NEW ENGLAND CAPITAL VENTURES

FOREIGN VENTURE CAPITAL INVESTMENT IN INDIA

Folks wanting to start a fund and invest in India will find this very functional article written by an old friend of mine from college, Ashish Bhakta, very useful. Ashish has been practicing corporate law within large to mid-sized venture / private equity deals in India and Europe.

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Introduction


The Indian capital market regulator, the Securities & Exchange Board of India (“SEBI”) is the single window clearance for both domestic and foreign venture capital funds (“VC Funds”) proposing to invest in India. VC Funds, operating in certain sectors, which are registered with SEBI, are entitled to tax benefits subject to certain conditions. However, in order to avail of these benefits, registration with SEBI is critical.

Foreign VC funds: Is registration MANDATORY?

SEBI has issued the Foreign Venture Capital Investor Regulations, 2000 (“the Regulations”) which apply to Foreign Venture Capital Investors (“FVCI”) incorporated and established outside India and which propose to invest in India.

Earlier, FVCIs avoided registering themselves with SEBI, due to the extremely confusing regulatory and tax position. FVCIs preferred to operate from outside India, usually through a liaison office in India. This is no longer the case following the enactment of the Regulations as also the amendment to the Indian Income Tax Act, 1961 (“IT Act”). Apart from clear advantages of registration, a view has been expressed that it is mandatory for an FVCI proposing to make investments in unlisted Indian companies to register with SEBI under the Regulations.

This view is based on Section 12(1B) of the SEBI Act, 1992 which provides that no person shall sponsor or carry on any venture capital fund, unless he obtains a certificate of registration from SEBI in accordance with the Regulations. Failure to so register may amount to a contravention of the provisions of Section 12(1B) of the SEBI Act, 1992, which can lead to penal consequences.

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 can be established from the nature of the agreements entered into by such foreign investor with the Indian investee companies and its promoters as also whether such foreign investor otherwise carries on the business of being a venture capital fund outside India.

This contention is reinforced with India’s central bank, the Reserve Bank of India (“RBI”), recently amending the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (“the Amendment”), to specifically bring within its fold investments by a SEBI registered FVCI in a domestic, SEBI registered venture capital fund (“Domestic Fund”) or an unlisted Indian company. The effect of the Amendment is that such 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 shall not be subject to compliance with the usual pricing 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/issuer.

The major advantage, of registration is that, under the IT Act, several tax benefits are conferred upon the FCVI, provided the FVCI is investing in the sectors specified below. Registration is evidenced by a certificate issued by SEBI after taking into consideration inter alia the track record, professional competence, financial soundness, experience, general reputation of fairness and integrity of the FVCI.

What does registration entail? : 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 the NYSE) and is not engaged in any activity except real estate, non-banking financial services or gold financing (“a venture capital undertaking”). All investment made or to be made by an FVCI shall be subject to the following conditions:
It shall disclose the investment strategy;
It shall not invest more than 25% corpus of the fund in one venture capital undertaking;
It shall make investments in the venture capital under-taking as enumerated below:
at least 75% of the investible funds shall be invested in unlisted equity shares or equity linked instruments
o Not more than 25% of the investible funds may be invested by way of
subscription to initial offer of a venture capital undertaking whose shares are proposed to be listed subject to lock-in period of one year;
debt or debt instrument of a venture capital undertaking in which the foreign venture capital investor has already made an investment by way of 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.

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 (“DTA”), may opt to be taxed either under the IT Act or the DTA, whichever is more beneficial to him.

Under Section 10(23FB) of the IT Act, any income of a registered FVCI shall be 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 DTA 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. However, pursuant the Union Budget 2007, this ‘pass through’ status has been restricted to the following sectors:

• nano-technology;
• information technology relating to hardware and software development;
• seed research and development;
• bio-technology;
• research and development of new chemical entities in the pharmaceutical sector;
• production of bio-fuels;
• building and operating composite hotel-cum-convention centres with seating capacity of more than three thousand;
• dairy or poultry industry;
• Infrastructure.
  

No tax shall be payable as tax on dividend and no tax deduction at source shall be made from income paid by a FVCI operating in these sectors.

However, any FVCI providing management, marketing, networking or any other services, may fall under the category of ‘taxable services’ under service tax regulations. In case of a FVCI having no office in India providing ‘taxable services’, the recipient of such services in India i.e. venture capital undertaking shall be liable to pay service tax.

Taxation of the Investor: Section 115U of the IT Act provides that 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.

Nature of the income derived by an FVCI: This brings us to a question as to 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, there are conflicting views as to whether profits made by a private equity fund/ 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 DTA 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 characterise the same as dividend under the DTA, by opting to be taxed under the DTA and not the IT Act. However, it is possible that the Indian tax authorities may contend that the investor is not entitled to the DTA 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 in as much as while the income of an FVCI is tax free, the income of a domestic AMC is subject to 35.7% tax in India (foreign AMC - 48% tax). 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 DTA 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 DTA. 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 DTA, so that its income continues to be tax free. Thus, 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 shall have to apply to RBI, through SEBI, for permission. The manner in which these Regulations are drafted, it appears that the FVCI may have to obtain such permission on a case to 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 a time span of 90 days. The total tax exemption in certain sectors makes these investments very attractive indeed.

Article Authored and By:

Ashish Bhakta, Partner

Kanga & Co. - Advocates & Solicitors

Address: Readymoney Mansion 43, Veer Nariman Rd Fort Mumbai 400 001 INDIA

Tel: +91 (22). 663.32288

The views expressed are of his own and should not be construed as legal advise

Labels: India

posted by Janak Joshi @ 10/05/2007 01:23:00 PM