Passage to India

Author: | Published: 1 Apr 2007
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These are interesting times for India. Venture capital and private equity are not alien to Indian entrepreneurs. India's IT industry could once claim the greatest acquaintance with VC/PE funds but, today, more than a few sectors of the Indian economy have a story to tell.

There are three broad schemes for investment in India:

  1. Foreign direct investment is the standard vanilla route for bringing in foreign exchange.
  2. The foreign venture capital investor route is a special facility for investors incorporated outside India that propose to invest in venture capital undertakings, meaning unlisted Indian companies. Foreign VC investors must be registered with the Securities and Exchange Board of India (SEBI). Foreign VC investors are mostly involved in primary investment.
  3. The foreign institutional investor scheme for investment in listed companies in secondary markets and subject to SEBI registration.

VC and PE investment is primarily governed by central (federal) authorities. The regulators are the Foreign Investment Promotion Board (FIPB) under the Department of Economic Affairs, Ministry of Finance; the Reserve Bank of India (RBI), India's central bank; and SEBI, the Indian counterpart to the US Securities Exchange Commission and regulator of the capital markets. SEBI regulates domestic venture capital through the SEBI (Venture Capital Funds) Regulations 1996 (VC Regulations) and foreign venture capital through the SEBI (Foreign Venture Capital Investors) Regulations 2000 (FVCI Regulations).

Model investment structure

Depending mostly on tax considerations, the model for VC investment in India involves an offshore entity, which will be registered with SEBI as a foreign VC investor. Mauritius remains a favourite destination for setting up offshore entities.

The offshore entity could be 100% owned by a company set up in the same or another jurisdiction, or it could be funded directly by contributors subscribing to its units.

This SEBI registered-offshore entity invests in VC undertakings.

It is possible for a VC or a PE to invest directly, under the foreign direct investment scheme, and often one-off PE investments are based out of jurisdictions that are not always the acknowledged tax havens, under the restrictions of the foreign direct investment scheme, including pricing guidelines for shares issued and transferred and corresponding filing requirements.

Indian markets are no longer closed to foreign investment. In fact, the negative list of industries for foreign direct investment has shrunk to sectors such as retail trading, real estate, print media, broadcasting, defence and insurance and even this restricted category comes with exceptions. The foreign VC investor route is preferred because of its benefits under existing Indian law.

Benefits for foreign VC investors

Press Note 1 (2005 Series) (PN1) liberalizes the regime of Press Note 18 (1998 Series), which denied the automatic route to foreign investors who have or had an existing joint venture, trade mark or technology transfer agreement in the "same or allied field" as the proposed new investment. Such a foreign investor was required to obtain FIPB approval subject to proving that the new investment would not harm existing joint ventures or its Indian shareholders, and a no-objection certificate from its Indian partners to this effect was needed.

PN1 requires that FIPB approval needs to be obtained only when the new investment falls under the same field as the foreign investor's existing venture and restricts the approval requirement to existing ventures. SEBI registered funds are exempt even from the limited PN1; their investment would be automatically approved despite previous investment in the same field as their new investment.

As a precautionary measure, VC and PE funds not registered with SEBI obligate Indian partners, as part of investment documentation, to submit a no-objection certificate, and procure a declaration that investment by the PE/VC fund in another entity in the same field would not harm their interests. An exception in favour of Indian partners is often made for direct competitors, based on geographical or other factors.

Regulations issued under the Foreign Exchange Management Act 2000 cover foreign exchange flows into, and out of, India. There has been substantial liberalization of processes and procedures, but a company issuing shares or resident shareholders in an Indian company seeking to transfer their shareholding to non-residents, are required to comply with the (minimum) pricing requirements for the issue or transfer.

Foreign VC investors registered with SEBI are allowed to acquire equity, equity-linked instruments, debt, debt instruments or debentures of a VC undertaking or VC fund through an initial public offer or private placement or in units of schemes/funds set up by a VC fund. The price for the securities is freely determinable between parties. Foreign VC investors registered with SEBI are exempt from the pricing norms governing sale or issue of securities by residents to non-residents.

VC/PE investors could structure their exit from unlisted companies through an initial public offering made by the investee company within a certain time frame specified in the investment documentation.

