Move to scrap LTCG may unlock domestic funds, stem start-up exodus: experts

The proposal will also encourage domestic financial institutions to see start-ups as an alternative asset class that has been heavily dependent on foreign capital still now

The Parliamentary panel's recommendation to abolish long-term capital gains (LTCG) tax for investments in start-ups for a period of two years is expected to result in long-term benefits for the community.

The move will offer a level-playing field to domestic investments in start-ups in comparison with foreign-based sources and will also encourage domestic financial institutions to see new enterprises as an alternative asset class that has been heavily dependent on foreign capital still now, according to experts.

"It is a very good first step as domestic money is not flowing into the (start-up) ecosystem like other countries. A lot of foreign capital is taking a larger slice of the pie. The tax incentives will go a long way in kickstarting the domestic contribution as most private equity (PE) and venture capital (VC) funds have also raised money outside India. Also, the tax incentive will also unlock domestic capital from insurance and financial institutions who don't usually invest in start-ups," said V Balakrishnan, partner and chairman at Exfinity Venture Partners. 

Of the $14 billion raised by start-ups from VCs in the year ending December 2019, roughly only $1 billion came from Indian sources, say experts.

On Tuesday, the panel headed by former minister Jayant Sinha recommended that the tax incentive should apply to investments made through collective investment vehicles (CIVs) such as angel funds, alternate investment funds and investment LLPs.

It suggested that after this 2 year tax holiday period, the Securities Transaction Tax (STT) may be applied to CIV so that revenue neutrality is maintained. The report suggested several other measures to boost the domestic start-up investment scene, including exempting domestic fund managers from Goods and Services Tax (GST), and mobilising domestic funds to pool into funds of funds which is more common in foreign countries. 

"These reforms would open the floodgates of domestic capital going into start-ups like never before as long as the eligibility criteria of the tax benefits are not too narrow, enabling the widest set of startup investors and companies to benefit for a long enough period of time," said Kunal Bahl, CEO and co-founder of Snapdeal.

"The long-term capital gains tax in India is higher for private, unlisted securities, that is at 20 per cent, when compared to publicly-listed securities (10 per cent). This policy is short-sighted because startups directly create jobs and technological advancements including IP in India and startup investments are a lot riskier," said Kushal Bhagia, chief executive officer at Firstcheque.vc, an early-stage fund that invests in early-stage or pre-seed start-ups.

"Fully loaded, Indian investors into startups pay 2.54 times the rate paid by their foreign counterparts. This is the reason for the emaciated participation of Indian investors in Indian start-ups. In addition to increasing foreign investments, it will help unleash the shackled rupee capital ecosystem as well," said Siddarth Pai, founding partner at 3one4 Capital.

The tax incentive will also dissuade a lot of India-focussed startups from registering their headquarters in cities such as Singapore or Delaware instead of India as encouraged by the foreign-based PE or VC funds who have backed them. "Tax is a big motivator for foreign funds to encourage such a move (of setting up foreign-registered holding companies) as it fetches them a better internal rate of return (IRR). Now that argument doesn't hold as much water," he added.

Industry experts also say the recommendations are likely to be adopted as the long-term benefits of the move will outweigh the quantum of revenue impact that is anyway projected to be minimal.

"Government is recognising startups to play a larger role in the Indian economy going forward. The supportive regulations are similar to what the IT industry had in the early 1990s. This is an incremental change that may not have a big impact on the government's finances. It can be expected to be adopted in next year's annual budget," said Balakrishnan who is also a former CFO of Infosys. 

The Covid pandemic has also impacted the overall fund flow to the startup ecosystem. According to Tracxn, funding activity in the start-up ecosystem fell by nearly 29 per cent to $4.2 billion in the first six months of this year compared to $5.9 billion in the same period last year. Only 443 companies were funded in the January-June period this year against 725 in the corresponding period in 2019.

"In the current scenario, with the global pandemic and restrictions on FDI from China affecting the funding ecosystem, the recommendation is the need of the hour and will help prop up start-ups," said Rajiv Chugh, partner and national leader (Policy Advisory & Speciality Services) at EY India. "This is the right way of thinking and it seems the wind is finally blowing in the sails and will lead the startups in the right direction."