Over the last 15 years, PE/VC funds have added over US$200b in Indian businesses.
The recent sharp reduction in corporate tax rates has signaled the intent on part of the government towards creating a progressive, enabling and competitive business environment in the country. This, along with a very attractive corporate tax rate of ~17% for new manufacturing investments, is likely to drive a wave of new investments into India, kicking off a virtuous cycle where investment, jobs, productivity, exports and demand feed into each other. A key source of equity investments to kick off this investment boom, apart from corporate investments, would be Alternative Investment Funds (AIFs). Globally and in Indian context, AIFs (also known as private equity and venture capital or PE/VC) are seen as a major source of capital for private companies driving entrepreneurship, jobs and economic growth.
Indeed, over the last 15 years, PE/VC funds have added over US$200b in Indian businesses, mainly for growth[1]. In addition to the volume of capital, PE/VC capital is one of the highest quality sources of capital, which is largely institutional, long term in nature, stickier and steadier than other sources like capital markets. PE/VC capital also helps in streamlining and professionalizing businesses making them more scalable and globally competitive. While helping entrepreneurship, PE/VC capital also supports government’s objective in formalizing the economy and instituting better governance. India’s PE/VC activity has grown and now exceeds the annual deal value of ~US$26.3b[2] across segments, but it needs to be stepped up significantly to meet India’s investment, job creation and GDP growth requirements.
So how can India further leverage AIF as a source of capital as well as garner a larger share of global wallet? First and foremost, India will have to put in place a globally competitive tax regime for PE/VC investments. The good news is that the government has been taking the right steps in this direction. For example, during the 2019 budget, tax benefits were announced for International Financial Services Centres (IFSC) that currently exist at GIFT City, Gujarat. Another important change was the angel tax exemption given to AIFs Category I and II, thus improving ease of doing business by reducing the risk of frivolous tax disputes.
But more can and needs to be done.
Firstly, with regards to the rates at which India taxes its domestic investors on private market sales made by AIFs, while taxes on public market sales are more competitive to other jurisdictions, India needs to re-look at how it taxes private markets sales by broad-based institutional pools of capital like AIFs viz.-a-viz. public market sales. Major economies like the US, the UK, Germany and Japan as well as Asian/BRIC economies like Singapore, Brazil and South Africa have a parity between private and public sales which is not in India’s case. Indian risk capital is being punished by charging significantly higher tax rates (in spite of longer holding time period to qualify as long-term capital gains) in comparison to public share sales. For example, resident Indian investors in an AIF (structured typically as a trust) pay a tax at 28.5% (on sale consideration less indexed cost of acquisition) as compared to foreign investors who pay 14.25%, when realizing the sales prior to a listing. All public market investors, on the other hand, pay a tax at 11.96% with lower holding period requirements. Despite the AIF investments into private companies incur higher risks, they are illiquid for several years and usually provide primary growth and expansion capital.
Additionally, investors into AIFs are not allowed tax deductibility of legitimate fees and expenses incurred by the AIFs when their capital gain is computed. This results in the management fees being a dead loss for investors, unlike in mutual funds and other public market funds. The investors thus pay taxes on an amount higher than their real gain. There is no logic to support this anomaly, which must be corrected.
Finally, AIFs managed by India-domiciled fund managers are liable to GST of 18%, even when a majority of the AIF capital is sourced from overseas. Instead, if this capital was pooled overseas and only managed rom India, fund advisory services to overseas investors would have qualified as exports and exempted from GST in India. The government has rightly targeted to pool more PE/VC capital through Indian AIFs because of the related economic activity and the benefits of creation of financial hubs in India. However, financial hubs in other parts of the world allow significant GST/VAT rebates as they recognize PE/VC as a global business and often as an export of fund management services. The 18% GST on foreign funds being pooled into Indian AIFs is a significant friction cost to deter on-shoring of funds and merits being urgently looked into. A city like Mumbai has a great opportunity in the context of the current global order to become a PE/VC hub, with the right approach to issues like GST on deemed exports of services and the creation of an IFSC here.
Thus, while the government and regulator have shown the right intent to spur up the economy, the understanding and recognition of the role of long term, sticky and risk-taking private capital in the growth of companies, job creation, higher tax revenues and thereby economic growth, is imperative. The three critical steps, highlighted above, will go a long way in aligning policies that will attract larger flows from marquee global investors like sovereign funds, insurance companies, foundations and endowments into the Indian PE/VC asset class. Given India’s size, scale and ambition to quickly reach the US$5t GDP mark, the benefits are obvious.
