Mumbai: Private equity (PE) firms are taking tax insurance on exits from investments in order to protect themselves from litigation, having been spooked by the recent travails that have beset acquisitions by HSBC and Vodafone.

According to tax consulting firms such as KPMG, Deloitte Haskins and Sells and PricewaterhouseCoopers (PwC), and law firms that help PE firms structure the exits, funds are seeking such cover while negotiating the deals.

However, they declined to disclose details of such transactions due to client confidentiality agreements.

“Funds are actively looking to take some cover regarding uncertainties on the taxation aspect," said Pranay Bhatia, associate partner at legal firm Economic Laws Practice (ELP). In the past one year, he has worked on at least five exits where such insurance cover was taken.

“There is a lot of uncertainty regarding the Mauritius tax treaty protection in the (proposed) direct taxes code, so we want to protect ourselves from any tax exposure," said a fund manager of a foreign PE fund that invests in India. He declined to be identified.

In 2010, there were 157 exits worth $5.4 billion (Rs 24,624 crore) compared with 32 exits worth $2.1 billion in 2009, according to VCCEdge, a financial research platform.

“PE firms are taking tax insurance cover," concurred Muneesh Chawla, managing director, Blue River Capital India Advisory Services Pvt. Ltd, a Mumbai-based PE firm.

Having to obtain the cover to avoid potential tax disputes may discourage exits through trade sales and this would delay deal closure.

The trend is a recent one, consultants say.

“There was no such concept of tax insurance one year back. It is only because of the E*Trade and Vodafone case that people are taking insurance," said Punit Shah, head of financial services and tax, KPMG, who has worked on at least three deals in the past year where tax cover was taken. “In the case of E*Trade, the tax treaty was questioned and now the tax authority is not giving a withholding tax certificate. As a result, people are taking this cover."

Withholding tax is charged on the repatriation of income from equity or debt. An overseas investor can approach the tax authority in the home jurisdiction to offset tax deducted in India.

“The E*Trade ruling had created uncertainty around the Mauritius treaty protection until it was overruled by a subsequent ruling which granted treaty protection to the Mauritius seller," said Gautam Mehra, executive director, financial services tax and regulatory practice, PwC.

In the last one year, PwC has worked on two deals where tax insurance was taken, he added. Most foreign PE funds are registered in Mauritius, with the Indian entity acting as an advisor.

E*Trade Mauritius Ltd, a subsidiary of E*Trade Financial Corp., sold its stake in listed Indian firm IL&FS Investsmart Ltd to HSBC Violet Investment (Mauritius) Ltd in 2008. The tax department then raised a demand of 24.5 crore on HSBC. After two years of litigation, the Authority for Advance Rulings (AAR) last year ruled in favour of E*Trade and said that the firm was not liable to pay capital gains tax in India as per the Double Tax Avoidance Agreement (DTAA) between the two countries.

Last year, the income-tax department raised a tax liability of 11,217.95 crore on Vodafone International Holdings BV, treating it as an assessee in default for its failure to deduct tax at source/withhold tax before making a payment of $11.2 billion to Hutchison Telecommunications International Ltd. Later in November, the Supreme Court had directed Vodafone, which is contesting the tax demand, to deposit 2,500 crore, along with a bank guarantee of 8,500 crore, within eight weeks for adjudication of the suit.

Earlier in May 2007, Vodafone International had bought Hutchison’s 66.98% stake in Hutchison Essar for $11.2 billion. Hutchison controlled its Indian telecom subsidiary through a Cayman Islands firm called CGP Investments (Holdings) Ltd. CGP’s shares were sold to Vodafone, which consequently became majority owner of the Indian telecom firm. Vodafone’s contention is that existing Indian law does not give its tax authorities jurisdiction over an overseas transfer of the kind it undertook. Tax authorities dispute this and say Vodafone should have deducted tax at source before paying Hutchison.

Insurance broking firms such as Marsh India Insurance Brokers Pvt. Ltd and Aon Global Insurance Brokers Pvt. Ltd help in providing tax insurance cover in India.

Tax insurance cover falls under transactional risk insurance and is offered mostly by offshore insurance companies such as AIG among others.

“Typically, the insurance company evaluates the entire transaction and in the case of India compares it to the facts of the ongoing Vodafone case to ascertain the risk involved," said a lawyer involved in structuring exits for PE firms. He declined to be identified.

All buyers are now seeking indemnity or tax insurance from the seller.

“Obtaining insurance cover for potential tax liability on overseas PE deals is becoming increasingly common as no tax withholding is applied in most deals after considering the beneficial tax treaty provisions," Shah said.

Such cover is applicable more to big-ticket deals, said Mehra of PwC.

Apart from insurance cover, firms are also creating escrow accounts in which the tax component of the deal is saved until all tax-related issues get resolved. “We have worked on two deals where these escrows have been set up," said Bhatia of ELP.