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Tax-free foreign venture capital investment

Under new rules in India, the entire income of registered VC funds, whether foreign or domestic, is exempt from Indian income tax, subject to certain conditions. But to take advantage of this tax-exempt status, funds must register with the regulator, the Securities and Exchange Board of India. Berjis Desai of Udwadia, Udeshi & Berjis explains further.

In late 2000, Sebi issued the Foreign Venture Capital Investor Regulations, 2000. They apply to foreign venture capital investors (FVCI) incorporated and established outside India and which propose to invest in India. Until recently, FVCIs avoided registering themselves with Sebi due to the extremely confusing regulatory and tax position. FVCIs preferred to operate from overseas, usually through a liaison office in India. However, this is no longer the case following the enactment of the Regulations, and also amendment to the Indian Income Tax Act, 1961 (IT Act).

The clear advantages of registration notwithstanding, there is an argument that it is mandatory anyway. This view is based on Section 12(1B) of the Sebi Act, 1992, which provides that no person may sponsor or carry on any venture capital fund without a certificate of registration from Sebi, in accordance with the Regulations. Failure to register may amount to a contravention of the provisions of Section 12(1B) of the Sebi Act, 1992, which can lead to heavy fines.

This view proceeds on the assumption that a distinction must be made between a non-resident making a foreign direct investment (FDI) and an FVCI. This distinction is established from the nature of the agreements entered into by a foreign investor with the Indian investee companies and its promoters, and also whether the foreign investor otherwise carries on the business of being a venture capital fund outside India.

This contention was reinforced when India's central bank, the Reserve Bank of India (RBI), amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000, to specifically bring within its fold investments by a Sebi-registered FVCI in a domestic, Sebi-registered venture capital fund or an unlisted Indian company. The effect of the amendment is that such an investment will no longer be regarded as FDI, but as a separate category of investment. The advantage of such treatment is that shares issued by unlisted Indian companies to an FVCI will not be subject to compliance with the usual price guidelines and the FVCI may acquire or purchase the shares issued by unlisted Indian companies at a price that is mutually agreed between the buyer and the seller or issuer.

Advantages of registration

The obvious advantage of registration is that, under the IT Act, its income is tax free. But another advantage is that under the normal FDI rules, all FDI investors require the central government's prior permission to invest in a similar field to any of its previous investments or tie ups. In other words, automatic approval is not allowed and a no-objection certificate of the Indian investee company (with whom there is an existing tie up) is required. However, Sebi-registered FVCIs are exempted from this requirement.

There is no minimum capitalization requirement for being registered as an FVCI. It can invest either in a domestic fund or in a domestic company whose shares are not listed on a recognized stock exchange in India (it does not matter if its shares are listed on a stock exchange outside India, such as the Nasdaq or NYSE) and is not engaged in any activity except real estate, non-banking financial services or gold financing (a venture capital undertaking). While granting registration, Sebi will take into account the FVCI's track record, reputation of the group and financial soundness. While it can invest its total funds even in one domestic fund, it cannot invest more than 25 per cent of its committed funds in any one venture capital undertaking (and at least 75 per cent of such investments must be in equity).

The Regulations require an FVCI to appoint a domestic custodian as well as open a non-resident rupee or foreign currency account with a designated bank. Banks are allowed to offer forward cover (for hedging against forex risk) to FVCIs to the extent of their inward remittance. Registration fees payable to Sebi are about $11,000.

Taxation of FVCI

Under Section 90(2) of the IT Act, a non-resident assessee based in a country with which India has a double taxation avoidance agreement (DTAA), may opt to be taxed either under the IT Act or the DTAA, whichever is more beneficial.

Under Section 10(23FB) of the IT Act, any income of a registered FVCI is exempt from income tax. The FVCI can carry on business in India through a permanent establishment in India, and yet its entire income would be tax free. On the other hand, if the FVCI opts to be taxed under the DTAA and it has a permanent establishment in India, its Indian income will not be tax free.

