AIFs which are determinate and are considered as business trusts would be required to pay tax at MMR on the entire income of the AIF as a “representative assessee”. The circular is silent on the tax treatment of AIFs set up as determinate trusts which are not business trusts.

Capital gains

Another major change affecting the PE industry is the change in how long unlisted securities need to be held for gains arising on their transfer to be classified as long-term capital gains. The Finance Act has amended the ITA to increase this period from 12 to 36 months. Long-term capital gains are subject to taxation at the beneficial rate of 20%, while short-term capital gains are taxed according to the tax slab (bracket) of the seller (the highest rate is 30%). This amendment reduces the flexibility available to fund managers with regard to the timing of their exits from investments.

Rohit Jayaraman
Rohit Jayaraman

General anti-avoidance rules

The general anti-avoidance rules (GAAR) provisions of the ITA are scheduled to come into force from 1 April 2015. The GAAR provisions give wide discretion to tax authorities to disregard structures they deem to be “impermissible avoidance arrangements” and the coming into force of GAAR could affect the tax treatment of offshore funds domiciled in tax efficient jurisdictions such as Mauritius with which India has double taxation avoidance agreements.

The PE industry was expecting the budget to either extend the date for the coming into force of GAAR or to amend GAAR to reduce the discretion available to tax authorities to deem structures as impermissible avoidance arrangements. However, the budget was silent on GAAR though the finance minister later clarified that the government was still studying the implications of GAAR and would form a view in this regard at a later date.

Income of foreign investors

However, one area in which the budget offered greater clarity to investors and fund managers was with respect to the characterization of the income of foreign investors registered as foreign institutional investors (FIIs) or foreign portfolio investors (FPIs) under the SEBI (FII) Regulations, 1995, or the SEBI (FPI) Regulations, 2014. The Finance Act amended the ITA to clarify that any income earned by a FII or a FPI would be considered as capital gains and not as business income and would be subject to tax at the rate prevailing for the taxation of capital gains.

Therefore, while the budget represented a small step in reviving investor confidence and providing clarity on the taxation of PE funds, it could be said that the budget signifies a missed opportunity to clarify several open issues which are of concern to both investors and fund managers today.

Bijal Ajinkya is a partner and Rohit Jayaraman is an associate at Khaitan & Co. Views of the authors are personal and should not be considered as those of the firm.

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