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Private Equity

A case study
June 24, 2008

Contents

Typical investment / operating structure

Outline of the structure

Income-tax issues

Analysis

Conclusion

June 24, 2008

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Private Equity A case study

Typical investment / operating structure


US investors

Non-US investors

GP Company

US based Fund
Manager

100%
Cayman Islands
Fund

Investment
management
agreement

100%

Mauritius Company

Investment
advisory
agreement

Invest in shares
of Indian Cos

Outside
India
In India

Indian Co 1

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Indian Co 2

Indian Co 3

Private Equity A case study

Indian advisory
company

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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Private Equity A case study

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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Private Equity A case study

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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Private Equity A case study

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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Private Equity A case study

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

IACs 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--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)]

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Private Equity A case study

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.

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Private Equity A case study

Thank you

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