The Hindu Business Line : Venture capitalists look for positive tax signals

By way of amendments, the tax legislators have not only restricted the exemption of all the income of a domestic venture capital fund but also limited the sectors which would qualify for tax exemption.

Pranay Bhatia
Rachana Kapadia

The advanced estimate figures issued by the Central Statistical Organisation (CSO) indicate that the Indian economy grew by 7.1 per cent in 2008-09.

Specific measures for small units, exporters, automobiles, textiles, infrastructure and housing are among the priority areas of the UPA Government to keep up the economic pace.

With just a week to go before the presentation of Budget 2009, many venture capitalist are looking forward to positive tax proposals.

Business enterprises engaged in greenfield capital intensive projects, technology and knowledge-intensive sectors need start-up capital to fund their projects.

The Domestic Venture Capital Company and Funds (DVCFs) are an important source of domestic risk capital for such business enterprises, providing funds for start-ups. To mitigate multiple taxes, trust structure is more common than company structure. As on March 12, 2009, there were 132 venture capital funds registered with the Securities and Exchange Board (SEBI) and as on March 31, Rs 1,45,00 crore was invested by DVCFs ( www.sebi.gov.in ) in the various sectors of the economy.

Earlier tax positions

Prior to the amendments in the Finance Act, 2007, any income earned by a registered DVCF set up to raise funds for investment in the venture capital undertaking was exempt from tax under Section 10 (23FB) of the I-T Act, 1961.

Under the Section 115-U of the I-T Act, DVCF investors would be taxed directly on income distributed by the DVCF as if the investors had made the direct investments in the portfolio companies. Thus, DVCFs were enjoying a tax “pass through status” under the I-T Act.

The amendments

The amendments made vide Finance Act, 2007 were intended to limit the tax benefit of DVCFs in the sectors which, according to legislators, were truly deserving. The Finance Ministry made two key amendments in the I-Tax Act, restricting exemption to DVCFs.

The amendment restricted the tax exemption to incomes earned from investments in venture capital undertaking, and the Finance Act 2007 enumerated the number of specific sectors for investments by DVCF for it to be eligible to claim tax exemptions.

By way of these amendments, the tax legislators have not only restricted the exemption of all the income of a DVCF but also limited the sectors for investments by a DVCF which would qualify for tax exemption.

Such amendment has primarily affected the ability of domestic investors to invest. However, foreign investors investing directly in India are not affected by this change.

Investments in venture capital undertaking engaged in nine specific sectors would only entitle the investing DVCF to be eligible to claim the exemption against any income earned from investments in such venture capital undertaking.

As a corollary, venture capital undertaking not engaged in the specific activities would not enable investing DVCF to claim such exemptions.

As a result, based on legal/judicial interpretation, determinate trust structures were adopted so as to enable local investors of DVCF to achieve tax efficient structures. Determinate trust is understood to be one where the names of the beneficiaries are mentioned and their shares are ascertainable on the date of the trust deed. Due to the nature of the fund raising activity, which is continuous, it is difficult to achieve the determinate trust structure unless legal interpretations are adopted.

If the trust is taxed as determinate trust, the investors are taxed on their share of income according to their tax status (which takes them close to the pre-amendment position).

Else, the DVCF could end up paying tax on maximum marginal rate of tax (that is, 34 per cent), which could be higher than the tax otherwise payable.

Not only is such structure open to litigation (as it is based on legal/ judicial interpretation) but it is also vulnerable if some investor defaults, as the shares are sought to be made ascertainable before the investments are made by the investors and default could result in alteration of distribution pattern.

Budget expectations

To provide necessary impetus to SMEs and social, educational, healthcare and infrastructure sectors, the legislators need to reinstate exemption under Section 10(23FB) of the I-T Act. Such a move will provide the following benefits:

Investors would not be required to resort to structuring their investments, thereby reducing hardship to domestic investors.

Relaxation will mitigate the possible litigation on the existing DVCF, which may not have been structured to achieve status of determinate trust.

There is no tax leakage as the investors would pay taxes as against the DVCF.

Such transparent provisions will help in boosting investor confidence due to clarity on tax position, thereby facilitating investments.

(The authors are Partner and Associate, respectively, Economic Laws Practice.)

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