Whitepaper on Venture Capital Industry by IVCA and PwC. August 2018

Transcription

1 Whitepaper on Venture Capital Industry by IVCA and PwC August 2018

2 Table of Contents We have divided this white paper into the following sections: 1. Part A: Alternative Investment Fund (Income-tax, Regulatory and GST); 2. Part B: Start-up related; and 3. Part C: Other venture capital industry recommendations Table of Contents 1 Part A1: Alternative Investment Fund (AIF) Income-tax 4 2 Part A2: Alternative Investment Fund (AIF) Regulatory 10 3 Part A3: Alternative Investment Fund ( AIF ) Goods and Services Tax Act ( GST Law ) 13 4 Part B: Start-up related 15 5 Part C: Other venture capital industry recommendation 17 Page 2 of 18

3 Table of Contents Preface The Indian VC Ecosystem is more mature than ever, whereas the number of deals are declining we can clearly see calculated bets with thorough due diligence by fund managers. There is indeed a missing middle opportunity in the Indian context which is a trend in sync to other emerging markets, this means that several startups are struggling to leap from the early stage to growth stage. Also, the early stage investments are getting diversified as investors are looking beyond E-commerce and Fintech. At the Indian Private Equity & Venture Capital Association (IVCA), we are constantly striving to promote the complete alternative asset class. This is only possible with the collaborative endeavor of the fund managers, regulators, entrepreneurs, consultants working in sync which has been happening as we move in that direction, that dream and vision which was set by our Prime Minister Narendra Modi in the form of Startup India. The IVCA is working closely with a mission to on shore more offshore capital in the country, building a domestic capital ecosystem, increasing industry awareness and this vital cycle can get complete only with the support of the Indian government and regulators, when they in turn support and approve of relevant policy changes to boost this asset class. To push forth the Venture Capital investments and thus boost entrepreneurship in India, we are pleased to put together pressing industry concerns and respective recommendations in this whitepaper. The intent is to highlight, present and discuss, major tax and regulatory issues with startups as well as Alternative Investment Funds and Venture Capital Funds. We are hoping to work closely with all the government bodies, regulators to ensure that they understand the on-ground challenges faced by fund managers, entrepreneurs and help us in bringing about relevant policy changes to foster the overall Startup-VC ecosystem. Thanking You, Rajat Tandon, President IVCA Page 3 of 18

4 Part A1: Alternative Investment Fund (AIF) Income-tax 1 Part A1: Alternative Investment Fund (AIF) Income-tax 1. Pass through tax status to be extended to net losses incurred at the AIF level, i.e., losses incurred by AIFs should be available for set-off to its investors Conceptually, pooling vehicles are formed to derive two advantages: (a) engage experienced professionals for investment management; and (b) achieve economies of scale. Further, investors who invest in AIFs could have chosen to directly invest in portfolio companies of their own accord. Therefore, tax implications play an important role in an investor choosing one form over the other, i.e., pooling vehicles or direct investing. The above-mentioned advantages will be lost if the tax impact on investing through AIFs is higher. Under the AIF Regulations, Category I and II AIFs are close-ended funds and the tenure of a specific fund/ scheme is determined at the time of its launch. Typically, an AIF s tenure would not exceed 10 years from its launch. Based on the provisions, where Category I and II AIF incur net losses on investments towards the end of their lives or have unabsorbed losses, which they cannot utilise, such losses would lapse. In such a scenario, investors would be taxed on an amount that would be greater than the real taxable income derived by them from their investment in the AIF, causing the AIF alternative becoming unattractive from a tax perspective to investors vis-à-vis direct investments. A pass-through tax regime should not distinguish between gains and losses. Therefore, similar to the pass through for income, the losses incurred by Cat I and Cat II AIFs, under any head of income, should also be allowed to be passed on to the investors. This will ensure that tax has been levied on the real income of the investors. 2. Taxation policy for AIFs to be conducive for a listed AIF SEBI (AIF) Regulations allow the listing of the units of close-ended AIFs on a stock exchange, i.e., all AIFs, except an open ended-category III AIF, can be listed on a stock exchange. While the present AIF Regulations enable listing of AIFs subject to conditions, the taxation policy for AIFs is not conducive to a listed AIF. In case the units of the AIFs are listed on the stock exchange, the investors may keep changing from time to time during any financial year. It may happen that the set of investors at the time of investment by the AIF may be different from those at the time of earning of the income by the AIF, which, in turn, may differ from those when the AIF distributes such income to the investors. Define separate taxation rules for listed AIFs. Ideally, a listed AIF would need to have tax provisions for a unit-based taxation system where the fund itself is exempt from tax on its income. The taxation of listed AIFs could be made similar to listed mutual funds. Clarify the holding period in case of the AIF acquiring further investments in the investee companies. Listing of the units of the AIF should also be included within the definition of section 112A and 111A of the Act. Page 4 of 18

