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February 28, 2007

Tax proposal 173 in Budget '07-08: Impact on Indian Private Equity

At the Venture Intelligence APEX'07 event, an executive from a Fund-of-Funds that invests in India-based Private Equity (PE) funds remarked that his firm did not find much incentive to invest in Indian Venture Capital (VC) firms - as against later-stage PE firms - unless there were some specific tax breaks for the former. While the Finance Minister was unable to attend the event himself, someone from the ministry seems to have heard the LP's remarks - at least, partially.

As PE and VC firms are considered pass through vehicles under SEBI regulations, they do not usually find a mention in the Indian government's budget. Which is why, I was taken by surprise when journalists started calling me for comments on the impact of the 2007-08 budget on the Indian PE industry.

Tax proposal 173 in Mr. Chidambaram's budget speech says the following:
Venture capital funds are a useful source of risk capital, especially for start-up ventures in the knowledge-intensive sectors. Since such funds enjoy a pass-through status, it is necessary to limit the tax benefit to investments made in truly deserving sectors. Accordingly, I propose to grant pass-through status to venture capital funds only in respect of investments in venture capital undertakings in biotechnology; information technology relating to hardware and software development; nanotechnology; seed research and development; research and development of new chemical entities in the pharmaceutical sector; dairy industry; poultry industry; and production of bio-fuels. In order to promote business tourism, I also propose to allow this benefit to venture capital funds that invest in hotel-cum-convention centres of a certain description and size.

The move has "sent out shock waves to the venture capital community", according to leading corporate law firm Nishith Desai Associates.

Extract from NDA's interpretation:
Currently, any income of a VCF set up to raise funds for investments in Venture Capital Undertakings (“VCUs”) is exempt from taxation. A VCU is defined as an Indian company, which is not listed on any stock exchange. With a view to restrict this tax exemption only to certain truly deserving sectors, the exemption shall now be available only to income from Indian unlisted companies engaged in the (sectors named in the budget).

The changes in the VCF regime were not necessary as the investors paid tax on distribution received from the VCFs in any case. At least completed transactions should have been “grand-fathered” from these adverse changes. In most countries, venture capital investments are pooled into tax transparent entities. Absence of such tax transparent entities in India would make it challenging for the Indian companies to attract venture capital funding.

Let me now try and break up the impact by type of PE/VC firm:

Large foreign PE firms - like Warburg Pincus, Temasek, Citigroup, ChrysCapital, etc. - who invest in India as either FIIs/via their entities registered in Mauritius and are not registered with SEBI: NIL.

This is borne out by this extract from an Economic Times report:
Foreign funds, which are registered in Mauritius and only have an asset management arm in India, will remain unaffected from this restriction. “It does not impact us; it only impacts the domestic venture capital. The FM is concentrating on sunrise sectors since other sectors are already mature and have seen enough attention from big PE and VC players,” says Ajay Relan, managing partner, Citigroup Venture Capital International (CVCI).

Early-stage VC firms registered in India - like APIDC VC, SIDBI VC's IT-focused first fund, etc. - which invest in sectors named in the budget: NIL.

Other VC firms registered in India - including sector agnostic late-stage firms (like ICICI Venture and IIML) and growth-stage firms (like UTI Venture, Kotak PE, India Value Fund, etc.) as well as VC firms (including the early-stage focused GVFL and SIDBI VC's new SME Growth Fund) - that dabble in sectors beyond those named in the budget: Maximum irritation value.

More voices from the ET report which confirm this:
“It is an ill-advised move. The government has not understood the VC industry. Worldover, governments never interfere in VC funding. The move will kill industries in which pass-through status is not allowed, like BPOs. All global VCs are setting up funds in India. As this is applicable to only India-based funds, it will create a rift between foreign and domestic funds,” said Saurabh Srivastava, chairman of Indian Venture Capital Association.

“The incentive to register in India as a VC fund is lost,” says Nitin Deshmukh, head (private equity), Kotak Mahindra Bank.

These firms typically have several investments in sectors that have been deemed as "desirable" (for continuing to grant pass-through status) by the FM. But, they also have quite a few investments in new growth sectors like Auto Components manufacturing, Textiles & Garments, Retail, etc.

Here are some (potential and real) irritants that these players will have to ponder:

1. When we create new funds in the future, do we create different vehicles to invest in those sectors that enjoy pass-through status and separate ones for "other" sectors? How will the LPs react?

2. What about our existing investments? How will our existing funds - which have mixed investments - be treated?

According to a report in the new business paper, The Mint, "Caught off guard by the announcement, venture capitalists call the change an exercise in futility." "The VC industry cannot be restricted to certain sectors, risk capital must flow to any start-up that has promise,” Vishnu Varshney, Managing Director of Gujarat Venture Fund, says in the report.

From a macro-perspective, what is this FM signalling? According to the ET report, the government wants to disincentivise funds from foraying into areas away from the "desirable" sectors:
The government has rapped the domestic venture capital and PE funds registered with the Securities and Exchange Board of India (Sebi) on their knuckles for trying to behave in an ‘opportunistic’ manner.

The FM is clear about punishing funds which are registered with Sebi, but has not touched foreign funds at all. Domestic funds like ICICI Venture, Gujarat Venture Capital, IL&FS VC Fund, Kotak VC Fund and IDFC Private Equity could get affected.

But I'm not convinced. Why would the Indian government want to irritate domestic firms like SIDBI Venture, GVFL, UTI Venture, ICICI Venture, IIML, etc. - some of which were actually floated by government-sponsored institutions and let foreign funds get away without any impact?

Let me now wear my thinking/speculation hat and see if there are other answers.

Maybe the answer lies offshore and its true impact will be felt down the line when the double taxation treaty with Mauritius comes up for review? To take this line of thought further, let us examine how the impact of the new rules will change if - hypothetically - Mauritius-based companies no longer enjoyed tax-free status in India.

Early-stage VC firms registered in India which invest in the "desirable" sectors: NIL.

Other VC firms registered in India that dabble in sectors beyond the "desirable" ones: Medium since they would, presumably, have had time to restructure their investment vehicles to invest differently in the "desirable" and other sectors.

Large foreign PE firms who are not registered with SEBI: Maximum Impact. These firms will have to begin paying tax in India. If they register, they would get tax exemption as long as they invest in the "desirable" sectors.

Hmmm...kind of makes sense, right?

Anyways, time will tell.

Arun Natarajan is the Founder & CEO of Venture Intelligence, the leading provider of information and networking services to the private equity and venture capital ecosystem in India. View free samples of Venture Intelligence newsletters and reports.