Venture Capital- Finance Bill 2007.

Venture Capital India- A short brief in the light of budget proposal to restrict tax ‘pass through’.


Venture capital funds are 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 to limit the tax benefit to investments made in truly deserving sectors. Accordingly, I propose to grant pass-through status to venture capital funds only in respect of investments in venture capital undertakings in 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; and production of bio-fuels. In order to promote business tourism, I also propose to allow this benefit to venture capital funds that invest in hotel-cum-convention centres of a certain description and size.

Finance Minister P Chidambaram –Budget speech, March 1, 2007.

The investment of venture capitalists in Indian industries in the first half of 2006 is $3billion and is expected to reach $6.5 billion at the end of the year.
Wikipedia

Venture Capital in India – A Brief Introduction
Now India has become a booming market for both venture capital investors and private equity players. Venture Capitalists and the private equity players began eying India in the late nineties with the growth of Information Technology. Indian economy witnessed the dot com downfall in the year 2000-2001 and it reduced the flow of investment in to Indian market. However within a short span of time Indian market regained its vitality and now with the accelerated growth of IT- ITES sector India is treated as a growing market for investment.
Legal Framework
The main statutes in the arena of venture capital in India includes, the 1996 Venture Capital Regulations by SEBI ( Securities and Exchange Board of India), the 1995 Guidelines for Overseas Venture Capital Companies and the 1995 Guidelines issued by Central Board of Direct Tax (CBDT). The relevant authorities/regulators are the Foreign Investment Promotion Board 7, the Reserve Bank of India8 (‘RBI’) and the Securities and Exchange Board of India 9(the ‘SEBI’).

Foreign Venture Capital Investment in India

A FVCI (or Foreign Venture Capital Investor) is an investor incorporated or established outside India which proposes to make investments either in domestic Venture Capital Funds (‘VCFs’) or Venture Capital Undertakings10(‘VCUs’) in India (defined to mean a domestic unlisted Indian Company) and which is registered under the Foreign Venture Capital Investor Regulations, 2000 (‘FVCI Regulations’). Even though foreign private equity players and offshore Venture Capital Funds can invest in India directly under the Foreign Direct Investment Scheme (the ‘FDI Scheme’) , the SEBI grants certain benefits to those investors who register themselves under the FVCI Regulations.

Advantages of Registering under the FVCI Regulations[1]

In spite of the fact that Registration under the Foreign Venture Capital Investor Regulations is not compulsory; the Indian Government has sought to make this registration attractive by giving certain benefits upon those institutions that have registered, under FVCI Regulations including:
1. Other than a registered FVCI investment, all other non-resident investments are subject to a condition that subsequent investments require the Government’s approval, where the non-resident has an existing joint venture, technology transfer agreement or trademark agreement in the same field in India.
2. FVCIs are exempt from the usual practice of valuing the shares on the basis of their listed price or on the basis of their net asset value (in the case of an unlisted company) in any investment or M&A transaction 13. This exemption also helps when an FVCI is looking to exit its investment from an unlisted company. In such a situation, instead of paying a price based on the net asset value of the investee company, it could pay the negotiated price.

3. The provisions of the SEBI (Substantial Acquisitions of Shares and Takeover) Regulations, 1997 (‘Takeover Code’) do not apply to shares transferred from an FVCI to the promoters of the company or to the company itself, if effected in accordance with a pre-existing agreement between the FVCI and the promoters of the company. This ensures that in the event the promoters decide to buy back the shares from the FVCI, they will not be required to comply with the public offering requirements of the Takeover Code, which would otherwise require that an offer be made to the other shareholders of the company for up to twenty percent (20%) of the outstanding share capital.
4. The shares acquired by a FVCI in an unlisted company are not subject to the one year lock-up period upon the Initial Public Offering (‘IPO’) of the shares of the company. Thus, the FVCI would be able to exit its investment in such a company after the listing of the shares without having to wait for the completion of the lock-up period.
5. FVCIs registered with the SEBI are ‘Qualified Institutional Buyers’ in the SEBI (Disclosure and Investor Protection) Guidelines, 2000 (‘DIP Guidelines’). As a result, they are eligible to participate in the primary issuance process, meaning that they would be able to subscribe for the securities in an IPO under the typical book-building process.

