Budget 2012 proposal may make private equity, venture funds investment difficult

MUMBAI: Private equity firms and capital venture funds, eyeing stakes in companies, will find it tougher to make investments in the country if a Union Budget proposal becomes a law. The proposed rule requires firms to pay income tax on the premium they have charged over their fair market value while selling shares to unregistered investors, including private equity or venture funds.

Though the government's plan to introduce this clause is aimed at curbing money laundering, investors and tax consultants say the move could also hinder genuine deals.

"The move effectively sounds the death-knell for the private equity industry as many of them are not registered as venture capital funds," said UR Bhat, managing director, Dalton Capital India.

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The Union Budget memorandum says share sales to venture capital company and venture capital fund are exempt from the provision.

Majority of the stake sales in companies to investors are usually sealed at a premium to the fair market value. Existing rules allow companies to determine the fair market value at their book value. The premium usually depends on factors such as market conditions and cash flow.

For instance, if the face value of a company's stock is 10 and the fair market value (or book value) is 20, it can sell the stock to any investor at any price depending on the negotiations without paying any taxation. The new provision in the Budget says if the face value is 10, the fair market value is 20 and the shares are sold to the investors (other than registered venture capital funds) at 30, the company will have to pay income tax of 30% (along with cess) on the 10 premium it received over the fair market value.

"The government's intention is discourage transactions where buying shares at a steep premium is a typical modus operandi to park unaccounted money," said senior chartered accountant Dilip Lakhani.

However, the new provision is yet to specify the calculation of the fair market value, which is likely to be the biggest bone of contention, is such deals.

"A definition of the fair market value aligned to the book value, as is the case under existing law, would create huge issues for any new investment," Gautam Mehra, executive director, PricewaterhouseCoopers.

A bigger irritant for companies will be that they will be at the mercy of the tax assessing officers to determine the fair market value.

"Under the new provision, private companies will have to necessarily issue shares based on the fair price calculated by them subject to the satisfaction of the assessing officer or at the prescribed method," said Prafulla Chhajed, a Mumbai-based chartered accountant. "If it fails to do so, the assessing officer will treat such excess amount as business income," he said.

Companies in the so-called sunrise industries and those who rely on estimated discounted cash flows could be affected the most as majority of the deals happen on future projections.

"The step to allow the tax assessing officer to virtually decide the terms of a deal is absolutely draconian," said Bhat. The new rule could lead to lot of litigation as there is lack of clarity on determining the fair value, said Ajit Tolani, Associate Partner, Economic Laws Practice.

This new tax provision comes on the heels of a Sebi proposal to categorise fund pools into nine formats including private equity funds, venture capital funds and private investment in public equity (PIPE funds) among others. The classification, which comes under Sebi's alternative investment fund (AIF) regulations, could hinder private equity investments into unlisted companies.