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17 May 2013
Smt. Poonam Saxena
Central Board of Direct Taxes
Department of Revenue
Ministry of Finance
North Block, New Delhi 110 001

Dear Madam,

SUB: REPRESENTATION FOR EXTENDING TAX PASS THROUGH STATUS UNDER
SECTION 10(23FB) OF THE INCOME-TAX ACT, 1961 TO AIF CATEGORY I AND
CATEGORY II

We would first of all like to congratulate the Ministry of Finance for bringing out a balanced Finance Act
2013 focused on the twin objectives of containing fiscal deficit and fuelling a higher economy growth
rate.

The Finance Act 2013 has amended section 10(23FB) of the Income-tax Act, 1961 (IT Act)
whereunder the tax pass through status accorded under section 10(23FB) read with section 115U of the IT
Act would be available only to funds registered under the sub-category of Venture capital funds
(VCF) within Category 1 Alternative Investment Funds (AIF) in terms of the Securities and
Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (SEBI AIF Regulations).
VCF registered under the erstwhile Securities and Exchange Board of India (Venture Capital Funds)
Regulations, 1996 (SEBI VCF Regulations) and which have since been repealed and replaced by the
SEBI AIF Regulations will continue to be entitled to the tax pass through status under section 10(23FB)
read with section 115U of the IT Act.

We would like to make a representation to extend the tax pass-through in terms of section 10(23FB) read
with section 115U of the IT Act to all Category I (irrespective of sub-categories) and Category II AIFs

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and on all income earned by them, which is extremely critical from a private equity (PE) / venture
capital (VC) industry standpoint:

1. Issue Brief Chronological Background

1.1. The Finance Act, 2012 amended section 10(23FB) of the IT Act providing tax pass through to a
VCF / Venture Capital Company (VCC) for any income earned from a Venture Capital
Undertaking (VCU) referred to in the SEBI VCF Regulations. The beneficiary of a VCF / VCC
is taxed as if it has made the investments directly in the VCU. The above amendment in section
10(23FB) of the IT Act read with section 115U led to the removal of sectoral restrictions
encapsulated under the erstwhile section 10(23FB) of the IT Act and thereby extended the pass
through status to income earned by VCF / VCC registered under the SEBI VCF Regulations from
PE / VC investment across all sectors. This amendment was greatly appreciated by the PE / VC
industry as a move, which would provide significant tax certainty to investors and thus greatly
foster development of domestic PE / VC funds. As a matter of fact, this was infact the position
from Assessment Year 2001-2002 upto Assessment Year 2007-2008 after which the sectoral
restrictions were first introduced in section 10(23FB).

1.2. Subsequently, in May 2012, the SEBI VCF Regulations were repealed and SEBI AIF Regulations
were enacted wherein AIFs were broadly classified into three categories viz. Category I (eg -
VCFs, social venture funds, SME funds), Category II (PE funds, debt funds, etc) and Category III
(hedge funds, etc) based on their eligibility criteria, investment restrictions and the positive effects
they would have on the economy. The AIF regulations provided that only Category I AIFs would
be deemed to be VCF or VCC for the purposes of section 10(23FB) of the IT Act. Consequently,
post the enactment of the SEBI AIF Regulations, all Category I AIFs were entitled to the tax pass
through status under section 10(23FB) read with section 115U of the IT Act (apart from VCF /
VCCs, which were registered and grandfathered under the erstwhile SEBI VCF Regulations,
which are already covered); Category II and Category III AIFs were not covered.

1.3. Post the Finance Act 2013, only VCF sub category of Category I AIF would be entitled to the tax
pass through status. Other sub categories of Category I (eg: infrastructure funds, social venture
funds etc) would not be entitled to the tax pass through in terms of section 10(23FB) read with
section 115U of the IT Act. This has resulted in the following disparities:


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a. Whilst all funds registered as Category I AIF would have the positive spillover effects on
economy, the tax pass through status is accorded only to the VCF sub-category of AIF-I
therefore, there is a disparity inter se in the tax treatment of different types of Category 1 AIF
funds;
b. Category II and Category III are not entitled to tax pass through status; and
c. Grandfathered VCF / VCC who continue to be governed by the VCF Regulations will enjoy
complete tax pass through status for any income earned from VCUs thus creating a disparity
between grandfathered VCFs and the non-VCF Category I, Category II and Category III
AIFs.

1.4. Such disparities will trigger needless confusion thereby increasing the possibility of litigation
between the funds and the revenue authorities and result in compliance costs for the reasons cited
below.

