Private Equity – A case study

June 24, 2008

June 24, 2008 Private Equity – A case studyPage 2

Contents

► Typical investment / operating structure

► Outline of the structure

► Income-tax issues

► Analysis

► Conclusion

June 24, 2008 Private Equity – A case studyPage 3

Typical investment / operating structureTypical investment / operating structure

Outside India

In India

Investment management agreement

Invest in shares of Indian Cos

Indian Co 1

Cayman Islands Fund

Indian Co 2 Indian Co 3

Mauritius Company

100%

US based Fund ManagerNon-US investors GP CompanyUS investors

Indian advisory company

Investment advisory

agreement

100%

June 24, 2008 Private Equity – A case studyPage 4

Outline of the structure

► Offshore investors invest in a Cayman Islands Fund (‘CIF’)

► CIF established to make investment in growth companies across geographies (including India). For

this purpose, the CIF invests in a Mauritius based subsidiary (‘M Co’) which in turn makes

investment in shares of Indian companies and other companies in the Asia Pacific region

► A US-domiciled Fund management company (‘FMC’) is appointed to manage the investments of CIF

and M Co

► The FMC establishes an Indian sub-advisory company (‘IAC’) for provision of investment advisory

and incidental support services in respect of potential Indian investments

► Decisions to make investments in Indian companies are taken by the Board of Directors of M Co

based on recommendations received from investment committee constituted in M Co. Investment

committee considers investment recommendations from FMC. Investment committee comprises of

individuals with necessary expertise in considering and evaluating investment opportunities

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Outline of the structure (contd…)

►The IAC broadly provides the following services to FMC on a non-discretionary basis:

► Undertake research and identify potential investment targets

► Make non-binding recommendations to FMC as to the purchase/ sale of investments by M Co

► Assist in negotiating purchase and sale of Indian investments

► Act as an interface in India with external consultants (including securities firms, investment

consultants, investment banks, financial institutions, solicitors and accountants) in relation to

investments

► Assist in review of agreements relating to acquisition/ sale of shares and other agreements

► Send periodic reports on the performance of the investee companies on a regular basis

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Income-tax issues

► Whether IAC constitutes a permanent establishment (‘PE’) in India of FMC/M Co?

► Even if IAC constitutes a PE of M Co, can capital gains earned by M Co from divestment

of shares of Indian companies be liable to tax in India?

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Analysis

Permanent Establishment

► Fixed Place PE:

► There must be a place of business in India, for example, any office space (owned or rented)

► The place of business must have a degree of permanence

► Agency PE:

► An agent of a non-resident acts in India

► The agent is dependent legally and economically on the non-resident principal

► The agent has and habitually exercises in India, an authority to negotiate and conclude

contracts for or on behalf of the non-resident principal

Capital Gains (India Mauritius tax treaty)

► Capital gains from the alienation of movable property forming part of the business property of a

permanent establishment may be taxed in India

► Capital gains earned from the alienation of Indian securities (other than the above), shall be

taxable only in Mauritius

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Conclusion

The following supports the argument that IAC should not constitute a PE of the FMC/M Co in India:

► IAC’s premises not at disposal of the FMC/M Co. Hence, IAC cannot constitute a fixed place

PE of the FMC/M Co [Ericsson, Motorola and Nokia ruling (95 ITD 269) Delhi ITAT SB]

► IAC represents FMC/M Co vis-à-vis third parties in India. Therefore, IAC will be regarded as an

agent of FMC and/or M Co

► IAC could be subject to detailed instructions and control with respect to the conduct of its

business. Therefore, IAC is potentially legally dependent

► IAC is setup as a risk free capital service provider in India. Therefore, the entrepreneurial risks

are borne by the enterprise that IAC represents in India. Thus, IAC is economically dependent

► IAC cannot therefore be regarded as an agent of independent status

► IAC has no authority (express or implied) to negotiate and conclude contracts on behalf of the

FMC/M Co

► Thus, it will not constitute a agency PE of FMC/M Co [DIT v Morgan Stanley & Co (2007) 292

ITR 416 (SC)]

June 24, 2008 Private Equity – A case studyPage 9

Conclusion

► If IAC constitutes an agency PE of M Co in India on the basis that it has and exercises an authority to

conclude contracts on behalf of M Co, gains earned by M Co on divestment of Indian securities

should still not be subjected to tax in the hands of its PE in India due the following reasons:

► The Indian securities are beneficially owned by M Co

► The risk arising from the price fluctuations of the investment is borne by M Co

► The funding for making the investment is made by M Co out of its own or borrowed capital

► Therefore, the Indian securities do not form part of the business property of the IAC (ie PE of

M Co).

► Hence, the gains arising on sale of investments should not be taxable in India.

Thank you