5 Part A1: Alternative Investment Fund (AIF) Income-tax 3. Tax treatment on an overall profits/ loss calculation and not on standalone profits As per the relevant provisions of the Act, the Fund is required to deduct tax on any income (other than income characterised under the head Profits and gains of business or profession ), at the time of credit of such income to the account of the Investor or payment thereof, whichever is earlier. An investor generally has a wide range of portfolio of investments other than the investments in an AIF. There may be situations in which an investor would be incurring losses on its other portfolio investments. The income earned or losses incurred by the investor on the other investments should also be considered by the Fund while computing the withholding tax liability of an Investor. The tax treatment for an Investor should be considered on a consolidated income basis and not on standalone basis. This will reduce the hardship to investors when they incur losses on their other investment portfolios. In such a situation, the AIF distributing income could rely on a declaration provided by the Investor, giving details of brought forward losses or losses incurred in the current year, which will enable the Fund to compute income and withholding taxes accordingly. 4. Applicability of provisions of section 56(2)(viib) of the Act to be restricted to certain cases only Currently, the provisions of section 56(2)(viib) of the Act are not applicable only upon an investment made by Category I Venture Capital Fund. Therefore, the provisions of section 56(2)(viib) of the Act are applicable to all other sub categories of Category I AIF, namely, Social Venture Funds, Infrastructure Funds, Angel Funds and SME Funds, which also fall within the AIF Category I. Further, any investment made by Category II AIF is also not exempted from the provisions of section 56(2)(viib) of the Act. Investee companies are currently facing difficulties in justifying the value of investments received from AIFs and assessing officers are challenging the valuation reports obtained by investee companies from Chartered Accountants/ Category I Merchant Bankers. It is recommended that the provisions of section 56(2)(viib) of the Act be completely removed or the provisions of section 56(2)(viib) of the Act be restricted to dormant companies that have not been operational for at least three years the rationale for our recommendation is as under: In case the assessing officer is not satisfied with the investment made by the investors, the provisions of section 68 of the Act already provide significant discretionary powers in the hands of the assessing officer to tax any sum credited in the books of accounts of an assessee company if the assessee is unable to explain the source of the credit, or the explanation does not satisfy the assessing officer. The PAN details of the investors should be sufficient explanation by the investee company to justify the source of capital under the provisions of section 56(2)(viib) or section 68 of the Act. Based on the PAN, the assessing officer can easily determine the investors past tax filings and initiate scrutiny assessments against them. Domestic investors should not be discriminated against and should be treated at par with foreign investors in terms of the legitimacy of their money, which is the current status quo under 56(2)(viib) of the Act. Page 5 of 18

