Risk avoidance and allocation in secondaries transactions

Ropes & Gray’s Raj Marphatia and Jianing Zhang explain how a secondaries transaction on an Indian-focused fund nearly fell apart.

The avoidance and allocation of risk is critical in secondaries transactions. One risk allocation area is whether the buyer is required to withhold tax on the proceeds payable to the seller. This note briefly describes an actual transaction that almost collapsed because the parties could not agree on how to allocate tax withholding risk between the buyer and the seller. The deal was a classic secondaries transaction in which the seller was selling a fund portfolio (including an India-focused fund) to a sovereign wealth fund.

An Indian statute requires the buyer to withhold tax on the indirect sale of an interest in an Indian company. It is not clear whether this statute applies to the secondary sale of an interest in a direct fund that focuses on investments in Indian companies.

Applying this statute to such a sale does not make sense from a policy or practical perspective. From a policy perspective, the tax should be imposed at the level of the direct fund, and not at the level of the owners of the direct fund. From a practical perspective, the owner of the interest in the direct fund would not have the information necessary to calculate the gain on this indirect sale, nor is it clear how the tax it paid could be credited against the tax payable when the underlying direct fund sold its interest in the Indian company.

Both the buyer and the seller agreed that it was unlikely that the statute applied to the proposed transaction. The seller offered to indemnify the buyer if the tax authorities held the buyer responsible for a failure to withhold.

However, the buyer was unwilling to accept this allocation of risk because as a SWF it felt obligated to comply with the literal language of the Indian statute. It proposed to withhold tax and remit it to the government and recommended that the seller seek a refund because the statute should not apply to the proposed transaction. This approach was unacceptable to the seller.

It appeared as if the deal was going to collapse over this issue. Before abandoning the transaction, however, the seller determined that there was in fact no gain on the sale and therefore no tax withholding was required. The buyer and its advisors concurred and agreed to proceed without tax withholding.

The parties to this transaction were fortunately able to resolve the risk allocation issue, but this case study is a reminder of the importance of identifying and allocating risk as early as possible in a secondary transaction.

This article first appeared in sister publication Private Equity International‘s September secondaries special.