Starting April 1, 2007, venture capital funds (VCFs) will have to pay tax on income whether interest or capital gains earned from their past investments in firms operating in a host of sectors ranging from manufacturing and real-estate to non-tech services.
By nature, VCFs invest in unlisted firms or start-ups (called venture capital undertakings (VCUs) in tax jargon) and exit a few years down the line after the firms stabilise their operations.

VCFs registered with Sebi enjoy the benefit of a pass-through status under the income-tax law: they dont pay tax on any income earned from investments made in a VCU. Sebi regulations define a VCU as a domestic company which has not listed its shares on the and is in the business of providing services, production or manufacturing that are not in the negative list of the Central Government. Venture funds are also not permitted to invest in financial services and gold financing.

The government has now proposed to limit the tax benefits to investments made by venture funds in nine select sectors from April 1, 2007. A VCU is being redefined as an unlisted company engaged in the business of biotechnology, information technology relating to software and hardware development, nanotechnology, seed research and development, R&D of new chemical entities in the pharma sector, dairy industry, poultry industry, production of bio-fuels and hotel-cum-convention centres with a capacity of at least 3,000.

According to officials, Sebi-registered VCFs which have until now invested in sectors other than those specified in the finance bill 2007 (and listed above) will cease to enjoy a tax exemption on income that accrues to them from these investments after April 1, 2007.

This means such VCFs will have to pay tax on income earned on investments made in equities prior to April 1, 2007. Officials said that the government has decided to curtail the tax benefits after getting reports of misuse of the tax benefits by several funds.

It is another matter that the move will also help further discourage investment flows into real estate. In fact, some venture funds investing in India had revised their original charters to include investment in realty also as a permissible activity.