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A closer look at taxation of private equity and funds in India

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In light of the increasing foreign investment in Indian companies, Uday Ved and Amitabh Khemka of KNAV discuss the tax implications of different types of investment.

Globally, a large number of mergers and acquisitions (M&As) are happening in different sectors and India is no exception. In 2021, a number of foreign investors invested in the technology, telecommunication, pharma and manufacturing industries in India.

Among foreign investments, large private equity (PE) houses have invested in closely held companies. In addition, funds have invested in capital markets in shares and securities. This article focuses on taxation of PE and funds in India.

PE investments increasing

PE investments are substantially increasing in India – including in start-ups, technology, pharma and healthcare and the financial sector. A number of PEs from the United States and other countries have invested in India.

Generally, they have a mid- to long-term horizon and exits take place through listing of the investee company or another PE/investor buying it out. The largest part of income comes from capital appreciation (on exit) and not from regular income from dividends.

The tax implications of the various types of investment are summarised below.

Foreign direct investment route

A number of PEs take the traditional route of investing in India either directly or through a special purpose vehicle (SPV) outside India. The SPV is located in tax- and investor-friendly jurisdictions such as Mauritius, Singapore and the Cayman Islands.

Direct transfer – tax implications

When a PE makes a direct investment in an Indian company, generally withholding tax provisions are applicable if there is a secondary purchase (i.e. transfer of shares from existing shareholders) made by the PE.

As per Section 195 of the Indian Income Tax Act (IT Act), a payer (including both resident and non-resident payers) at the time of making a payment to a non-resident is obligated to deduct tax at the appropriate rate if such income (i.e. capital gains) is subject to tax in India.

There are practical nuances of obtaining the tax deduction account number, permanent account number and remittance procedure for depositing withholding taxes, including forex conversion rate, which need to be followed. This can sometimes delay the closure if appropriate proactive measures are not taken in time.

After deducting taxes, the net amount is remitted to the non-resident seller. The withholding tax is to be deposited in government treasury within seven days from the end of the month in which the closure takes place. The withholding tax certificate should be given to the seller and this can be used by the seller to avail tax credit against tax liability in India when the income tax return is filed at the year end. Withholding tax obligations and issue of the withholding tax certificate (Form 26A) are normally part of the closing conditions and share purchase agreement.

“In 2021, a number of foreign investors invested in the technology, telecommunication, pharma and manufacturing industries in India.”

In addition, a certificate under Section 281 of the IT Act needs to be obtained from the tax authorities regarding the status of pending proceedings and outstanding demand in order to avoid the transfer being regarded as void. Considering that obtaining such certificates can be time consuming, the acquirer often relies on a chartered accountant certificate. The 281 certificate from the tax department follows as a condition subsequent to the closing.

Further, it is imperative and critical that appropriate and adequate tax indemnities should be incorporated in the share purchase agreement so as to safeguard the buyer from onerous tax exposures especially if the buyer is remitting the consideration without withholding tax and giving double tax avoidance agreement (DTAA) benefit.

As per Section 112(1)(c) of the IT Act, the tax rate on long-term capital gains on the sale of shares of a closely held company to a non-resident seller is 10% plus applicable surcharge (without indexation benefits). Shares held for over 24 months qualify as a long-term asset. The tax rate on short-term capital gains is 30% plus surcharge.

Generally, no withholding obligations arise on the acquirer (i.e. non-resident) if the shares are acquired from a resident. Recently, Section 206C(1H) was amended in connection with the sale of goods wherein a seller needs to undertake tax collection at source (TCS) while collecting proceeds on sale of goods. The question is being raised in a few transactions at the time of closing is whether TCS provisions are applicable to the sale of shares (considering some judgments/precedents that ‘shares’ are ‘goods’). In our view, it is a stretched argument and TCS provisions ought not to be applicable.

As per Section 90(2) of the IT Act, a non-resident has the option to be governed by either provisions of the domestic tax law (the IT Act) or the respective DTAA, whichever is more beneficial to the non-resident. Also, for withholding tax obligations, Section 2(37A)(iii) of the IT Act defines ‘rate in force’ as rate per Finance Act or respective DTAA, whichever is applicable.