6 Part A1: Alternative Investment Fund (AIF) Income-tax There is prolonged litigation on these provisions, considering that the provisions of section 56(2)(viib) of the Act provide that the assessing officer has the discretionary power to disregard the valuation of a company, even when the investee companies obtain valuation reports from Chartered Accountants/Category I Merchant Bankers. All investors who invest in SEBI-registered AIFs must comply with the KYC norms prescribed by SEBI. Even when the provisions of section 56(2)(viib) were to continue to be in force, these provisions should at least not apply to SEBI-registered pooling vehicles, considering that these investors are already KYC compliant. 5. Cost step up to the secondary investor In case of secondary transfer of units to a new investor, the new investor is not entitled to cost step-up in respect of fair value of units paid on acquisition, and may get taxed on redemption of units, based on the amount of capital contributed. Example Facts Mr A acquires 10 units in an AIF at the rate of INR 100 each on 1 January Total investment of Mr A in the AIF amounts to INR 1,000. AIF invested the entire sum received from Mr A in Indian investee companies on the same day. On 31 March, 2018, the AIF earned a certain taxable income from investee company out of which INR 100 was attributable to Mr A. As per section 194LBB of the Act, the AIF is under an obligation to withhold taxes on income distributed to investors. In case the AIF does not distribute the income as on 31 March, 2018, such income shall be deemed to be distributed and AIF is still under an obligation to withhold taxes. Accordingly, the AIF withheld 10% income-tax on INR 100 (INR 10) and did not distribute such income to Mr A but held it in its own bank account. Mr A now proposes to transfer the units held in the AIF to Mr B on 01 April, 2018, for a consideration of INR 150 per unit. Accordingly, the total consideration payable by Mr B to Mr A is INR 1500 (for 10 units). The issues faced by the investors are as follows: - Double taxation of same income While Mr A sold the units of the AIF at INR 150 per unit, he had considered the appreciation in the value of investee companies and the income accrued but not distributed by the AIF to Mr A. Accordingly, the total appreciation of INR 500 (INR 50*10 units) is on account of the following: a) Income accrued at the AIF level but not distributed: INR 100 (on which taxes have already been withheld) b) Increase in the value of investee company: INR 400 It should be noted that the AIF has already withheld taxes on the income of INR 100 as on 31 March, However, upon sale of units of the AIF, the entire gains of INR 500 shall be subject to capital gains tax in the hands of Mr A, thereby, causing double taxation on the same income. Page 6 of 18

7 Part A1: Alternative Investment Fund (AIF) Income-tax - Cost step-up to secondary investor Mr B is unable to obtain the cost step-up for the units purchased from Mr A. In other words, while redeeming its units, the AIF shall consider the cost of units as INR 1,000 and not INR 1,500. Additionally, Mr B may not be able to claim INR 1,500 as the cost of acquisition of the units of the AIF, despite paying INR 1,500 as purchase consideration to Mr A. - Computation and period of holding Assuming that on 01 April, 2018, if the AIF sold the shares of the investee company and earned a profit, such gains shall be characterised as long term capital gains. However, Mr B, the new investor in the AIF, acquired the units on 01 April Accordingly, one may argue that the gains earned from sale of shares of investee company should be characterised as short term capital gains in the hands of Mr B. Conceptually, the period of holding should be determined at the Fund level, and hence, irrespective of the change in the investor, such gains should be characterised as long term capital gains. Considering the above issues, the recommendations are as follows: Enabling provisions under section 115UB of the Act to state that in case of a secondary transfer of units by any investor, the sale consideration should be reduced by the income already accrued at the AIF level and on which taxes have already been withheld by the AIF. This will ensure that there is no double taxation of the same income of the investor. Any secondary investor should be able to claim a cost step-up for purchase consideration paid to the exiting investor. Provide clarity on the period of holding in case of secondary transfer of units of the AIF, i.e., provide that the period of holding has to be computed at the AIF level itself and not in the hands of the investor. 6. Applicability of section 56(2)(x) of the Act on issuance of securities Section 56(2)(viia) of the Act, which was replaced with section 56(2)(x) of the Act, was meant to target transactions involving the transfer of shares. Considering the language of the section, a reference is to the receipt of the property and there is ambiguity whether the issuance of shares is covered within the scope of this section, which clearly is not the intention of the legislature. It is recommended to provide clarification on the applicability of the provisions of section 56(2)(x) of the Act upon issuance of securities by investee companies or issuance of units by the AIF to its investors. Section 56(2)(vii) and section 56(2)(viia), now subsumed into section 56(2)(x) of the Act, were introduced as anti-abuse rules in lieu of abolition of gift tax in India. This would imply that the said provisions necessarily envisage an element of transfer of property from one person to another and should not cover a situation where property is created in the hands of the recipient. Page 7 of 18

