The Indian Venture Capital Association (IVCA) has asked the finance ministry to extend the benefit of tax pass-through on investments across sectors in the upcoming Union Budget. Currently, under the Finance Act, 2007, tax pass-through benefit has been allowed to investments in only nine sectors information technology, biotechnology, nanotechnology, poultry, dairy, bio-fuels, hotels and hospitality centres, seed research and chemical research & development.

In taxation parlance, a pass-through means an exemption from paying taxes by the exempted group. The tax payable by the group is passed on to the end beneficiary, in this case, the investors or limited partners in these VC funds. Funds investing into non-specified sectors (sectors that do not fall inside the exempted bracket) will have to pay tax (on gains) at every exit.

Through its representation, IVCA has asked the government to do away with sectoral specification and restore tax pass-through benefits across sectors for venture capital funds. The industry body has asked the ministry to treat VCFs (venture capital funds) at par with mutual funds, which are automatically exempted from paying taxes at the pool level.

Non-availability of tax pass-through status could lead to higher taxation of income and, therefore, lower returns for the investors, said Pranay Bhatia, partner, Economic Laws Practice.

If tax pass-through benefit is allowed across sectors, as is proposed under the draft Direct Tax Code, it will alleviate tax interpretation challenges which are currently faced by domestic venture capital funds, Mr Bhatia added.

According to IVCA, tax pass-through for select sectors is causing tremendous hardships to VCFs in terms of uncertain interpretations and operational ambiguity. Moreover, most VCFs are set up in the form of trusts. With pass-through unavailable in sectors other than those specified, these trusts (or VCFs) will be governed by the provisions of trust taxation.

Trust laws according to IVCA are archaic and hold good only for private trusts; the provisions of trust laws are difficult to apply in the context of contributory trusts or pooling vehicles (like VCFs), the industry body said.

Pass-through basis of taxation without sectoral restrictions will resolve several of the current issues in the taxation of VCFs. Such a provision will allow the investors in VCFs to be taxed on income directly without any revenue loss to the government, said Hiresh Wadhwani, partner, financial services, Ernst & Young.

Venture capital experts are asking the government to maintain parity with foreign venture capital funds which are exempted from paying tax in India. Currently, there are 137 Sebi-registered domestic VC funds and 135 foreign venture funds.