Section 90(2) of the Tax Act, provides for relief from double taxation. Pursuant to this Section, a non-resident investor based in a country with which India has a tax treaty may choose to either be taxed under the IT Act or the tax treaty (Double Taxation Avoidance Agreement, ‘DTAA’), whichever is more beneficial. Therefore, if the non-resident investor elects the DTAA if the treaty is more favorable, the provisions under Sections 10(23FB)[2] and 115U[3] would not be applicable. However, by the 2007 Amendment this position has been changed. The Amendment restricted the tax exempted sectors in to certain areas. Still the FVCI can invest without tax hindrance, if it opts under the treaty act. It should be keep in mind that if the Foreign Venture Capital Investor elects to be taxed under the DTAA and it has a permanent establishment in India, its Indian income would not be tax free.

Usually the venture capitalists opt to incorporate a company in a country with which India has a favorable tax-treaty. This also provides protection against the annual revisions to the Tax Act.
Govt. of India has entered into DTA agreement with several countries, some of the main countries are Australia, Bangladesh, Canada, China, Germany, Japan, Malaysia, Mauritius, Nepal, Singapore, Sri Lanka, UAE, UAR, UK, USA, USSR etc.
If there are any disputes in the interpretation / implementation of the terms of DTA Agreements, normal remedies of appeal etc. provided in the Income-tax Act are available to the aggrieved party. The DTA Agreements also contain mutual agreement procedure. The aggrieved party may approach the Competent Authority of the contracting State wherein he is a resident, who, if he is unable to resolve the dispute by himself will approach the competent Authority of the other Contracting State to arrive at a solution after mutual discussion.[4]
Double Taxation Avoidance Agreement with Mauritius and Singapore
According to Double Taxation Avoidance Act between India and Mauritius, Capital Gains arising from sale of shares are taxable in the country of residence of the shareholder and not in the country of residence of the Company whose shares have been sold. Therefore, a Company resident in Mauritius selling shares of Indian Company will not pay tax in India. Since there is no Capital Gains tax in Mauritius it will escape tax altogether. The Supreme Court in its order dated October 7, 2003 held that on the basis of certificate of residence issued by Mauritius Government, a Company can claim exemption from Capital Gains tax on sale of shares. Therefore, residence in Mauritius assumes importance.[5] Further, the business profits of a Mauritius offshore company are taxable at an effective tax rate of only 3%. Most investors who come into India via Mauritius do not have any substantive business in Mauritius and are incorporated there only to take advantage of the DTAA.
The Comprehensive Economic Cooperation Agreement (CECA) between India and Singapore was signed on 29th June, 2005. It intends to give Singapore the same status as Mauritius. As per CECA the tax residents will enjoy capital gains exemption on investments in India. However, it should be note that if the company set up its affairs in Singapore to evade the income tax laws of India and to take advantage of the benefits of the DTAA and it found that if the company is having negligible business or nil business operations in Singapore then such concerns will be disallowed from enjoying the capital gains exemption.[6]
The Finance Bill, 2007
The Finance Bill, 2007 proposes to restrict the pass through status for Venture Capital Funds ("VCFs")/Venture Capital Companies ("VCCs") to only income from investment in domestic unlisted company engaged in certain specified businesses such as IT, bio-tech etc ("VCU").
For the time being, Venture Capital Funds/ Venture Capital Companies enjoy complete pass-through status under Section 10(23FB) of the Indian Income Tax Act, 1961, irrespective of nature of income.[7] Instead, the income is taxed in the hands of its investors at the time of distribution under Section 115U of the Act, on a pass-through basis. Venture Capital funds normally get themselves registered as a company in any country with which India has a double taxation avoidance agreement (DTAA) and since these countries have little or no taxes on either business profits or capital gains, it has been a case of tax freedom for the Venture Capital funds so long as they have registered themselves with the Securities and Exchange Board of India (SEBI).
The proposal is to amend the definition of a "venture capital undertaking" to a domestic unlisted company which is engaged in the business of:
A. nanotechnology;
B. information technology relating to hardware and software development; C. seed research and development (i.e., plants and not seed stage);
D. bio-technology; E. research and development of new chemical entities in the pharmaceutical sector;
F. production of bio-fuels; or
G. building and operating large hotel and convention centers; or H. diary or poultry
Impact of the Proposed Amendments
The government by proposing the concerned amendment intends to develop certain sectors of the economy by giving special tax through benefit to the sectors mentioned above. But at the same it should be keep in mind that it is having a tendency to the disappearance of investment in the other sectors, which are not mentioned in the categories, like infra structure and real estate and it has a tendency to retard the growth of domestic capital venture in India. Foreign Venture Capital Investors incorporated in a jurisdiction such as Mauritius may therefore still avail of the tax benefits under the Mauritius-India tax treaty and the above amendment may have limited impact on Foreign Venture Capital Investors. However, the impact on Domestic Venture Capital Firms may be greater because they are taxed under the IT Act, including proposed amendments such as the above.
It is the shared feeling that venture capital industry in India is at its initial stage. It is not the right time to make decisions as to where to give the tax exemptions or not.

