Private Equity – A case study

1. Private Equity – A case study June 24, 2008

2. Contents • Typical investment / operating structure • Outline of the structure • Income-tax issues • Analysis • Conclusion

3. Typical investment / operating structure US based Fund Manager US investors Non-US investors GP Company 100% Cayman Islands Fund Investment management agreement 100% Mauritius Company Investment advisory agreement Invest in shares of Indian Cos Outside India In India Indian Co 1 Indian Co 2 Indian Co 3 Indian advisory company

4. Outline of the structure • Offshore investors invest in a Cayman Islands Fund (‘CIF’) • CIF established to make investment in growth companies across geographies (including India). For this purpose, the CIF invests in a Mauritius based subsidiary (‘M Co’) which in turn makes investment in shares of Indian companies and other companies in the Asia Pacific region • A US-domiciled Fund management company (‘FMC’) is appointed to manage the investments of CIF and M Co • The FMC establishes an Indian sub-advisory company (‘IAC’) for provision of investment advisory and incidental support services in respect of potential Indian investments • Decisions to make investments in Indian companies are taken by the Board of Directors of M Co based on recommendations received from investment committee constituted in M Co. Investment committee considers investment recommendations from FMC. Investment committee comprises of individuals with necessary expertise in considering and evaluating investment opportunities

5. Outline of the structure (contd…) • The IAC broadly provides the following services to FMC on a non-discretionary basis: • Undertake research and identify potential investment targets • Make non-binding recommendations to FMC as to the purchase/ sale of investments by M Co • Assist in negotiating purchase and sale of Indian investments • Act as an interface in India with external consultants (including securities firms, investment consultants, investment banks, financial institutions, solicitors and accountants) in relation to investments • Assist in review of agreements relating to acquisition/ sale of shares and other agreements • Send periodic reports on the performance of the investee companies on a regular basis

6. Income-tax issues • Whether IAC constitutes a permanent establishment (‘PE’) in India of FMC/M Co? • Even if IAC constitutes a PE of M Co, can capital gains earned by M Co from divestment of shares of Indian companies be liable to tax in India?

7. Analysis Permanent Establishment • Fixed Place PE: • There must be a place of business in India, for example, any office space (owned or rented) • The place of business must have a degree of permanence • Agency PE: • An agent of a non-resident acts in India • The agent is dependent legally and economically on the non-resident principal • The agent has and habitually exercises in India, an authority to negotiate and conclude contracts for or on behalf of the non-resident principal Capital Gains (India Mauritius tax treaty) • Capital gains from the alienation of movable property forming part of the business property of a permanent establishment may be taxed in India • Capital gains earned from the alienation of Indian securities (other than the above), shall be taxable only in Mauritius

8. Conclusion The following supports the argument that IAC should not constitute a PE of the FMC/M Co in India: • IAC’s premises not at disposal of the FMC/M Co. Hence, IAC cannot constitute a fixed place PE of the FMC/M Co [Ericsson, Motorola and Nokia ruling (95 ITD 269) Delhi ITAT SB] • IAC represents FMC/M Co vis-à-vis third parties in India. Therefore, IAC will be regarded as an agent of FMC and/or M Co • IAC could be subject to detailed instructions and control with respect to the conduct of its business. Therefore, IAC is potentially legally dependent • IAC is setup as a risk free capital service provider in India. Therefore, the entrepreneurial risks are borne by the enterprise that IAC represents in India. Thus, IAC is economically dependent • IAC cannot therefore be regarded as an agent of independent status • IAC has no authority (express or implied) to negotiate and conclude contracts on behalf of the FMC/M Co • Thus, it will not constitute a agency PE of FMC/M Co [DIT v Morgan Stanley & Co (2007) 292 ITR 416 (SC)]

9. Conclusion • If IAC constitutes an agency PE of M Co in India on the basis that it has and exercises an authority to conclude contracts on behalf of M Co, gains earned by M Co on divestment of Indian securities should still not be subjected to tax in the hands of its PE in India due the following reasons: • The Indian securities are beneficially owned by M Co • The risk arising from the price fluctuations of the investment is borne by M Co • The funding for making the investment is made by M Co out of its own or borrowed capital • Therefore, the Indian securities do not form part of the business property of the IAC (ie PE of M Co). • Hence, the gains arising on sale of investments should not be taxable in India.

10. Thank you