What to expect on AIFs, taxation, and compliance from the government?

India is bracing for a familiar yet exciting transition in the upcoming months. As the nation gears up for general elections in April-May 2024, Union Finance Minister Nirmala Sitharaman will present the Interim Budget 2024-25 on February 1. While an interim budget rarely offers major announcements, there may be a few areas where long term policy design should not be left waiting.

The Interim Budget 2024 is expected to focus on several key sectors, including social welfare, agriculture, infrastructure, education, and healthcare. The budget may hint at long-term policy initiatives that the new government could pursue after the elections, including public-private partnerships in climate financing. This could help attract private sector investment in sustainable projects and contribute to India’s commitment to achieving net-zero emissions by 2030.

Indeed, it hasn’t happened many times in modern history, that a large consumption economy is also a massive innovation economy – the only other country that saw both the engines fire at this scale was the US. And while the central characters will always be the entrepreneurs building businesses, private market players are playing a profound role in fueling them – both on the startup economy, and scaling the SMEs.

According to the ‘No Ifs about AIFs 2023’ report, the introduction of GST and state-of-the-art digital public infrastructure such as Aadhaar for identification and Unified Payments Interface (UPI) for payments created opportunities for the VC-PE ecosystem to reach a larger demographic across sectors and geographies. Similarly, investment in physical infrastructure, such as roads and airports increased market access and lowered costs. By continuing the budget’s focus on the nation’s physical and digital infrastructure, the commercial opportunities offered by these policies will continue to drive robust capital and deal flow for the Indian VC-PE industry.

The private markets and the Alternative Investment Fund (AIF) landscape at large stands at a pivotal juncture, beckoning for strategic reforms to bolster growth trajectory across AIFs, taxation, and compliance.

Uniform taxation rate for all securities

The existing disparity in tax rates and holding periods between listed and unlisted shares has led to a skewed preference for the listed market among investors. Non-resident investors benefit from a level playing field with equivalent tax rates for both listed and long-term unlisted shares. Advocating for uniform tax rates for resident investors in unlisted shares is crucial for creating a fair investment landscape. This adjustment not only promotes parity but is also poised to directly stimulate growth in the startup sector—an area of strategic focus for the government.

The PE/VC sector, primarily invested in unlisted markets, stands to gain substantially, ensuring a more favorable environment for fund managers and increased capital infusion for early-stage entities. This move aligns with the goal of nurturing a diverse and dynamic investment ecosystem in India.

Treatment of management fees as cost of investment provisions under Section 56(2)(VIIB) of the Act

The relaxation of Place of Effective Management (POEM) rules for fund managers offers the potential for a seamless influx of management fees into India. Recognising management fees as a legitimate cost of investment under Section 56(2)(VIIB) of the Act is a strategic imperative, underscoring governmental support for the investment ecosystem’s core. This nuanced adjustment not only aligns with industry expectations but also solidifies the financial foundation of these entities, ensuring their continued contributions to India’s economic trajectory.

Relaxation of conditions to qualify as a recognised startup with the Department of Promotion of Industry and Internal Trade (DPIIT)

The current 10-year incorporation limit, rigid company type prerequisites, Rs. 100 crore turnover cap, and restrictions on restructuring hinder the diverse trajectories of emerging ventures. Advocating for a more inclusive approach involves revisiting these conditions. A flexible time frame for company age, a broader acceptance of legal structures, and graduated turnover thresholds can foster a supportive environment. Recognising the unique challenges faced by startups, these adjustments align with the dynamic nature of the entrepreneurial landscape.

Taxation of ESOPs at the time of sale of shares instead of issue

Employee Stock Ownership Plans (ESOPs), crucial for talent acquisition and retention, currently face a dual taxation process. Presently, individuals bear tax liability upon exercising stock options, despite no cash inflow, followed by additional taxation on capital gains during share sales. The shift sought is the need to tax ESOPs solely at the time of share sale, thereby eliminating the existing two-stage taxation. This proposed change aims to synchronise tax accrual, mitigating the initial tax burden on employees and enhancing ESOPs’ appeal as a strategic incentive.

Clarification on excuse clause by insurance companies and pension funds to invest in AIFs

Insurance companies and pension funds can invest in AIFs, with the current framework allowing an ‘excuse’ clause. This clause permits investors to abstain from specific opportunities if it conflicts with their internal policies, disclosed in their agreement with the AIF. However, seeking clarity on its implementation is essential. Investors should disclose policy contraventions in their agreements, with side letters potentially facilitating these terms. The framework specifies that insurance companies and pension funds can invest in Category I and II AIFs, with unique considerations for Category II AIFs. While these regulations provide opportunities, a clear understanding of the ‘excuse’ clause is crucial for fostering transparency and encouraging institutional participation in the dynamic AIFs space.

With the Interim Budget around the corner, these expected reforms signify a commitment to dynamic growth and a forward-looking approach, promising an inclusive and impactful change.

Views expressed on Live Mint on Jan 23, 2024