Passage to India

The allure of India has been felt by the full spectrum of private equity, from buyout big-boys like The Carlyle Group to early stage venture firms like Canaan Partners (profiled on p. 14). Warburg Pincus has long been active in India through its global funds, while newcomer The Blackstone Group entered the country last year and is reportedly planning a $500 million India fund.

Limited partners large and small also are attracted to the country's growth prospects, and a number of Asia- and Indiafocused funds of funds have emerged to capture some of this demand.

The increasing flows of private equity capital into India have led to a change in the way US-sourced investment is structured in the region, and with this to new tax considerations. It used to be that most India-related investments were made through US companies with Indian subsidiaries, but within the changing landscape, there are more instances of direct investments by US private equity funds in India.

For a GP, ?investing in private equity in India is very different from investing in private equity in the US. There are many things we take for granted in terms of clarity and workability of the law, and that doesn't apply in India,? says Jonathan Axelrad, a partner in the fund services group at Wilson Sonsini Goodrich & Rosati law firm. ?Private equity and venture capital are still pretty new in India, and people are struggling to achieve US-style transactions in the context of a legal system that hasn't fully caught up.?

Perhaps the most challenging part of investing in Indian companies comes in the form of the fund structure. Here, the considerations for the GP – and the lawyers helping the GP structure its fund – boil down to a few key goals, says Axelrad. By no means should a fund structured for Indian investment be ?unduly burdened? by the many jurisdictions involved. At the same time, limited partners should both understand and be comfortable with the structure. Specifically, a key goal of the structure should be to avoid having to pay unnecessary taxes which – in the case of India – first involves enabling the fund itself to be free of Indian tax liability.

In a well developed fund structure for investing in India, a GP is dealing with the laws of at least three or four jurisdictions: India, Mauritius, the Cayman Islands, and any jurisdiction where the investors are based. In this article, we trace the path of capital leaving the pockets of a hypothetical US-based institutional investor through a private equity limited partnership to its ultimate destination in an Indian company, making sure to point out the regulatory highlights along the way. The chart on page 21 provides a visual representation of the structure.

Borne in the USA
Starting with the tax needs of a typical US limited partner in mind, a smart fund structure will take into account tax-exempt investors, although this isn't much of a challenge.

?From the perspective of a hypothetical LP, if you are normally a tax-exempt investor, any tax at all being imposed on the fund is a shock to you. You're not used to paying taxes at all on capital gains,? notes Axelrad. ?If you invest through a fund and the fund itself has to pay Indian taxes, that's going to be a surprise and you will want to know why the structure used for the fund subjects you to tax, when the GP could have set up a structure intended to avoid such tax.?

The largest US investors in private equity funds continue to be public and private pension systems, endowments and foundations, which may have slight variations on how they deal with taxes. For the most part, notes Axelrad, pension funds – be they public or private – want to be treated as tax-exempt entities. Whether a pension fund investor is private and subject to unrelated business taxable income (UBTI), or is public and may not be subject to UBTI, tends not to have a strong impact on how they would prefer a private equity fund be structured to invest in India versus one structured to invest in the US, says Axelrad.

With regard to UBTI, the fundamental issue is whether the underlying portfolio company held by the private equity fund is treated as a corporation for US tax purposes. Typically it is not all that complicated, under the US check-the-box-rules, for a foreign entity to be treated as a US corporation for US tax purposes, and not a pass-through entity, says Axelrad. Most funds have a covenant in the partnership agreement to use reasonable efforts to avoid UBTI, which can generally be accomplished by ensuring that portfolio companies are treated as corporations for US tax purposes.

?From the perspective of the fund's LPs, the presence of the fund in India does not pose any special significance,? says Brian McDaniel, a senior associate and an India specialist in Wilson Sonsini's funds group. ?LPs will want to have covenants in the fund's partnership agreement to avoid bad tax outcomes. However, foreign-based fund managers and portfolio companies may require substantial guidance as to how to comply with these rules.?

Don't miss the Caymans
In terms of where to actually domicile a non-US-facing private equity fund, the Cayman Islands typically is the preferred jurisdiction, whether the fund will invest in India or other jurisdictions outside of the US. There are three reasons for this. First, the Caymans do not impose their own taxes on the fund. Second, Cayman Islands partnership law is quite similar to that of Delaware, the preferred US corporate domicile. And third, many investors are already familiar with investing through a Cayman entity.

While not an India-specific issue, private equity GPs should keep in mind that, when proposing to invest in a foreign corporation, they will have to consider whether the foreign corporation they are investing in will be treated as a ?controlled foreign corporation? under US tax law. The impact for investors who hold 10 percent or more of the foreign corporation includes the potential for US taxation of the investor's pro rata share of the controlled foreign corporation's ?subpart F? income – which generally includes passive income such as bank interest – along with the possibility of having a portion of the gains recognized from the sale of stock of a portfolio company being recharacterized as ordinary income, rather than capital gain, says John Chase, a senior associate at Wilson Sonsini's tax group. On this issue, an additional advantage of organizing a fund outside of the US in a jurisdiction like the Cayman Islands is that it greatly reduces the risk that a fund's investment in a foreign company will cause it to be a controlled foreign corporation, adds Axelrad.

According to McDaniel, the disadvantage of skipping the Caymans leg of the journey and going straight to a jurisdiction with friendly tax relations with India – the most popular such jurisdiction being Mauritius – is that Mauritius does not have a limited partnership structure, while the US and Cayman Islands do.

