Taxation of a Private Equity and Venture Capital Fund

Summary:

Over the past decade India is witnessing a Private Equity boom due to the robust economic growth and domestic demand. There is no surprise that India saw the largest deal activity in CY 2010 for the Asia Pacific region. The private equity / venture capital investments in India doubled from CY 2009 to US$ 9.5 bn in CY 2010.[1]

These private equity / venture capital Funds raise money from many institutional and high net worth investors. A general concern of these investors is the taxation of their investments in these private equity / venture capital Funds. This paper aims to provide an overview on Indian taxation laws.

SEBI Registered Venture Capital and Private Equity Fund:

The Income Tax Act, 1961 defines a Venture Capital Fund under section 10(23)(FB) stating that a venture capital fund means –

1.  operating under a trust deed registered under the provisions of the Registration Act, 1908 (16 of 1908) or operating as a venture capital scheme made by the Unit Trust of India established under the Unit Trust of India Act, 1963 (52 of 1963);
2.   which has been granted a certificate of registration under the Securities and Exchange Board of India Act, 1992 (15 of 1992), and regulations made thereunder;
3. which fulfils the conditions as may be specified, with the approval of the Central Government, by the Securities and Exchange Board of India, by notification in the Official Gazette, in this behalf;

All funds fulfilling the above 3 characteristics may be classified as a venture capital fund for Income Tax purpose. Therefore under section 10(23)(FB) of the Income Tax Act, any income of a venture capital company or venture capital fund from investment in a venture capital undertaking is exempt from tax in the hands of the fund. This income will however be taxed in the hands of the investor at the time of distribution u/s 115U of the Income Tax Act.

As per section 115U of the Income Tax Act –

1)      Notwithstanding anything contained in any other provisions of this Act, any income received by a person out of investments made in a venture capital company or venture capital fund shall be chargeable to income-tax in the same manner as if it were the income received by such person had he made investments directly in the venture capital undertaking.

2)      The person responsible for making payment of the income on behalf of a venture capital company or a venture capital fund and the venture capital company or venture capital fund shall furnish, within such time as may be prescribed, to the person receiving such income and to the prescribed income-tax authority, a statement in the prescribed form and verified in the prescribed manner, giving details of the nature of the income paid during the previous year and such other relevant details as may be prescribed.

3)      The income paid by the venture capital company and the venture capital fund shall be deemed to be of the same nature and in the same proportion in the hands of the person receiving such income as it had been received by, or had accrued to, the venture capital company or the venture capital fund, as the case may be, during the previous year.

4)      The provisions of Chapter XII-D or Chapter XII-E or Chapter XVII-B shall not apply to the income paid by a venture capital company or venture capital fund under this Chapter.

Explanation: For the purposes of this Chapter, “venture capital company”, “venture capital fund” and “venture capital undertaking” shall have the meanings respectively assigned to them in clause (23FB) of section 10.

Therefore the important points from section 115U is that

• Income is chargeable to tax in the hands of the investors
• The nature (head of the income) donot change. Ie. If the fund has received a long term capital gain, it will charged to tax in the hands of the investor as long term capital gain.
• The tax liability arises in the financial year of the distribution of income by the fund to the investors and not at the time the income was earned by the fund.
• The fund would provide a Form 64 to the investor and the income tax authority providing the details of the income so distributed.

As per rule 12C  –

1)      The statement of distributed income shall be furnished by the 30th November of the financial year following the previous year during which such income is distributed, to the Chief Commissioner or Commissioner of Income-tax, within whose jurisdiction, the principal office of the Venture Capital Company or the Venture Capital Fund, as the case may be, is situated.

2)      The statement of distributed income which is to be furnished under sub-section (2) of section 115U by the Venture Capital Company or the Venture Capital Fund shall be in Form No. 64, duly verified by an accountant in the manner indicated therein.

Therefore, the fund will issue a Form 64 to the investor and submit a copy to the income tax authority. The investors will pay their tax based the form 64. Form 64 needs to be certified by an Accountant as defined in section 2 sub section 28 of the Income Tax Act. An Accountant is a member of the Institute of  Chartered Accountants of India. The fund needs to appropriate the income earned in the proportion of the beneficial interest of the investors in the fund. The Form 64 will also carry the PAN numbers and ward numbers where the investors file their return. In case a fund has many investors, this could be an administrative bottle neck.

