Private equity (PE) investors having an Indian focus are facing challenging times. Slowing growth in the Indian economy, a challenging fund raising environment, lack of portfolio exits and a variable tax and regulatory environment are just some of the challenges faced by PE fund managers today.
The year 2012 began on a high note. The Supreme Court of India in January 2012 pronounced a favourable verdict in the universally-followed Vodafone Hutch case. The decision was hailed as a milestone development in the taxation of international transactions and on the judicial approach to tax avoidance. The euphoria unfortunately was very short-lived.
The Union government, while presenting the Budget for 2012-2013, introduced in the Indian tax law provisions to deal with aggressive tax planning in the form of General Anti Avoidance Rules (GAAR) only days after a Parliamentary Standing Committee on Finance recommended a number of aspects for consideration before finalising the GAAR provisions. Amongst others, GAAR provisions are relevant to every foreign investor that has made an investment from a country with which India has signed a tax treaty that provides a tax treatment that is more favourable than the Indian domestic tax law (for example capital gains exemption under the India-Mauritius and India-Singapore tax treaties).
The Budget also proposed extensive retrospective amendments to the tax law to introduce provisions to tax gains arising from offshore transactions that derive value from underlying Indian assets. These two provisions have since their introduction contributed to widespread criticism amongst the international investor community, significantly dampened investor sentiment and caused the government to engage in extensive stakeholder consultation by forming an expert committee to look into all the aspects and make recommendations. While the recommendations made by the committee are very encouraging, the final decision of the government is still awaited.
The tax rate parity (at 10 per cent) for long-term capital gains derived by any foreign investor for investment in unlisted Indian companies was a welcome step. Uncertainty (perhaps unintended) over its application to investment in shares of private limited companies should hopefully be clarified in the forthcoming Budget.
From a regulatory standpoint, the Securities and Exchange Board of India (Sebi) introduced the Alternative Investment Funds (AIF) Regulations repealing the almost two-decade-old Venture Capital Funds Regulations. These regulations are expected to steer the development of the alternative funds sector in India while balancing the need for protection of investors investing in private pools of capital. The new regulations provide much greater flexibility to fund managers to design new fund offerings in asset classes which hitherto were not possible (like debt funds and hedge funds).
The AIF sector however awaits the policy framework governing foreign investment in such vehicles which should hopefully enable free flow of foreign capital. The sector also anticipates tax policy certainty for investors by enabling a tax pass through scheme of taxation for the fund vehicle. A comprehensive tax and regulatory framework for the sector to enable raising foreign capital directly in Indian pooling vehicles will also go a long way in the growth of the sector in India and check the ongoing export of the sector to Mauritius and Singapore.
The slew of bold reform initiatives taken by the government in the last quarter of 2012, notwithstanding a relentless opposition, are certainly a step in the right direction and should tangibly contribute to improve investor sentiment. Consistency and certainty in taxation and regulation are key to maintaining India as an attractive investment destination. Only time will tell if the initiatives and reform measures help India forge ahead in 2013.
The author is partner, Ernst & Young