Thus, if the DTAA provisions are more favourable than the IT Act, then the withholding tax obligations are covered as per the DTAA. It should be noted that with introduction of base erosion and profit shifting (BEPS), India has already re-negotiated DTAAs with countries where capital gains were exempt, for example Mauritius, Singapore and Cyprus. Having said that, a DTAA with a country such as the Netherlands still provides exemption from capital gains tax in certain situations.

Instead of a secondary transfer/purchase, if a fresh issue (i.e. a primary issue) is made to a non-resident, then the funds would be received by the issuing Indian company. There is no withholding tax obligation on the non-resident acquirer/purchaser under Section 195 of the IT Act. In this case, one needs to examine the provisions of Section 56(2)(x) (i.e. it is deemed a gift if shares are acquired at less than fair value) in the case of a buyer or Section 56(2)(viib) and Section 68 of the IT Act in the case of a seller, as applicable. These provisions deal with the issue of shares to a non-resident at less than fair value (fair value for this purpose is generally book value or a discounted cash flow value, as applicable). These are anti-tax avoidance provisions.

Goods and services tax (GST) is not applicable on sale of shares/securities under the Indian GST law. Securities are specifically excluded from the definition of ‘goods’ and ‘services’. However, such sale may impact the input tax credit in the tax period (for GST purposes) in which the shares/securities are sold.

If the PE is already an existing investor with more than 26% holding control, then transfer pricing provisions are applicable. Also, a fresh issue of shares to a non-resident has to be undertaken at fair value as per exchange control regulations of the Reserve Bank of India (exchange control authority in India).

Indirect transfer – tax implications

As mentioned above, PEs also invest in Indian companies through a SPV located outside India in a tax- and investor-friendly jurisdiction. The exit normally takes place through a sale of shares of the SPV outside India, say to another non-resident.

There was a tax litigation in the case of Vodafone on this subject in which Vodafone acquired a share of the Hutchison entity outside India. The question before the tax authorities was whether such transfer of shares between two non-residents outside India was subject to capital gains tax in India and whether Vodafone International Holdings had withholding tax obligations in India.

The matter was litigated at the highest level. The Honourable Supreme Court of India held in favour of Vodafone in its judgment in Vodafone International Holdings v UOI (2012) 341 ITR 1. It stated that the transfer was of a capital asset situated outside India (the situs of shares was outside India – as it was a foreign company incorporated outside India).

This led to a change in the IT Act in 2012 with the insertion of a new explanation to Section 9(1)(i). This states that such an indirect transfer ought to be taxable in India where the substantial value of the asset (being 50% or more of global asset plus consideration more than Rs100 million) of the entity (being the subject matter of transfer) is located in India.

Vodafone challenged this retrospective change in the tax law. The company won the case in arbitration process outside India. Going forward, such indirect transfers are subject to capital gains tax in India.

Explanation 7 to Section 9(1)(i) of the IT Act also provides an exemption from ‘indirect transfer’ to shareholders owning/having control of up to 5% of the company. The Central Board of Direct Taxes has also prescribed detailed valuation rules for the applicability of indirect transfer as well as compliance requirements by the Indian entity.

Domestic tax law compared to DTAA

As stated above, indirect transfers are subject to capital gains tax in India where a substantial value of the asset (defined as 50% or more) is located in India. The question arises whether or not DTAA benefits would be available on such an indirect transfer. The matter was debated at the Authority for Advance Ruling (AAR) in the case of case of Tiger Global International II Holdings, In re (Application Nos. AAR/4, 5 & 7/2019) (429 ITR 288) (AAR – New Delhi), which concerned a PE.

