Indian venture capitalists and private equity firms registered with SEBI and managed out of India suffer adverse tax regulations as compared to foreign VC funds, says Arjun Malhotra, veteran business mentor and co-founder of the Indian tech conglomerate HCL.
He said this in a recommendation letter submitted to Piyush Goyal, India’s minister for commerce, who was in California this past week to attend the Indo-Pacific Economic Framework (IPEF) ministerial meeting and held several meetings with tech companies, academic experts, venture capitalists and entrepreneurs to understand their concerns as well as to pitch them to invest in India.
Malhotra, an alumnus of Harvard Business School and IIT Kharagpur, met Goyal at one of the meetings held at India Community Center in Milpitas, CA, and spoke to him about start-up issues related to VC Funds and differential capital gains.
He urged the minister that Indian VCs should be treated the same as foreign VCs or investment would go out of India. “In foreign VC funds, the asset management company (AMC) doesn’t need to pay GST on its management fees. By contrast, Indian AMCs of SEBI registered VC Funds have to pay 18% GST on fees. This puts the Indian funds and fund managers at a disadvantage in giving good returns to investors and makes it harder for them to attract capital.”
Another question raised was how employee stock ownership plan (ESOPs) should be taxed when the shares are sold and not at the time of exercise as there is no monetizing at that time. Also, employees cannot sell the shares to pay for the tax as they have no liquidity.
Goyal said that, in terms of same taxation for Indian VCs and foreign VCs, the challenge will be that foreign VCs get the benefit of Double Taxation Avoidance Agreement (DTAA).
“It won’t be easy for us, to unless the policy is uniform for all the investors. It will be difficult to differentiate between the VC investors and any other investor,” Goyal replied. “The decision will be taken in consultation with several departments, but the point is taken.”
Here are the points raised by Malhotra:
1 a. In Foreign VC Funds, the asset management company (AMC) doesn’t need to pay GST on its management fees. By contrast Indian AMCs of SEBI registered VC Funds have to pay 18% GST on fees. This puts the Indian Funds and Fund managers at a disadvantage in giving good returns to investors and makes it harder for them to attract capital
b. To understand from illustration: Let’s assume a corpus of ₹1,000 croreore. AMC fees for operating the fund are typically approximately 20% of the corpus over the life of the fund, i.e., ₹200 croreore. Hence the capital available for investing is ₹800 croreore, but investors expect a 5x return on the capital contributed (₹5000 croreore) so the AMC has to provide a 6.25X return on capital invested. This is true for foreign funds
c. For Indian SEBI registered funds, the AMC fees attract a GST of 18%, so the corpus is depleted by (200+36) or ₹236 croreore. Hence capital available for investing is ₹764 croreore. Since investors still expect the same returns on contributed capital, the AMC has to deliver a 6.5 X. Like for like, if they deliver a 6.25X as in b above, they will return to investors ₹4,775 crore which is Rs 225 crore less than a foreign VC Fund. This makes them unattractive for investors
d. This is detrimental for Indian start-ups as Indian VC Funds are more likely to invest in early-stage innovative companies solving major Indian challenges in affordable healthcare, education, agriculture, etc than foreign VCs who prefer later stage and in mostly tech and consumer businesses
e. Also, this prevents the growth on an Indian VC industry in stark contrast to other countries, especially China
f. Finally, we need to incroreease the amount of domestic capital which goes to fund start-ups and this tax prevents that from happening, which is a pity as domestic capital is more open to taking early stage risks than foreign capital. Today, over 90% of capital invested in India by VC/PEs is foreign capital. By contrast, the number in China is under 50%
2. Indian VC/PE Funds registered with SEBI and managed out of India are also subject to very restrictive and complex policies/regulations imposed by SEBI which are not in line with global norms and put them at a major disadvantage vs Foreign VC Funds
a. There is minimum investment defined whereas abroad the restriction is only to have accredited investors
b. SEBI mandates an LP Advisory Board (LP). In foreign Funds this decision is left to the investors and the AMC
c. There are very high minimum thresholds for LPs for the LPAC
d. Applications to SEBI for registration of a VC Fund have to be made through a Merchant Banker. This adds no value but increases the costs. No country in the world has this
e. Funds must report to SEBI and make public their performance on an annual basis. No other country requires this.
f. VC Funds primarily invest in unlisted companies, in the first 4 years they are mostly investing and over the next 4 years they begin to harvest or get exits. Hence the NAV of all Funds looks bad in the early years and improves later on. As a result, we start to look unattractive vs foreign funds
g. SEBI has mandated that Investment Committee members now have the same liability as the partners managing the Fund. This is akin to non-executive directors having the same liability as founder/promoters and exec directors and is not there in any country. Hence Indian VC Funds are finding it difficult to get reputed, experienced people for helping make the difficult investment decisions. This may impact their performance and puts them at a disadvantage vis a vis foreign funds which have no such restrictions
h. SEBI now mandates that VC Funds registered by SEBI must do their first close within six months of getting certification. This is an unnecessary and impractical mandate as it routinely takes more than 6 months and it should be left for the investors, not SEBI, to take this call. Domestic government FOFs take more than 6 months to clear an investment proposal, hence this will work at odds with the governments FOF strategy
i. Also, SEBI now mandates that all VCs proposing to set up a VC Fund will need to apply through an empanelled Merchant Banker. This adds one more layer in addition to the legal and financial advisers and additional costs on the Investment Manager or GP of the Funds. It also takes more time as Indian Merchant Bankers are clueless about VC Funds
j. There are many such regulations which put Indian funds at a disadvantage to foreign funds and will end up restricting the flow of foreign capital into Indian Funds, something which will be detrimental to the interests of Indian start-ups.
k. It may also drive Indian Fund managers overseas as then they do not have to register with SEBI and can invest through the FDI route. Hence India will lose revenues and taxes and any SEBI Oversight
3. Investors in early stage VC funds in the US, UK, Israel, Singapore etc get tax croreedits. Doing the same in India will make more domestic capital available for Indian start-ups
4. Also angel investors in start-ups get tax croreedits of upto 50% for their investments
5. While the government has tried to largely mitigate the angel tax issue the fact remains that foreign investors making angel investments in Indian companies does not attract angel tax but Indian investors doing so remains subject to angel tax
6. Foreign VC Funds raise the majority of their capital from Pension Funds, Insurance companies and University endowments. The government needs mandate a small percentage (say 3%) of the corpus of Pension Funds and Insurance companies to be invested in VC/PE Funds. Such a regulation made the US VC industry take off and the same will happen in India
7. Enforcing contracts in India is difficult (e.g. Drag along)
8. In all countries abroad the LTCG and STCG tax rates are the same for listed companies and start-ups. Government in India should do the same, especially as these investments create new innovative start-ups and new jobs plus the investments are illiquid and are taking a higher risk.
9. ESOPs should be taxed when the shares are sold and not at the time of exercise as there is no monetizing at that time. Also, the employees cannot sell the shares to pay for the tax as they as they have no liquidity.