Investors in offshore investment funds that invest in India through multi-layered structures have something to cheer about. The tax department has clarified the tax liability on these investors once they redeem their investment in the offshore funds.
The clarification was necessary since offshore investment funds suffered multiple taxation of the same income as a result of indirect transfer provisions of the Income Tax Act. As per the tax law, gains arising from overseas transactions involving substantial underlying assets in India are subject to capital gains tax in India.
Need For Clarification Benefit
Here’s a simple structure for which the clarification will be useful:
‘X’, a foreign investor invests in a pooling vehicle ‘Y’ based in Netherlands, which in turn invests in an India-based fund ‘Z’ that deploys the amount in domestic assets. As a result of the indirect transfer provisions, Y was being subjected to tax twice - once, at the time of sale of Indian asset by Z, and second, a withholding tax liability when ‘Y’ distributed the income to ‘X’ as a result of redemption.
The tax department has now clarified that income arising to non-resident investors as a result of redemption or buyback from such pooling vehicles will not attract indirect transfer provisions.
This situation created the possibility of double taxation for investors who have been investing through multi-layered structures in India through private equity and other kind of funds which act as pooling vehicles or feeder fund for these investors, Daksha Baxi, executive director at law firm Khaitan & Co. explained.
When the feeder fund exits its investment in Indian assets and realises capital gains it would be paying capital gains tax. Then when it redeems the shares of the investor in the feeder fund, then it would still be deriving substantial interest from Indian assets. And therefore, the shares that the feeder fund redeems would be considered to be situated in India and would attract tax. So there will be double taxation on the same income.Daksha Baxi, Executive Director, Khaitan & Co.
The income could be in the form of dividends or a buyback, Prakash Nene, managing director at Multiples Alternate Asset Management pointed out.
Here is the issue- when there was a buyback and if you do a strict reading of Section 9(1), it would appear that there is an indirect transfer. Something that has already been taxed in India, why should there be another level of taxation – either at the level of one feeder or there could be a layer of feeders.Prakash Nene, Managing Director, Multiples Alternate Asset Management
This clarification primarily addresses the issue that once the tax has been paid as a result of portfolio company divestiture thereafter any further remittance to investors would not be subject to taxation, Nene added.
Who Does The Clarification Apply To?
But this exemption comes with a few riders.
First, it only applies to investors in pooling vehicles that have invested in a venture capital fund or a venture capital company or a Category I or II Alternative Investment Fund. Baxi said that the logic of why investments only in these categories have been granted an exemption isn’t clear.
I’m not entirely sure what is the logic of giving it to AIF I and II and VCFs being the specified funds that the foreign feeder fund should’ve invested. As we know, a feeder fund may even be making investment outside these categories. There are private equity funds which would be investing outside these four categories. They continue to be left out.Daksha Baxi, Executive Director, Khaitan & Co.
Nene added that the tax department should’ve provided this exemption for all types of funds.
In my view, it should’ve been applied to everybody, including all the FDI vehicles, as long as the concept that the money being paid is coming to those funds which have paid tax in India. Category I is sovereign funds, pension funds etc and Category II is institutional investors and then there are other under Category III including foundations, endowments, university funds, family office- all those don’t get coveredPrakash Nene, Managing Director, Multiples Alternate Asset Management
The second rider says that the exemption will only be available in cases where the redemption proceeds or the buy-back amount arising to the non-resident investor does not exceed its pro-rata share in the total amount realised by feeder fund.
Baxi explained this to mean that the exemption will be proportionate to a non-resident’s investment in the feeder fund.
In the feeder fund, there would be let’s say 15 investors. Their share in the feeder fund won’t be equal and will depend upon how much they’ve invested. So if one investor has 10 percent investment, then the redemption amount that should be paid to him out of the sale that the AIF has made, should not be more than 10 percent that the feeder fund has received. If another investor has made 50 percent investment in the feeder fund, then he can receive 50 percent of the amount available for redemption.Daksha Baxi, Executive Director, Khaitan & Co.
Nene pointed out that this could result in unintended consequences for funds where there are General Partners and Limited Partners.
As you know, in all structures there are General Partners and Limited Partners. General Partners are those working outside of India and they get disproportionate gains from those structures because of the work they are involved in. So, there could be a higher level of distribution to the General Partners disproportionate to their investments. In this situation, the underlying shares have been sold in India and now the money has gone abroad and now it’s simply a matter of distribution. Why do I have to pay tax again is not very clear.Prakash Nene, Managing Director, Multiples Alternate Asset Management
The indirect transfer provision was on outcome of the Vodafone situation where there was transfer of entire holding located in India but it wasn’t the intent that tax-paid money which is going abroad has to be taxed again only because of the way a fund is structured, he added.