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Tax proposal on VCFs must be withdrawn
March, 28th 2007

The most unkindest cut of allthat was how Mark Antony described the wound inflicted by honourable Brutus on Caesar. The 2007 Budgets most unkindest cut targets VC funds. The Budget has taken away the benefit of tax pass-through from all venture funding other than in nine specified sectors. That, too, with retrospective effect. The measure goes beyond being good, bad or ugly and crosses over to the realm of the anti-thesis of reform.

Venture funds represent a true revolution in the march of human progress. A venture fund offers capital to projects that do not qualify for capital from anywhere else, either because the would-be entrepreneur has no track record (nor his father), or because the business plan is so unconventional that its chance of success cannot properly be evaluated.

Traditional sources of finance would turn up their nose at such absence of pedigree and conventional viability. Venture funds do not because they work on the principle that even if only a tiny fraction of all the projects they fund turn out well, the return on the few successes would more than make up for all the money lost in the failures. Google, Yahoo and Indias own i-flex grew to fame and fortune out of capital supplied by venture funds.

Historically, VCFs started off in the IT sector. But this does not mean that venture funds should stay confined to the world of tech. Rather, they should be encouraged to enter every conceivable field of human creativity that lends itself to commerce.

Traditional finance is conservative. Banks can and should provide capital only to projects whose viability is beyond questionit is not their job to provide risk capital. Such caution is, however, inequitable or iniquitous: it means that the initial capital has to come from a rich father or you amass it by hook or by crook, violating assorted sections of the penal code, not excluding 420 and 302.

Before the modern revolution in finance, human creativity could blossom into full bloom only if it flowered on a high branch of privilege or on a fetid pile of crime. Not any more. Now, financial ingenuity has made it possible to channel societys savings to people who possess talent, grit, one bright business idea and little else.

Angel investing, venture funds, private equity are different links in a chain of intermediation, each different from the other with regard to how early in a projects take-off it supplies capital. Venture funds democratise entrepreneurship, liberating it from inherited wealth and primitive accumulation. Anyone interested in promoting reform should be promoting venture funds, not clipping their wings.

Since such funds enjoy a (tax) pass-through status, it is necessary to limit the tax benefit to investment made in truly deserving sectors, says the Budget speech. What makes for a truly deserving sector? Why is one rupee of value added, or one additional job created in one sector, superior to its counterpart in another sector? The answer was clear to the garden variety of Soviet planners. But why has the honourable FM fallen prey to such delusions of godly prescience?

The only tax benefit venture funds have is that of pass-throughthe income generated by the venture fund will be taxed not from the venture fund but at the time when it is passed on to those who have invested in the venture fund. This represents a tax deferral, not tax loss. Only if VC funds are open-ended affairs that go on in perpetuity would the government suffer a loss of tax. It is legitimate to insist that VCFs should be close-ended and wind up and return their funds to the original investors within a finite period. Tax would inevitably kick in, at this point.

Reportedly, the provocation for the Budget move was money pouring into real estate via VC funds. Restricting the flow of bank credit to dodgy real estate projects is understandable but why cut off capital that enters, at its own risk, an area of vital importance to Indias fast growing economy? The tax proposal on venture funds is anti-growth, distrustful of the animal spirits of enterprise, elitist and anti-reform. It should be withdrawn, not modified.

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