IRDAI’s Private Equity-Promoter Norms Akin To A Maze With No Escape

India’s insurance regulator may have allowed the entry of private equity funds as promoters in unlisted insurance companies, but the rules, experts say, throw up structuring problems and make for a difficult exit, especially for foreign funds.

What’s Changed?

So far, a private equity fund—foreign or domestic—could only purchase up to 10 percent of the equity of an insurance company. The cumulative limit for all private equity investments in an insurance company was capped at 25 percent. The Insurance Regulatory and Development Authority of India has now permitted private equity funds to own more than 10 percent and even control the company as a promoter.

“...the applications from PE funds to acquire majority stake in insurance companies and market realities of the insurance sector coupled with the absence of set guidelines for PE funds being promoters, forced the hand of the regulator to come out with appropriate guidelines,” Alina Arora, partner at legal consultancy firm Luthra and Luthra, told BloombergQuint.

But these guidelines come with a rider. This investment by a promoter PE fund must be made through a Special Purpose Vehicle, which will then invest in the Indian insurance company.

It is this rider, however, that experts point out, will also make foreign PE funds feel unwelcome – both through the life of their investment and at the time of exit.

Structuring Problem

The Irdai has stated that the SPV can either be a Limited Liability Partnership or a company. But both come with their own set of problems.

The LLP structure would conflict with the existing laws. The foreign direct investment policy states that an LLP, created for the purpose of investment, will need prior government approval for any foreign investment to come in. The ‘automatic route’ under the current FDI norms for insurance, however, allows foreign companies to increase their shareholding to up to 49 percent with just the Irdai approval.

If foreign PE funds are to go through the LLP structure of the SPV, they would have to take an additional approval to first infuse capital into the LLP under the foreign exchange laws, and therefore, they would not be able to avail the automatic route, she said.

If the SPV is designed as a company, every time it pays a dividend to the promoter PE fund, there will be a 20 percent dividend distribution tax levy.

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“The tax burden will be higher than before, even for an unlisted insurance company,” said Amrish Shah, partner at financial advisory firm Deloitte Haskins & Sells LLP. This, as all the interim dividends must now be routed through the Indian SPV. Now whenever these dividends are to be sent up to the shareholders, a 20 percent DDT will apply on the PE fund-owned SPV. Earlier, this tax was borne by the insurance company and not the shareholders, he said.

Any promoter PE fund would target capital appreciation rather than dividends from the insurer. This is consistent with the market trend over the last decade as very few insurers have actually managed to pay out dividends.

The Exit Problem

A Higher Tax Bill

The expensive tax implications are not just limited to the investment phase; they extend to the exit phase as well, whether by way of an initial public offer or stake sale.

In the case of an IPO and subsequent listing the private equity investor is likely to face double taxation. When the PE fund sells its stake in the insurer through public listing, the sale amount will first accrue to the SPV.

As this amount will be considered as income generated by the investment vehicle, it will be liable to pay a minimum alternate tax of 20 percent on its profits. After paying the MAT, the leftover proceeds will have to be transferred by the SPV to the PE fund and that transaction will be subject to either a dividend distribution tax or a buyback tax. Together the MAT and dividend/buyback tax add up to 35 percent.

“Despite the PE funds investing as a long term players because of the lock-in requirements, they will be paying taxes as if it was short term capital gains tax,” said Shah. This will affect their yield from investments, he said.

Earlier, PE funds had a cheaper exit through the IPO route as only a 0.1 percent of securities transaction tax was payable.

In the alternate scenario of a stake sale in the SPV, a 10 percent capital gains tax will apply on the foreign PE fund. This, too, is not a favourable situation.

“The issue then is that the entire burden passes on to the new buyer and he is going to discount it in the value,” said Shah. Earlier when there was a direct investment possible, any sale would have led to, at best, a 10 percent tax if it was an unlisted company or even lower if the company was listed, as then the investor would just pay the STT, he said.

The exit problem is not just plagued by higher tax implications; lock-in requirements will prove to be a challenge too.

Lock-In Issue

Besides tax tangles, the private equity investor will also trip on different regulations of the Securities and Exchange Board of India, and Irdai regarding promoter lock-in period.

The Irdai has mandated a lock-in period of five years for promoter PE funds from the date of investment. But SEBI’s lock-in requirements kick in from the date of listing. It’s a three-year lock in for promoters with 20 percent shareholding and one year for promoters with above-20 percent shareholding.

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“This dichotomy between Irdai and SEBI rules needs to be resolved soon because if you want to invite PE investments in the insurance space, you cannot have this disconnect,” said Anuj Shah, partner at legal consultancy firm Khaitan & Co. If there is a PE fund recognised as a promoter by IRDAI, and has already suffered a lock-in of five years, you cannot expect the same PE fund to suffer an additional lock-in only because SEBI requirements mandate an additional lock-in, he said.

The Road Ahead

The mandatory requirement of the SPV, experts said, will hamper investments in the insurance sector as it will throw up major structuring and exit challenges.

It will be extremely difficult for PE funds to invest through the SPV due to the high tax incidence, said Deloitte’s Amrish Shah.

The regulator, however, may have had its own reasons to make the SPV mandatory for all promoter PE funds.

The structure of PE funds is quite complicated and in order to avoid these complexities, the SPV structure was made compulsory by the regulator, said Arora.