Budget 2021: Key takeaways for Private Equity and Venture Capital industry

Union Budget 2021: The Indian stock market cheered the growth-focused Budget presented early last week. Budget 2021 was expected to address a number of concerns to stimulate growth and to put the economy back on a roll.

The Honorable Finance Minister (‘FM’) in her Budget Speech re-emphasized on ‘Aatmanirbhar Bharat’ and provided a major boost to the infrastructure, healthcare, fintech, agriculture sectors and the overall start-up ecosystem.

The FM after having round table discussions with the stake holders in the private equity and venture capital industry has positively responded to the demands of the investor community and has proposed various amendments from a tax and regulatory perspective.

The critical changes proposed in the Budget 2021 which will impact Deals and Alternative Investment Industry going forward are as given below:

a) Amendment in the definition of ‘Securities’

The Budget 2021 has proposed an amendment to the Securities Contract (Regulations) Act, 1956 (‘SECRA’) to include units of Alternative Investment Fund (‘AIF’), Infrastructure Investment Trust (‘InvIT’) and Real Estate Investment Trust (‘REIT’) in the definition of Securities as given under SECRA. With this amendment the question on whether stamp duty of 0.015 percent will apply on units of AIFs, InvITs and REITs will again come into light as one of the arguments by the industry was these units are not covered under the definition of securities as given under SECRA.

Further, with this amendment the argument that these units are not securities and will not attract gift tax provisions under section 56(2)(x) will not be available to investors. However, this amendment clears the ambiguity around long-term capital gains tax rate on sale of units by non-residents.

b) No withholding tax on dividend income paid to business trust i.e REIT and InvIT

No withholding tax to apply on dividends paid by Special Purpose Vehicle to REIT / InvIT (in whose hands, such dividend is exempt). This will avoid cash lock-up in the hands of business trust and improve investors Internal Rate of Return (‘IRR’).

c) Higher Tax Deducted at Source (‘TDS’)

Higher TDS rate is proposed for the non-filers of income-tax returns. Exemption is proposed for non-resident investors not having Permanent Establishment in India. AIFs while distributing the income to its resident investors will have to rely on the representation provided by the investors with respect to the filing of income-tax return compliance.

d) Proposal impacting portfolio companies

Proposal to exclude goodwill from the definition of ‘block of assets’ and disallowing depreciation on goodwill will have serious impact on concluded deals and control deals. This proposal is certainly going to impact the investor IRR.

Slump Exchange transactions are proposed to be taxable going forward. This proposal effectively reduces tax structuring opportunities for the portfolio companies, thereby impacting the investor returns.

e) Reduction of Re-assessment period

Time-limit for re-opening of assessment has been brought down from 4/6 years to 3 years from end of relevant assessment year only in specific cases time-limit of 3 years can be enhanced to 10 years. This will positively impact the deal indemnity negotiations at the time of exits, on account of reduction in the look back period.

f) Non-resident buyers to undertake additional compliance

0.1 percent TDS applicable on purchase of goods from resident seller. This will result into certain additional compliance for the non-residents acquiring shares from residents.

Relaxation in tax laws aimed at attracting institutional fund flow in India:

a) Rationalization of conditions for tax exemption to Sovereign Wealth Fund (‘SWF’) and Pension Fund (‘PF’)

Finance Act 2020 provided exemption for dividend, interest and long-term capital gains earned by notified SWF and PF from investments in specified Infrastructure sector, subject to conditions. Satisfying some of the specified conditions created challenges and the FM has proposed to relax certain conditions as mentioned below:

Allow SWF / PF to invest through domestic holding company set up after 1 April 2021 with minimum 75% investment in one or more entities engaged in specified infrastructure sector. While the investment by SWF / PF is eligible for exemption, the income earned by the domestic holding company does not seem to be covered by the exemption, this could possibly result in cash trap and impact investors IRR.

Exemption extended to SWFs and PFs that invest in AIF subject to certain investment conditions. This should help AIFs which have many SWFs and PFs as their investors.

The definition of eligible investments is proposed to be expanded to include Non-Banking Finance Company – Infrastructure Debt Fund / Infrastructure Finance Company, subject to conditions.

Certain other onerous conditions with respect to undertaking ‘commercial activity’, leveraging etc. has been proposed to be relaxed.
The above proposals set the tone for welcoming SWFs and PFs for investments into India.

b) Tax exemption on relocation of assets held by offshore funds to fund set up in International Financial Services Center (‘IFSC’)

In order to promote IFSC, tax incentives have been proposed for relocation of assets held by offshore funds to funds set up in IFSC, resulting into no taxes in the hands of the offshore funds and their respective investors on account of the relocation albeit subject to conditions.

c) Relaxation of Safe Harbor Rules for funds / manager in IFSC

Certain stringent conditions for availing safe harbor for offshore funds shall not apply or apply with modifications to eligible investment fund or its eligible fund manager, located in IFSC, subject to certain conditions. This has opened paths for various funds / manager to reconsider relocating in IFSC.

The Finance Minister has provided the much-required relief to the pandemic-hit Indian economy with the tax proposals and have endeavored to make India a more attractive destination for investments with an objective of ease of doing business and minimum government and maximum governance.

(By Kalpesh Desai, Partner, M&A and Private Equity, Tax, KPMG in India, and Shital Gharge, Director, Private Equity Tax, KPMG in India)