A venture capital undertaking is defined  u/s 10(23)(FB) as a domestic company whose shares are not listed in a recognised stock exchange in India and which is engaged in the –  

1.  business of—
   1. nanotechnology;
   2. information technology relating to hardware and software development;
   3. seed research and development;
   4. bio-technology;
   5. research and development of new chemical entities in the pharmaceutical sector;
   6. production of bio-fuels;
   7. building and operating composite hotel-cum-convention centre with seating capacity of more than three thousand; or
   8. developing or operating and maintaining or deve-loping, operating and maintaining any infrastructure facility as defined in the Explanation to clause (i) of sub-section (4) of section 80-IA; or
2. dairy or poultry industry;

Funds that donot have income under section 10(23FB) of the Income Tax Act:

Now a question arises what happens if the investment are not made in the above 9 sectors by the fund. As the fund is structured as a Trust, the Representative Assessee provisions u/s 160-164 of the Income Tax Act or clubbing provisions u/s 61 of the Income Tax Act will apply depending upon the structure of the Fund.

The private equity / venture capital fund can be incorporated as a determinate or indeterminate trust and revocable or irrevocable trust.

• Determinate Trust: A fund can be said to be determinate if at the time of formation of the trust the shares of all the beneficiaries is specific and know. The important point here is ‘at the time of formation’. This means when the trust deed is prepared, the details of all the investors should be there and should form a part of the trust deed.  This has major implications for fund raising as the trust can be formed only after all the commitments have been received and the fund will close at the time of registering the trust deed. Hence, due to the structure of the fund only a single close is achievable. Multiple fund closings will not be possible as in such a scenario at the time of trust creation the all the fund investors will not be known and the shares of the investors will not be specific or determined.

• Indeterminate Trust: A fund would be indeterminate if the shares of income of the investors are not specific at the time of formation of the fund. Hence, the fund may be formed with minimum capital commitment from the sponsor or anchor investor, which is rupees five crores at present. As an indeterminate fund does not require the investors to be known at the time of fund formation, it can have multiple closings. This generally helps in fund raising activities as the fund may be open for a longer duration. It may also push sales activity as the subsequent close investor would not come in a completely blind pool.

A Fund can also be structured as a revocable or irrevocable trust –

• Revocable Trust: A revocable trust is one that may be revoked or its provisions may be altered by the settler of the trust.

• Irrevocable Trust: An irrevocable trust is one where the provisions of the trust / assets cannot be modified / revoked by the settler during the lifetime of the beneficiary. The irrevocable transfer is defined under section 62 of the Income Tax Act as –

1)      The provisions of section 61 shall not apply to any income arising to any person by virtue of a transfer—

 

1. by way of trust which is not revocable during the lifetime of the beneficiary, and, in the case of any other transfer, which is not revocable during the lifetime of the transferee ; or
2. made before the 1st day of April, 1961, which is not revocable for a period exceeding six years :

 

Provided that the transferor derives no direct or indirect benefit from such income in either case.

2)      Notwithstanding anything contained in sub-section (1), all income arising to any person by virtue of any such transfer shall be chargeable to income-tax as the income of the transferor as and when the power to revoke the transfer arises, and shall then be included in his total income.

Therefore a private equity / venture capital fund may be structured as an –

1. Irrevocable Determinate Trust
2. Irrevocable Indeterminate Trust
3. Revocable Determinate Trust
4. Revocable Indeterminate Trust

Taxation of Various Fund Structures:

The structuring of the Trust is very important to determine the taxation under The Income Tax Act, 1961. An Irrevocable Trust will be taxed as per the provisions of section 160-164 of the Income Tax Act. Under these sections the trustees are taxed as a ‘Representative Assessee’ on behalf of the investors.