The tax authority argued that DTAA benefits are available only in the case of direct transfers and that indirect transfers are not entitled to DTAA benefits. It should be noted that an AAR is binding on the applicant and tax authorities and not to other cases. Having said that, it does have a persuasive value in other cases. There is a contrary decision in the case of Sanofi Pasteur Holding SA v Department of Revenue, Ministry of Finance (2013) 354 ITR 316 (AP) where the Honourable Andhra Pradesh High Court has allowed DTAA benefits under the India-France DTAA and held in favour of the assessee. Thus, there is controversy on this issue, but the better view seems to be that DTAA benefits should be available even in the case of indirect transfers.

The payer would be subjected to withholding tax obligations in India even though the transfer is effected outside India between two non-residents if the substantial asset value test is satisfied.

Investment by funds

Investments in shares and securities are permitted by the Securities Exchange Board of India (SEBI), which regulates capital markets, for both resident and non-resident investors. The investment is done through a foreign portfolio investor (FPI) route or through a fund structure.

FPI investments

Regulated by the SEBI, FPIs can make investments in India in the shares of a listed company, non-convertible debentures, etc. Investments by an FPI are neither considered foreign direct investment nor external commercial borrowing. FPIs have favourable tax implications under the IT Act: long-term capital gain for shares and securities is taxable at 10% (without indexation benefit) and short-term capital gain is taxable at 15% (listed shares) or 30% (other assets).

A number of foreign investors use a vehicle outside India by forming a master-feeder structure to invest in capital markets in India. Funds are pooled at feeder fund level outside India, for example in the Cayman Islands or Singapore. The feeder fund then invests in a master fund outside India, for example in Mauritius or Singapore and the master fund invests in capital markets.

FPIs can also invest through a master-feeder structure for final investment in India. A feeder fund provides a flexibility of exit outside India and also potential exemption from ‘indirect transfers’ in specified cases.

Alternative investment funds

The SEBI has also permitted investments through alternative investment funds (AIFs) in the past decade and many AIFs have been formed in India. Both domestic and foreign investors can participate in an AIF in India. There are three categories of AIFs: AIF-I, AIF-II and AIF-III depending on needs and sectors for investment. AIFs can be formed as a private trust, a company, or a limited liability partnership. Most AIFs use trust as a vehicle for tax and other reasons.

AIF-I and AIF-II are pass-through for tax purposes i.e. such AIFs are tax free and only unit holders/members are taxable as if these are direct investments in shares and securities in India. AIF-III is taxable but depending on the nature of vehicle, the unitholders/members are exempt from taxation, for example, AIF-III (trust) is subject to tax, but the beneficiaries are exempt from taxation.

Investment through IFSC

The government of India has long wanted to make India a hub for the financial sector similar to locations such as Singapore, New York and London. In that light, a concept of an international financial services centre (IFSC) was conceived and Gujarat International Finance Tec-City (GIFT City) was set up.

The IFSC in GIFT City has the best infrastructure and provides tax and other incentives that are needed for the financial services sector. A number of Indian and foreign banks, financial and fintech companies, funds, insurance, and re-insurance companies are setting up units in the IFSC.

As per Section 80LA of the IT Act, a unit within the IFSC is entitled to a 10-year tax holiday for income earned within the IFSC unit from its business for which it has been approved for setting up in such a centre in a special economic zone.

Income from business is exempt and hence capital gains, dividends and interest income will continue to get taxed like a unit outside of the IFSC. However, DTAA benefits will be available to non-residents/foreign investors, as usual. It is interesting to note that income earned by an asset manager located in the IFSC would be entitled to 10-year tax holiday on fees it receives. This is not the case for asset managers located outside of the IFSC.

As per the Foreign Exchange Management Act, 1999, a unit in the IFSC is treated as a non-resident thus providing all flexibilities to deal in transactions in foreign exchange. Thus, the IFSC is emerging as an alternative to foreign investors setting up funds in India instead of normal jurisdictions such as Mauritius, Singapore and Cyprus. Relocation of an existing offshore fund into the IFSC is also exempt from capital gains tax. The tax will be levied eventually on exit of shares and securities.

