Venture capital industry has been going through a metamorphosis in the recent times. While good deals with the right valuations have been difficult to come by, increased uncertainty with respect to regulations have only added to the misery.
The Finance Minister in the Union Budget 2012-13 provides some level of respite to the venture capital industry though. While acknowledging sluggish growth of the Indian economy this year, he has also expressed his intention of implementing a growth strategy. Among others, incentivising investments in India seems to be on his agenda rather expressly.
Some of the key proposals impacting the venture capital sector are:
Tax Pass-Through Extended Across Sectors
Currently, the Venture Capital Funds/Venture Capital Companies (VCF/VCC) enjoy a tax pass-through status only with respect to investment in specified sectors such as bio-technology, nano-technology, etc. The specified sector exemption was introduced to boost investment in certain sectors. However, there were other sectors, vital to the economy, where investment needed to be incentivised.
A large number of domestic funds needed to be orgainsed as “irrevocable determinate trusts,” which enable them to get an effective tax pass-through status irrespective of the sector restriction. However, such forms of trusts entail a lot of trust taxation complexities. Various representations were made by the funds to extend the exemption benefit across all sectors (available currently to only a few sectors).
The budget has put to rest these concerns. One of the proposals is to extend the tax pass-through benefit to VCFs irrespective of the investment sector, by aligning the definition of VCU in the tax law with that of SEBI regulations. This has been a welcome change for the VC industry.
Fair market value for investment in shares of closely held companies not applicable to VCF/VCC
A key tax proposal relating to curbing tax avoidance has been made in relation to issue of shares in excess of the fair value by closely held companies. Share premium received by private companies over the “fair market value” on subscription of shares is proposed to be taxable in the hands of the issuer company. The Finance Minister has been thoughtful to carve out investment from domestic VCFs from this provision.
Accrual-based taxation introduced for investors in VCF/VCC
Investors are now proposed to be taxed as when income accrues/arises/is received by the VCF/VCC, as against the current law, where the taxability would trigger only when the income was distributed by the VCF/VCC to its investors. This could potentially result in investors requiring to pay tax even when the VCC/VCF have not made any distribution. For example, there are several transactions undertaken today which provide that while the initial investment is made in the holding company, the VCF/VCC could sell its investment in the holding company and in consideration, receive shares of the operating company, depending upon which entity derives a better valuation. Such transactions could now result in tax liability for investors although the eventual exit may be a few years away.
Tax withholding/distribution tax provisions
Additionally, VCFs/VCCs are no more exempt from the provisions of dividend distribution tax and withholding tax. Introduction of these provisions will have to be examined closely as they may increase procedural difficulties for domestic funds.
The budget proposals have left behind mixed sentiments in the market. While there have been certain tax proposals which could be detrimental to the VC industry, the government has also brought about positive developments which would continue to encourage venture capital investment, resulting in growth of the Indian Economy.
(Anish Sanghvi is an associate director at PwC.)