Venturing into India: A Legal and Structural Overview of Indian Private Equity

Siddharth Shah, Nishith Desai Associates

India continues to attract substantial portion of the global private equity capital. Backed by a strong IT services sector and the more recent IT enabled services (more commonly understood as business process outsourcing), India continues to be on the radar screen of most global private equity players. In 2002, during the period Jan-December, India attracted private equity investment of USD 980.18 million and fourth after in the Asia Pacific region only after South Korea, Japan and Australia (Source: AVCJ Journal: December 2002). China which continues to be India's closest competitor in the Asian region, attracted private equity investments of USD 423.22 million which is way below that of India (Source: AVCJ Journal: December 2002). The investment for the year 2002 is lower than the total private equity disbursements that happened in the previous year, which stood at USD 1.2 billion. This potentially reflects the global slow down faced by almost all economies throughout the year 2002. The annual private equity disbursements in India have grown significantly over the past several years and as per the IVCA (Indian Venture Capital Association), the private equity investment is likely to touch USD 10 billion by 2007-08. A snapshot of the Indian private equity scenario is given below:

Year Rupees (in millions) US Dollars (in Millions)
1996-97 700 20
1997-98 3,200 80
1998-99 10,520 250
1999-2000 21,600 500
2000-01 54,700 1,200
2001-02 52,000 1,100
2007-08 F 600,000 10,000

Source: Nasscom website

While these numbers may not look significant when compared to funds committed in other countries like the US and Israel, the players in the industry reckon that India is on its way to be one of the significant player in the world.


Domestic funds

For domestic venture funds (in which the funds are raised within India), the structure that is most commonly used is that of a domestic vehicle for the pooling of funds from the investors and a separate investment adviser for carrying on asset management activities. In terms of choice of entities for setting up the pooling vehicles, the choice is generally between a trust and a company. Unlike most developed countries, India does not recognize a limited partnership, which is a common choice of entity in countries like the US. On account of operational flexibility, trust structure has been the most favoured option for the domestic VCFs.

Offshore funds

Commonly there are two alternatives available to offshore investors participating in Indian venture capital investments. The offshore investors can either use an 'offshore structure' or a 'unified structure'.

Offshore structure

Under this structure an investment vehicle, which could be a LLC or an LP organized in a jurisdiction outside India, makes investments directly into Indian portfolio companies. There would generally be an offshore manager for managing the assets of the fund and an investment advisor in India for identifying deals and to carry out preliminary due-diligence on prospective investment opportunities. The structure is depicted in figure 1 below.

Figure 1: Offshore Structure

Unified structure

This structure is generally used where domestic (i.e. Indian) investors are expected to participate in the fund. Under this structure, a trust or a company is organized in India. The domestic investors would directly contribute to the trust whereas overseas investors pool their investments in an offshore vehicle and this offshore vehicle invests in the domestic trust. The portfolio investments are made by the trust. The trust would generally have a domestic manager or an adviser. The structure is depicted in figure 2.

Figure 2: Unified Structure

The Regulatory Framework

Domestic and offshore VC funds investing in India are regulated by the SEBI. Until recently, SEBI only regulated the domestic VC funds vide the SEBI VCF Regulations. India did not have any mechanism to regulate or monitor foreign VC/private equity investors although regulations existed for domestic VC funds. While this put the domestic VC investors at a disadvantage especially after foreign investment in most sectors were through the automatic route, the Indian government felt the need to monitor (if not regulate) foreign investment in the VC sector. In order to address this, in September 2000, in addition to bringing in some major reforms to the existing SEBI VCF Regulations, which apply to VC funds based in India, the SEBI also introduced a new set of regulations applicable to offshore funds, called the SEBI (FVCI) Regulations, 2000.

The SEBI (Venture Capital Funds) Regulations, 1996

Under the VCF Regulations, a venture capital fund can be organized either in the form of a trust or as a company. Though the guidelines do not appear to make registration with SEBI mandatory, SEBI has made its intention clear to regulate all domestic VCFs.

The VCFs are permitted to invest only in venture capital undertakings (VCUs) which are not engaged in activities which have been classified under the negative list which broadly includes undertakings engaged in real estate business, non-banking financial services, gold financing etc. Furthermore, the VCU has to be a domestic company whose shares are not listed on a recognized stock exchange, which effectively means that domestic VCFs are not permitted to invest in companies whose securities are listed on a stock exchange or in foreign securities.

Investment conditions and restrictions

VCFs are subjected to following investment conditions/restrictions.

