July 1, 2016

New Opportunities for Private Equity in India

India recently adopted a new Insolvency and Bankruptcy Code that provides more leverage to creditors. Other reforms announced include measures that encourage foreign investment into Asset Reconstruction Companies, significantly loosened sectoral caps on foreign investment, lowered capital gains tax rates and changes to foreign exchange laws which permit indemnity escrows, post-closing price adjustments and earn-outs. This client alert summarizes the impact on foreign investors of the principal reforms announced in 2016.

New Insolvency Code and Asset Reconstruction Companies

  • Prior to the new code, insolvency proceedings in India lasted several years and effectively allowed management and owners to run these companies for their own benefit with little or no recourse for creditors. The Insolvency Code has changed the landscape considerably. It creates a 180-day period during which there is a moratorium or automatic stay of all actions against the company, and the creditors and company are required to attempt to agree upon a plan of resolution. Failing such an agreement, the moratorium is lifted and corporate debtor is placed in liquidation with a court appointed liquidator. In liquidation, the priority of creditors is as follows: (a) first, all insolvency resolution costs, including any interim financing obtained during the moratorium, (b) second, secured creditors, (c) third, workmen dues and unsecured creditors, and (d) fourth, governmental claims. As a practical matter, it will take some time before the new law becomes fully operational because the government must notify procedural rules and amendments to other laws. If indeed the new streamlined bankruptcy process functions as proposed, it would represent a sweeping reform of the insolvency process and put creditors in a much stronger position. That should result in increased appetite among foreign investors to participate in this process. We have already seen interest among private equity investors in distressed companies.
  • An Asset Reconstruction Company (ARC) purchases distressed assets from financial institutions, re-packages them and then sells a diversified portfolio in the market. Persons resident outside India can now invest up to 100% in ARCs registered with the RBI (previously 49%). It is also expected that investors who register with the Securities and Exchange Board of India (SEBI) as foreign portfolio investors will be allowed to purchase up to 100% of each tranche of security receipts issued by ARCs (up from 74%).

FDI Ownership Caps and Approvals

  • June 20 announcements: On June 20, 2016, the Government of India increased ownership caps in some sectors and dispensed with the need for prior governmental approval in certain cases. Significant changes include:
    • Pharmaceuticals: Up to 74% ownership permitted in brownfield pharmaceutical entities without government approval. Previously, any such investment required prior approval.
    • Single Brand Retail Trading: As before, up to 49% ownership permitted without governmental approval and with governmental approval thereafter. Additionally, where foreign investment exceeds 51% ownership, 30% of the value of goods would have to be sourced from within India, preferably from micro, small and medium enterprises, cottage industries and artisans and craftsmen. The local sourcing condition was an impediment to companies such as Apple, who had previously looked into seeking an exemption. The June 20 press release relaxes the local sourcing condition for three years generally, and for five years for entities trading products having ‘state-of-art’ and ‘cutting edge’ technology (neither of these terms are currently defined). The government’s intention is to encourage the entry of technology brands.

      Multi Brand Retailing Still Prohibited: Despite discussions, there has not been any change in the rules prohibiting foreign investment in multi brand retail trading which, for all practical purposes, remains off limits. As before, up to 51% ownership is permitted with prior governmental approval and subject to onerous conditions such as (1) a minimum $100 million investment of which half has to be invested in ‘back-end infrastructure,’ (2) procuring at least 30% by value from Indian micro, small and medium industries, and (3) stores only being permitted in cities with a population of at least 1 million and in states where the state government has decided to permit FDI in multi brand retail trading (currently 12).
    • Civil Aviation: 100% ownership now permitted in brownfield airport projects without governmental approval (previously 74%). Up to 49% ownership now permitted in domestic airlines without governmental approval; investment beyond 49% and up to 100% requires prior governmental approval.
    • Private Security Agencies: Up to 49% ownership permitted without governmental approval; investment beyond 49% and up to 74% requires prior approval. This could encourage large international groups to enter the market.
  • FVCIs and startups: Pursuant to the Consolidated FDI Policy issued on June 7, 2016 (the FDI Policy), Foreign Venture Capital Investors (FVCIs) registered as such with the SEBI are now permitted to invest in “startups” engaged in any sector. This is in addition to the 10 specific sectors to which FVCI investments are currently restricted. Important benefits of FVCI investments are: (i) not being subject to the entry floor price and the exit cap price under Indian exchange control regulations, (ii) not being subject to the one-year post-IPO lock-up, and (iii) certain tax pass-through benefits. While the term “startup” is undefined, the FVCI route would definitely be useful if it is later clarified as a broad concept. The post-IPO lock-up is a significant hindrance to IPO exits, and this is inapplicable to FVCIs.
  • E-commerce: The FDI Policy reiterates the position that companies engaged in the “marketplace model” (i.e., where the entity provides a platform on a network to act as a facilitator between buyers and sellers) are eligible to receive FDI of up to 100% without prior governmental approval. Marketplace e-commerce companies are prohibited from (i) permitting more than 25% of the sales from a single seller, and (ii) influencing the sale price of goods and services. FDI is not permitted in entities engaged in the “inventory based model of e-commerce” (i.e., where the entity owns the inventory and sells to consumers directly).

