The Finance Minister recently unveiled the new tax code (‘the Code’) which is expected to be effective from April 1, 2011. The significant thrust of the Code is to widen the tax base and have a simplified and moderate tax regime. Until 2007, SEBI registered Venture Capital Funds (‘VCFs’) enjoyed a complete tax pass-through status. The income received from investments was taxed only once, ie in the hands of the investors. This was in sync with the international practice of treating the funds set up mostly as Limited Partnerships, as pass-through. In the Finance Act, 2007 this benefit was restricted to income of VCFs from investments in certain select sectors. Most of the funds did not suffer adversely as they have been set up as ‘trusts’ which are taxed only once as opposed to companies which suffer from double taxation of income. The VC industry has been demanding full pass-through status since then, in order to bring in certainty. The Code proposes to do that and much more, for the VC industry. In this article, we have discussed the relevant proposals.
Taxation of VCFs and their investors
The Code proposes to treat all VCFs as tax pass-through provided they are registered with the SEBI and fulfill certain conditions as may be prescribed. All income received by VCFs will be tax exempt. The Discussion Paper released along with the Code mentions that the investors in such VCFs would be taxed in respect of such income. However, the Code provides that income received in respect of units in mutual funds (defined to include VCFs) would not be liable to tax in the hands of the recipients. Thus, the entire income in respect of investments through VCFs could be exempt from levy of tax. This seems to be unintentional. Looking at the intent, it may be safer to assume that the income may be taxable in the hands of the investors.
In order to facilitate the financial intermediaries including VCFs, the Code also proposes to exempt the dividends distributed by domestic companies to such VCFs from dividend distribution tax (‘DDT’). Therefore, now the dividends earned by the VCFs will be taxable in the hands of the investors. This will significantly increase the tax cost. While the DDT would have been paid at the rate of 15%, the tax incidence in the hands of investors would be at the rate of 30%. Further, the Code has done away with the tax concession for long term capital gains. Therefore, any capital gains earned on sale of portfolio companies will be taxable in the hands of the investors at their applicable rates as follows:
* Individuals – at applicable slab rates, highest being 30%
* Unincorporated entities (including LLPs) – at 30%
* Companies – at 25%
Capital gains in the hands of the non-resident investors would be liable to tax at the rate of 30%. Taxation of the non-residents would be subject to benefits available under applicable tax treaty.
Taxation of unregistered VCFs and their investors
In case of VCFs which are not registered with SEBI or do not fulfill the prescribed conditions in this regard, the tax pass-through is not provided under the Code. However, if they are set up as ‘trusts’ their income would still be taxed only at one level. The trustee would be treated as ‘representative assessee’ and tax can be recovered from the trustee in the same manner and to the same extent as each investor. The dividends distributed by the investee companies would be subject to DDT; such dividends would not be liable to tax again in the hands of the fund or the investors. Capital gains will be taxable in the same manner as in the case of VCFs. Hence, if the investor is eligible to claim treaty benefit, such benefit should be available in computing tax payable by the fund. Once tax has been collected from the trustee, the investors in such trust would not be liable to tax again in respect of that income.
Currently, the Code does not draw any distinction between a determinate trust and a discretionary trust. However, the Discussion Paper indicates that the intention is to tax private discretionary trusts as unincorporated bodies at a rate of 30%.
While there is a lot of cheer from the VC industry, there are many clarifications needed viz conditions to be fulfilled to avail pass-through status, deductibility of expenses incurred by the fund, time of tax incidence for the investors, availability of pass-through benefits to a foreign venture capital investor, etc. The Code is currently open for public comments and is likely to go through amendments before it is enacted. Further, provisions such as ‘Treaty override’ and ‘General anti avoidance rule’ are likely to impact the way portfolio investments are structured in India.
(Shefali Goradia is a partner with BMR Advisors. She was assisted by Kalpesh Desai, Director BMR Advisors).