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Monday, March 05, 2007

Para 173 of the budget speech is 100% wrong

This year, the budget speech has a proposal in para 173: ``Venture capital funds are a useful source of risk capital, especially for start-up ventures in the knowledge-intensive sectors. Since such funds enjoy a pass-through status, it is necessary to limit the tax benefit to investments made in truly deserving sectors. Accordingly, I propose to grant pass-through status to venture capital funds only in respect of investments in venture capital undertakings in biotechnology; information technology relating to hardware and software development; nanotechnology; seed research and development; research and development of new chemical entities in the pharmaceutical sector; dairy industry; poultry industry; and production of bio-fuels. In order to promote business tourism, I also propose to allow this benefit to venture capital funds that invest in hotel-cum-convention centres of a certain description and size.''

This is profoundly wrong, at three levels:

  1. A tax pass-through status of all fund managers is a core principle of sound tax policy. If you hire me as a fund manager, I'm your agent. Your funds pass through me into investments and back to you. The only taxable unit is the customer of the fund manager. If the fund management vehicle were taxed, this would amount to double taxation, and it would kill all professionalisation of fund management. To retreat from a tax pass-through status for any fund management is profoundly wrong. The pass-through status of fund managers is not a privilege, it is a foundation of sound tax policy.
  2. By making the tax pass-through status conditional on investments in certain industries, the government is playing god on which industries should receive investment. What is special about `hotel-cum-convention centres of a certain description and size' or `nanotechnology' which makes investment in these fields `desirable'? No government has the information processing capacity to decide where investment must take place. Such sentences show the Indian State going back to the archaic reflexes of industrial policy. Conversely, if investments into all industries are double-taxed but these few privileged industries receive single-taxation, then this corresponds to a fiscal subsidy for investors in these industries. That is bad economics.
  3. The ground reality in the Indian private equity business is that the PE funds are incubators for business. They are inciting entrepreneurship amongst people who are not traditional business families. It is to India's benefit, because the best entrepreneurial minds do not have to be born into business families. A good chunk of the PE investments in India are in old economy industries such as cinemas or retailing or readymix concrete. And there is nothing wrong with that: for India to go from a per capita GDP of $800 to $8,000, 99% of the job lies in good quality investments in traditional businesses. The real role of private equity lies in supporting entrepreneurship and in fostering first-generation entrepreneurs; not in fostering investments in nanotechnology.

A great deal of money has been contracted by the existing private equity industry where the customer expected a tax pass-through and expected the PE fund to engage in a certain investment strategy (most of which was not in fields like nanotechnology or seed research). If the government goes through with the above paragraph, then it would make India look foolish in the eyes of the investors. I would expect that the bulk of commitments would be withdrawn, and the Indian private equity industry would shrink dramatically in size and significance.

One would dearly hope that this paragraph gets deleted in the Finance Bill that will get voted upon. Update (28/3/2007): M. P. Chitale & Associates have a thoughtful piece on this subject.


  1. Is that only para you find objectionable? what about the dual tax structure, and esops being bracketed as a fringe benefit to be taxed in the hands of the company?! and I cannot believe the asinine thought of ranking rent from commercial premises as a service. Will that not be economically speaking, a return on capital? All this arm twisting of cement and steel manufacturers to make them confirm is so disappointing. What signals are we sending out? I don't think the ministry is aware of expectations theory at all.

  2. I hope PC is reading your mail, as this is a pernicious development in the alternative asset management arena of the country.

    But, I would like to do a little bit of hair splitting here and state that theoretically the withdrawal of 10(23)(FB) does not mean double taxation. In fact there are other sections in the IT act (sec 160-164 and sec 61 read with 63) which envisages to give pass through status to trust funds. Parts of the PE funds are established under these sections and hope to get the said benefits, if they can be called benefits at all.

    However, what will happen is a vitiation of the tax environment. As it is, our experience is that most of the asessment officers fid it difficult to comprehend the principle of pass through and carried interest of the funds. After this budget, even if it is legit to avoid double taxation, getting the tax credit in the hands of the investors will be a very stiff challenge.

  3. "the government is playing god on which industries should receive investment."

    Really? But our government is so good at it. Instead of making substantive investment, FDI and divestment, policy decisions, Chidambaram was just using up his time. Overall it was a pretty lame budget.


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