Taxation of Private Equity (PE) Investment
Income tax law in India is governed by the Income-tax Act, 1961 (“ITA”). Under the ITA, residents are taxed on their worldwide income in India, whereas non-residents are taxed only in respect of their India-sourced income.
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. In order 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. For the purpose of filing 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 under 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 ITA 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. High-level 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% on a grossed-up basis, 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 ITA 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 ITA). 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 ITA 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 ITA.
Tax on capital gains depends upon the (i) holding period of a capital asset before the sale, and (ii) the manner in which the sale is effected.
- Short-term capital gains (STCG) arise if an asset has been held for 36 months or less before being transferred. If the holding period exceeds 36 months, then gains made from the sale of said assets is regarded as long-term capital gains (LTCG).
- If the listed securities are held for 12 months or less, gains from their sale will qualify as STCG; if held for longer, the gains will qualify as LTCG. LTCG on the sale of listed securities on a stock exchange was exempt as long as the transactions were entered into after the coming into force of the securities transaction tax (STT) and were chargeable to STT. Finance Act 2017 removed this exemption and introduced Section 112A levying capital gains tax @ 10% on LTCG arising from the transfer of listed equity shares, units of an equity-oriented mutual fund, or units of a business trust where such gains exceed INR 100,000. On the other hand, STCG from the sale of listed securities (being listed equity shares or units of an equity-oriented mutual fund on the floor of the recognized stock exchange), where STT has been paid, is taxed at the rate of 15% (this rate is applicable to both, resident and non-resident unit holders). STCG from the sale of other listed securities is taxed as per the ordinary corporate tax rates applicable to the taxpayer. For instance, this rate should be 40% in the case of non-resident companies.
- 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 15% on STCG and 10% on LTCG. All income earned by such Foreign Institutional Investors or Foreign Portfolio Investors is also treated as capital gains income.
- India also has provisions for taxation of transfer of foreign securities held by non-residents, which derive substantial value (directly or indirectly) from assets situated in India. Therefore, the shares of a foreign incorporated company can be considered to be “situated in India” and capable of yielding capital gains taxable in India, if the company’s share derives their value “substantially from assets located in India”.
- Under Section 56(2)(vii)(a) of the ITA, tax is levied on private companies and firms that ‘receive’ shares of a private company for less than their fair market value.
- In cases of transfer of unlisted shares of a company at less than their fair market value, the fair market value would be deemed to be the full value consideration for computing capital gains under the ITA.
Frequently Asked Questions (FAQs)-
What is PE investment?
The firms that invest in equity of private companies with an aim to exit at higher valuations in the future are called private equity firms and the investment that they bring is called a private equity investment or PE Investment.
What are the types or strategies of PE investment?
There are three key types of private equity strategies: venture capital, growth equity, and buyouts
What is the taxation on PE investment?
The return to a PE investor is generally in the form of dividend, interest, and/ or capital gains
- Dividend: The resident recipient is taxed @10% and non-resident recipients taxed @20%
- Interest: taxable @5% or 20% under the ITA (plus applicable surcharge and cess) beneficial provision under the applicable DTAA may be explored.
Capital Gain: In the case of listed securities, LTCG may either be taxed at @10% or 20% (plus applicable surcharge and cess). In the case of STCG, arising on securities on which STT has been paid, the rate of tax applicable is 15%. STCG arising on other securities is generally taxable at the rate of tax applicable to such taxpayers.