Domestic private equity funds, even those investing in infrastructure, will now be taxed twice on account of the changes introduced in the Union Budget.
The Budget takes away tax exemptions on income earned by the funds while imposing a tax on income distributed to their shareholders, potentially impacting thousands of crores of rupees of domestic funding of infrastructure through private equity. In addition, since the Budget provision does not specifically exclude previously existing funds, the impact will be retroactive.
“We have raised these funds on the promise of a prevalent tax regime. By effecting a change retrospectively, the country is going back on its own promise. We will be making a representation to the government,” says the head of a leading Indian private-equity fund who did not wish to be identified.
Mint spoke to five private-equity fund managers, all of whom talked at length but declined to go on record for the fear that they would be singled out for openly commenting on the issue.
In 2006, according to venture fund tracker, Venture Intelligence, of the 302 private equity and venture capital deals that brought in investments of Rs33,300 crore, nearly a third, or about 99 deals, were in engineering, construction, food and beverages, media, textiles and pharmaceuticals—all sectors no longer eligible for the pass-through benefit.
Until now, such income was totally exempt as the funds have benefited from what is known as “pass-through” tax treatment, meaning profits earned on exit from unlisted firms are not taxed, while individual investors are taxed when they receive distribution from the fund.
Under the Budget, starting 1 April 2008, the tax benefit will only extend to investments in sectors such as software and hardware development and nano-technology; development of new drug molecules; dairy and poultry industries; biotechnology, seed research, and bio-fuel production. Funds investing in business tourism outfits that build hotels and convention centres will also be eligible.
The income earned on such investments will now get taxed first at the corporate tax rate at 33.99% when it accrues to private equity funds and then taxed as dividend distribution at 16.99% when paid out as dividends to the high net-worth entities or individuals contributing to the funds.
Finance ministry officials justify the change in the tax treatment of venture capitalists, saying it was primarily initiated to contain exposure of these funds in the real estate sector. One industry estimate is that 25% of the Rs 12,000 crore investment by VCs went into real estate, fuelling what many see as a potential bubble in the sector.
However, private equity fund managers do not believe that this change alone would stop funds flowing into real estate, especially since bulk of the real-estate investments are routed through tax havens such as Mauritius. “Money into real estate will continue to flow through the Mauritius private equity route. We, as an Indian company, can do the same thing. The Budget move really hurts Indian investors who support venture capital,” said a private equity fund manager.