Venture capital is a useful source of risk capital, especially for start-up ventures in the knowledge-intensive sectors. Since such funds enjoy a pass-through status, it is necessary for the government to limit the tax benefit to investments made in truly deserving sectors.
As of December 2007, there were more than 60 major venture capital funds (VCF) in India. These funds have been attracted by the pass-through status available under the tax laws as well as the educational level and technological expertise of the Indian population.
The Indian government’s efforts to develop venture capital investment in order to promote industrial growth have resulted in various regulatory changes that affect both domestic and offshore investors.
Tax pass through of income earned by VCFs registered with the Securities and Exchange Board of India (SEBI) was initially introduced by the Finance Act, 1995, which inserted section 10(23F) in the Income Tax Act, 1961.
The rationale for the introduction of this section was to encourage setting up of pooled vehicles for risk capital financing.
Section 10(23FA) was added in 1999 and section 10(23FB) in 2000 to supplement the provisions of Section 10(23F).
Under section 10(23FB) of the IT Act, VCFs and venture capital companies enjoy complete pass through status, irrespective of nature of income. Instead, the income is taxed in the hands of its investors at the time of distribution under section 115U, on a pass-through basis.
Changes mentioned in the 2007-08 Budget have amended section 10(23FB) making the pass-through benefit available to income received from venture capital units as defined in the act which include investments in industries engaged in the business of biotechnology; information technology relating to hardware and software development; nanotechnology; seed research and development; research and development of new chemical entities in the pharmaceutical sector; dairy industry; poultry industry; production of bio-fuels and building and operating hotel-cum-convention centres with a seating capacity of more than 3,000.
Struggle for domestic funds
Foreign funds investing in India directly into Indian portfolio companies will not be affected by the amendment. As most of these funds have been set up in tax neutral jurisdictions like Mauritius, they will continue to enjoy tax exemption on capital gains tax under dual tax avoidance agreements, effectively getting the equivalent of a “pass through” notwithstanding which sector they invest in.
It is indeed fortunate that they are able obtain this treatment, as it has resulted in major VCFs overseas engaging with India, making it one of their strong focus areas in Asia and greatly benefiting Indian entrepreneurs and the Indian economy.
However, SEBI registered domestic funds suffer as they are limited to investing in the prescribed sectors only to obtain the tax exemption and will therefore be denied the opportunity to benefit from long term investment in key sectors such as infrastructure/ real estate.
Domestic funds that would like to invest outside the select list will not get pass through status and will therefore be unable to raise any funds at all since investors will see their rate of return dramatically reduced as a result of taxation at two levels.
Consequently, the possibility of a domestic venture fund investing outside of the above mentioned sectors will be remote, thereby restricting the flow of much needed funds to several promising sectors that are capital starved.
Impact on tax revenues
Ironically, for all the damage that this will do, virtually nothing will flow to the exchequer.
Foreign VCFs, which account for almost 90% of the investments, will not be impacted by the changes and domestic funds wishing to invest outside the chosen list will be unable to raise funds anyway for this purpose.
Therefore, it is unlikely that any new tax revenues will accrue to government as a result of the change.
Impact on investors
A number of funds are now facing a dilemma as they were raised from institutions from around the world on the basis of tax treatment which has now been changed.
Any new provisions should therefore be applicable prospectively but even then, this will adversely impact the frame of mind of investors globally as there was an exception of further reform and clarification of uncertainties even in the current tax treatment.
This would indeed be a pity, as the venture capital reforms of 1999-2000 had resulted in venture capital and private equity into India going up from US$7 billion in 2006 to close to USD$17 billion in 2007, perhaps making the most significant contribution to the inflow of foreign direct investment.
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