Going straight to Mauritius creates a ?relationship between the investor and the fund manager that is governed by a shareholders' agreement [for Mauritius-based funds]. The enforceability of a shareholders' agreement is not as certain as a limited partnership agreement, and in general, investors are less comfortable with investing directly in a Mauritius structure,? McDaniel says. By setting up the fund in the Cayman Islands, the GP can still provide investors with the tax objective of investing through Mauritius, while at the same time presenting LPs with a fund structure that they are familiar with.

?The technique of having both a Cayman Islands limited partnership for the fund and one or more Mauritius subsidiaries is actually relatively new,? says McDaniel. ?Our experience is that many firms miss the advantages of the Cayman structure by having LPs invest directly into a Mauritius-based entity.?

What happens in Mauritius
To avoid the issue of having a fund's portfolio investment activity be taxable on capital gains in India – which may be the case if a Cayman Islands-based fund invests directly in India – the preferred approach is to have the Caymans fund create one or more subsidiaries in a jurisdiction which holds a favorable tax treaty with India, such as Mauritius, Singapore or Cyprus. As mentioned above, of these jurisdictions, Mauritius tends to be the most popular for investors seeking to access India, due to the availability of local administrators and other administrative conveniences, notes Beena Chotai, chief financial officer of Indian private equity firm ICICI Venture.

There are two types of entities that can be organized in Mauritius: Global Business Company (GBC) Type 1 and GBC Type 2. Type 2 entities are restricted to activities within Mauritius, while Type 1 companies can have activities outside of Mauritius.

?The Mauritian government has a variety of restrictions on what's required to form these entities, and one of these is to have a board of directors with at least two local Mauritius directors,? says McDaniel. ?Typically, you see investment funds create a Type 1 subsidiary in Mauritius and forming a board of directors comprised of fund managers and two Mauritius persons who are engaged to serve on the board of directors of the Mauritius entity.?

Through the India-Mauritius Avoidance of Double Taxation Treaty, Mauritius subsidiaries can then invest in Indian portfolio companies while not being subject to capital gains tax in India.

?Even Indian funds that are targeted at early-stage or midstage companies may want to consider forming both FVCI and FII investment subsidiaries.?

For a fund's subsidiaries to qualify for the India-Mauritius double taxation treaty, they must not have a ?permanent establishment? within India. The most important part of avoiding permanent establishment is ensuring that investment decisions are made outside of India.

The legal advice on how best to approach the investmentdecision issue – which impacts the structure of the investment committee – will hinge upon how conservative the legal advisors are and how conservative they are asked to be by the GP, as well as the actual composition of the investment team, says Axelrad.

One way of addressing the issue is to make sure that a majority of the investment committee members qualify as non-Indian residents. A more conservative approach would be to avoid having any Indian residents on the investment committee. At first glance this would seem to mean that investments in India need to be made by people who are not actually Indian. In fact, to allow Indian residents to have a say in the investment activities of the fund, the agreements might, for instance, state that investments can be proposed by any member of the team but the investment committee has the final decision to approve or veto investment proposals.

Inside India
Investing in India can be a tricky matter and, unless some sort of special qualification from the Indian government is obtained, an investor could find itself subject to a variety of regulations, such as pricing regulations, statutory lock-ups, minimum prices at which one can purchase or sell shares in a company, and restrictions on the kinds of securities one can own.

The way that foreign investors in India avoid many of these regulations is typically by applying for one of two routes to make investments in India: registering as a foreign venture capital investor (FVCI) or as a foreign institutional investor (FII). Under the FVCI and FII programs – which are administered by the Reserve Bank of India and the Security Exchange Board of India (SEBI) – ?one can be largely exempted from the illiberal regulations that restrict investment pricing and the lockup requirements,? says McDaniel.

These two programs are aimed at slightly different investment targets. Generally speaking, the FVCI is applied to exempt investors in private companies, and the FII is used to exempt investors of publicly listed companies.

?An entity has to qualify separately either under the FVCI or FII program – one entity can't be qualified as both,? says McDaniel. For funds that intend to invest only in private companies or only in public companies, they might apply only as a FVCI or FII company respectively. If a fund is going to invest in both private and public companies, then it will need to set up two separate investment subsidiaries – one FVCI and one FII.

?The exemptions available under the FVCI program also apply to companies that list after the investment,? says McDaniel. ?There is no need to separately apply under the FII program for private companies that later go public.?

However, according to McDaniel, companies may be listed in India at a much earlier stage than in the US. ?As a result, even Indian funds that are targeted at early-stage or mid-stage companies may want to consider forming both FVCI and FII investment subsidiaries,? he says.

According to McDaniel, many of the funds advised by Wilson Sonsini have chosen to set up and register both FVCI and FII subsidiaries. He notes that since the FVCI and FII companies are essentially wholly owned subsidiaries of the Cayman Islands fund, their addition presents little additional complexity to the overall fund structure, while providing the fund with the flexibility to invest in privately held or publicly listed companies in India.

Once the proper fund structure is in place, private equity GPs are poised to face the real challenge – identifying, investing in and growing promising Indian companies. Success in this endeavor will create wealth in India and send profits home through Mauritius, the Caymans and finally to the coffers of overjoyed US limited partners. Not every GP will succeed of course, which will mean a number of one-way passages to India.