JP Morgan will buy Canaan Partners’ portfolio in India, says the Economic Times. Canaan is a VC fund that decided to shut down India operations, where they had invested around $160 million. This includes Happiest Minds, Naaptol.com, Cartrade, Matrimony.com and so on.

Supposedly JP Morgan is offering $200 million for the portfolio.

This transaction is likely to trigger part of the dreaded “Vodafone” tax clause. Even if Canaan’s investments are housed in a vehicle in, say, Mauritius, the eventual investments are in Indian companies (or companies that have substantial operations in India). If Canaan wants to sell its “vehicle” to JPM, this triggers the clauses that involve a transfer of ownership of such entities (which will eventually move from Canaan to JP Morgan).

Basically, any such transaction will involve payment of tax to Indian authorities. If JP Morgan’s US arm were to buy the assets of Canaan’s Mauritius entity, it will be treated as a transaction that sold Indian assets effectively. JP Morgan will be required to deduct TDS from any payment to Canaan and pay the Indian authorities.

Now in the Vodafone transaction the government demanded $2.5 billion of the $11 billion transaction value. This was not the “profit”, it was more than 20% of the transaction itself! So in this case, will the sale at $200 million involve a TDS of over $40 million paid to the Indian government? At least on the face of it, this seems likely (though the CAs might debate this better).

This may be avoidable if JPM were to buy shares of each Indian company directly from Canaan, meaning that instead of acquiring Canaan, JPM will have to acquire shares of each company owned by Canaan. Meaning, in those company’s books, the shares will be transferred by Canaan to JPM. This involves a substantially higher cost (since each company has to be valued and RBI guidance has to be followed) and a longer period of compliance. Plus, undoubtedly, certain other triggers such as needing approval from other investors which might have veto rights or an ROFR on such transfers. But TDS can be avoided this way, since such a transaction isn’t an “indirect” buyout of Indian assets, it’s as direct as it gets. And a direct share transfer means capital gains to the Mauritius entity which is not taxable in India.

This could become a thorn in the neck for all VCs looking for portfolio exits through a VC level consolidation. That is, when their LPs can choose to sell their stakes in the VC firm directly to someone else, while the entity holding all the rights and shares remains the same. If Canaan is considering such a structure, then the dreaded TDS will come into play.

Note: Please correct me if I’m wrong. It struck me today morning when I read the news, and the Lawyers might know this better.

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