Realising the importance of venture capital funds in promoting the growth of high risk businesses, “pass-through taxation” regime for taxation of capital funds (VCFs) was introduced in 1995. However, the tax regime applicable to VCFs has undergone several amendments since its inception. A clear and stable tax environment, which is critical for the development of VCFs, is what the industry players expects from the Government during this Budget.
Section 10 (23FB) and 115U of the Income-tax Act, 1961 provides the framework for the taxation of VCFs. It envisages that any income earned by VCF from investments in Venture Capital Undertakings (VCU) is exempt from tax in the hands of VCF and the same is taxed on distribution in the hands of the investors in VCF. Thus, essentially it is a tax deferral benefit i.e. income is taxed if and when the same is distributed by VCF to investors.
In its current form, the pass-through benefit is restricted to income from investments in VCUs engaged only in specified sectors, which include biotechnology; information technology; nanotechnology and so on. However, the data on investments channelised through VCF suggests that significant investments have been made in sectors such as real estate, industrial products, media & entertainment, telecom, services and so on, which do not fall within the specified sectors.
Considering, the importance of VCF in these sectors as well and the need to provide impetus to the economy as a whole, there is an expectation to extend the VCF Tax regime to the investments in any unlisted VCUs, irrespective of the industry in which it operates.
VCFs are organised in the form of contributory trusts, where the trustees are the legal owner of the investments in VCU and the investors are the beneficiaries in the trust to the extent of the units held by them. Where VCF earns income from investments in VCUs engaged in non-specified sectors, such income is taxable in the hands of the trustees as representative assessee of the beneficiaries.
The scheme for taxation of trusts provides that in case of a discretionary trust, tax is levied at maximum marginal rate and in case of determinate trusts, income is taxable in the hands of the trustees in the like manner and to the same extent as in the hands of beneficiaries. As per the existing provisions, a trust is said to be determinate when the individual shares of the beneficiaries are expressly stated in the trust deed.
This creates complications since, in case of VCF, the names and share of beneficial interest of the unitholder may not be available as on the date of the execution of the trust deed and hence, it becomes a matter of legal interpretation that trust deed should be read along with the contribution agreement and other documents to ascertain the individual shares of the beneficiaries.
The taxation of determinate trust should be, in principle, based on the aggregate tax liability of each of the beneficiary considering their respective share in the income of VCF. For this purpose, if there are any losses in the hands of a beneficiary then the same should be set off against the share of income from VCF.
Also taxes deducted at source, if any, by VCUs on income distributed to VCF are also available as credit to the investor. However, there are various practical issues in achieving this.
VCFs pay significant amount as investment management fees to the investment manager. Since, VCFs hold investments as capital assets, the deduction is available only in respect of cost of acquisition and cost of improvement on transfer of capital asset.
Since a significant part of the management fees is paid for identifying, analysing and making the investments in VCU, an issue arises whether some portion of the management fees can be considered as a part of cost of acquisition of the shares acquired in VCU.
Although, VCF plays a pivotal role in development of the economy, it is still in its nascent stage in India as compared to the developed economies. Hence with a view to provide a clear and a stable tax incentive framework it will be useful to restore the “pass-through” framework of taxation to VCFs investing in any VCU regardless of the industry or sector. This will go a long way in flourishing VCFs in India.
(The authors are senior tax professionals with Ernst & Young, India)