8 Part A1: Alternative Investment Fund (AIF) Income-tax 7. Significant costs incurred by the AIF are not factored in determining the investors tax liability Typically, an AIF would incur 15-20% of the investors capital commitments towards fees payable to the investment manager, bankers, advisers, lawyers, accountants, administrators, and other service providers. Therefore, the amount actually invested by the AIF stands reduced by this amount and only 80-85% of the investor s capital commitments are actually invested. Commercially, the investor s gain on their investment is the net of all expenses incurred by the AIF. Several expenses of an AIF, viz., investment management fee, service providers fee for investments that are not consummated, administration expenses of the AIF are incurred even if there is no acquisition or exit during a particular period. Under the tax law, such expenses may not be included in the cost of acquisition/ improvement of the asset or treated as an expenditure incurred for transfer of that asset for computing capital gains. In effect, the AIFs have to write-off the expenses, which means that neither the AIF nor their investors are able to offset the expenses against income/ gains that may eventually result from the investment leading to an incongruence in the gains commercially derived by the investors (net of expenses) v. gains treated as taxable (gross of expenses). Allow management fee and other expenses incurred from the date of the investment to the date of its divestment to be capitalised as the cost of improvement. 8. Share for share transfer to be exempt Mergers and acquisitions have become an integral part of the Indian economy and also the daily headlines, even in the start-up space. Several sectors in India are in consolidation mode especially the e-commerce sector, telecom sector, banking sector, energy sector, insurance sector etc. Such mergers and acquisitions activity has increased on account of shareholder activism and positive governmental changes like opening up sectors under FEMA, Make in India initiatives, etc. Currently, from an income-tax perspective, there are no exemptions available to the investors whereby investors give up shares in one entity in exchange of acquiring shares in another entity except where a court approval has been obtained. Considering the quantum and frequency of such transactions, it is imperative that the government exempts transactions which involves a share for share transaction with adequate provisions for cost of acquisition, period of holding etc, considering the following: o o o Currently, income-tax is levied on notional income (exchanged shares) and not on real income of investors. Acquiring shares of other companies in barter of shares does not give rise to investor income. In a lot of merger/acquisition cases, there are common investors in both the entities whose shares are being swapped. In such cases, the buyer and the seller of shares is the same investor and still investor is bound to pay taxes on the fair value of shares Obtaining a court approval is not feasible for all companies undergoing a restructuring considering the timelines for the process and cost involved. Page 8 of 18

9 Part A1: Alternative Investment Fund (AIF) Income-tax 9. Tax pass through to all kinds of income Category I and II AIFs registered with SEBI have been given a tax pass-through status with respect to income in the nature of capital gains and other sources. The Investors are liable to pay tax on such income on accrual basis. However, no pass through has been given with respect to income of these Funds that is regarded as business income, on which tax is payable by the Fund at the maximum marginal rate. It is recommended to grant pass-through status to all kinds of income to bring parity. Page 9 of 18