2. Purpose of 10(23FB) of the IT Act and complexities of trust taxation

2.1. section 10(23FB) of the IT Act provides for exemption from tax of any income of a VCC or VCF
from investment in a VCU. section 115U of the IT Act, provides any income accruing or arising to
or received by a person out of investments made in a VCC or VCF to be chargeable to income-tax
in the same manner as if it were the income accruing or arising to or received by such person had
he made investments directly in the VCU. This means that the VCF would be explicitly considered
as a pass through entity for Indian income tax purposes and the investors in the VCF would be
taxed on the income earned by them from the VCF.

2.2. In India, for a host of regulatory and legal reasons, most VC/PE funds are typically constituted as
trusts formed under the Indian Trusts Act, 1882. Subsequent to the amendment brought about by
Finance Act 2013, since only VCF sub category of Category 1 AIF have been included in the
definition of VCC / VCF, other categories of Category 1, Category II and Category III AIF which
are established as a trust would not be able to tax pass through under section 10(23FB) read with
section 115U of the IT Act, but would be liable to be taxed as per Part B and Part C of Chapter XV
of the IT Act (primarily section 160 to section 164A), which deal inter alia with general trust
taxation.


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2.3. The general trust tax provisions provide for a single level of taxation either at the level of the
trustee or the beneficiary. In case of determinate trusts, the taxability is based in the same and
like manner as though the income was directly earned by the beneficiaries
1
. In case of an
indeterminate trust, normal income would be sought to be taxed at maximum marginal rate
2
.

2.4. Fundamentally, general trust tax provisions also provide for a single level tax regime and the tax is
charged based on the taxability of the beneficiary for determinate trusts. To this extent, the tax
effect under general tax provisions is similar to the tax pass through status available under section
10(23FB) read with section 115U. However, to achieve complete tax pass through under the
general trust tax provisions, certain conditions also need to be complied. The above trust tax
provisions were introduced in the statute book decades ago primarily to deal with private trusts
(eg: family trusts); various conditions / safeguards were stipulated under those provisions in the
context of private trusts and preventing misuse thereof for tax avoidance. The problem arises in the
fact that provisions enacted to primarily tax private trusts are being applied to PE / VC funds set up
as trusts (ie: non-VCF Category I AIF, Category II and Category III AIF). There is not much
jurisprudence available on the applicability of general trust tax provisions in the context of VC/PE
funds set up as Trusts. Therefore, at a practical level, there may be a risk of such provisions being
misinterpreted in the context of VC/PE funds and jeopardizing complete tax pass through status.
Such an uncertainty and consequential litigation risk is unwarranted and highly detrimental to the
growth of the VC / PE funds.

2.5. In light of the above, the underlying principle for taxation of income of VC/PE funds constituted as
trusts, broadly remains the same, i.e. single level of taxation and chargeability based on the tax
position of the beneficiary. However, there is a negative bias against investments by other sub
categories of Category I AIF, Category II and Category III AIF by unjustly subjecting them to
uncertainties of general trust tax provisions. In particular, this creates nervousness amongst the
investors in such funds including offshore investors investing in domestic funds who need tax
certainty.





1
Section 161(1)
2
Section 164

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3. Revenue neutrality

3.1 Under the tax pass through status, the income is taxable in the hands of the investors instead of
VCF/VCC. It must be noted that section 10(23FB) read with section 115U of the IT Act provides
only a flexibility to the VCF for being treated as a tax pass through entity. The IT Act does not
provide any income-tax exemption on the income earned by the VCF since the investors of the
VCF have to pay tax on the same. Accordingly, there is no loss to the revenue by providing the tax
pass through status.

3.2 Further, there is no deferral of tax as well since the investors pay tax as and when income is
accrued to the VCF.

3.3 In a nutshell, the income is subject to tax in the hands of the investors (subject to other provisions
of the IT Act). Hence, this mechanism of pass through only provides flexibility and tax certainty
without compromising on the tax base or the timing of tax collection.

3.4 There is total neutrality in terms of the tax revenue collection, being the concern of the revenue
authorities since there is no exemption or deferral of tax as the investors would pay tax as and
when income is accrued to the VCF / AIF.

4. Non-VCU income not covered

4.1 The language of section 10(23FB) of the IT Act, as it stands currently, grants exemption only to
income from investments in VCUs. As per the Budget, VCU has been defined to mean a VCU
referred in the SEBI VCF Regulations or in SEBI AIF Regulations.

