India: Venture Capital Funds: End Of An Era

Last Updated: 8 November 2007
Article by Sakate Khaitan and Radhika Iyer

The Indian real estate sector has attracted investments from numerous quarters, including offshore jurisdictions. Offshore funds have led the pack of investors by utilising tax efficient structures spanning across jurisdictions. However, as a result of certain changes introduced in the Budget 2007, investors have been compelled to revisit their strategies related to structuring of investments in Indian realty sector. This article examines the impact of these fiscal changes in the long term structural strategy of funds.


Offshore funds used Indian venture capital funds ("VCF") as their India-based conduits to channel investments into Indian companies engaged in the business of real estate during the last two years. The choice of VCFs as entities for structuring the Indian end of investments was tax-efficient because of the benefit of a "pass-through" status available to VCFs under the Indian tax laws pre 2007. (Indian VCFs, whether existing or newly organized, who wish to avail of the tax benefits available to venture capital funds under the Indian Income Tax Act, must register with the SEBI under the VCF Regulations and comply with the SEBI Venture Capital Fund (Regulations), 1996. )

VCUs were earlier not allowed to invest in real estate sector. Real estate featured in the negative list where VCU were disallowed from making investments. However, in April 2004, amendments were introduced in the SEBI Venture Capital Fund Regulations 1996, which took off the Real Estate from the negative list, thereby allowing the VCUs to make investments into the real estate sector. The pass through benefits were already available to these VCFs. Hence, the offshore funds lapped up the opportunity and began utilizing VCFs as the preferred vehicle for making investments in real estate.

An illustration of a typical offshore fund piggybacking an Indian VCF is as follows:

Investors pool funds together to form a Special Purpose investment vehicle ("SPV") based in an appropriate treaty jurisdiction like Mauritius or Cyprus. The SPV then seeks registration as a Foreign Venture Capital Investor ("FVCI") with the Securities and Exchange Board of India ("SEBI"). Once the SPV is registered as a FVCI the SPV then invests into a SEBI registered Indian VCF, which in turn invests into a Venture Capital Undertaking (VCU) i.e. an Indian operating company engaged in the real estate sector.

The main advantages of this structure was as follows:

  • The FVCI did not need to meet the minimum capitalisation requirements as prescribed for investments into a non-banking financial company (a VCF is classified as such under existing regulations).
  • Ease of exit due to non-application of pricing guidelines for sale to resident Indians and lower lock-in requirements if the VCU is seeking listing for FVCIs.
  • The Indian VCF being a domestic entity had no restrictions in investing into the Indian real estate sector.
  • Beneficial tax treatment pre 2007 budget.

Though the above structure was for sometime typical in nature it will be necessary to clarify that presently FVCI registrations in India are not easily accorded to real estate focused FVCIs, due to the divergent views taken by SEBI and RBI. According to the RBI, FVCI investments should not be permitted in the real estate sector. Consequently, though the FVCI regulations do not prohibit investments in the real estate sector, the RBI has been slow to approve applications of real estate focused SPV’s for FVCI status. Under such circumstances, in the event the Fund seeks to register itself as FVCI, it is likely that the Fund may not receive FVCI registration until the aforesaid issue is resolved. Further, there is also some debate as to whether or not a simple FVCI structure is tax efficient and can claim all treaty benefits.

Tax treatment of structure:

Pre 2007 budget

As per the provisions of section 115U of the Income Tax Act 1961 ("ITA"), a VCF qualifying for exemption under section 10(23FB) of ITA is not required to withhold any tax in India on the income distributed by it to its investors. Any income distributed by such VCF is chargeable to tax in the hands of the investors in the same manner as if it were the income of the investors, had they made such investments directly in the Indian operating company and for this purpose income received by the investor is deemed to be of the same nature and in the same proportion as it is in the hands of the VCF.

A VCF is typically expected to earn income by way of dividend, interest or capital gains. Tax implications prior to the change in tax code in 2007 was as follows:

  • Dividend was exempt from tax where the Indian operating company had paid Dividend Distribution Tax ("DDT") on such dividend.
  • Interest on loan, being a rupee denominated loan, was taxed at the rate of 41.82% while Interest income in respect of borrowings in foreign currency was taxed at the rate of 20.91% (assuming treaty does not provide for lower rate e.g. Mauritius treaty).
  • Capital gains was exempt from tax as the SPV was usually based in a jurisdiction where treaty benefits is available and care was taken that the gain did not form part of the Permanent Establishment (PE) of the SPV in India.

However, this preferred structure took a hit because of the certain provisions being introduced into the ITA by the Budget of 2007.

