New direct tax code to make fund-raising easier for VCs

With the government allowing tax pass-through to financial intermediaries, including domestic venture capitalists (VCs), in the direct tax code unveiled on August 12, VCs are optimistic about fund raising.

A pass-through in taxation means that the business entity need not pay tax. Instead, all taxable income is passed through to its owners or members.

According to the provisions of the Income Tax Act, VC funds that invest in nine designated sectors — biotechnology, nanotechnology, IT hardware and software, research and development for new chemical entities, seed research, dairy, poultry, bio-fuels and large hotel-cum-convention centers — do not pay any tax on the gains realised on such investments. But the investors or limited partners (LPs) in these funds pay the tax.

“It will create a level-playing field for investors. For instance, people who are investing from Malaysia will get the benefit of tax pass-through. At present, we have a trust structure where investors cannot exit from a fund in the middle. The direct tax code has opened various sources of funding and now we can even raise funds from high net-worth individuals,” said Axis Private Equity CEO Alok Gupta.

Foreign VC funds registered with the Securities and Exchange Board of India (Sebi) are exempted from paying any tax in India as most of them are also registered in Mauritius.

Funds have to pay tax while exiting their investments other than the prescribed sectors. VCs and private equity players said the tax treatment often discouraged a lot of domestic funds from investing in other sectors even if the underlying opportunity was good.

“It is unfortunate that most of the funds have registered in Mauritius. It is a welcome step, but a bit-too late since the industry has been demanding this for long. Since most PEs have raised funds, it will be beneficial for the new ones,” said Arun Natarajan, managing director, Venture Intelligence.

“This will bring us in parity with foreign funds. There will be no difference as we will not pay any tax. We will have to see whether the funds raised in 2005 and will exit in 2011 will get the benefit of the new tax regime,” said Rajesh Singhal, managing partner, Religare Milestone Private Equity.

At present, there are 132 Sebi-registered domestic VC funds and 129 foreign venture funds.