  • Minimum investment to be accepted from any investor should be Rs. 500,000 (approximately USD 11,500) except in the case of employees, principal officers or directors of the VCF, employees of the manager of the VCF where lower amounts may be accepted.
  • Minimum capital commitments from its investors should be Rs. 50 million (approximately USD 10 million).
  • A VCF is not permitted to invest in associate companies. An "associate company" is defined to mean a company in which a director or trustee or sponsor or settlor of the VCF or the investment manager holds either individually or collectively, equity shares in excess of 15% of its paid-up equity share capital of VCU.
  • A VCF cannot invest more than 25% of its corpus in one VCU.
  • An VCF can make investments in VCUs subject to the following restrictions:
  1. atleast 75% of the investible funds has to be invested in unlisted equity shares or equity linked instruments.
  2. not more than 25% of the investible funds can be invested by way of:
  3. subscription to the initial public offer of a VCU whose shares are proposed to be listed subject to a lock-in period of one year;
  4. debt or debt instrument of a VCU in which the VCF (defined later) has already made an investment by way of equity.
  • The SEBI VCF Regulations restrict VCFs from listing their securities for a period of three years from the date of their issue.

Further, a VC fund registered under the SEBI VCF Regulations will be subject to investigation/inspection of its affairs by an officer appointed by SEBI and in certain circumstances the SEBI has the power to direct the VCF to divest the assets of the VCF, to stop launching of any new schemes, to restrain from disposing any assets of the VCF, to refund monies of investors to the VCF and also to stop operating in, assessing the, capital market for a specified period.

The SEBI (Foreign Venture Capital Investor) Regulations, 2000 ("FVCI Regulations")

Foreign private equity players can invest in India either directly under the foreign direct investment (FDI) regime or may invest under the Foreign Venture Capital Investor (FVCI) regime. To invest under the FVCI regime, the foreign investor is required to register with the SEBI under the FVCI Regulations. While it is not mandatory to register with SEBI as a FVCI, in order to encourage foreign investors to register with SEBI, several benefits have been granted to SEBI registered foreign venture capital investors ("FVCI"). These benefits have been discussed later in this article.

Eligibility criteria

The eligibility criteria for a FVCI registration are broad. In order to determine the eligibility of an applicant, SEBI would consider, inter alia, the applicant's track record, professional competence, financial soundness, experience, whether the applicant is regulated by an appropriate foreign regulatory authority or is an income tax payer or submits a certificate from its banker of its or its promoter's track record where the applicant is neither a regulated entity nor an income tax payer. The applicant can be a pension fund, mutual fund, investment trust, investment company, investment partnership, asset management company, endowment fund, university fund, charitable institution or any other investment vehicle incorporated and established outside India.

Investment conditions and restrictions

The investment restrictions applicable to FVCI are similar to those applicable to VCFs under the VCF Regulations (as listed above) except for the following:

  • no minimum corpus or capital commitment requirement for FVCIs;
  • no minimum individual contribution prescribed under the FVCI Regulations;
  • no mandatory exit clause in respect of investments by an FVCI in unlisted securities; and
  • for determining the maximum investment in a single VCU (i.e. 25% of the corpus), the funds earmarked for India will be taken into consideration.

The FVCI Regulations make it mandatory for a FVCI to appoint a domestic custodian for the purpose of custody of securities and for entering into an arrangement with a designated bank for the purpose of opening a special non-resident Indian rupee or foreign currency account. SEBI acts as a nodal agency for all necessary approvals including the permission of the Reserve Bank of India (RBI) for opening of the bank account.

In addition to the above investment conditions and restrictions, there are certain reporting and disclosure requirements that need to be satisfied by a registered FVCI on an continuing basis.

Benefits of FVCI registration

  • India still has exchange controls. While any fresh issue of shares by an Indian company in most sectors has been made automatic under the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 (FDI Regulations), any purchase of shares of an Indian company by a non-resident from a resident requires to be approved by approval of the Foreign Investment Promotion Board (FIPB) and the RBI. Such approval is granted on a case-by-case basis and generally takes approximately 6-8 weeks. However, as an FVCI, no prior approval of the FIPB or the RBI is needed for making investments into Indian VCUs either by way of fresh issue or by way of purchase from existing shareholders.

