Mumbai: A proposal in the Union Budget to levy tax on companies and funds that buy shares for less than their actual market value could affect future deals by venture capital and private equity (PE) firms, say finance executives and lawyers.
Graphic: Yogesh Kumar / Mint
According to the proposal in the Budget, a firm that buys shares at a price lower than the market value of such shares will have to pay tax on the difference between the two, which will be treated as income. The proposal will come into effect after the Finance Bill is passed.
The new norm will apply to investments in unlisted companies by foreign venture capital investors (FVCIs), private placements or off-market share sales by listed companies, investments made by domestic venture capital funds, rights issues, and certain merger transactions.
There are concerns that the new rule will put off investors as absence of clear valuation norms for unlisted firms could lead to time-consuming disputes with the tax authorities.
“It will have a serious impact on the health of the private equity industry in India,” said Alok Gupta, managing director and chief executive officer, Axis Private Equity Ltd. “If you are doing a Rs30 crore deal and the fair market evaluator says that the fair market value is Rs50 crore, you will need to pay tax on Rs20 crore. No one will want to do such a deal.”
Legal experts also agree that the move will give rise to objections from tax officials over what amounts to fair value and can lead to long litigations.
“No rules have been prescribed with respect to the valuation of such share transfers. This results in considerable amount of uncertainty on how the provision would be applied,” said Nishith Desai, founder of Mumbai-based law firm Nishith Desai Associates.
The move could come as a blow to the industry which is still recovering from the recession. Venture capital investment in India virtually halved from 154 deals worth $841million (Rs3,860.2 crore now) in 2008 to 82 deals worth $444 million in 2009, according to Venture Intelligence, a research service focused on private equity and mergers and acquisitions.
And private equity activity too slowed, from 543 deals worth $16.93 billion in 2008 to 289 deals worth $4.97 billion in 2009.
According to lawyers, the proposed rule introduces the concept of a “deemed fair market value” of transferred property, which permits taxmen to question the value at which shares are transferred. “This may effectively result in any type of transaction being questioned by tax authorities on account of valuation issues and would lead to extensive litigation,” Desai said.
“Syndicated deals, where a group of private equity or venture capital investors are involved, would complicate matters further if the new rule were to come into effect,” he said. “What happens when there are four private equity investors looking to invest in one company and each one has a different fair value?”
Indian law doesn’t require private equity and venture capital transactions to be at market value and the capital market regulator’s pricing guidelines are not applicable to such deals.
According to Alok Mittal, managing director, Canaan Advisors Pvt. Ltd, investors will have to take on the task of determining the fair market value and be ready to defend this when and if questioned by tax authorities
“No firm makes investments to pay tax. One of the benefits of getting registered as an FVCI is that they don’t have to get in a third party each time and meet the compliance requirements,” Alok Gupta said. “They can do the deal directly. But this move will increase the compliance cost.”
Interestingly, the new rule goes against the spirit of India’s continuing effort, since 2000, to make it easier for foreign venture capital firms to do business in the country. As part of these, foreign venture capital firms are exempt from entry and exit pricing norms, lock-in restrictions after share sales, and the takeover code in the event of sale of shares back to Indian promoters.