This has been an enabling provision for existing offshore funds to relocate to the IFSC and enjoy tax and other incentives provided by the IFSC. Finally, there is a single regulator called the IFSC Authority (IFSCA) which consists of members of the Reserve Bank of India, SEBI, Insurance Regulatory and Development Authority, Finance Ministry, etc. This provides a single window clearance for all approvals rather than having to go to multiple regulators. The units in the IFSC are set up within couple of weeks and operationally it is a great step in ease of doing business as well as promoting the financial services sector in India.


India is a significant contributor to, and an integral part of, the BEPS project of the OECD/G20. The key issues surrounding BEPS are substance over form, focusing on anti-abuse provisions and transparency measures. Commercial substance and actual conduct are more relevant than mere legal agreements. India has re-negotiated tax treaties with countries such as Mauritius, Singapore and Cyprus. Relevant changes have also been made with respect to international tax and transfer pricing in domestic tax law, i.e. the IT Act, in the past four or five years. BEPS essentially covers international transactions/arrangements.

It is interesting to note that whereas a DTAA such as the India-Mauritius Treaty has been re-negotiated with respect to ‘shares’, some tax planning opportunities are still possible in the case of debt instruments and derivative products under the India-Mauritius Treaty. The DTAA should be read along with the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, wherever entered and approved.

If an entity is a resident of more than one contracting jurisdiction, the competent authorities shall endeavour to determine by mutual agreement the residential status of that entity having regard to its place of effective management, place of incorporation and other relevant factors. In such a case, the entity shall not be entitled to any relief or exemption from tax provided by the treaty except as agreed upon by such competent authorities.

Following the Vodafone judgment, the government of India constituted the Dr Shome Committee to look into abusive transactions and come out with a General Anti-Avoidance Rule (GAAR). Accordingly, India has introduced the GAAR (Sections 95-102 of the IT Act) effective April 1 2017 (i.e. financial year 2017–18 onwards), wherein ‘substance over form’ is critical. GAAR covers both international and domestic arrangements. Tax authorities have wide powers to treat abusive transactions as impermissible avoidance arrangements.

As per Section 96 of the IT Act, an impermissible avoidance arrangement is an arrangement where the ‘main purpose’ of the arrangement is to obtain a tax benefit (defined widely) and one or more of the four tainted tests are satisfied. These tainted tests deal with arm’s length, misuse/abuse provisions, lack of commercial substance and bona fide test. It is extremely important to have commercial substance in any transaction or an arrangement from the BEPS and GAAR perspective.

A great destination

In summary, India is a great destination for foreign investments by PE houses and funds. It allows them to capitalise and leverage on the growth story of India. Tax benefits and global tax reforms in line with international taxation regimes provide an extra reason for making investment decisions. However, one should also bear in mind practical nuances and adhere to the local provisions to make required reporting to, and compliance with, the government authorities in a timely manner. 

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Uday Ved




T: +91 982 005 8327


Uday Ved is the lead partner in the global tax practice group at KNAV, based in the Mumbai office. He has been national head of tax for KPMG India, global tax partner at Anderson India and co-head of tax at RSM, India.

Uday’s career spans over 30 years, during which he has worked in M&A, inbound and outbound tax structuring, cross-border transactions and global reorganisations. He has often been nominated as a leading tax adviser by Euromoney.

Uday is an adviser and on the board of Taxsutra, a leading India tax portal, and often speaks about tax issues on various news channels.

Amitabh Khemka




T: +91 982 129 8432


Amitabh Khemka is lead partner, global indirect taxes at KNAV. He has over 20 years of experience in indirect tax including with KPMG India, Vodafone India, BMR Advisors and Sthir Advisors.

Amitabh’s experience includes tax-cost optimisation, tax efficiency opportunities, transaction structuring and supply-chain mapping, risk mitigation, standardisation, automation and implementation of tax processes, advocacy and litigation.

Amitabh was a member of the working group on GST (a sub-group of the Empowered Committee of State Finance Ministers in India) and is a member of the National Taxation Committee of the Confederation of Indian Industry, the Indirect Taxation Committee of Assocham and the Indirect Taxation Committee of the IMC Chamber of Commerce.

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