The SEBI (Disclosure and Investor Protection) Guidelines 2000 (DIP Guidelines), among other regulations, govern initial listing of shares of domestic companies on Indian stock exchanges. The DIP Guidelines aim to safeguard public investor interests and towards this purpose identify the promoters associated with the company that proposes to list. This practice of close identification is also applied to persons investing in the company before its listing. One of the outcomes of this identification is a lock-in requirement for the mandated minimum promoters' contribution in the post-issue listed capital of companies.

Provisions governing lock-in require the entire pre-issue capital, excluding capital locked in as promoters' contribution, to be locked in for a year from the date of allotment in the proposed IPO. Keeping in mind the larger object of VC funding, however, SEBI-registered VC funds and foreign VC investors are exempt from lock-in requirements and may exit the company as soon it is listed on an Indian stock exchange, provided the shares have been held by the foreign VC investor or VC fund for a year before the date of filing the draft prospectus. The DIP Guidelines also specify that shares held by a SEBI-registered fund must be locked in, if at all, in accordance with the VC Regulations and FVCI Regulations.

It is possible for existing shareholders to exit through an offer for sale of their shareholdings. If the offer for sale is to more than 50 persons, the offer is deemed to be made to the public and will be subject to the DIP Guidelines, including satisfaction of eligibility norms for listing shares and prescribed forms and disclosures of the offer document. If the public offer for sale is made of shares in a company that proposes to list on an Indian exchange, lock-in requirements will not apply to the capital offered for sale, provided it has been held for at least one year at the time of filing the draft offer document with the SEBI.

These provisions might be of interest to a vanilla PE fund, not registered with SEBI, if it desires to structure an offer-for-sale mechanism as part of its exit options.

The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 1997 (Takeover Code) govern transfer and acquisition of shares. Certain thresholds of shareholding in a listed company, when crossed, would trigger public offer requirements of the Takeover Code. There is an exemption for SEBI-registered funds when they transfer shares to a VC undertaking or to its promoters, pursuant to an agreement with the promoters or VC undertakings.

VC funds and foreign VC investors, registered with SEBI, are also defined as qualified institutional buyers or QIBs under the DIP Guidelines and can therefore participate in the bookbuilding process, subject to restrictions under the VC Regulations and FVCI Regulations.

Conditions for foreign investment

Foreign VC investors cannot buy securities in public market transactions. Private investment in private and public companies, and purchases of securities pursuant to an IPO are permitted.

Investment conditions under FVCI Regulations require at least 66.67% of investible funds invested in unlisted equity shares or equity-linked instruments of VC undertakings.

No more than 33.33% of investible funds may be invested by way of subscription to IPOs of VC undertakings; debt or debt instruments of the same VC undertaking in which investment has been made in equity shares; preferential allotment of equity shares of a listed company subject to a lock-in period of one year; equity shares or equity-linked instruments of a financially weak company or a sick industrial company whose shares are listed; or special purpose vehicles created to facilitate or promote investment in accordance with the FVCI Regulations.

The lock-in requirement for shares acquired pursuant to a preferential issue reads well with similar provisions in the DIP Guidelines.

Besides these conditions there are disclosure and reporting formalities at the time of application and for continued registration as a foreign VC investor.

There is no relaxation in the norms for eligibility for listing shares of a company that has VC/PE investment.

Tax issues

Section 10(23FB) of the Income Tax Act 1961 (the ITA) exempts from taxation any income of VC funds set up to raise funds for investment in VC undertakings, subject to the conditions that the fund is registered with SEBI and fulfils conditions notified by SEBI. A VC undertaking, for the purposes of the ITA, refers to its definition in the VC Regulations and is awarded the pass through status accorded to VC funds registered with SEBI. But this might soon change for domestic VC funds on April 1 2007 because this status has been taken away under the Union Budget 2007 and is available only for select sectors of the economy. There is also some doubt about the pass through status applying to foreign VC investors because provisions of the ITA refer only to VC funds. By interpretation and implication, the pass through is often attributed to foreign VC investors.

Section 10(23FB) must be read in conjunction with Section 115U of the ITA, which provides that the income derived by a person out of investments in foreign VC investors will be chargeable to income tax as if it were income derived from an investment in the VC undertaking directly. This income consists mostly of dividends, interest and gains in sale of securities in India.

Dividends declared by an Indian company are exempt from taxation in India in the hands of the investors. However, the portfolio company pays a dividend distribution tax of 14.025% (about 17% in 2007-2008) on the dividends it distributes. Dividends earned by the VC fund or foreign VC investor are exempt from taxation in the hands of its contributors/investors.

