The government is reviewing the tax treatment of venture capital funds to see if there is a case for softening the blow, particularly for venture funds operating in sectors ranging from manufacturing to non-tech services.

A top government official confirmed that the review follows post-Budget representations made by the $7-billion industry to the finance ministry and regulators Sebi and RBI. Till FY07, Sebi-registered VCFs that invested in start-ups or unlisted firms enjoyed the benefit of a pass-through under the income tax law.

They did not have to pay tax on any income earned from investments made in these firms known as venture capital undertakings. However, investors had to pay a tax whenever the income was distributed by the fund.
From this fiscal, the government has proposed to restrict the tax benefits to investments made by VCFs in nine select sectors biotechnology, information technology relating to software and hardware development, nanotechnology, seed research and development, R&D of new chemical entities in pharma sector, dairy, poultry, production of bio-fuels and hotel-cum-convention centres with a capacity of at least 3,000.

The venture capital industry wants the government to withdraw the Budget proposal to bring VCFs under the tax net. Their contention is that the incentive is, at best, a tax deferral as the income distributed by the fund is in any case taxed in the hands of the investor. Simply put, they want the continuation of the pass-through status for all Sebi-registered VCFs.

A complete rollback appears unlikely though a final view is yet to the taken. Sources said there were demands from some quarters to add infrastructure to the list of nine sectors that will continue to enjoy tax breaks. The original list proposed by the government is set to be reviewed. The real estate sector is, however, out as the government is clear that it wants to discourage funds from investing in realty.

According to the Budget proposals, VCFs operating in sectors other than nine select sectors also have to pay tax on any income interest and capital gains earned from their past investments. We are looking at some of the issues raised by venture capital industry such as protecting past investments, and a final view will be taken by the finance minister P Chidambaram, said a senior official.

According to the official, the proposal to levy tax on income earned by VCFs from past investments is modelled on the lines of taxation of enterprises earning income from investments in infrastructure facilities. Enterprises investing in infrastructure facilities enjoyed a tax exemption on income in the form of interest, dividend or capital gains earned till FY06. The exemption was knocked off last fiscal and no protection was given to investments made in the past.

The Budget stipulations will hit domestic funds and not foreign funds investing directly into Indian portfolio companies. This is because most of the foreign funds route their investments through Mauritius and other tax-neutral jurisdictions. They will continue to enjoy tax exemption under the Double Taxation Avoidance Agreements. This means they will get the equivalent of a pass-through in any sector that they invest in, said a tax expert. Domestic funds are demanding a level-playing field vis--vis foreign funds. Some domestic funds are formally shifting the assets from their books to that of the investors so that the tax liability shifts to where the asset resides. This appears one way of avoiding the tax on VCFs.

Most of the funds are set up in the form of trusts. If the trust is a specific one, the income of the trust is taxable either in the hands of the trustee or the beneficiary. The only exception to this general rule is in the case of trusts carrying on business. In such cases, the entire income of the trust is taxable in the hands of the trustee at the maximum marginal rate.

If the Budget proposal is passed by Parliament, trustees who are held to carry on business will have to fork out a 33.9% tax on business income. Their income from sale of shares would be categorised as business income. The government may have to clarify this issue as well.