New tax code pushes taxation of vencaps back to its old form
September, 08th 2010
The Direct Taxes Code, 2010 (DTC) was tabled in Parliament on August 30. While the venture capital industry was expecting clarifications on the tax regime prescribed in the earlier Draft Direct Taxes Code, 2009, the finance minister had something else to offer.
The Draft DTC treated registered venture capital funds (VCFs) as pass-through entities, which meant specific tax exemption was available to a VCF irrespective of the sector it invested in. The DTC now proposes to restrict the tax exemption to investments of VCF in nine specified sectors only, thereby retaining the existing tax regime applicable to VCFs under the Income-Tax Act, 1961 (Act).
In line with the current provisions of the Act, the DTC also prescribes that the income distributed by a VCF to its investors will be taxable in the hands of investors on receipt basis. However, specific exemption from tax withholding on distribution of income by a VCF to its investors appears to have been given the miss in DTC.
VCFs are traditionally set up in the form of trusts, where investors are beneficiaries in the trust and trustees are legal owners of the investments. VCFs usually fall back on trust taxation wherever they are unable to get a pass-through status.
DTC has simplified the provisions relating to trust taxation by eliminating the concept of determinate and indeterminate trust. The Code provides that the trustee of a VCF trust will be taxable in representative capacity, as the tax would have been levied directly on the investor. However, in case of the revocable trust, income will be taxable directly in the hands of beneficiaries.
Provisions relating to taxation of capital gains have undergone a few changes. The existing tax exemption on capital gains tax on sale of equity shares held for more than one year and which are subject to securities transaction tax (STT), has been restored. However, capital gains on shares held for more than one year, which is not subject to STT, will now be taxable at 30%. Currently, these gains are taxable at 10% or 20%. VCFs provide seed funding to start-up ventures or provide growth capital to developing companies.
At the time of exit, quite likely the investee company may still not be ready for public listing and thus, divestment could be in the form of sale to strategic/ financial investors. Capital gains tax rate of 30% on such divestment will impact the return on investments. This also does not provide a level playing field for the domestic VCFs as compared to foreign funds who are in position to claim tax relief. This may discourage participation of domestic investors in VCFs.
Under DTC, a foreign company shall be treated as resident of India if its place of effective management is in India. Place of effective management is defined to mean the place where the board takes its decisions or the place where the executive directors or officers of the company take commercial and strategic decisions. It will now be very important for the offshore funds (more specifically, offshore funds of Indian promoters) to demonstrate that the local board in the respective jurisdiction of offshore funds is involved in performing commercial and strategic decisions of the company.
Transfer of shares of a foreign company is sought to be taxed in India if assets in India (even if held indirectly) represent at least 50% of the fair market value of all its assets. Exits at offshore level will now require detailed analysis of the facts.
Dividend distributed by holding companies to its shareholders will not be subject to dividend distribution tax (DDT) provided such dividend is received from its subsidiary and the subsidiary has already paid DDT on it.
The condition of a holding company not being a subsidiary of another company is relaxed in the DTC. This will facilitate the holding company distributing dividend to its investors without levy of DDT. While the levy of double DDT is avoided, it appears the dividend so received by the investor from the holding company may not be exempt from tax.
General Anti-Avoidance Rules (GAAR) provisions enable a commissioner of income-tax (CIT) to declare an arrangement as impermissible if it has been entered with the objective of obtaining tax benefit and lacks commercial substance. CIT may invoke GAAR provisions where the Offshore Funds are set up primarily to obtain tax benefit under the Double Taxation Avoidance Agreement.
Controlled Foreign Company (CFC) Rules shall apply when a foreign company is controlled by resident taxpayers, the tax payable in the foreign company is less than 50% of the corresponding tax payable under the DTC, and similar other conditions are satisfied. If CFC Rules apply, pro rata net profit of the CFC will be attributed to the resident taxpayer.
As a result, offshore investments of resident funds and individuals may have an impact on account of CFC Rules. Further, where a foreign company is treated as a resident in India and is taxable on net income basis; it appears its Indian parent may also be subject to CFC rules and the same income could be subject to double taxation.
The VC industry, by its very nature, is very important and the government should take a re-look at the provisions in the DTC with a view to relax it further.