  • Under the FDI Regulations, for purchase of shares of an unlisted company by a non-resident, the minimum price to be paid by a non-resident is be linked to the net asset value of the shares. Similarly, for exits involving transfer from a non-resident to a resident, the exit price is capped at the price of the shares on the stock exchange (in case of listed company) or to the net asset value (unlisted company). However, a special exemption has been carved out for FVCI's in as much that an FVCI may acquire or sell its Indian shares/ convertible debentures/units or any other investment at a price that is mutually acceptable to both the parties. Thus, there are no entry or exit pricing restrictions applicable to an FVCI.
  • This could be a very significant benefit for FVCI's, especially in the case of a strategic sale or buy-back arrangement with the promoters at the time of exit from unlisted companies.
  • The transfer of shares from FVCIs to promoters is exempted from the public offer provisions under the SEBI (Substantial Acquisitions of Shares and Takeover) Regulations, 1997, if the portfolio company gets listed on a stock exchange post the investment. This ensures that if the promoters have to buy-back the shares from the FVCIs, they will not be burdened with the public offer requirement, which would otherwise require an offer to the other shareholders of the company to buy upto 20% of the paid-up capital of the company.
  • FVCIs registered with SEBI have been accorded the status of Qualified Institutional Buyer and are accordingly eligible to subscribe to the securities at the initial public offering of a VCU through the book-building route.
  • Under the SEBI (Disclosure and Investor Protection) Guidelines, 2000, the pre-issue share capital of a company, which is in the process of an IPO, is locked-in for a period of one year from the date of allotment. However, an exemption has been granted to VC funds registered under the SEBI VCF Regulations and SEBI FVCI Regulations. This would facilitate the FVCI to exit from their investments post-listing. However, in the case of securities subscribed by a FVCI in an IPO, there would be a lock-in of one year applicable to such investments.


Domestic VCFs and investors

Domestic VCFs are entitled to tax benefits under Section 10(23FB) of the Income Tax Act, 1961 (ITA). As per this section, any income earned by a SEBI registered VCF (which could be a trust or a company) set up to raise funds for investment in a venture capital undertaking is exempt from tax. This section has to be read with Section 115U of the IT Act which gives SEBI registered VCFs a pass-through status whereby the investors in the VCF are directly taxed on any income distributed by the VCFs as though the investors have made direct investment in the portfolio companies. The taxation of such income in the hands of the investors will depend on the nature of income, which will remain the same as in the hands of the VCFs. Under the ITA, the capital gains tax applicable in the hands of the domestic investors varies between 10% to 35% (exclusive of any surcharge) depending on the status of the investor i.e. individual or corporate; the nature of capital gains (i.e. long-term (above 12 months) or short term); and type of investment (i.e. listed or unlisted). In case of non-resident investors the tax rate could be as high as 40% (exclusive of surcharge). In the Finance Bill 2004, which is yet to be passed by both the houses of the parliament and needs the assent of the President before it becomes an act (which is expected to happen by sometime by the end of May, 2003), it has been proposed that long term capital gains on securities (i.e. securities held for a period of atleast 12 months) acquired between March 1, 2003 to March 1, 2004 of listed companies will be exempt from tax. Subject to the final print of the legislation, it appears that this exemption may even cover those securities which are held by investors in entities which are unlisted and which would go for a listing within the period mentioned above. It this were true, it would mean that in case of entities in which VCFs have invested and which go for an IPO during the above period and if the VCF exits from such entities after the IPO within the prescribed period, any long term capital gains earned on such divestment will be completely tax exempt in the hands of the investors.

The tax rates (as proposed by the Finance Bill, 2003) applicable to residents as well as non-residents in respect of the various types of income earned in India have been summarized in the table below:

Category Status Capital Gains Dividend/Withholding
Long Term* Short Term W.e.f. April 1, 2003 it has been proposed to make dividends tax exempt in the hands of the shareholders and the company distributing dividends will be required to pay an additional dividend distribution tax at the rate of 12.5%
Listed Unlisted Listed Unlisted
Individual Resident










Corporate Resident










* Long-term means where securities are have been held for more than 12 months.

# Long term capital gains on securities acquired between March 1, 2003 to March 1, 2004 of listed companies will be exempt from tax.

Offshore investors

There is no specific tax exemption available for the income earned by a FVCI. However, based on the jurisdiction from which the FVCI invests into India, it can avail of any benefit available under double taxation avoidance treaty (DTAT) that India may have with such jurisdiction. On account of its favourable tax treaty with India, Mauritius has become a favourite jurisdiction for investing into India. Under the India-Mauritius DTAT, any capital gains earned by a resident of Mauritius are exempt from tax in India. Further, the withholding tax on dividend also gets reduced to 5% (or 15%) as against normal applicable withholding tax of 20%.