It also creates some types of dilemma when it comes to taxation also, since it results in two levels of taxation like tax in the hands of venture capital companies and in distribution of income to the investors. This list has some obvious, inexplicable exclusion such as telecom, value-added services in the wireless arena, real estate, infra structure, media, etc.
The Amendment has its effect on the Indian economy and the venture capitalist. It is obvious in the decision of UTI to register as a foreign venture capital investor.

“Though SEBI has given us approval to start asset management as domestic venture capital fund, we will file for a fresh application to register as foreign venture capital investor in a few weeks. The change in tax rules means that it is best if we have an offshore fund with UTI Bank’s contribution being the Indian component of the fund,” said UBL Asset Management Company CEO Alok Gupta.[8]

It is true that Indian venture capital scenario is in the initial stage and the government has to find out the promising areas, where the tax pass through exemption should be allowed.




[1] Sajai Singh, Venture capital in India
[2] As per 10 (23FB) Income from invest­ment in venture capital undertaking is exempted.
[3] Section 115U of the IT Act, confers a pass-through status on SEBI-registered venture funds. Investors in such funds would be liable to tax in respect of the income received by them from the FVCI in the same manner as it would have been, had the investors invested directly in the venture capital undertaking. In other words, income earned by an FVCI by way of dividend, interest or capital gains, upon distribution, would continue to retain the same character in the hands of its investors. http://www.altassets.net/casefor/countries/2002/nz2873.php
[4] http://www.laws4india.com/indiantaxlaws/dtaa/dtaa-rd.asp
[5] http://www.laws4india.com/indiantaxlaws/dtaa/dtaa-judgements.asp
[6] http://www.bridgesingapore.com/events/ceca_092004/ceca.htm

[7] Section 10(23FB) of the Income Tax Act, 1961 (the “IT Act”) provides that in computing the total income of the previous year of a venture capital company/fund, any income of such venture capital company or fund set up to raise funds for investment in a venture capital undertaking shall not be included, i.e., a pass through tax benefit.
"Venture capital undertaking" is defined in clause (c) of the Explanation 1 of Section 10(23FB) to mean a venture capital undertaking referred to in the Securities and Exchange Board of India Regulations. According to the SEBI website, there are 88 domestic venture capital funds (“DVCFs”) and 66 foreign venture capital investors (“FVCI”s) currently registered with SEBI.
[8]http://economictimes.indiatimes.com/UTI_Bank_to_set_up_500m_offshore_fund/articleshow/1776220.cms