A number of tax tweaks in the Budget may hurt global private equity funds investing into the country.
The tax rate on long-term capital gains on unlisted share sales has been raised from 10 per cent to 12.5 per cent for non residents, a move that may impact returns on foreign direct investment. What’s more, compulsorily convertible debentures (CCDs) which have often been used as capital instruments for FDI investments are now exposed to a higher tax rate on transfer.
The amended section 50AA covers any gains on transfer or redemption of unlisted debentures as short-term capital gains which will be taxed at the maximum marginal rate. “This will lead to a significant increase in tax outflows on CCDs held by foreign companies from 10 per cent to 35 per cent. Taking positions on taxability of CCD capital gains under the tax treaties will now need to be considered,” said Vaibhav Gupta, Partner, Dhruva Advisors.
CCD gains
CCDs are a preferred mode of investing in unlisted companies as they allow for interest payment unlike a pure equity mode where only dividends are paid. Depending on the deal construct, the higher taxation may compel investors to avoid taking the CCD route or convert their CCDs into equity before a share sale, said experts.
On the flip side, investors will not have to wait for listing of startups to avail the lower tax rate for offloading shares on the market since long term gains on unlisted shares will also be taxed at the same rate as listed securities now, said Rajesh Gandhi. , Partner, Deloitte India.
Abhay Sharma, Head of Tax, Bombay Law Chambers, feels that while the increase in tax rates on debentures will be a blow to foreign investors, its impact will be somewhat cushioned where treaty benefits are available. Tax treaties prescribe a lower rate of tax on interest income earned by a non resident.
“Indian private equity funds and investors will have significantly better post tax returns on a go-forward basis as against their global counterparts, who will pay more tax than what was budgeted at the time of investment,” said Bhavin Shah, Private Equity Leader and Deals Leader, PwC India.
According to Shah, overall parity was important to allow both foreign and Indian investors to price the tax component of the deal, which has now been achieved. “Baring few exceptions, tax rate is more or less similar for listed and unlisted securities, whether the investor is foreign or Indian. This parity will help investors and government in the long run,” he said.
Hit from Buybacks
The tweak on buyback taxation will also impact returns of foreign investors on exit. The entire buyback proceeds will now be taxed as dividend without offset of the investment cost. Earlier the buyback proceeds were taxed in the hands of the company net of the amount received against the shares by the company at an effective tax rate of around 20 per cent. The entire proceeds will now be taxed as dividend.
Let’s assume that a foreign investor invests ₹100 in the shares of an Indian company. The company does a buyback of these shares and pays ₹200 to the investor. Earlier the company would deduct 20 per cent on the extra ₹100 paid out to the investor. Now the entire ₹200 will be treated as dividend and taxed at the maximum marginal rate in the hands of the shareholder.
“The investment cost will only be available as a capital loss for the investors which can be offset against other capital gains income,” said Gupta. “The good part is that any beneficial rate on dividends under a tax treaty (such as a 5 per cent tax under the India-Mauritius treaty), should be available. However, not allowing cost to be offset is a bit surprising.”
“The Budget was a bit of a mixed bag for PE investors. While the Angel tax was abolished, taxation of buybacks as dividend and bringing unlisted debentures and bonds within the ambit of short term capital gains tax will hit them hard. While treaty benefits can be evaluated, it is going to add to the complexity of doing business in India,” said Sunil Badala, Deputy Head of Tax and National Head BFSI-Tax, KPMG India.