Private Equity Investment and its taxation
Private equity (PE) investments involve investors pooling their funds to acquire ownership in private companies or invest in the equity of companies that are not publicly traded. PE investment is done by Private equity firms, which usually target companies with high growth potential and proven track record of generating revenue and sometimes even profit, companies that require additional resources, strategic guidance, or operational improvements to achieve their full potential.
They participate actively in the management of the company by working closely with them and implementing changes that can unlock the full potential of the company.
Private equity has become a popular way for entrepreneurs and investors in India to achieve their goals and growth and access capital.
Private equity investors typically remain invested in their portfolio companies for at least 10 years during which they carefully consider and plan their exit.
Overall, private equity investment involves a long-term commitment to identify and nurture companies with the potential for growth and profitability to achieve a successful exit strategy that benefits the investor and company.
There are few sectors where there are sector-specific restrictions on private equity investment in India such as defence, media, and aviation, and have specific restrictions on private equity investments in India. Private equity firms must comply with the applicable regulations and obtain necessary approvals before investing in these sectors.
Participants in the PE fund
- General partner: The general partners are responsible for managing the fund, which includes raising capital from investors, identifying investment opportunities and managing the portfolio of investment. They receive management fees and a portion of profits earned by the fund
- Limited partner: Limited partners are the investors who provide the capital for the fund which is typically made of institutional investors like pension funds, endowments, funds, insurance, company, etc. They receive a return on their investment in the form of a share of the profit earned by the fund after the general partner receives their share.
Types of Private Equity Investments in India
- Growth Capital: this involves providing capital to companies that have an established business model and are looking to expand their operation into new markets or launch new products.
- Buyout: in a buyout, the private equity firm acquires a controlling stake in a company and takes over its operations, to improve its performance and profitability.
- Venture Capital: venture capital investments are typically made in early-stage companies that have promising business ideas, but are yet to generate significant revenues.
- Distressed Assets: in this type of investment, the private equity firm acquires distressed assets such as non-performing loans to turn them around and realise a profit.
- Mezzanine Financing: Mezzanine financing is a hybrid form of debt and equity financing, where the private equity firm provides a company with capital that is structured like debt but has an equity-like return.
- Infrastructure financing: This involves investing in infrastructure projects, such as power plants, airports and highways to generate stable long-term returns.
Taxation of Private Equity (PE) Investment
Overview of the Indian Taxation System
Income tax law in India is governed by the Income-tax Act, 1961 (“I-T Act”). Under the I-T Act, residents are taxed on their domestic as well as foreign income in India, whereas non-residents and foreig PE firms are taxed basis a different tax structure.
In addition, India has entered into Double Taxation Avoidance Agreements (“DTAAs” or “tax treaties”) with several countries. A taxpayer may be taxed either under domestic law provisions or the DTAA, whichever is more beneficial. To avail of benefits under the DTAA, a non-resident is required to furnish a tax residency certificate (“TRC”) from the government of which it is a resident in addition to satisfying the conditions prescribed under the DTAA for applicability of the DTAA. Further, the non-resident may also be required to file its tax returns in India and furnish certain prescribed particulars in Form 10F to the extent they are not contained in the TRC. To file tax returns in India, the non-resident should obtain a tax ID in India (permanent account number or “PAN”). PAN is also required to be obtained to claim the benefit of lower withholding tax rates, whether under domestic law or the DTAA. If the non-resident fails to obtain a PAN, payments made to the non-resident may be subject to withholding tax at the rates prescribed under the I-T Act or 20%, whichever is higher (except in certain specific cases wherein prescribed details and documents may be furnished in the absence of PAN).
The return to a PE investor is generally in the form of dividends, interest, and/ or capital gains. The tax implications in each of these cases are as follows:
Dividends distributed by Indian companies were previously subject to a distribution tax (DDT) at the rate of 15%, payable by the dividend-distributing company. The Finance Act of 2020 has abolished the DDT with effect from April 01, 2020. The dividend income is now taxable in the hands of the recipients (i.e., shareholders or unit holders) as ‘Income from Other sources as follows:
- Resident Recipient: At the tax rates applicable to the recipient (i.e., the shareholder). Additionally, the Indian company declaring dividends will also be required to withhold/deduct taxes at the rate of 10% (excluding applicable surcharge and cess) while making the dividend payment to the resident recipient.
