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Private Equity – A case study June 24, 2008 Contents Typical investment / operating structure Outline of the structure Income-tax issues Analysis Conclusion Typical investment / operating structure US based Fund Manager US investors Non-US investors GP Company 100%

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Private Equity – A case study

June 24, 2008


Contents l.jpg
Contents

  • Typical investment / operating structure

  • Outline of the structure

  • Income-tax issues

  • Analysis

  • Conclusion


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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


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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


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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


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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?


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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


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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)]


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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.



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