Interest income in the hands of a non-resident contributor is taxable at the slab rates, with a maximum marginal rate of 30% (plus surcharge of 10% where total income exceeds Rs10 million ($226,000) during the relevant year and education cess of 2%) and, where contributor is a foreign company, of 40% (plus surcharge of 2.5% and education cess of 2%).

It might be possible for the foreign VC investor to avail concessional tax treatment in terms of Section 115A(1)(a) of the ITA, which states that interest received by a non-resident (not being a company) or a foreign company from a government or Indian concern on monies borrowed or debt incurred by a government or Indian concern in foreign currency is chargeable to tax at the rate of 20% (plus surcharge of 2.5% and education cess of 2%).

Because this tax treatment is available only in respect of monies borrowed or debt incurred in foreign currency, it is unclear whether tax authorities would allow the benefit of Section 115A(1)(a) in respect of investment made by foreign VC investor in a VC fund, and a subsequent loan given by the VC fund to the VC undertaking, in rupees.

Liability for capital gains tax depends on residential status and the period for which securities are held. Where securities are held for more than 12 months, long-term capital gains tax applies on their transfer. If the holding period is less than 12 months, short-term capital gains tax is payable.

Where securities are listed on recognized stock exchanges, securities transaction tax at 0.125% is levied on their transfer and the transfer is exempt from payment of long-term capital gains tax. Where transfer of securities qualifies for securities transaction tax, short-term capital gains tax is levied at 10%. The normal rate for short-term capital gains for foreign companies is 40% (plus surcharge of 2.5% and education cess of 2%, no surcharge payable if total income exceeds Rs10 million).

If non-resident contributors are tax residents of a country with which India has signed a double taxation avoidance agreement (DTAA), their tax liability is determinable at the domestic tax rate or at the rate provided in the DTAA, whichever is more beneficial to the contributor.

Beneficial tax treaties face the ire of a section of the Indian public offended by alleged post box companies from destinations such as Mauritius gaining unfair advantage. The issue of substance in tax havens is likely to garner much attention in political circles, despite the ruling of the Supreme Court of India in the Azadi Bachao Andolan case upholding the DTAA between India and Mauritius.

A vanilla PE investor might not be entitled to the benefits of pass through status but it would be generally subject to similar principles of taxation for income earned from its India investments.

The tax laws and rates will be revised with the Union Budget 2007 effective April 1 2007.

The investment

Investment in portfolio companies could be a mix of equity and debt, for foreign VC investors, subject to the FVCI Regulations. Often, this investment is a mix of equity and preference shares, the latter being shares with non-voting rights that have priority in respect of a fixed rate of dividend claim on arrears of dividend when the company is wound up. Preference shareholders' voting rights at shareholders' meetings trigger on non-payment of dividend for a consecutive period of two years.

Investment could be structured in tranches and provide for conversion of preference or debt into equity capital on achievement of milestones. Preference and debt components do not have voting rights, and investors participate as members of the company through minimal equity holdings and minority rights detailed in shareholders agreements.

The terms of the shareholders agreement may be enforced against a company only if they are incorporated in its articles of association. It is customary to include an obligation on the part of the company to incorporate terms of the shareholders agreement in its articles.

With listed companies, investors are often faced with the dilemma of whether SEBI's insider trading regulations would affect their due diligence of the company and often term sheets state that the diligence may only be carried out on information that is not unpublished and price sensitive.

It is necessary to maintain a distinction between promoters and investors in the target, in letter and spirit, to guard against applicability of the Takeover Code because of clubbed promoter and investor shareholdings.

Stamp duty (regulated mostly by the separate states of the Indian union and sometimes at the federal level) payable on executed documents is a concern when deciding the place of execution of agreements, their ultimate destinations, including the place where records will be maintained and choice of jurisdiction. Failure to pay appropriate stamp duty renders documents inadmissible as evidence in Indian courts. The duty is generally payable by the purchaser unless otherwise agreed.

It is the peculiarity of PE/VC investment to impose non-compete covenants on promoters and management of the target. Case law suggests that these covenants may be enforceable despite being restrictive trade practice, but their enforceability regarding individuals might not be welcome assertions before the Indian courts if they are perceived to be restricting them from practising their trade or profession. Much would depend on facts.

