Mauritius tax treaty impact: PEs look for clarity on preference share implication

Fund-raising could become tough after capital gains tax kicks in from April 2017

At a time when 'down round' in billion-dollar start-ups have become common, the amendments in India-Mauritius double taxation avoidance treaty might impact PE investors.

PE firms invest through preferential shares to protect themselves from such down rounds, where their investee companies raise funds at lower valuation than what they invested at. Usually, these preference shares are converted before their exit, which could be through a public issue that offers ordinary shares.

Now, the amended protocol provides window till April 1, 2017, for investments made in shares to avoid any capital gains tax in future. PE funds are looking for clarity if this applies to preference shares also.

"We are seeking clarity if preference shares need to be converted into ordinary shares for getting the 'grandfathering' benefit (sparing existing investments from capital gains tax)," says Venky Natarajan, managing partner, Lok Capital. "Foreign investors take the preference share route to protect their investments from down rounds, so it is a critical issue for them."

PEs are looking for clarity if the preference shares are converted into ordinary shares after April 1, 2017, then they will be treated as fresh investment or not.

Nishchal Joshipura, partner (private equity and mergers & acquisitions) at Nishith Desai Associates, says: "It is still ambiguous whether capital gains tax exemption will be applicable for those preference shares converted into ordinary shares after April 1, 2017."

While the PE investors get clarity on this, what they are sure about is the tougher negotiation they will need to do when they raise funds starting the next financial year. PE funds typically invest for two years or more and this will attract a 10 per cent capital gain tax on their investments, at the time of selling.

"PE funds are expected to provide 20 per cent annualised dollar return to their limited partners," says Deepesh Garg, managing director, O3 Capital, a leading investment bank in private equity syndication business. "Continuing currency depreciation coupled with capital gains tax will make PE fund managers' task quite tough now." This also means that India will lose its sheen as a preferred destination for PE investments; limited partners will look at other geographies in their chase for better return. Pritin Kumar, partner, Deloitte Haskins & Sells, says: "India's attractiveness as a private equity investment destination is likely to go down as fund managers will have to factor in the tax cost and have to work harder to meet their investors' return expectations."

PE has been one of the largest sources for FDI with $20 billion commitment in 2015. "This will certainly put pressure when PE fund managers go out to raise their next fund," he says.

Alok Mittal, former India chief of Canaan Partners, says: "This will get incorporated into returns expectations. If long-term capital gains continue to be taxed at lower rate, I would think it will have minimal impact on VC investments."
TAX TROUBLES

• PEs invest through preferential shares to protect from down rounds
   
• Preference shares are converted before exit; window till April 1, 2017
   
• PEs are seeking clarity if preference shares need to be converted into ordinary shares to be exempted from capital gains tax
  

 

No clarity if tax exemption will be applicable for those preference shares that are converted into ordinary shares after April 1, 2017