- Non-resident Recipient: at the rate of 20% (excluding applicable surcharge and cess), or rate provided under the relevant tax treaty, whichever is more beneficial to the non-resident unit holders. This will be withheld/ deducted by the Indian company at the time of making the dividend payment.
The I-T Act provides for a beneficial concessional withholding tax rate of 5% for interest on various types of long-term borrowings from non-residents (under Section 194LC/ LD of the I-T Act). In case these provisions are not applicable, the general rate of tax on interest is 20%. However, one may explore a beneficial rate of tax on interest applicable in terms of the DTAA concerned. The I-T Act also provides an exemption from filing returns of income in the case of non-resident recipients, where the only income earned by them is interest and tax has been withheld thereon under the I-T Act.
Tax on capital gains depends upon the
- holding period of a capital asset before the sale, and
- how the sale is affected.
- If unlisted securities are held for 24 months or less, gains from their sale will qualify as STCG; and if held for longer, will qualify as LTCG.
- LTCG earned by a non-resident on the sale of unlisted securities is taxed at 10%, while
- LTCG earned by a resident on the sale of unlisted securities is taxed at 20%. On the other hand,
- STCG from the sale of unlisted securities is taxed as per the tax rates generally applicable to the taxpayer.
- Foreign institutional investors or foreign portfolio investors are also subject to tax at
- STCG- 15% and
- LTCG- 10%
All income earned by such Foreign Institutional Investors or Foreign Portfolio Investors is also treated as capital gains income.
- Under Section 56(2)(viia) of the I-T Act, tax is levied on private companies and firms that ‘receive’ shares of a private company for less than their fair market value by more than INR 50,000. In cases of transfer of unlisted shares of a company at less than their ‘fair market value’ (FMV) (and the difference is more than INR 50,000), the FMV** would be deemed to be the full value consideration for computing capital gains under the I-T Act.
**‘FMV’, in respect of unlisted shares, is determined in accordance with the book value method and calculated in the manner prescribed under Rule 11UA of the Income-tax Rules, 1962.
Example: For instance, ABC Pvt. Ltd purchased 10,000 equity shares of XYZ Pvt. Ltd. (face value Rs 10) for Mr M at Rs 80 per share. The book value per share of XYZ Pvt. Ltd. is INR 200. Accordingly, the FMV of XYZ Pvt. Ltd. works out to INR 20,00,000. However, ABC Pvt Ltd has purchased such shares for Rs 800,000 (80*10,000). In such a scenario, the difference of Rs 12,00,0000 (i.e., 20,00,000-800,000) will be considered as Income from other sources in the hands of ABC Pvt. Ltd. u/s 56(2)(viia) of the I-T Act.
Frequently Asked Questions (FAQs)
- Are there any exemptions available for private equity investments in India?
Yes, certain exemptions are available for private equity investments in India. For example, long-term capital gains from investments in eligible startups are exempt from tax, subject to certain conditions.
- What is the role of the Securities Transaction Tax (STT) in private equity investments in India?
The STT is a tax on the transaction of securities, including shares, derivatives, and equity-oriented mutual funds. The STT applies to private equity investments in listed securities in India, and the rate depends on the type of security and the transaction value.
- What are the risks associated with private equity investments in India?
Private equity investments in India are subject to various risks, such as regulatory risks, political risks, liquidity risks, and currency risks. Private equity firms must conduct thorough due diligence and risk assessment before investing and adopt appropriate risk management strategies.
- What is the role of SEBI in private equity investments in India?
SEBI is the primary regulatory authority for private equity investments in India. SEBI regulates and supervises the securities market, including the private placement of securities by private equity firms. Private equity firms must comply with SEBI regulations and obtain necessary approvals before investing.