Structured exits and restrictions on transfer featured in VC and PE documentation must be stated in the articles to be enforceable, and must also not violate the Companies Act 1956. Precedents, including judgments of the Supreme Court of India, suggest that courts frown upon agreements restricting transferability of shares in public companies because the Companies Act mandates free transferability of shares as a defining feature of public companies. Sometimes Indian courts have mandated that the shareholders agreement may also be unenforceable inter se shareholders in absence of their incorporation in the articles and/or for violating principles of free transferability.

From recent debates regarding the Hutch-Essar and Sterlite-Government of India cases, the matter of enforceability of shareholders agreements swings somewhere between free transferability under the Companies Act and reconciliation of this principle with the right to encumber movable property under Indian sales law, shares being movable assets.

Foreign VC investment in Indian real estate drew flak from the RBI recently and was seemingly unwelcome in realty-oriented VC undertakings as there is no system for regulating compliance with the conditions for foreign direct investment in real estate in these cases. But that RBI has started approving these investments on an undertaking that the investments will be complaint with foreign direct investment rules.

Despite its nuances and pitfalls (and seemingly contrary feelers sent out by the government), an estimated $7.46 billion was invested in 2006, which was three times the amount invested in India in 2005, and the number of deals exceeding $50 million rose from nine in 2005 to 26 in 2006. India remains a happy destination for venture capital investment.

Author biographies

Haigreve Khaitan

Khaitan & Co

Haigreve Khaitan has rich experience in all aspects of project finance and financing, mergers and acquisitions (due diligence, structuring, documentation involving listed companies, cross-border transactions). In securities law he provides advice and documentation relating to domestic initial public offers, international issues of securities by Indian companies, takeovers and other public offers, buyback of securities, and reduction of capital etc. In restructuring he advises on creditors restructuring, sick companies, demergers, spin-offs, and sale of assets. His privatization work covers privatization of government businesses and companies in India on behalf of several bidders. He advises on foreign investment, joint ventures and foreign collaboration – obtaining regulatory approvals, joint ventures and licensing, shareholder agreements and arrangements, technology transfers, import of plant and equipment. His finance work involves advice and documentation relating to corporate financing, debt issues, trade financing, project financing (including concession agreements, construction contracts, operation and maintenance contracts) and creation of security. He handles commercial and software contracts, such as licensing, transfer of technology, and trade agreements, and also handles litigation work.

He advises a range of large Indian and multinational clients in various business sectors, including infrastructure, power, telecom, automobile, engineering, steel, cement, agriculture and agri-products, software and information technology, retail, and services.

Avaantika Kakkar

Khaitan & Co

Avaantika Kakkar is a member of the corporate, securities and funds team in the firm. She specializes in all aspects related to M&A deals, private equity investments, initial public offerings, overseas listings, acquisitions on stock markets, environment legislation and liability issues, insider trading, foreign exchange laws, contract law, employees stock options, software technology parks of India and tax holidays, transaction document work, employment agreements, structuring and advising international and local private voluntary organizations, drafting media agreements and due diligence. She has authored a comprehensive text titled A Perspective on Product Liability Law and Consumer Safety.

Ravi Kulkarni

Khaitan & Co

Ravi Kulkarni has immense experience in all aspects of project financing and mergers and acquisitions (due diligence, structuring, documentation involving listed companies, cross-border transactions). In securities law he provides advice and documentation relating to domestic initial public offers, international issue of securities by Indian companies, takeover and other public offers, buyback of securities, and reduction of capital. His capital markets-related work includes IPO/GDR/FCCB issues. In restructuring his work involves creditors restructuring, sick companies, demergers, spin-offs, and sale of assets. He provides advice and documentation in relation to privatization of government businesses and companies in India on behalf of several bidders. He advises on foreign investment, joint ventures and foreign collaboration – obtaining regulatory approvals, joint ventures and licensing, shareholder agreements and arrangements, technology transfers, and import of plant and equipment. In financing he provides advice and documentation relating to corporate financing, debt issues, trade financing, project financing (including concession agreements, construction contracts, operation and maintenance contracts), creation of security. He drafts commercial and software contracts – such as licensing, transfer of technology, and trade agreements and has also handled litigation work.

He advises a range of large Indian and multinational clients in various business sectors, including infrastructure, power, telecom, automobile, engineering, steel, cement, agriculture and agri-products, software and information technology, retail, and services.