India needs to clarify tax issues to prevent it from becoming a digital colony

Investments in innovation need a better tax regime.

By TV Mohandas Pai & S Krishnan

India has seen a boom in the number of startups. It currently has the third-largest startup ecosystem in the world, with around 50,000 startups and 35 unicorns creating a value of $170 bn. Due to good government policy in the past few years, about 685 AIFs have been set up in India with a capital commitment of $40 bn. It is a tragedy, though, that only 10% of the capital invested in startups between 2014 and 2020 is from India. Indian industry has a target of 100,000 startups, 100 unicorns and employment of 3.25 million people by the year 2025. The biggest challenge in reaching this target is to ensure that Indian capital participates in this exercise in a big way, and India does not become a digital colony.

Even though AIFs have grown in numbers, they face considerable difficulty with regards to taxation. The tax policy does not promote healthy growth of the industry. Investments in innovation need a better tax regime. All around the world, investment funds are tax-exempt pass-through entities, whereby, the entire income of such funds are passed through to the investors. Contrary to this, Category I and Category II AIFs in India (referred to as investment funds for tax purposes) are required to compute business and non-business income separately. The investment fund is required to pay income tax on its business income, which will be tax-free income to its unitholders on distribution. Investment funds pass through investment income to their unitholders, who are required to pay income-tax on such income. The nature of income to the unitholders will be similar to the nature of income earned by the investment fund.

Investment income is tax-exempt for an investment fund. Another unique feature of the tax laws in India is the carry-over of losses incurred by an investment fund. There was no pass-through treatment for investment losses, unlike investment income. The Finance (No 2) Act, 2019 amended this requirement, whereby non-business loss, if any, accumulated by an investment fund as on March 31, 2019, was passed through to the unitholders. Such losses will not be available to the investment fund on or after April 1, 2019.

Unitholders who hold units for less than 12 months at the end of the year will not be eligible for pass-through of investment losses. The income-tax law is, however, silent on the treatment of investment loss incurred from FY20 in the case of unitholders holding units for 12 months and more. This appears to be an oversight by the authorities drafting the tax law. Since this issue is not specifically addressed, it can lead to interpretations and litigation in the in future. The income-tax authorities should specifically provide that investment losses incurred by an investment fund from FY20 should also be passed through to its unitholders holding units for 12 months and more.

Losses also occur when expenses are more than income. Many investment funds invest in the initial years and generate profits after a few years of investment. During this period, they incur expenses in managing their investment activities, a significant part of which relates to management fees. The law is silent on the treatment of these expenses either by the fund or by the unitholders. Mutual funds, which are tax-exempt entities in India, offset all their expenses against capital gains for determining the net asset value of its units. It would be useful if the law specifically provides that investment funds should capitalise all its expenses to be set off against capital gains when generated. And, the net capital gains should be passed through to its unitholders.

The Income-Tax Act specifically provides for taxation of business income of an otherwise exempt investment fund. The income-tax authorities have not issued any specific guidelines on the determination of business income of an investment fund. What is considered by an AIF as non-business income could be re-characterised by the income-tax authorities as business income during an assessment process, and taxed accordingly. This causes uncertainty in income characterisation for an AIF, and thereby, its taxation.

Sebi regulations do not permit Category I and Category II AIFs to undertake business activities. AIF is defined under the Sebi (AIF) Regulations, 2012 as any private pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of investors. “Category I Alternative Investment Fund” are permitted to invest in a startup 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. “Category II Alternative Investment Fund” cannot undertake leverage or borrowing other than to meet day-to-day operational requirements, and as permitted by Sebi. When the tax regulations require these AIFs to determine business income, it creates confusion and provides scope for interpretation and harassment by the income tax officers. Ambiguities in law are unnecessary and uncalled for, and it is affecting the growth of the investment sector.

In the past, when the short-term capital gains of Foreign Institutional Investors (FIIs) were assessed as business income, it resulted in litigation. The Finance Act 2014 amended the definition of “capital asset” to include “any securities held by a Foreign Institutional Investor which has invested in such securities in accordance with the regulations made under the Securities and Exchange Board of India Act, 1992, but does not include any stock-in-trade [other than the securities referred to in sub-clause (b)]”.

FIIs are now subject to only capital gains taxation in India since any securities held by an FII, which has invested in such securities in accordance with Sebi regulations, qualify as a capital asset. All gains made from investments in financial instruments by investors in public markets in India are taxed under the head “Capital Gains”. Investment gains of AIFs should be deemed to be ‘capital gains’ in nature, is another recommendation of The Alternative Investment Policy Advisory Committee (AIPAC) set up by Sebi under the chairmanship of NR Narayana Murthy to advise on various issues including taxation, relating to the alternative investment industry and development of the startup ecosystem in India. Considering that, Category I and II AIFs cannot undertake business activities, the reference to computation of profits and gains from business or profession is not relevant and should be removed for taxation of investment funds. Investments in innovation require tax clarity on the above issues urgently.