10 Part A2: Alternative Investment Fund (AIF) Regulatory 2 Part A2: Alternative Investment Fund (AIF) Regulatory 10. Sub-category of the category I AIF Angel Fund Angel Funds are a sub-category of Category I AIFs. As per the AIF regulations, Angel Funds can accept investments from only specified investors, and can invest only in companies that satisfy the following conditions: i. Turnover of less than INR 25 crores; ii. Companies that are not backed or promoted by an industrial group; iii. Satisfy the age criteria as per the DIPP notification of start-ups, etc. Increase the number of investors from the existing threshold of 200 investors to 1000 investors to get the Angel Funds at par with other categories of AIF. Relaxation of the lock-in period of one year of investment by an Angel Fund in Venture Capital Undertaking to get the Angel Fund at par with other categories of AIF. 11. We hereby submit that the pooling entities that are formed only for the purposes of making investments alongside the AIFs should be exempted from seeking separate AIF registration/nbfc Typically, the managers of AIFs offer co-investment opportunities to certain investors of the AIF who are willing to invest over and above their investment amount, in cases where the AIF could not fully utilise a particular investment opportunity due to certain investment restrictions and concentration norms of the AIF agreed with all the other investors in the AIF. Such co-investments are made by these investors alongside the AIF on the same terms and conditions as agreed to by the AIF with the investee company; However, given that pooling of funds is not allowed unless the pooling entity takes an AIF registration, each investor makes these co-investments individually in the investee companies. This in turn leads to operational difficulties of managing multiple co-investors in an investee company and such individual co-investors are deprived of exercising certain minority rights in the investee companies. Accordingly, it is submitted, that special purpose vehicles (SPVs) must be allowed for the purposes of facilitating co-investments without the need of obtaining separate AIF/ NBFC registration by the SPVs, subject to the following conditions: i. Such SPVs must be allowed to be for persons who are already investors in an AIF; and ii. Such SPV must be allowed to make investment only in such portfolio companies that were considered for investment by the AIF and/ or in which the AIF has already made an investment (one SPV should be allowed to invest in one portfolio company and not in multiple portfolio companies). Page 10 of 18

11 Part A2: Alternative Investment Fund (AIF) Regulatory 12. Restrictions of 25% per investee company to be relaxed As per the SEBI AIF Regulation, Category I and Category II AIFs are not permitted to invest more than 25% of the investible funds in one investee company. The ceiling of investment of not more than 25% of the investible fund of the AIFs in one single investee company was introduced to meet the requirement of diversification of risk of AIFs. Globally, VCFs invest in sufficient number of investments that are part of the investment strategy. However, in the Indian context, and since the VC industry is still in the evolutionary stages, it would be desirable to remove the ceiling of 25% of the investible funds for investment in a single VCU. Alternatively, the investment threshold of 25% may be considered to be increased with the approval of the super majority of 75% investors, in a single VCU. 13. Clarity on material change as per SEBI circular SEBI circulars (dated 19 June, 2014 and 18 July, 2014) set out circumstances that constitute a material change and these circumstances are not exhaustive. From these SEBI circulars, it appears that only with respect to any change in financial terms of the AIF, a process for obtaining consent from all unit holders and affording an exit to dissenting unit holders will have to be followed. For all other changes in non-financial terms, approval from not less than 75% in value of investors should be obtained. It is submitted to clarify that financial terms could be changed only with the consent of all unit holders by value in the AIF and the SEBI should provide examples of such financial terms. For ease of reference, some financial terms that are generally relevant for an AIF are categorized below: Sr. No. Financial terms of AIF that requires exit process to be followed a. Change in fee structure, which may result in higher fees being charged to the unit holders b. Change in hurdle rate, which may result in lower pay-out to unit holders c. Change in threshold of operating expenses d. Change in carried interest rate It is submitted to clarify that that non-financial terms could be changed with the consent of not less than 75% of unit holders by value in the AIF and the SEBI should provide examples of such non-financial terms. Page 11 of 18

