Why PE Investors May Be Staring At Taxing Times

The Central Board of Direct Taxes (CBDT) in May this year issued a circular on the tax liability on income arising from transfer of unlisted shares. It was an unsettling move for the country's major private equity (PE) investors because the body gave its assessing officers the right to decide whether a particular case should be taxed under capital gains or business income or not.

The move, according to the CBDT is taken "with a view to avoid disputes/litigation and to maintain uniform approach that the income arising from transfer of unlisted shares, irrespective of period of holding, would be taxable under the head capital gain, except in certain circumstances where the assessing officer would examine the issue and take an appropriate view". In February, the CBDT had issued a similar circular on transaction of shares of listed companies.

Investors, however, have taken an unfavourable view of the latest decision.

A look at why the new circular is keeping private equity investors on tenterhooks:

• Typically, the sale of shares of unlisted companies is treated as capital gains. However, the circular states that it would now be an assessment officer's prerogative to decide whether a particular transaction should be treated as business income or not. While the circular lays down certain ground rules on the parametres based on which a tax category could be marked, according to experts, when assessment officers will have the right to decide the category under which a transaction falls, they would 'invariably' put it under the head of business income. It is to be noted that while capitals gains tax on a transaction ranges between 22 and 33 per cent, business income is taxed much higher and could be in the range of 30 to 40 per cent.

• In its February circular, the CBDT had clearly stated that while “it recognised that no universal principle in absolute terms could be laid down to decide the character of income from the sale of shares and securities”, it instructed its assessing officers to decide whether the “surplus generated would be treated as capital gains or business income”. This decision on the sale of listed shares, which has now been extended to unlisted ones, according to the tax department, was done to reduce litigation and uncertainty. However, industry experts fear that owing to the lack of a set definition and the discretion individual officers, transaction of shares in the unlisted businesses would see a lot of litigations.

What could be the likely impact?

• In a hope that the Opposition may urge the government to change norms, PE investors would wait and watch before they plan an exit from their investments. This would lead to the number of PE transactions seeing a remarkable reduction. Simultaneously, this may also dry up the liquidity from the market.

• Any uncertainty on rules and regulations can be discouraging for investors' sentiment. Startups, for instance, would find it hard to attract funds if investors have to pay more taxes on existing businesses. The overall market sentiment may turn gloomy.