Taxing venture funds is bad for growth

  • Share

Economic Times
By

Sudhir Kapadia
National Tax Leader, EY
and
Subramaniam Krishnan
Director – Tax, EY

Public and private investments spur economic growth. In an emerging economy like India, capital investment is key to maintaining the current growth rate. Over the next five years, for instance, the construction industry alone will need an additional investment of $150 billion to $200 billion to fund assets and working capital.

Investments by private equity and venture capital funds have been a major source of funding in India. The total investments by these funds since 2006 have been around $55 billion spanning across 2009 investment transactions. So, like any other segment of the economy, venture capital funds need a stable tax framework.

Going by the current income-tax law, all investors including venture capital funds are taxable on long-term capital gains from transfer of unlisted shares at a rate of 20%. A higher rate of 30% is charged on short-term capital gains (the rate is 40% for non residents).

The Direct Taxes Code, 2010 (DTC) has proposed a uniform tax rate of 30% for capital gains on unlisted shares, be it short-term or long-term gains. However, for long-term investments an indexation of costs will be available to all taxpayers in determining capital gains.

The proposed increase in tax rate for long-term capital gains from 20% to 30% may have an adverse effect on capital formation. The capital gains tax rate of 30% proposed under the DTC will be the highest amongst the Bric countries. The capital gains tax rates in Brazil, Russia and China are 15%, 15.5%-20% and 25% respectively.

A higher tax rate in India vis-Ã -vis other countries that compete with India for foreign investments could reduce the country's attractiveness as an investment destination for private equity funds. So, the tax rate in India on capital gains should be competitive to its counterparts in Bric countries. Else, there is a risk of re-allocation of foreign investment to other countries.

Under the present tax law and the proposed DTC, long-term capital gains from listed shares are exempt from income tax. The tax exemption on transfer of listed shares may be extended to investment in unlisted shares by private equity and venture funds with suitable conditions. In fact, these funds present an equal if not more compelling case for tax exemption, given that they provide long-term risk capital to unlisted companies and contribute seed capital for new ventures.

Besides, private equity funds also provide management support to investee companies during their growth phase. In any event, a more benign long-term capital tax rate (say 5-10%) would make it a far more attractive investment proposition for foreign investors.
Today, the fledging domestic venture capital fund industry faces significant challenges while defending its tax position. The current tax law provides a pass-through status for the fund and taxation at the investor level for capital gains from investments in nine specified sectors.

These include nanotechnology, information technology, seed research and development, bio-technology, research and development of new chemical entities in the pharmaceutical sector, production of bio-fuels, building and operating specified hotel-cum-convention centre, specified infrastructure facility, and dairy or poultry industry.

However, in the case of capital gains from investments in other sectors, there is ambiguity on whether the trustee (as representative of the fund) or investors in the fund should be taxable. Although the tax law provides for a single level of taxation (i.e., the trustee of the venture fund or the investor), practically, the venture fund as well as the investor may be subject to tax on the same income, leading to double taxation.

Further, if trustees pay tax on capital gains earned by the fund, there is no mechanism for the beneficiaries to claim credit on such taxes paid in their individual tax returns when they report income earned from the fund. In countries with a sizeable fund management industry, there are regimes for pass-through basis of taxation for private equity and venture funds. Here, income of the fund is taxed at the investor level.

Given that there is no loss to the revenue (whether the fund is taxable or the investor is taxable), the private equity or venture fund should be accorded complete tax exemption and investors should be taxed on the income of the fund. For this to happen, the definition of venture capital undertaking (VCU) under the current provisions or DTC should be aligned to the broader definition of a VCU under the Sebi (Venture Capital Fund) Regulations, 1996.

A pragmatic, clear and stable tax treatment for private equity funds in India will go a long way in building a conducive environment to further develop this alternative source of funding.