4.2 section 10(23FB) of the IT Act does not cover tax pass through status for income from investment
in non-VCUs, even though the SEBI VCF /AIF Regulations explicitly permits VCFs to invest in
non-VCUs subject to certain limits. Also, an issue may arise with respect to a company, which
may be a VCU (unlisted) at the time of investment but is listed prior to exit and hence, technically,
may not be a VCU for the purposes of section 10(23FB) of the IT Act. Such a consequence seems
inequitable and unintentional given that the investment was made at the stage when the investee
company was a VCU. Further, an AIF / VCF / VCC may also earn sundry sources of income such
as bank interest, directorship fees etc.


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4.3 Akin to a mutual fund whose entire income is exempt under section 10(23D) of the IT Act, similar
blanket exemption provision should be introduced for the whole of the income earned by such
SEBI registered funds to be taxed on a pass through basis under section 10(23FB) read with
section 115U of the IT Act in the hands of the investors. Interestingly, this position was already in
place in the tax regime prevalent between Assessment Year 2001-02 upto Assessment Year 2007-
08 prior to the amendments introduced by the Finance Act 2007.

4.4 Consequently, an AIF /VCF / VCC may have two income streams subject to differing tax
treatments income from VCUs would be taxable under the section 10(23FB) and section 115U
framework and the balance income would be taxable as per general trust tax provisions (for VCFs
/ AIF constituted as trust).

4.5 To eliminate any uncertainty in the tax consequences, it would be a welcome move to make an
amendment extending the pass through regime to all income earned by a SEBI registered fund
under section 10(23FB) of the IT Act. This will obviate needless litigation between the funds and
the revenue authorities and reduce cost of compliance.

5. Significance of PE/VC investment in India

5.1 As you will appreciate, PE/VC investment has various benefits viz.:

Providing long term growth capital and mentoring to entrepreneurs
Developing new business models
Expanding to new markets
Improving corporate governance
Attracting talent & access to management expertise
Contributing to infrastructure and R&D development, etc

Overall, the PE/VC industry has had a positive impact on various stakeholders.

5.2 Category I AIFs invest in start-up or early stage ventures or social ventures or SMEs or
infrastructure or other sectors or areas which the government or regulators consider as socially or
economically desirable and shall include VCFs, SME Funds, social venture funds, infrastructure
funds and such other AIF as may be specified. Clearly, Category I AIFs would have significant
positive spill-over effects on the economy and it is imperative that all Category 1 AIFs and their

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investors are incentivized by according complete tax certainty and bringing them within the fold of
tax pass through available in terms of section 10(23FB) of the IT Act.

Similiarly, Category II AIFs would include PE funds, debt funds or any other fund which is not a
Category I or Category III AIF. These types of funds would be critical to provide growth capital to
corporates at different stages, finance expansion/buy-outs, deepen and strengthen corporate debt
markets etc. The capital made available by Category II AIFs would be gainfully utilised for overall
economic development. Accordingly it is urged that Category II AIFs must also be brought within
the ambit of section 10(23FB) of the IT Act.

7. Request

7.1. In todays times when there are several economic challenges, globally and locally, an economy like
India which is in urgent need of capital and investment to push its economic growth rate cannot
afford to lose out especially on the ground of tax uncertainty.

7.2. Whilst there is a clear argument to bring all AIFs Category I, Category II and Category III AIFs
within the scope of section 10(23FB) on the ground of revenue neutrality and tax certainty, from the
standpoint of adopting a calibrated approach, it is critical that atleast all Category 1 (irrespective of
sub-category) and Category II AIFs are immediately brought within the scope of section 10(23FB)
of the IT Act.

7.3. In view of the above, the provisions of section 10(23FB) of the IT Act may please be amended as
follows:

(i) all Category I and Category II AIFs should fall within the scope of the terms venture
capital fund and venture capital company as defined for the purposes of Section
10(23FB) so that the tax pass through benefit in terms of section 10(23FB) read with
section 115U of the IT Act is duly available to all Category I and Category II AIFs; and

(ii) all income earned by erstwhile VCF / VCC registered under the SEBI VCF Regulations,
Category I AIF and Category II AIF should be covered under the provisions of section
10(23FB) of the IT Act so that the tax pass through in terms of section 10(23FB) read with
section 115U of the IT Act is duly available on all incomes earned by such funds.


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We request you to consider the above request. If you have any questions / need any clarifications, we
would be glad to provide the same.

Thank you.

Yours sincerely,


Mahendra Swarup
President
For Indian Private Equity and Venture Capital Association