The Finance Act, 2007 amended Section 10(23FB) of the Income-Tax Act, 1961, thereby restricting the tax pass through status for venture capital funds (VCFs) and venture capital companies (VCCs) to only income from investment in domestic unlisted company engaged in specified nine sectors such as IT, biotech, etc (VCU). Prior to the amendment, VCFs and VCCs enjoyed complete pass through status under Section 10(23FB), irrespective of nature of income. Instead, the income was taxed in the hands of its investors at the time of distribution under Section 115U, on a seethrough basis.

While the revised definition of VCUs includes IT, biotechnology, pharma sector with infrastructure being added subsequently, a whole lot of other key sectors, which are in need of funds, such as healthcare, real estate etc have not been covered within the definition of VCUs. The amendment, therefore, raises certain issues in respect of income of VCF from non-VCUs.

Firstly, being in the nature of a trust vehicle, the taxation of VCFs is now guided by the complex provisions relating to trust taxation. Whilst the taxation regime for trusts also aims at one-level taxation, the implications could be manifold ranging from issues relating to determinate trust vs. indeterminate trust, revocable vs. irrevocable transfer, taxation on accrual basis rather than on distribution to investors, etc. Issues could also arise in respect of deducting tax at source on certain streams of income and also claiming of TDS credits by the investors due to complexity of tracking of income streams. Further, tax implications can become even more complex for foreign investor in VCF. There being not enough precedents in the context of contributory trust taxation, this would be an uncharted territory both for the tax department and the venture capital industry. Further, in case of VCCs, the amendment could result in two levels of taxation ie tax in the hands of VCC on VCCs income and on distribution of income to investors. It is not clear as to whether the DDT provisions would apply to VCC having mixed investments (i.e. VCU and non-VCU).

Also, the existing non-VCU investments that have already been made by VCFs would also be governed by the revised provisions, and therefore are retro-active in that sense. It would be unjust to subject these investments under the proposed regime considering that the investments were made based on the position of a complete pass through status which was made available to VCFs.

While the objective of the government, based on certain press statements, largely seems to have been to restrict investment in the negative list sector, the amendment in Section 10(23FB) definitely does not seem to have achieved the objective. The amendment has affected venture capital funding in a range of sectors (most of which are in need of funds), in a manner that the entire investment process has now become more cumbersome, with the need to come up with structures which seek to achieve single level of taxation, and implement the same.

The amendment certainly would not result in contributing significant additional tax revenues to the exchequer. All that the amendment has achieved is to create uncertainty and complexity in matters of taxation for the investors and going forward, administrative difficulty for the tax department owing to difficulty at assessment stage followed by protracted litigation. In view of the above, the government should consider restoring the pre amendment tax position. Governments objective of restricting investment in certain sectors could, on the other hand, very easily be achieved by including those sectors in the negative list of investment under the SEBI Venture Capital Fund Regulations rather than making an amendment in the tax provisions. 

Punit Shah
The author is financial services tax leader, PricewaterhouseCoopers