Post 2007 budget

As stated above Section 10(23FB) of the ITA exempted any income of a registered VCF from income tax. This tax exemption under section 10(23FB) when read in conjunction with section 115U of the ITA, established the pass-through status of VCFs registered with SEBI. Accordingly, pre-2007 Investors in VCF’s were liable to tax in respect of the income received by them from the VCF in the same manner as it would have been, had the investors invested directly in the VCU.

Thus, under section 115U income from VCFs was taxed in the hands of the investors at the time receipt of distributions from the VCF. However, if the FVCI was based in a territory through which the investor could seek treaty relief, the gains from investments could have been sheltered resulting in an effective tax rate of 0% on capital gains.

In 2007 the Government moved to close this loophole and thorough the Finance Act of 2007 restricted the pass-through status of VCFs to investments in certain specified sectors, namely: biotechnology; information technology relating to software and hardware development; nanotechnology; seed research and development; research and development of new chemical entities in the pharmaceuticals sector; dairy; production of bio-fuels, and hotel-cum-convention centres.

Accordingly, since real estate business is now not a specified business qualifying for tax pass through status, income from investments by the VCF in Indian portfolio companies engaged in real estate business are now taxable as below:

If the VCF is regarded as a determinate trust, its income shall be taxable in the hands of the trustees of the VCF as per section 161 of the ITA and the tax shall be levied upon and recovered from the Trustees in the like manner and to the same extent, as it would be leviable upon and recoverable from the investors (beneficiaries) in the SPV. For this purpose, treaty benefits available to SPV may have to be taken into consideration for computing tax liability of the VCF.

Accordingly, the tax consequences on the income of the VCF proportionate to the share of the SPV in such income would be (on account of the application of the Treaty, read with the provisions of the ITA) as follows:

  • capital gains resulting from the sale of Indian securities (listed or unlisted) issued by the VCU will not be subject to tax in India;
  • dividends on shares received from the Indian Portfolio Companies on which dividend distribution tax has been paid will be exempt from tax;
  • interest income from Indian securities in respect of borrowings in Indian rupees will be taxed at the rate of 42.23% where income of the SPV is more than Rs. 10 million and at 41.2% where income is up to Rs. 10 million (assuming treaty does not provide for lower rate e.g. Mauritius treaty).

If however, treaty benefits are not available, the income of the VCF proportionate to the share of the SPV in such income would be as follows:

Gains earned on the transfer of shares and other listed securities held for a period of 12 months or less are termed as short-term capital gains. The taxation of both long term and short term capital gains under the ITA would be as follows:

  • Long-term capital gains arising on transfer of listed equity shares on a recognised stock exchange in India will usually be exempt from tax in India;
  • Short-term capital gains arising on transfer of listed equity shares on a recognised stock exchange in India is taxed at the rate of 10.558% where income of SPV is more than Rs.10 million and 10.3% where income is up to Rs. 10 million.
  • Short term capital gains arising on a sale of listed equity shares not executed in a recognised stock exchange in India and other Indian listed securities is taxed at the rate of 42.23% where income of the SPV is more than Rs. 10 million and at 41.2% where income is up to Rs. 10 million. In respect of long term capital gains, while the benefit of the indexed cost of acquisition will not be available for computing such gains, it could be contended that such gains will be taxable at the rate of 10.558% or 10.3% as the case may be and not at the rate of 21.115% or 20.6%.
  • Capital gains arising on sale of unlisted Indian securities is taxed at the rate of 21.115% or 20.6% for long-term gains and at the rate of 42.23% or 41.2% in case of short-term gains.

However, if the VCF is regarded as a discretionary trust or to be carrying on business then the entire income of the VCF would be taxed at the maximum marginal rate i.e. at the rate of 33.99%, and such distribution on which tax has already been paid by the trustees would not be subject to tax in the hands of the SPV.

Impact of change

The change in tax laws has made the typical structure mentioned above inefficient due to the following reasons:

  • Treaty benefits may be lost because of non-availability of pass through status to the income of VCF.
  • Effective increase in hurdle rates as distribution from VCF’s are now post tax rather than pre-tax, thereby reducing fund managers carry.
  • Impact of tax being brought forward as tax is now chargeable in the VCF’s hand rather than in investors’ hand on distribution. This also makes the reinvestment provisions, if any, in placement memorandums in most respects redundant.


Given the above the added administration and transaction costs of a VCF cannot now be justified making the use of VCF’s inefficient. Accordingly, we now see most funds avoiding the VCF route and making investments into the real estate sector directly in compliance with existing foreign direct investment regulations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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