12 Part A2: Alternative Investment Fund (AIF) Regulatory For ease of reference, some non-financial terms that are generally relevant for an AIF are categorised below: Sr. No. Non-financial terms of AIF that can be modified with at least 75% of unit holders by value in AIF a. Change in final close date b. Change in commitment period c. Change in original term of AIF (i.e. other than the two-year extension permitted under the Regulations) d. Increase in corpus of the Fund e. Change in criteria for offering co-investment opportunities to unit holders The above is only a representative list and not an exhaustive list of non-financial terms relevant for an AIF. 14. Provide flexibility for the extension of the term of the Fund As per the SEBI AIF Regulation, Category I AIF and Category II AIF shall be close-ended and the tenure of fund or scheme shall be determined at the time of its application. Category I AIF and Category II AIF or schemes launched by such Funds shall have a minimum tenure of three years. Further, the extension of the tenure of these Funds may be permitted up to two years, subject to the approval of two-thirds of unit holders by value of their investment in the Alternative Investment Fund. In the absence of consent of unit holders, the Alternative Investment Fund shall fully liquidate within one year following the expiration of the fund tenure or extended tenure. It is recommended that a proviso to this clause should be inserted for certain exceptional cases as follows: 1. Instances where the manager of a Fund at the end of the fund s life is unable to find a suitable buyer; 2. The extension of tenure should not be capped at two years. It should be commercially agreed with the investors (i.e. with the super majority) via an amendment to the Trust deed; 3. It is imperative to a capture situation where the Investment Manager along with the Trustee forecasts the Fund s growth opportunities in coming years. This is important when the Fund is incurring losses but due to some change in Law/ Regulation/ Government in future years is expected to present greater opportunities for the Fund. 15. AIF should be permitted to make temporary investments in debt schemes of mutual funds Under the AIF regulations, AIFs are permitted to invest their un-invested funds only in liquid mutual funds due to the risk of capital erosion and possibility of entry/exit load on investments/exits in other types of mutual funds. With the growth of the mutual funds industry, various debt schemes of mutual funds seek to provide capital protection and better returns than liquid schemes of mutual funds. In addition to liquid mutual funds, AIFs should be free to deploy temporary monies in Debt funds to provide better returns to investors said the IVCA White Paper. Page 12 of 18

13 Part A3: Alternative Investment Fund ( AIF ) Goods and Services Tax Act ( GST Law ) 3 Part A3: Alternative Investment Fund ( AIF ) Goods and Services Tax Act ( GST Law ) 16. GST on Fund Management fees: AIFs are privately pooled investment vehicle that collect funds from foreign investors. Such investments are made by the foreign investor with the objective of attaining long term capital appreciation. To manage the funds pooled by AIF from the foreign investors, AIF appoints an investment manager. The investment manager charges fund management fees to the AIF. The investment manager is required to charge GST on the fund management fees as the said transaction qualifies as a taxable supply under the GST Law. However, the AIF cannot avail the input tax credit of the GST paid on such fund management fees as the AIF does not have any taxable output supply. The GST charged on management fees becomes a cost in the transaction and ultimately, it becomes a burden on the foreign investors. As stated above, AIF is a pooling entity that collects money from a number of foreign investors who share a common investment objective and invest in equities, bonds, money market instruments and/or other securities in India on behalf of such foreign investors. AIFs play an important role in accelerating growth of companies by funding investments to such companies. The growth of investee companies augurs well for the export oriented Indian economy. The investment made by the foreign investors bring foreign currency to India which helps the country to improve its balance of payment position and thereby, contributes to economy of the country. The fund management services provided by the investment manager are ultimately consumed and benefited to the foreign investors who invest their money in AIF. Hence, adding a tax burden even on the foreign investment made in the AIF could be against the generally accepted rationale of encouraging foreign investment flows. Hence, measures should be taken to reduce tax cost where the AIF has majority foreign investors. In light of the above factors, it is submitted that either of the following two approaches should be implemented: 1 Upfront exemption of GST on procurements made by AIF It is recommended that a notification should be issued notifying that all procurements made by an AIF where foreign investors exceed 50% shall be exempt and not liable to GST. A certificate to evidence the investment split between domestic and foreign investors can be issued by the AIF to the vendors as documentary proof for the exemption. 2 Provide benefit of GST refund to AIF (In case above option is not granted) It is recommended that a notification should be issued notifying the AIF where foreign investors exceed 50% as persons entitled to claim refund of GST paid on procurements made by the AIF. The notification can be issued basis Section 55 of the Central Goods and Services Tax Act (CGST Act) and respective State Goods and Services Tax Act (SGST Act) which states that the Government can notify persons / class of persons eligible to claim refund of GST paid on notified goods or services procured by such persons / class of persons. Page 13 of 18

