PEs seek pass-through & capital gains tax parity

The private equity (PE) industry is planning to approach the market regulator and the government to address anamolies in the new taxation regime. According to the industry, the recent changes in the rules have put domestic PE funds at a disadvantage.

The new regime that came into effect on the passing of the Finance Act, 2012, restricts the “pass-through” benefit to income of venture capital (VC) funds, whereas PE funds and leveraged funds are left in the lurch.

A pass-through status allows the intermediary body, like a fund, to pass on the tax liability to the end-investor. 

PASS THROUGH FLIP-FLOP

• Prior to 2007, VCs registered with SEBI under VCF Regulations provided a tax “pass-through”
   
• In 2007, the IT Act was amended tax “pass-through” benefit was restricted only to VC in in nine specified sectors
   
• 2012, Sebi repeals VCF Regulations, notifies Alternative Investment Funds Regulations
   
• AIF broader in scope, covers PE, hedge funds
   
• Finance Act, 2012 has reverted to the pre-2007 position
   
• Tax “pass-through” benefit for all VCs but category II and III that covers PEs, hedge funds excluded

Entities not allowed this benefit will be taxed at the fund level.

Second, non-resident investors, including foreign PE/VC funds, enjoy a reduced capital gains tax of 10 per cent, against 20 per cent payable by resident investors.

The domestic fund industry is keen on getting a level-playing field here, too.

“Under the current rules, the tax pass-through is available only for category-I. We want the pass-through status to be extended to the other categories as well. We are planning to approach the Securities and Exchange Board of India (Sebi) soon,” said Mahendra Swarup, president, Indian Venture Capital and Private Equity Association (IVCA), an industry body.

Indian Venture Capital and Private Equity Association is also seeking parity in capital gains tax with non-resident investors.

“At present, capital gains of overseas PE and venture capital investors are taxed at 10 per cent, whereas the domestic investors are liable for a tax of 20 per cent. It would be appropriate that the domestic PE/VC investors are also taxed at a concessional rate of 10 per cent,” said Punit Shah, partner, KPMG.

IVCA would soon approach Sebi with a detailed representation, highlighting these points, officials said.

In May, Sebi notified alternative investment fund (AIF) regulations, which replaced the earlier VC fund regulations.

These regulations had a broader scope, as they covered two other categories in addition to VC funds, which came under category-I.

According to the rules, category-II covered funds that did not come under classification and did not use leverage. Funds that used leverage and other complex strategies fell in category-III.

Since these two hitherto unregulated categories were now brought under the framework, it was expected these should also be granted a pass-through.

The draft paper on AIF regulations had said: “Sebi may represent that similar provision for tax pass-through may be provided for AIFs once the VCF regulations are repealed and the AIF regulations are notified.”

However, this has not materialised.

“The assured pass-through is almost a must and right on top of the expectations from the industry,” said Mumbai-based law firm Nishith Desai, in a recent note on AIF regulations.

“A spill-over effect of this restrictive interpretation may also mean the proposal in the Finance Bill to tax consideration received by a company for issue of shares which exceeds fair market value will also apply where the payer is a category-II AIF or a category-III AIF. The Finance Bill had exempted, from such levy, payments made by a ‘venture capital fund’ to a ‘venture capital undertaking’, an exemption which, given the lack of clarity, may now apply only to category-I AIFs,” the note added.