India’s tax code change-up

A reworking of the country’s domestic tax system could lead to a 30 percent tax on carried interest. Shefali Goradia, partner at Indian tax advisory firm BMR Advisors speak about the risks facing foreign investors, local managers and Mauritius-domiciled funds.

Please explain how India currently taxes Mauritius-domiciled funds?

India, unlike most other countries, taxes even non-residents on sale of Indian shares. India and Mauritius have a favourable tax treaty under which all Mauritius residents are exempt from capital gains tax in India. This treaty has been in existence since 1983. Under this treaty, there are no limitation to benefits conditions, which means that there are no anti-treaty shopping restrictions, so any third country resident can set up a company in Mauritius. That company can be treated as a tax resident of Mauritius, and then if they invest in India the gains are not taxable.

Is India looking to change its tax policy?

India is about to change its domestic tax code. We are replacing the current law with a new direct taxes code, which will come into effect from April 2012. The proposal is to introduce a general anti-avoidance rule in the new tax code, which will empower the Indian revenue to disregard any transaction or structure which lacks commercial substance. If Indian revenue is able to invoke the general anti-avoidance rule, then the domestic tax code will override the tax treaty.

So this could impact both domestic and foreign managers?

This could impact all offshore funds whether investing directly into India or through an onshore fund. The apprehension has been that once this new tax code comes into effect, all the structures set up in low tax jurisdictions such as Mauritius, Cyprus, etc. where the primary motive is to avail of a favourable tax treaty with India, could come under detailed scrutiny. At present, the ordinary income tax rate is 40 percent for foreign companies and 30 percent for others, whereas the capital gains tax is 20 percent, so there is a 10 percent differential. Under the new tax code there will be a uniform 30 percent rate for all taxpayer on all income, as per the current proposal. There will be certain deductions, however, for capital gains. For example, if one were to sell listed company shares on the floor of the stock exchange after holding them for one year, then there will be 100 percent deduction from the capital gains tax, so [essentially] there will be zero tax.

Have any private equity firms been rushing to make exits as a result of the pending tax changes?

Some of them were thinking along these lines when the first draft was released but since then, the draft code has been watered down significantly. We’ve not seen any exodus to sell Indian portfolio, though generally speaking if there is a tax-motivated transaction then there is an anxiety to complete it before 31 March, 2012.

What impact, if any, has the potential change already had on private equity?

Fund managers are now exploring alternative jurisdictions where they have a better chance of meeting with the substance test. Many fund managers are exploring Singapore because India also has a favourable treaty with Singapore, the difference being that the Singapore treaty already has some anti-treaty shopping provision built into it. So somewhere there is an expectation that it might sustain even after the new tax code comes in.

Secondly, Indian fund managers are more concerned if they are controlling the fund from India. In such cases, the protocols that are put in place for the investment decisions etc. are likely to face more scrutiny.  Many fund managers have also started exploring structures where they can pass on the tax credit to their investors.