India budget promotes foreign investment, clarifies PE tax

One significant clarification applies to the indirect transfer provision of the 2012 Income Tax Act, which many investors feared could tax foreign portfolio investors (FPI) exiting Indian companies. The government plans to issue a clarification exempting investors from taxation on selling shares that have already been taxed, as well as exempting Category I and II FPIs, which includes most PE and VC funds, from the indirect transfer provision entirely.

The government also plans to extend existing tax incentives. For instance, the income tax exemption for start-ups, which was announced in last year’s budget and which eliminates taxes on any profits in three of the first five years of a start-up’s life, will be expanded to apply to three of the first seven years. Some GPs had criticized the previous limit, noting that start-ups often do not reach profitability within the first five years anyway.

The tax changes were part of a package of regulatory changes proposed by Finance Minister Arun Jaitley in his annual budget address aimed at encouraging more foreign direct investment (FDI) in India. The government's success in this area was a theme of the speech, with Jaitley noting a 36% increase in FDI from 2016-2017.

However, while some measures could provide long-requested tax clarity to investors the government introduced confusion in other areas, with an announcement in the budget memorandum that the current capital gains tax exemption on sales of shares on the open market will be ended unless the investor paid securities transaction tax (STT) at the time of purchase. This proposal was introduced as a means to limit tax avoidance, but market watchers noted that it could lead to a substantial tax burden for PE and VC investors and employee stock ownership plans (ESOP), since unlisted stocks are not typically subject to STT. India’s revenue secretary has promised more detailed rules to exempt these investors.

Along with the tax measures, Jaitley announced that the government plans to shut down the Foreign Investment Promotion Board (FIPB), which is required to approve FDI that does not come under the automatic route. Due to previous reforms that expanded the automatic route to cover more than 90% of FDI inflows, and the successful implementation of e-filing and online processing for applications, the government believes that the FIPB has served its purpose.

The budget also included a review of the progress of the government’s demonetization policy implemented last November, under which INR500 and INR1,000 banknotes were removed from circulation. Jaitley emphasized the measure’s importance for ending tax evasion and counterfeiting and formalizing the Indian economy, and indicated that issuance of new notes is accelerating and will soon reach a comfortable pace. He said that any economic impact from the policy is expected to be limited to this year.

Indian PE investors have generally expressed optimism about the long-term effects of demonetization, but have advised caution in the short term due to temporary reductions in earnings for portfolio companies while the amount of money in circulation returns to the previous level. The financial technology industry is expected to make big gains as previously cash-reliant small vendors reconsider their options.

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• Topics
• South Asia
• Regulation
• GPs
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• India