While, the India-Mauritius DTAT has been in the eye of the storm time and again, it still continues to be one of the most favoured jurisdiction for investing into India. Recently, the Supreme Court of India has heard a case involving a public interest litigation undertaken by a NGO which besides questioning the powers of the government to enter into such a treaty has also questioned the validity of the India-Mauritius DTAT. While the ruling on this issue has been reserved and is expected to be published in next few weeks, we are hopeful that the Supreme Court will uphold the governments position on the treaty as well as the treaty itself.

It is extremely important for the private equity players using Mauritius for investments into India to ensure that their operations are structured appropriately so as to minimize the risk of denial of treaty benefits by the Indian tax authorities. There have been instances in the past where the use of Mauritius as a conduit for investing into India has been looked upon unfavourably by the Indian tax authorities. In the case of NatWest, the Authority for Advance Rulings (AAR) had denied a ruling on the grounds that use of Mauritius was merely for tax avoidance and the AAR need not rule on an application, which is prima facie for avoidance of tax.

However, post NatWest, there has been a ruling in case of AIG followed by DLJ and several others, wherein the AAR granted the benefits of India-Mauritius Tax Treaty and observed that if there was a commercial justification for setting up an SPV and then if the same was established in Mauritius, that per se should not result in denial of the benefits under the India-Mauritius Tax Treaty. In one of the recent rulings, the AAR held that the income of private equity player is in the nature of business income and not capital gains. However, it was argued that even if the income is in the nature of business income and if the investor does not have a "permanent establishment" (PE) in India, such income is not taxable in India. In light of the above ruling and even otherwise, it is extremely important to ensure that the operations of the FVCI should be carried out in a manner so as to avoid constitution of any PE in India. The consequences of having a PE in India would result in the income attributable to such PE being subject to tax in India. There is a fair amount of subjectivity involved in the determination of a PE and hence very careful thought has to be given while finalizing structure, especially to the management of the FVCI.


The venture capital regime in India is still evolving and the government is quite upbeat on the future prospects of the venture capital industry in India. India continues to offer great investment opportunities in the knowledge sectors and these sectors are likely to attract lot more venture capital funds, both domestic and offshore. The regulators have also made their intentions clear that they are willing to go an extra mile to facilitate such inflow of venture capital investments into the country. Further, the current slowdown resulting in attractive valuations makes this an opportune time for private equity investors to look at India as an investment destination.

About the Author

Siddharth Shah

Siddharth Shah heads the funds practice group at Nishith Desai Associates, a prominent Indian law firm with a strong focus on the funds industry. He has vast experience of working on a variety of funds including domestic and offshore private equity funds, offshore investment funds and mutual funds. Within the Funds practice group, he deals with issues related to structuring, regulatory framework, exchange control, incentive based management structures, etc. Besides the Funds practice group, he is also a member of the firm's M&A and Banking and Structured Finance groups of the firm and as a member of these groups he focuses on advising clients on corporate and securities law issues and on structuring of inbound and outbound investments.

He has authored various articles and research papers and has spoken at various conferences. Some of the articles and research papers authored by him include "Venture Capital at Crossroads", Presented at the CII Venture Summit at Bangalore; "Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Ordinance, 2002 - Boon or Bane?", "ADR Offerings by Indian Companies", "Acquiring Companies in the US", "Issues in domestic takeover of companies" for The Economic Times, India; "Legal and Tax issues in Cross-border M&A", "Foreign Investment into India - in comparison to China", OFC Asia Pacific Journal, December 1996, Campden Publications, London Practice.

Nishith Desai Associates

Nishith Desai Associates is a research based international law firm with offices in Mumbai and Silicon Valley. The multidisciplinary firm specializes in globalisation of Indian corporates, international financial & tax laws, corporate & securities laws, information technology and media & telecom law. The firm has structured and acted for a large number of private equity funds for India. The firm has also acted as counsel to several ADR offerings out of India including Infosys, Wipro, Rediff. The firm also has a strong focus on M&As and has worked on several cross-border M&A deals involving stock swaps, ADR-Share swaps, asset purchase, etc. The firm also has a dedicated team focusing on intellectual property, technology laws and media and entertainment. On the infrastructure side, besides working on project finance deals, the firm has been actively participating on the public policy formulation and was instrumental in drafting the Andhra Pradesh Infrastructure Development Enabling Act ("APIDEA").

The firm is intensely research oriented and has undertaken studies in different areas of law and tax, some of which can be found on its website

Nishith Desai Associates has received the 'Indian Law Firm of the Year 2000' and 'Asian Law Firm of the Year 2001 (Pro Bono)' awards which were presented by IFLR (a Euromoney publication).