14 Part A3: Alternative Investment Fund ( AIF ) Goods and Services Tax Act ( GST Law ) 17. No GST liability for directors Ordinarily, the AIFs appoint their nominees in the management of their portfolio companies. The nominees are frequently appointed as non-executive directors. As per Section 89 (1) of the CGST Act, in cases where the company defaults in payment of tax, interest or penalty, the liability is joint and several on all directors of the company. Accordingly, basis the said provisions, even non-executive directors who are appointed by the AIF will be held equally responsible in case of any default by the portfolio company. The non-executive directors are appointed in the management of the portfolio company to protect the interest of the investors. They are merely engaged in a stewardship role and do not participate in the day-to-day functionality of the portfolio company. Hence, they should not be held liable for the acts not undertaken by them. In light of the above, it is recommended that nominees / non-executive directors appointed by AIF in the management of the portfolio companies should be excluded from the provisions of Section 89(I) of the CGST Act. Further, even under the Company s Act, 2013, there is a specific carve out for non-executive directors from such obligation. The non-executive directors can be made liable only if there is any omission or commission by the company of which the non-executive directors are aware or have given their consent or in scenarios where such non-executive directors have not acted diligently. Page 14 of 18

15 Part B: Start-up related 4 Part B: Start-up related 18. Widening the definition of an eligible start-up An eligible start-up means a company or a limited liability partnership engaged in eligible business, which fulfils the following conditions: Up to a period of seven years from the date of incorporation/ registration or up to 10 years in case of start-ups in the biotechnology sector. With an annual turnover not exceeding INR 25 crore for any of the financial years since incorporation/ registration. Working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation. It is suggested that the threshold of turnover for a start-up to be increased from the current limit of INR 25 crores. It is recommended that to be consistent with the definition of start-up, the benefit under section 80-IAC should be extended to partnership firms as well. It is recommended that the definition of start-up to be made more objective to provide clarity to entrepreneurs if their businesses would qualify as a start-up or not. 19. Holding period for long-term capital asset to be 12 months Long-term capital gains tax (LTCG) has been the most debatable subject for the start-up industry. While listed companies attract LTCG beyond the holding period of 12 months, unlisted companies (start-ups and privately held) companies enjoy the same benefit after 24 months. It is recommended that the holding period in case of start-up should be reduced from the current holding period of 24 months to 12 months. Reducing the tenure of the LTCG for start-ups will not only give a big boost to the industry and attract more investors but also bring them in parity with the listed securities. 20. Change in ownership structure should not result in lapse of tax losses An eligible start-up in any prior year is allowed to carry forward and set off tax losses against the income, if all the shareholders of entity continue to hold those shares on the last day of such previous year. Since the start up industry is in a growth phase, in order to meet the right combinations, there are regular changes that occur at the shareholders level. It is recommended that the provisions of the Act to be structured in such a manner that the tax losses do not become ineligible for the start-ups to carry forward in case of change to all the shareholding; Alternatively, we can cap the limit of change of the shareholding. For example, any change in the shareholding of more than 51% in number should result in making the tax losses ineligible to carry forward to future years. An attempt should be made to bring parity between provisions applicable to the start-ups and the Company. Page 15 of 18

16 Part B: Start-up related 21. Taxation of Employee Stock Option Plan (ESOPs) In case of ESOPs granted to employees, taxes are required to be paid upfront and there are no specific provisions under the Act, wherein these taxes paid can be claimed as refund. Taxes are paid upon ESOP allotment and employees would not be eligible to claim refunds when the share price reduces drastically (at a later point in time). This is on the assumption that employees will be unable to revise the return of income. ESOPs should be taxed at the time of sale of shares as against at the time of allotment of share so that employees do not have to go out of pocket to pay income-taxes. 22. Carry back of losses Start-ups are running their business in a very dynamic business environment. Some start-ups can incur profits in initial years and losses in future years. Accordingly, a concept of carry back of losses should be allowed where the losses incurred in later years should be allowed to be set-off. This is explained through an example: Suppose in year 1 and 2, a start-up has earned profit of INR 100 and INR 200, respectively. Therefore, the start-up at the start of the third year will have a profit of INR 300. Suppose, in year 4, the start-up incurs a loss of INR 500. In such a situation, the start-up should be allowed to set-off the losses incurred in year 4 with the profits earned in year 1 and 2. Carry back of losses should be allowed for three years, which will ensure that they are fairly taxed on their overall income. This will provide a boost to the start-up industry and improve growth. However, the refund mechanism in such case will have to be evaluated. 23. Contingent consideration Deferred consideration is a portion of the purchase price that is payable by the buyer in the future. Various factors influence the actual negotiated price. Payment may be in the form of cash, debt, assumption or payment of liabilities, stocks, or future pay-outs. There will be a payment up front, in the form of equity in the buying firm or a promise to pay cash depending on the achievement of profit targets or turnover targets. The concept of deferred consideration has lot of ambiguity, where the payment due is deferred over a period of time. As various transactions involve deferred consideration, (viz., earn-out deals, profit-based, etc.), where the consideration is contingent upon occurrence of certain future events/ formula and is not ascertainable in the initial year of transfer. Therefore, the entire estimated consideration should not be taxable in the year of transfer but taxed only upon crystallisation of the event, thereby, taxing the real income. Alternatively, the taxability should be such that the fixed consideration should be taxed in the year of transfer and the balance to be taxed in subsequent years based on the payment terms. Page 16 of 18

