Tax conundrum for Indian-focused offshore private equity funds
Foreign private equity investors typically set up offshore pooling vehicles for routing investments into India, which offer them twin advantages of ease of administration and single window compliance with the Indian regulatory regime. Setting up such pooling vehicles in a tax favourable jurisdiction ensures that the interposition of the pooling entity comes at no additional tax cost and provides a common treaty vehicle to foreign investors. As India revamps its international tax rules, Indian-focused offshore private equity funds face four key tax challenges in relation to such offshore pooling vehicle.
Previously, any sale or redemption of shares or units of the offshore fund was not taxable in India. Offshore funds could distribute returns to their investors without attracting Indian taxes. However, post the indirect transfer tax-related amendments, sale or redemption of shares or units of the offshore fund may be taxed in India. Now, offshore funds need to evaluate payout options for structuring tax-effective distribution to their investors.
Secondly, the governance structure of offshore funds has become critical in view of India’s new residency test for foreign companies, that is, the place of effective management (POEM) test. Offshore funds are likely to qualify as companies that are not engaged in active business outside India in terms of the Central Board of Direct Tax’s draft guidelines on POEM, and will need to satisfy an exhaustive criteria to demonstrate that their tax residency is overseas.
Third, the permanent establishment risk continues to dictate the offshore fund’s presence in India. The safe harbour rule introduced by Finance Act, 2015 for encouraging the re-location of fund managers in India is rendered otiose by the impracticability of the conditions, which an offshore fund is required to meet before it can seek its refuge.
Fourth, the withdrawal of the capital gains tax exemption under the India-Mauritius tax treaty and its domino effect on the India-Singapore tax treaty, has left investors in search of a favourable tax jurisdiction for routing investments into. Hitherto, bulk of the private equity investments into India were routed through such jurisdictions. Moreover, with the General Anti Avoidance Rules on the anvil, instilling commercial substance in the offshore pooling vehicle will become crucial for availing tax treaty benefits.
In light of India’s evolving tax law, offshore funds need to re-evaluate governance structures and payout mechanisms to protect the efficacy of the offshore pooling vehicle.