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Tax bug clogs PE fund flow
March, 19th 2007

The ill effects of the budget proposal to restrict tax benefits of venture funds and private equity funds to just nine sectors are beginning to show. With the removal of pass-through status for private equity (PE) investments in most sectors, domestic PE players are now hesitant to infuse funds.

Experts say nearly $800 million of the existing funds of domestic PE players like IL&FS Investment Managers, ICICI Ventures, IDFC Private Equity and UTI Ventures are waiting to be deployed. These players together manage about $2.8 billion worth of funds.

We have deployed 26% of our second fund and with the change in the law, there is uncertainty over how the remaining funds would be deployed, said IDFC Private Equity president & CEO Louis Miranda.

In this years budget, income-tax exemptions for venture capital funds registered in India have been restricted to nine sectors including biotechnology, nanotechnology, IT hardware/software, R&D for new chemical entities, seed research, dairy, poultry biofuels and large hotel-cum-convention centres.

If domestic venture capital funds invest in any other sector and make money, they will have to pay taxes now. Till date, these funds enjoyed a pass-through status. Foreign funds, which are registered in Mauritius and only have an asset management arm in India, will remain unaffected from this curb.

While future funds can be raised as offshore entities to avoid the changed tax laws, it is the existing funds of these PE players that will be severely impacted. As these existing funds have been incorporated in India, the investments cannot be routed through tax havens like Mauritius.

Investors park money in funds, keeping in mind the existing tax rules. A change in tax law implies these players will have to take fresh approvals from their investors for deploying the existing funds.

The change in the pass-through status will slow down deployment for existing funds as we will now have to go back to our investors and take fresh approvals for making investments. The overall returns will also be skewed, said IIML MD Shahzaad Dalaal.

Some PEs like IDFC and IL&FS are considering setting up future funds in tax havens like Mauritius to circumvent the new regulation. But this requires RBI approval.

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