17 5 Part C: Other venture capital industry recommendation 24. To allow Venture Capital Funds (VCFs) to invest in nonbanking finance companies (NBFCs) The ecosystem in India is in its nascent stage and most companies are start-ups or in early growth stages. VCFs have been categorised specifically under the AIF Regulations to invest in start-ups or early stage ventures or other sectors or areas, which the government or regulators consider as socially or economically desirable, and accordingly, VCFs should be encouraged to invest in such companies. In view of the above, it is submitted that the SEBI should allow VCFs to invest in companies registered as NBFCs, which currently form part of the negative list, as per the AIF Regulation. However, the following restrictions while permitting a VCF to invest in NBFCs to assuage any systemic risks associated with investments in NBFCs could be included: The maximum investment by a VCF in all NBFCs could be restricted to 25% of its investible funds; and A VCF may invest in only those NBFCs that will utilise not more than 75% of the funds received from the VCF towards loan book. 25. Other issues Encouraging investments by charitable trusts, EPFO Institutions such as pension funds and endowment trusts have been instrumental in the expansion of the AIF industry, given their staying power (Yale has a 30% allocation to VC/PE funds). In India, banks, insurers and the NPS have been permitted to invest in AIFs. Charitable, religious and educational trusts are looking to deploy significant capital outside conventional low-return avenues. The AIF vehicle is ideally suited to such investors. It is suggested that large charitable, religious trusts and educational trusts (over 100 crore) be permitted to invest up to 10% of their assets in AIFs. The EPFO can also be enabled to invest in AIFs in line with PFRDA regulations. Standard unified investment term sheet and guidelines for all government funds The SIDBI fund of funds for encouraging start-ups has done a commendable job in catalyzing capital commitments for Indian startups. It has invested 1,418 crores in 46 AIFs, which has in turn helped them attract 4.5X that capital ( 6,432 crores) from other investors. These investments have incrementally employed 4,180 people. The only suggested tweak is a more long-term budgeting framework for SIDBI fund of funds, given that drawdowns happen over 4-5 years. The SIDBI model also deserves to be replicated by others such as NIIF, which can take up a fund of funds for private equity Introduction of digitally accredited qualified investor for evaluating potential investors The main objective of DAQI is to protect investors who may be unable to sustain economic risks of investing in Alternate Funds and provide the industry with a readily available pool of sophisticated investors to which it can market its products. DAQI shall collate and authenticate financial health of investor in a central repository and verify investor information for AML screening. Further basis an established accreditation methodology, the Investor shall be endorsed, qualified as per DAQI. The major benefits of DAQI are: Page 17 of 18

18 - Convenient for Investors to upload their documents in one place and reduces burden of constantly producing and verifying accredited investors for a new Alternate Investment Fund. - Cost optimization, as DAQI introduces consolidation of costs across multiple AIF s by facilitating inter-usability of DAQI records - AML screening at a central level The timeframe for processing any application/ approval has to be reduced. It has been very challenging and time consuming for both the company and the investor to obtain the necessary approvals from the relevant authorities in India for carrying out their activities. Page 18 of 18