The tax exemption under section 10(23FB) has to be read with section 115U of the IT Act, which confers a pass-through status on Sebi-registered venture funds. Investors in such funds would be liable to tax in respect of the income received by them from the FVCI in the same manner as it would have been, had the investors invested directly in the venture capital undertaking. In other words, income earned by an FVCI by way of dividend, interest or capital gains, upon distribution, would continue to retain the same character in the hands of its investors.

This bring us to a question as to what is the nature of the income derived by an FVCI from its Indian investments. While dividend declared by an Indian company is tax free in the hands of any recipient, including an FVCI, the gains, an FVCI would make upon exit from an Indian investment, was so far regarded as capital gains. However, the Authority for Advance Ruling on March 7 2001 held that profits made by a private equity fund or venture capital fund should be taxed as business profits and not as capital gains.

Are non-resident investors in an FVCI, therefore, liable to pay Indian income tax on what they receive from the FVCI as business profits, even though the FVCI itself does not have to pay any tax? Although Section 115 U begins with the words ‘Notwithstanding anything contained in any other provisions of this Act', and it would override the normal provisions relating to taxability of individual items of income, it cannot override Section 90(2) relating to DTAA provisions. India is a signatory to the Vienna Convention on the Law of Treaties and, therefore, tax treaties have a special status as compared to domestic tax legislation and would prevail unless there is an express specific domestic provision to override the treaty. In the present case, it does not appear to be the intention of the legislature that Section 115 U should override Section 90(2).

Accordingly, a non-resident investor in an FVCI, who receives dividend from the FVCI, is entitled to characterize the same as dividend under the DTAA, by opting to be taxed under the DTAA and not the IT Act. Due to its very recent enactment, obviously, there is no precedent or case law and, therefore, it is not improbable that the Indian tax authorities may contend that the investor is not entitled to the DTAA benefit in view of Section 115 U and is liable to pay tax on business profits in India. Tax planning structures could be worked out to protect against such an eventuality, however remote it may be.

Taxing the carry

Under the Sebi regulations relating to mutual funds, it is mandatory that a mutual fund must have a separate asset management company (AMC). However, the Regulations do not make this a mandatory requirement for an FVCI. This difference is critical from the viewpoint of tax because while the income of an FVCI is tax free, the income of a domestic AMC is subject to 35.7 per cent tax in India (48 per cent for a foreign AMC). It is not advisable for an offshore AMC to render services to an FVCI by deploying its personnel to India for carrying out various activities such as validation of business plans, due diligence, etc, as the Indian tax authorities may contend that such AMC is deemed to have a permanent establishment in India and liable to be taxed in India on such part of the ‘carry' as is attributable to its operations in India.

Structuring FVCIS

On account of its favourable DTAA with India, Mauritius has become a favourite jurisdiction for investing into India. An obvious question arises. If the FVCI is to avail of the total tax exemption under Section 10(23FB), why does it require to be incorporated in Mauritius or any other country with whom India has a favourable DTAA. The answer is, that having regard to the legislative fickleness with which the IT Act is amended annually, even if the tax exemption provisions contained in Section 10(23FB) are withdrawn, the FVCI could then rely upon the provisions of the DTAA, so that its income continues to be tax free. So, there is dual protection. Of course, in such an event, the FVCI cannot have a permanent establishment in India.

The FVCI can be incorporated as a Mauritius offshore company and will be a tax resident of Mauritius. This process is quick and user friendly. The second step is to register with Sebi as an FVCI. If the FVCI intends to have a place of business in India, under the Foreign Exchange Management (Establishment in India of Branch or Office or other place of Business) Regulations, 2000, it will require RBI approval.

Before investing in a venture capital undertaking, the FVCI will have to apply to RBI, through Sebi, for permission. Given the manner in which these Regulations are drafted, it appears that the FVCI may have to obtain such permission on a case-by-case basis, every time it makes an investment. However, in practice, RBI may grant a general or blanket permission as in the case of foreign institutional investors.

Conclusion

As is evident from the above analysis, there are still a couple of grey areas which require tax planning for FVCI and their investors. While Sebi efficiently handles registration, formal permissions under Exchange Control Laws are still required. However, the entire process of setting up an FVCI is much simpler now and can be completed in as little as 90 days. The total tax exemption makes these investments very attractive indeed.

© Copyright IFLR 2002

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