• Irrevocable Determinate Trust: In such a scenario the trustees of the Fund will pay the tax at the applicable tax rate of the income earned by the fund under the respective heads of income. This tax paid will be ‘qua’ (on behalf of) the beneficiaries of the Fund. Because, the trustees have paid the tax qua the investors, the income received by the investors  ought not to be taxed again in their hands. The trustees are liable to pay the tax at the applicable tax bracket of the investor. This implies that the respective share of each investor will be determined and then the applicable tax will be paid by the trustees qua the investors base on the particular investor’s tax bracket. This is a tedious task as during the payment of tax the trustees need to get confirmation from all investors of the fund regarding their  tax status and tax bracket. They also have to take into account any carry forward or set-off of losses in the tax computations of the individual investors. This becomes an administrative hassle for the venture capital / private equity fund. As the investors in a venture capital / private equity fund  are high net worth individuals or institutions who come in the top taxable bracket, the trustees can pay the tax assuming all the investors come under the top taxable bracket. The investors may claim a refund  if the trustees have paid excess tax on their behalf or have not taken into account the carry forward or set-off of losses.

• Irrevocable Indeterminate Trust: As the shares of the investors are indeterminate the provisions of section 164 of the Income Tax Act will apply. As per section 164 of the Income Tax Act –

1)      Subject to the provisions of sub-sections (2) and (3), where any income in respect of which the persons mentioned in clauses (iii) and (iv) of sub-section (1) of section 160 are liable as representative assessees or any part thereof is not specifically receivable on behalf or for the benefit of any one person or where the individual shares of the persons on whose behalf or for whose benefit such income or such part thereof is receivable are indeterminate or unknown (such income, such part of the income and such persons being hereafter in this section referred to as “relevant income”, “part of relevant income” and “beneficiaries”, respectively), tax shall be charged on the relevant income or part of relevant income at the maximum marginal rate :

 Provided that in a case where—

1. inone of the beneficiaries has any other income chargeable under this Act exceeding the maximum amount not chargeable to tax in the case of an association of persons or is a beneficiary under any other trust; or
2. the relevant income or part of relevant income is receivable under 1[a trust declared by any person by will and such trust is the only trust so declared by him]; or
3. the relevant income or part of relevant income is receivable under a trust created before the 1st day of March, 1970, by a non-testamentary instrument and the Assessing Officer is satisfied, having regard to all the circumstances existing at the relevant time, that the trust was created bona fide exclusively for the benefit of the relatives of the settlor, or where the settlor is a Hindu undivided family, exclusively for the benefit of the members of such family, in circumstances where such relatives or members were mainly dependent on the settlor for their support and maintenance; or
4. the relevant income is receivable by the trustees on behalf of a provident fund, superannuation fund, gratuity fund, pension fund or any other fund created bona fide by a person carrying on a business or profession exclusively for the benefit of persons employed in such business or profession,

 tax shall be charged on the relevant income or part of relevant income as if it were the total income of an association of persons

As the investors in a private equity / venture capital  funds will either high networth individuals or institutions, they will be having other incomes. Therefore the provision of section 164 (1)(i) of the Income Tax Act will apply and the Fund will be treated as association of persons and tax will be paid by the trustees at the maximum marginal rate. Once the Trustees of the fund have paid the tax ‘qua’ the beneficiaries, the income received by the beneficiaries ought not to be taxed in their hands.

Summary: Hence, the taxation of the private equity / venture capital Fund can be determined by the following steps below –

1. If the Fund is a SEBI registered venture capital fund and has received income under the provisions of section 10(23)(FB), then the income that falls under the definition of a venture capital undertaking will be exempt in the hands of the Fund. This income will be taxed in the hands of the investors only at the time of distribution u/s 115U.

2. If the income of a SEBI registered venture capital  fund does not fall under section 10(23)(FB) or the fund is not registered with SEBI then we need to test the applicability of sections 160-164 (Representative Assessee provisions)
   1. If the Fund is structured as an irrevocable determinate trust then the income is taxed in the hands of the trust and the trustees pay the tax qua the investors at the applicable tax rates
   2. If the Fund is structured as an irrevocable indeterminate trust then the income is taxed at maximum marginal rate as an association of persons as per the provisions of section 164 of the Income Tax Act.

3. If the Trust is a revocable trust then provision of section 61 apply where income of the trust, even if it is not distributed, is liable to be taxed in the hands of the investors on accrual basis at the applicable tax rate.

As it can be seen above the structuring of the Fund has a substantial tax impact. The structuring also has an impact on fund raising, as a determinate trust can have only one close compared to an indeterminate trust that may have multiple closings.

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