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Budget 2018: Tax tweaks, steps to boost fund flow on PE/VC industry’s wish list

Tax reform, measures to bring offshore pool onshore and steps to enhance capital formation are the key demands of the Indian private equity and venture capital industry from the government’s upcoming budget.

While the government and regulatory bodies have introduced as many as 27 rule changes since 2014 to boost the alternative investment fund (AIF) market, a few more corrective measures are required to help the industry reach its full potential, said Gopal Srinivasan, chairman at the Indian Private Equity and Venture Capital Association (IVCA).

The industry wants the government to make managing capital in India easy by restoring the pass-through status for losses at the fund level for AIF Category I and Category II funds as a short-term measure.

Essentially, this means that the tax liability will be on the investor, or Limited Partners in the PE/VC funds, and not the fund itself.

Finance minister Arun Jaitley had, in his budget for 2015-16, allowed Category I and II funds a pass-through status on gains from investments, but not for losses, as was permitted until a few years before. The IVCA now wants this benefit to be restored.

According to the capital markets regulator Securities and Exchange Board of India’s AIF norms, Category I includes venture capital funds, infrastructure funds and social venture funds. Category II includes private equity funds and credit funds. There is also a Category III, which includes hedge funds and PIPE funds, or those that make private investments in public equities.

The IVCA also wants management expenses to be capitalised as cost of improvement and introduce a pass-through system for Category III funds.

Currently, there is no framework for the Category III funds, so every assessing officer is taxing different rates on such funds, Srinivasan said. “I would suggest let the fund pay taxes based on the kind of income, whether it is a long-term capital gain, short-term capital gain or derivative profit. AIF III is a huge asset class which has an important purpose. Hedge funds, for example, keep price discovery smooth in the market,” he said.

In the long term, the industry suggests introducing a unit-based taxation system that allows listing of all close-ended AIFs on stock exchanges. While current regulations enable listing, the taxation policy is not conducive to listed AIFs. So a separate tax rule supporting listed AIFs can be potentially used to raise large domestic capital, said Srinivasan.

The IVCA also wants the government to take measures for onshoring foreign capital. In November last year, the policy on foreign investment in AIFs was unveiled. The policy, in effect, said that an Indian manager could raise foreign money to the extent that even if the entire fund is foreign money it could still get domestic treatment and invest without sectoral limitation.

The policy led to an “enormous shift” in favour of AIFs, said Subramaniam Krishnan, partner at consulting firm EY. However, the Goods and Services Tax (GST), which was rolled out nationwide from July last year, presents two challenges, he said.

“One, the moment you bring the fund onshore, management also happens to be onshore. As a result, your entire management fees gets charged 18% GST. Second, there is already controversy on the service tax on carried interest. Before it becomes a controversial point the industry wants some clarity,” Krishnan explained.

Srinivasan also said that, for onshoring foreign capital in the long term, the government should address regulatory issues in International Financial Services Centres (IFSC). Currently, the regulatory framework is complex as there is no single regulator to oversee foreign exchange transactions in such centres, he said.

“An IFSC is supposed to be a foreign zone. Why don’t we appoint one integrated regulator? Doing so could help India become a centre for AIF asset management globally and people can manage, say, African funds from India,” said Srinivasan.

For domestic capital formation, the industry wants the government to permit larger charitable and religious trusts to invest in AIFs. It also wants the government to allow Employees’ Provident Fund Organisation to invest in AIFs.

It also seeks digitisation of AIF data and accreditation of qualified investors via Know Your Customer norms. “The whole process of accreditation can be done like an Aadhaar using the central KYC system,” said Srinivasan, referring to the government’s unique identification programme.

Slew of reforms in past years
The industry has recorded a surge in investments in recent years thanks to government measures. Private equity and venture capital investment soared 70% from a year earlier to Rs 1.5 lakh crore in the fiscal year ending on 31 March 2018. Besides, the number of new registered funds grew to 366 in the first half of this fiscal year from 288 last year.

The amount registered by the AIF funds increased to Rs 1.16 lakh crore in the first half of this financial year from Rs 84,304 crore in the entire previous year. The industry expects fundraising to touch Rs 3 lakh crore in 2019-20.

In a major reform for the industry in June last year, SEBI decided to waive the one-year lock-in period after initial public offerings for category II AIFs.

In September, the government permitted banks to invest up to 10% of the paid-up capital or unit capital in a Category I or Category II AIF. It, however, said banks cannot invest in Category III AIFs.

Subsequently, the government relaxed transfer pricing norms to avoid multiple taxation for offshore funds set up as multi-tier investment structures. This addressed concerns raised by private equity and venture capital funds that non-resident funds set up as multi-tier investment structures suffer multiple taxation, at the time of subsequent redemption or buyback of shares.