06/01/23

INDIA: Panel bats for major tax relief to boost VC funding.

As published on financialexpress.com, Friday 6 January, 2023.

A government panel under former Sebi chairman M Damodaran is learnt to have suggested a raft of measures, including tax incentives, to bolster the private equity and venture capital eco-system in the country.

Sources told FE that the panel has, in effect, pitched for a capital gains tax exemption for ten years relating to employee stock option plans (ESOPs) in the start-up space, subject to certain riders. It has also batted for a more explicit provision to keep the so-called “carried interest” (percentage of profit that goes to the fund manager) for alternate investment funds (AIFs) out of the ambit of the goods and services tax (GST). The six-member panel submitted its report with the finance ministry last month.

To encourage start-ups to choose India for incorporation and help them retain talent, the panel has suggested that the capital gains tax on ESOPs should not be levied at the time of exercise, for the first 10 years of the establishment of the start-ups, except when these ESOPs are gifted, sold or transferred, or until six months after its listing on the stock exchange.

At present, ESOPs are taxed at two stages–at the time of the exercise of the ESOPs and at the time of selling the shares. The exercise of ESOPs is taxed under the head salary (perquisite) where the gap between the fair market value of the shares and the exercise price of the shares is subject to tax in accordance with the normal tax slab of the employee.

The panel has also called for the removal of the asymmetry in the capital gains taxation systems for listed and unlisted securities to support the AIF ecosystem in the country. The holding period for listed and unlisted shares for such a taxation also needs to be aligned, it believes. At present, the long-term capital gains tax on unlisted shares held for more than two years is as high as 20%, double that of listed equity shares held for a year.

Importantly, the panel has also suggested that GST should not be levied on the carried interest, which is essentially a part of the fund’s profit allocated to its fund manager, based on the fund’s performance.

Analysts say the carried interest, under the income-tax rules, has been treated as a “capital gain” from investment in securities, while under the GST regime, it was treated as “income” from securities. So, it was supposed to be exempt from the GST (in the past, it didn’t attract the services tax as well). However, a 2021 ruling by the Customs Excise and Service Tax Appellate Tribunal suggested that the GST can be levied on it. The appellate body held that carried interest is essentially consideration retained by funds for “services” provided by them to investors. This stoked fears that fund managers would be badly hit unless the government explicitly states that the GST won’t be levied on the carried interest and removes any ambiguity.

The panel also says the management fee for services provided to overseas investors by fund managers be considered as “deemed exports” and kept out of the GST purview.

The pass-through status permitted to AIFs should be across income and losses, and expenses–especially management fees incurred by them–should also qualify for tax deductions, the report suggests. Pass-through status basically suggests that the income or loss (other than core business income) generated by the fund will be taxed at the hand of the investor.

The report comes at a time when start-ups have been witnessing a slowdown in fund flows. The inflows in October crashed 75% on-year to $3.3 billion across 75 deals, including six large deals worth $2.2 billion, according to an industry analysis.

Following a Budget announcement, the finance ministry had in September set up the panel to look into issues being faced by VC and PE investors.

“Venture Capital and Private Equity invested more than Rs 5.5 trillion last year facilitating one of the largest start-up and growth ecosystem. Scaling up this investment requires a holistic examination of regulatory and other frictions,” finance minister Nirmala Sitharaman had said, while presenting the Budget for FY23.

The other members of the panel are G Mahalingam, former member Sebi, D P Nagendra Kumar former member CBIC, Ashish Verma former Principal Commissioner Income Tax, Poonam Gupta DG National Council of Applied Economic Research, and P R Acharya, Director Arun Jaitley National Institute of Financial Management.