Every year, the budget brings new possibilities and expectations for the industry and this year was no different. The Union Budget (“Budget 2015”) created some positive buzz for the private equity and venture capital funds.
Given below are a few of our preliminary observations on certain proposals put forth by Budget 2015 vis-à-vis the expectations of the private equity and venture capital segment.
Alternative Investment Funds: Pass Through Status
- The Income Tax Act, 1961 (“IT Act”), presently only provides a tax pass through status to a venture capital fund (“VCF”) being one of the sub-category within Category I Alternative Investment Fund(s) (“AIFs”). However, addressing a long-standing request of the industry, Budget 2015 under the Finance Bill, 2015 (“Bill”), proposes to extend the benefit of a tax pass through to all Category I and Category II AIFs under a special tax regime.
- Broadly, any income earned by a unit holder of a Category I or II AIF is proposed to be charged to tax directly in the hands of the investor. However, at the time of distribution of such income by the AIF to the investor, a withholding tax shall apply. The exception being income categorized as business or professional income/gain of the fund, in which case tax shall be payable at the fund level.
- While the proposed amendments are a welcome move, it may be worthwhile for the government to further examine and address the following issues:
(i) Allow pass through of losses (incurred at fund level) to the unit holders: While it is proposed to allow carrying forward of unutilized losses incurred at the fund level and set off such losses against future income of the fund, such losses are not allowed to pass through to the unit holders. The investors should be allowed to off-set its proportionate losses against its other profits and gains of the investor.
(ii) Clarity on application of withholding tax provision: Clarifications should be issued to ensure that the proposed withholding tax deductible from the income distributed to the investors does not apply to income which is otherwise exempted from such deductions such as income distributed to non-resident investors who are eligible to benefits under applicable tax treaties. Although Section 195(1) of the IT Act does provide for withholding obligation (applicable on payment to non-residents) on sums chargeable to tax under the provisions of the IT Act, a specific clarification would be welcome to avoid ambiguities.
Permanent Establishment Exemption To Fund Managers/Investment Advisors
- Under existing provisions, in case of off-shore funds, the presence of a fund manager in India may create sufficient nexus of the off-shore fund with India and may constitute a business connection in India even though the fund manager maybe an independent person. Once such a business connection is established, income attributable to the activities which constitute business connection becomes taxable in India.
- The Budget 2015 proposes to mitigate this risk (and encourage fund management activities in India) by clarifying that an India based fund manager or investment advisor shall not be treated to constitute a business connection in India of the said fund, under certain prescribed conditions (inter alia if, the investment by the fund in an entity does not exceed 20% of the fund’s corpus, the offshore fund is a broad-based fund with over 95% investors being non-resident and each investor’s holding in the fund (along with connected persons) is capped at 10%, the monthly average of the corpus of the fund to not be less than Rs. 100 crores).
- While a welcome move, due to the conditions imposed, it appears that in practice, this relief may not be effectively availed by the private equity or venture capital funds. For instance:
(i) the broad basing requirement of having a minimum of 25 members who are directly/ indirectly unconnected persons, is not appropriate for private equity/venture capital funds which very often have fewer investors and closely held;
(ii) similarly, capping of each investor holding to 10% restricts the ability of the fund sponsor/ anchor investor to have greater participation;
(iii) for availing the exemption the fund should not be engaged in any activity which constitutes a business connection in India and not have any person acting on its behalf whose activities constitute a business connection in India (other than the activities undertaken by the eligible fund manager on its behalf). This may be tricky requirement to be complied with, especially in light of the wide scope of the term ‘business connection’ and the existing ambiguities and interpretational issues surrounding the same.
(iv) the exemption does not extend to fund managers who are employees or connected persons of the fund. Accordingly, private equity/venture funds who either do not wish to engage independent entities as managers or engage them on a consultancy/independent basis on account of confidentiality and mitigation of risk, may find it difficult to meet this requirement.
Therefore, further discussions are required to be held with the government to enhance the possibilities of availing benefits intended by the Bill and to make the exemption more effective for private equity/venture funds.
For further information, please contact:
Seema Jhingan, Partner, Lex Counsel Law Offices
sjhingan@lexcounsel.in
Neha Yadav, Lex Counsel Law Offices
nyadav@lexcounsel.in
