The Hindu Business Line : Foreign VC fund norms on radar

Investment by the funds is channelled only into sectors such as real estate where foreign investment is generally permitted under the Government’s stated FDI policy.

Hiresh Wadhwani
Subramaniam Krishnan

At an Assocham-organised event at the launch of the Venture Capital Association of India, a senior Finance Ministry official spoke of developing a mechanism to regulate foreign venture capital funds (VC funds) and private equity funds , ostensibly to provide a level-playing field for foreign and Indian VC funds.

By regulating the funds, the Government seeks to ensure equitable growth of all sectors and restrict specific sectors such as realty from absorbing their investments for making quick returns. The official also states that the intent is to ensure that such funds fall under the tax net as currently Indian VC funds are subject to certain taxation while their foreign counterparts are exempted.

This is not the first call for greater regulation of foreign VC funds. The press has repeatedly reported the Reserve Bank of India’s request to the Finance Ministry to revisit the VC route spurred by the significant investments by such funds in the realty and pre-IPO space.

Greater regulation

Transparent and fair regulatory systems are essential to the development of deep and liquid capital markets. A system of regulation that is transparent instils the confidence needed to attract suppliers and users of capital, improves market efficiency, and contributes to increased overall economic activity and investment. Regulations that serve to achieve the above objective are always, therefore, welcome. However, the basis of the present call for greater regulation appears to be partially misplaced.

The regulatory framework for foreign VC funds is currently contained in the Securities and Exchange Board of India (Foreign Venture Capital Investors) Regulations, 2000 (FVCI Regulations). While it is not mandatory to register, registration has advantages relating to exemption from lock-in period, post-IPO, relaxation from takeover regulations and pricing guidelines, etc. Most of the provisions contained in the FVCI Regulations relating to investment conditions and restrictions mirror the provisions contained in the SEBI Domestic VC Fund Regulations. Foreign funds that do not register with SEBI cannot avail of the benefits described above; however, they can still invest in India under the foreign direct investment (FDI) route subject to compliance with the applicable sectoral and pricing norms.

In fact, in recent years, most of the investments by foreign funds have come in through the FDI route partly due to the fact that majority of applications for FVCI registration have been facing regulatory hurdles since 2007.

This has ensured that investment by the funds are channelled only into sectors (including real-estate) where foreign investment is generally permitted under the Government’s stated FDI policy. It is unclear as to how the Government would carve out a policy for foreign VC funds which is less liberal than the prevailing FDI policy. Any such policy will clearly be regressive and not viewed favourably by the international investor community.

Disparity in treatment

Another point of distinction that is often highlighted is the disparity in the taxation treatment of domestic and foreign VC funds. Again, the reality is that there is only one set of provisions in the Indian tax laws that deal with taxation of registered VC funds. Subject to certain conditions, the VC fund is not taxed and the investors in the fund are taxed on the income earned by the fund. It is common knowledge that most foreign VC funds invest in India through investment vehicles established in Mauritius.

India has a tax treaty with Mauritius which exempts from tax capital gains earned in India by a Mauritius tax resident and, therefore, foreign investors can legitimately structure their investments through Mauritius; in that sense, the disparity in tax treatment of an Indian investor in a SEBI registered domestic fund (not investing in qualifying sector for tax purposes) and a foreign investor in a Mauritius fund will continue. It appears to be difficult to address this issue through the SEBI regulatory framework.

The Government’s intent to ensure that the incentives to VC funds should be available only to investments in identified high priority sectors is understandable. There is clearly an economic case to promote investments in certain sectors (such as infrastructure development, emerging technologies, innovation, etc) where the need for capital exceeds its availability and vice-versa. One such measure has already been taken by the Government by amending the Indian tax laws to restrict the pass through status to only income from investments in nine specified high priority sectors.

PE investments in India have grown from $1.8 billion in 2001 to $16.1 billion in 2007. India has already received PE investment totalling $6.7 billion in 2008 (as of June 2008) despite subdued conditions in the Indian capital markets and the global credit turmoil during the same period. Almost all indicators suggest that PE activity in India is set to grow exponentially. Any move to regulate the flow of capital into India will, therefore, need to be calibrated and well reasoned.

(The authors are senior tax professionals with Ernst & Young. Responses to blfeedback@thehindu.co.in)

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