Taxation of Capital Gains

Foreign investors in India attempt to structure investments through treaty jurisdictions like Mauritius and Singapore in order to avail themselves of certain capital gains tax benefits in such treaty jurisdictions. In 2007, Vodafone bought Hutchison’s stake in Essar Telecom in India, and was promptly faced with a $2 billion tax bill. Ever since that case, foreign investors have been wary of Indian tax authorities disregarding established law and attempting to tax transactions. Further, there was significant uncertainty as to whether the tax authorities would respect the structuring of investments through treaty jurisdictions. Recently, the Indian government sought to eliminate this uncertainty by making certain amendments to the India-Mauritius tax treaty, as described below.

  • Amendments to India-Mauritius tax treaty: A significant proportion of foreign investment into India is routed via Mauritius principally because India and Mauritius have a double tax avoidance treaty that effectively eliminates Indian capital gains taxes on investments into India made via Mauritius. In May 2016, India and Mauritius signed a Protocol for amending the India-Mauritius tax treaty (the Protocol). As a result of these amendments, for a Mauritius resident entity:
    • Indian capital gains taxes will apply to gains arising from alienation of shares ‘acquired’ on or after April 1, 2017. Gains from transfers of shares acquired before April 1, 2017 were grandfathered and will not be taxable in India.
    • Gains from shares acquired on or after April 1, 2017 but sold before April 1, 2019 will be taxed in India at a beneficial rate of 50% of the domestic tax rate. To avail of the reduced tax rate, a two-pronged test has been specified: (i) Incur a minimum spending of INR 2,700,000 (~US$40,000) in Mauritius in the immediately preceding period of 12 months from the date the gains arise to avoid classification as a shell/conduit company; and (ii) the Mauritius entity’s affairs should not be arranged with the primary purpose to take advantage of the treaty. Accounting firms are of the view that investors who have fund vehicles in Mauritius are more likely to establish substance in Mauritius over investors that do not. However, accounting firms expect clarity on this point only when India’s General Anti-Avoidance Rules are notified (currently expected in 2017).
    • Interest income arising in India may be taxed in India, but at a rate not exceeding 7.5% of the gross amount of interest (there was previously no limit).

      The Protocol does not clarify the taxability of gains arising from the sale of certain securities acquired on or after April 1, 2017 in certain cases, such as: (i) debentures (which, under Indian tax law, are not considered “shares”), (ii) shares acquired on conversion of preferred shares, and (iii) bonus shares. Accounting firms have sought clarifications on these issues from the Indian tax department.
  • Singapore treaty: Commencing April 1, 2017, the Protocol effectively eliminates the benefits of the India-Singapore tax treaty, in which the provisions that effectively exempt Singapore entities from capital gains tax in India terminate if the corresponding provisions of the India-Mauritius treaty are terminated. It is expected that the Indian government will renegotiate the Singapore treaty along the same lines as the amendments introduced by the Protocol.
  • Indian tax rates: Indian capital gains tax rates vary from 0% to 40% depending upon the holding period of shares, manner of sale and type of company. Importantly, all gains are calculated on a rupee to rupee basis. The long term capital gains tax rate for transfers of shares in unlisted companies by offshore investors is 10% (previously 20%), and the holding period to determine whether long or short term rates apply has been reduced to 24 months (previously 36 months). Importantly, there is no capital gains tax imposed on the sale of listed company shares on the exchange, so long as they have been held for 12 months and securities transaction tax (as described below) has been paid.
  • Securities Transaction Tax: Securities Transaction Tax (STT) was introduced in India in 2004 and is levied on every purchase or sale transaction of securities that are listed on Indian stock exchanges. This includes transactions involving delivery-based trading, trading in index options and futures, or equity-oriented mutual funds units. While the rate of STT varies with different types of transactions and securities, the sale of shares in a listed company on a stock exchange in India is subject to STT of 0.1%. STT is deducted at source by a stock broker or asset management company.

Deferred Purchase Consideration, Escrows and Indemnities

In May 2016, the RBI amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000, pursuant to which up to 25% of the purchase consideration payable by a non-resident for a purchase of shares from an Indian resident can be deferred or placed in escrow for up to 18 months. This allows more effective remedies for warranty breaches and flexibility in structuring price adjustments. Prior to these amendments, locked-box closings were the norm in Indian share purchases, with any departures requiring RBI approval or being the result of creative structuring.

Please note that as with all international law firms, Goodwin Procter LLP is not licensed to advise on Indian law. This update is based on information that has been published in the press and from other sources in the public domain, and is intended to provide general information on law and policy. The information and opinions which it contains are not intended to provide legal advice, and should not be treated as a substitute for specific advice.