IMPACT OF THE BUDGET 2012-13 ON THE PRIVATE EQUITY SECTOR

With an attempt to take the country closer to Direct Tax Code (DTC) the Budget proposed for the year 2012-13 has a bearing effect on every strata of society. The Budget has posed a large impact on the private equity and early stage funding space, which is our intense focus at NovoJuris. Here’s some detailed analysis.

Given our first love, early stage investment, the top issue is:

Early Stage Investment is to be taxed

  • Share premium in excess of Fair Market Value (FMV) to be treated as income.
  • Section 56 (2) (viib) (New provision): Any consideration received for issue of shares above the face value of shares, then the consideration that is above the FMV will be taxed under the head “income from other sources”
  • Applicability: All unlisted or privately held companies
  • Non Applicability: Funds received by a company from a venture capital fund or venture capital company
  • FMV for the purpose of the above section will be higher of (i) as prescribed by the guidelines (ii) as substantiated by the issuing company
  • Effective from Assessment Year 2012-13.

Our opinion:

  • Startups are usually funded by friends and family, before raising VC funding. Investment in early stage funding is not just formula based, for example, arguing that the premium is because of a kick-ass team to an Assessing Officer will be an uphill task. Hopefully, some guidelines and rules will be issued soon.  More hopefully, this proposal is rolled back.
  • Till the time it is rolled back, it looks like convertible debentures might be a possible approach.
  • Or the early stage investors can approach only registered VC.  We are only ‘guessing’ at this point in time that co-investment by Angels with VCs should be ok with a supporting valuation report.

The Vodafone Effect:

The landmark Judgment of the Supreme Court (SC) early this year re-iterated the law and gave some relief on the structuring of the deals including tax impact.  But seems to be short-lived as the Government of India seems to have taken the SC words a little too literal “to change the law, if the state wanted to tax certain transactions”.

The proposed changes in the tax laws will have retrospective effect to tax cross border share sales in which the underlying assets is located in India.

The changes are as follows:

  • “capital assets” re-defined to include controlling interest in an Indian company, in other words, the rights in or in  relation to an Indian company to include rights of management of control and any other rights whatsoever.
  • ‘transfer” to include any transfer, disposition or parting directly or indirectly without consideration as to whether the transfer is effected or dependant on flow from transfer of shares of a company incorporated in India or abroad
  • Share or interest in a company or entity registered outside India is deemed to be situated inside India if the share or the interest derives either directly or indirectly its value substantially from assets located in India.
  • Section 195 of the Income tax Act which talks about withholding tax on sums paid to a non resident shall apply irrespective of whether the non-resident has a residence or a place of business or business connection or any presence in India.

Impact:

  • All indirect transfer of shares will be taxed, for example if an overseas company sells shares of another overseas company, if shares or assets of an Indian company are transferred to the buyer by virtue of the transaction.
  • Exits of private equity will now be taxable in India even if they come in through a tax treaty country.

Tax Treaty Amendment:

  • The rules on Double Taxation Avoidance Agreement (DTAA) or an agreement between the Government and a foreign country or external territory are proposed to be tightened.
  • A new clause capturing submission of a “Tax Residency Certificate” (TRC), a necessity for availing the benefits of a tax treaty. Aims to provide proof of tax jurisdiction of the entity.
  • Tax treaty benefits will not apply where provisions of the new Chapter 10 A i.e GAAR is evoked.
  • GAAR will be a set of provisions which will tax any transaction which aims to (i) create rights or obligation which wouldn’t arise between persons dealing at arm’s length; (ii) misuse or abuse of the provisions of the act; (iii) lacks in commercial substance in whole or in part; (iv) does not contain  a bona fide purpose.

Impact:

Overseas investors will be treated at par with the domestic investors to the effect that if taxes are paid in the country of origin no taxes to be paid in India by virtue of the DTAA.

  • Tax authorities to be provided a period of 1 year to process information and initiate action against persons liable to pay tax in India for funds accumulated overseas.

Venture Capital Fund (VCF)/ Venture Capital Company (VCC) related

  • Previously income of SEBI registered VCF/VCC was exempted as long as the investment is in nine specified sectors.

Proposal:

  • Sectoral restrictions are removed.
  • VCF/VCC will now be a pass-through entity and the income accruing to VCF/ VCC shall be taxable in the hands of investor on accrual basis with no deferral.

The exemption from applicability of TDS provisions on income credited or paid by VCF/ VCC to investors shall be withdrawn

Fair Market Value is now Full Value of Consideration

  • Section 50 D (new provisions): On the date of transfer, Fair Market Value of the capital assets will be considered as full value of consideration where sales consideration is not ascertainable or cannot be determined.
  • If the transfer is shares of an unlisted / private company, then the same FMV amount is deemed as income in both transferor and the transferee.

Cascading effect of Dividend Distribution Tax (DDT)

  • Proposal to remove cascading effect of DDT in multi tier corporate structure

Impact:

  • If the holding company receives dividend from the subsidiary and the subsidiary has paid DDT, then the holding company shall not be subject to DDT in the same year.
  • This amendment will take effect from 1 July 2012

Disclaimer: This is not a legal opinion and should not be construed as one. Please speak with your attorney for any advice.

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