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The key factor in determining how to structure India-related investments is the desired location of the primary exit vehicle for investor liquidity. A related factor is whether the U.S. is the primary market for the products/services of the investee company. In most cases, the U.S. is the primary target market. Therefore, many current India-related high tech investments by U.S. investors are structured as an investment in a U.S. corporation, the "front end," which then establishes and capitalizes a subsidiary in India, which is the "back end" for fulfillment for the operations of the U.S company. The India subsidiary can be owned via a Mauritius entity if there is a possibility it could be spun off. The U.S. "front end" approach is often used because an India centric business is unlikely to be successful unless it creates market pull in the U.S. The U.S. front end creates this pull. In addition, an India-based start-up by itself is unlikely to be scalable on a global basis. Other business reasons for using the U.S. front-end approach are:

• Familiarity with and ease of using U.S. capital markets as an exit strategy for investors;
• Relative valuations in the U.S. and India capital markets;
• Acquisitions of other companies are easier under U.S. law; and
• Stock option plans are more flexible under U.S. law

The Mauritius approach to investing in India is most applicable when the Indian company is the primary exit vehicle for investor liquidity. The primary benefit under the India-Mauritius tax treaty is that there is no capital gains tax on the sale of the shares of the Indian company in either India or Mauritius. Otherwise, the proceeds of a sale of shares in an Indian company are taxed in India even if the seller is not a tax resident of India.

In some cases, an investor may want the flexibility of both approaches. That is, some investments will go directly into India and some will go into U.S. front ends. The alternatives available for direct investment into India are:

• Invest directly from the U.S. without establishing a "permanent establishment" for tax purposes in India;
• Invest via Mauritius without establishing a "permanent establishment" for tax purposes in India
• Invest through a venture capital fund in India registered with the Securities and Exchange Board of India ("SEBI")

Reserve Bank of India approval of investments from outside India is facilitated if the entity is an Overseas Corporate Body ("OCB"). An OCB is a company owned at least 60% by non-resident Indians.

Under this approach, the U.S. investor forms an offshore company regulated by the Mauritius Offshore Business Activities Act 1992 ("MOBAA"). In order to have the benefits of the India-Mauritius tax treaty, certain requirements must be met in order to receive a Tax Residency Certificate including:

• Two local directors approved by the MOBAA authority
• Bank account in Mauritius
• Compliance with Mauritius corporate formalities

The primary benefit under the treaty is that there is no capital gains tax in India or Mauritius on the sale of shares in an Indian company.

The Mauritius authorities do not "rubber stamp" every action done or desired by the U.S. investor. The U.S. investor will have to make an effort to comply with the Mauritius requirements.

A venture capital fund which registers with SEBI and complies with the investment restrictions will receive the same tax benefits (no capital gains or withholding tax on dividends) as if it were a Mauritius entity. The permitted activities of a fund, however, are limited. No services such as incubation services may be provided. A separate entity would be needed in order to provide such services. There may also be restrictions on where the funds can be raised. One proposed restriction on a registered fund is that investments must be divested within a specified period after an investee company goes public.

At this time, the best business course of action is likely to not register in India unless having a fund in India is necessary for relationship or political reasons. This will reduce regulatory requirements and maintain investment flexibility.

The India Tax Authority for Advance Rulings issued a ruling in March, 2001 in the case of a private equity fund making investments in India through a Mauritius entity (the "Fund"). The ruling concluded that the investment activity created business income rather than capital gains income but that the Fund was not subject to tax in India because of the limited nature of its activities there.

The purpose of the Fund was to invest in securities of all kinds and ultimately sell them at a profit. The ruling concluded that such activity was a trade or business. The Fund did not have a place of management, branch, office, factory, warehouse or storage facilities in India. The Fund had an independent (as opposed to dependent) investment advisor and custodian in India. The investment manager was in Mauritius. The investment advisor’s role was limited to obtaining information on potential investments and communicating the same to the investment manager in Mauritius. The investment advisor had no authority to conclude contracts on behalf of the Fund and was providing similar services to other potential investors.

The Fund had also entered into a custodian agreement with an Indian company for the purchase of the shares for the Fund, sale of these shares, deposit of the sale proceeds in a bank in the name of the Fund and related activities. The Custodian was not working exclusively on behalf of the Fund but was acting in the ordinary course of business in rendering such services to the Fund.

Unless the investor registers as a venture capital fund with SEBI, activities in India must be planned so that they do not create a permanent establishment for tax purposes in India.

If the proceeds of a sale of securities by a company in the business of investing are considered business income in India and not capital gains then there is no benefit to be gained under the India-Mauritius Tax Treaty. Whether this ruling will govern the characterization of income is uncertain since factual circumstances will differ. Therefore, if an advance ruling is not obtained, a Mauritius entity should be used as an intermediary to secure the tax treaty benefit of no capital gains tax in India or Mauritius. If an advance ruling is obtained then the structure can be simplified and investment made directly from the U.S.