Relaxation from application of indirect transfer provisions to alternative investment funds

mea_subramaniam_krishnan_LThumbThe transfer of share or interest in a foreign company or entity deriving substantial value from assets located in India is taxable in India. However, where such transfer outside India is a consequence of a direct redemption or sale of an investment in India which is chargeable to tax in India, application of indirect transfer provisions results in double taxation (multiple taxation in case of multi-layered holding structures) of the same income, i.e., first on direct sale of the Indian securities and subsequently on upstreaming of the sale proceeds through multiple entities to the ultimate beneficiaries.

To address the aforesaid issue, in Budget 2017, an amendment was made to provide that (a) indirect transfer provisions shall not apply to Category I and II foreign portfolio investors and (b) it was stated that a clarification will be issued for other non-resident investors.

In this regard, the Central Board of Direct Taxes (“CBDT”) has now issued Circular No. 28/2017, dated 7 November 2017 (“Circular”), clarifying that indirect transfer provisions shall not apply in respect of income accruing or arising to a non-resident on account of redemption or buy-back of its share or interest held indirectly (i.e., through upstream entities registered or incorporated outside India) in a Venture Capital Fund or a Category I Alternative Investment Fund (“AIF”) or a Category II AIF (collectively referred as a “Specified Fund”). However, this exemption is subject to the following conditions:

(a)   The income accrues or arises in consequence of transfer of shares or securities by the Specified Funds which is chargeable to tax in India

(b)   The proceeds of redemption or buy-back arising to the non-resident do not exceed the pro-rata share of the non-resident in the total consideration realised by the Specified Funds from the transfer of shares or securities in India

The Circular is a welcome clarification from the CBDT and provides certainty to investments made by non-resident investors in Specified Funds through multi-layered structures. The impact of the Circular is explained by way of examples below.

Example 1

ABC is a private equity fund which has raised capital from non-resident investors for investments into India. Due to certain commercial considerations, the capital raised from non-resident investors is invested in India through a multi-layered structure described below:

  • ABC has raised capital from investors in different geographies/ with distinct attributes and pooled the same in a master fund (ABC Fund)
  • ABC Fund in turn has set-up a special purpose vehicle (SPV) to make investments in India
  • The investment in India is made in a Specified Fund (AIF) which then ultimately makes and realises the investments in portfolio companies in India (I Co 1, I Co 2, I Co 3 and I Co 4)

A diagrammatic representation of the above structure is provided below.

Image 1

Prior to the Circular, income arising to the AIF from sale of shares of a portfolio company (say, I Co 1) was chargeable to tax in the hands of the SPV on account of the “pass through” taxation provisions in the tax law applicable to AIFs. Further, subsequent up-streaming of the sale proceeds by way of redemption or buyback of share/interest could again be subject to tax in India (first in hands of ABC Fund, then in hands of the investors) thereby resulting in taxation at multiple levels.

Post the Circular, income arising to the AIF from sale of shares of I Co 1 should be chargeable to tax in India only in the hands of the SPV and any subsequent up-streaming of the sale proceeds by way of redemption or buyback of share/ interest should not be subject to tax in India again.

Example 2

ABC is a private equity fund which has raised capital from non-resident investors for investments into Asia (predominantly India). Due to certain commercial considerations, the capital raised from non-resident investors is invested in India through a multi-layered structure described below:

ABC has raised capital from investors in different geographies/with distinct attributes and pooled the same in a master fund (ABC Fund)

  • ABC Fund in turn has set-up a special purpose vehicle (SPV) to make investments in India
  • The SPV in turn has made investments as under:

o   In a Specified Fund (AIF) which has in turn invested in portfolio companies in India (say, I Co 1 and I Co 2)

o   In portfolio companies (say, C Co 1 and C Co 2) in other Asian countries

  • The SPV derives more than 50% of its value from assets in India

A diagrammatic representation of the above structure is provided below.

image 2

While the Circular provides relaxation from application of indirect transfer provisions on up-streaming of proceeds arising from sale of an Indian investment, it could result in India tax where proceeds from sale of a non-India investment are up-streamed when the SPV continues to derive more than 50% of its value from investments in India. In other words, sale of a non-India investment by the SPV which is not chargeable to tax in India could be subject to tax in India under the indirect transfer provision without there being any transfer of an Indian investment.

Example 3

In contrast to above, there are several large private equity funds which hold investments in India directly, i.e., instead of the SPV making investment in a Specified Fund, the SPV could directly invest in the portfolio companies in India (I Co 1, I Co 2, I Co 3 and I Co 4). A diagrammatic representation of such structure is provided below.

image 3

In this structure, income arising from the sale of shares of a portfolio company (say, I Co 1) is chargeable to tax in the hands of the SPV and subsequently up-streaming of the sale proceeds by way of redemption or buyback of share/interest could again be subject to tax in India (first in hands of ABC Fund and ultimately in hands of the investors) thereby resulting in taxation at multiple levels.

In all the examples, it is important to note that any transfer of share or interest at ABC Fund level or the investor level (whether related to India investments or not), which is not a consequence of transfer of shares or securities by the Specified Fund, continues to be subject to Indian indirect transfer provisions, unless eligible for the small shareholder exemption (< 5% interest) or beneficial treatment under a tax treaty.

Conclusion

Given the above, while the Circular adds to the list of clarifications issued by the CBDT for making AIFs a preferred route for making investments into India, the Circular still does not address the issues faced by regional funds investing in an Indian AIF and the general concerns of non-resident investors investing in India through other foreign investment routes (i.e., Foreign Direct Investment, Foreign Venture Capital Investor and Category III FPI). Thus, unless further clarifications are issued or an amendment is made in the indirect transfer law, the concerns of foreign investors investing in India (especially, direct investment) through multi-layered structures remain unresolved.

 

Subramaniam Krishnan, Partner, EY India

Dipen Shah, Director, EY India

Tina Sejpal, Manager, EY India


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