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Is the regulatory environment in India improving for Limited Partners?

24 February, 2017

Startup founders and investors in India have a difficult row to hoe. The Indian government has been trying to make the environment conducive to startups, but efforts in this direction haven’t gone far enough.

Innovative startups play an important role in economic progress. However, many startup founders and investors find the regulatory barriers in Indian markets deterring enough.

Limited Partners (LPs), who invest in venture capital and private equity funds, also have had a difficult battle investing in India. If the government does away with the ambiguity in regulatory affairs, LPs would be far more willing to invest. As the regulatory norms governing startups affect VC and PE funds, they consequently have an effect on LPs too.

The government has, in the past, initiated a few measures to create a friendlier investment climate for LPs. In the 2015 Union Budget, the government gave tax pass-through status to Category I and II alternative investment funds (AIFs). Category I AIFs include infrastructure, SME and social venture funds. Category II AIFs include mostly private equity and debt funds. In other words, the government decided that capital gains will be taxed only at the hand of investors, and not the funds. 

Since then, Category I and II AIFs have been able to raise significantly more funds. This has made LPs more willing to invest in such funds because double taxation has often worked as a huge barrier to investment. High net-worth individuals (HNIs) started investing more in AIFs. Investors will have more incentives to invest in AIFs when the gains derived are considered “capital”. 

In 2015, the government also allowed NRIs and other foreign investors to invest in AIFs under the automatic route. Till then, they had to get an approval from the Foreign Investment Promotion Board. Both LPs and fund managers benefited from this reform. Many expect the NDA government’s initiatives like Digital India and Startup India to help entrepreneurs, though things haven’t played out that way so far. There is still lack of clarity in the management of offshore funds in India. So, many funds do not have enough incentives to let fund management happen in India. 

Now, foreign venture capital investors can invest in all kinds of startups, though until over a year ago, they could invest only in certain sectors. Startups are also free to issue sweat equity shares up to 50% of their paid-up capital. This is an effective measure, as other firms are not allowed to issue sweat equity shares greater than 25% of their paid-up capital.

Still, LPs and PE and VC firms face many constraints. If the investor is a non-resident, long term capital gains from transferring securities of an unlisted public company will be taxed at 10%. But if a non-resident is transferring securities of a private limited company, the capital gains will be taxed at 20%. So, private equity firms do not have enough incentives to invest in private limited companies, because a substantial chunk of investments of private equity funds are in private limited companies. So, PE firms and investors have long been demanding that the government aligns the tax rate for long-term capital gains from transferring securities of such companies.

But as the regulatory environment for startups improve, PE and VC funds will have better incentives to invest in startups. LPs, in turn, will be keen to invest in PE and VC funds. In the previous year’s budget, finance minister Arun Jaitley proposed a 100% deduction of profits for three out of five years for startups set up between April 2016 and March 2019. 

The 2016 budget also proposed elimination of capital gains tax when the investment is made by individuals who hold majority shares in a regulated fund of notified startups. There was still, however, an upper ceiling of Rs 50 lakh in such investments. The budget also promised a better regulatory environment, with startups being able to complete registration within a day. 

The 2017 budget wasn’t radical, but still proposed some reforms.  In this budget, the government decided to extend the 100% deduction of profits to startups to three years out of seven years. Many startups are not likely to benefit much from this though. The government lowered tax for companies with revenue under Rs 50 crore from 30% to 25%, and extended Minimum Alternate Tax from 10 years to 15 years for startups. The government also allocated Rs 10,000 crore to Bharat Net to provide digital access to 150,000 gram panchayats

Some of these are positive reforms, but much remains to be done. Recent developments like demonetisation have led to much uncertainty in the policy atmosphere. Investors are likely to be more sceptical about investing in a country which received one of the biggest monetary shocks in the recent past.  But, it is difficult to deny that things are improving.

To find out what investors think and what the government can do to improve the investment climate, sign up for the News Corp VCCircle India Limited Partners Summit on March 1-2 in Mumbai and follow @vccircle and #LPMeet2017 on Twitter.

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Is the regulatory environment in India improving for Limited Partners?

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