There’s a way around the startup tax, but could SEBI’s new framework for VCs make it impractical for angel investors?

Budget 2012 proposes to introduce several provisions to modify the current taxation framework applicable to venture capitalists. In this post, we study the consequences of one much debated provision which incidentally makes startup funding taxable. What was the government thinking while introducing such a tax that will clearly affect angel investors? Is there any work-around? Is there any easy way out?

On the face of it, from a legal reading of the amendment, one possible way for angel investors seems to be registering as a Venture Capital fund with the SEBI – which, however, comes with some downsides. Additionally, SEBI has recently announced a modification of the regulatory framework applicable to VC funds, which may make it more difficult for angel investors to register as VC funds. We decided to explore in this article whether this is a practical solution for angel investors in India, and what it takes to register and operate a venture capital fund registered with the SEBI, both under the current regulations, and under the new regulations proposed by SEBI.

For those who are not clear on what is the startup tax all about (the rest can skip directly to the part titled “Registering a VC fund” below)

As per the budget the Income Tax Act (section 56 to be precise, which deals with how income from “other sources” will be taxed) would be amended (with effect from 1^st April, 2013), to state that any amount received by a company for issue of shares that is greater than the fair value ( reflects the real value of the company based on its assets and liabilities) as well as face value (nominal value of the share – usually Rs. 10 or 100 in most cases) of the shares will be taxed as its income (See VCCircle for a discussion on this). Therefore, the company will have to pay tax on such income at corporate income tax rates – 30% (40% for foreign companies) if it sells shares above face value as well as fair value.

Illustration

A startup issues 100,000 shares of face value Rs. 10 at a price of Rs. 50 to an investor. That amounts to a premium of Rs. 40 per share. As per the proposal in the new budget, if the shares are issued at a price which is higher than their fair value, it will be treated as the income of the startup, and the startup will be taxed on it. Assume that the fair value of the shares is Rs. 20. Therefore, the income of the startup form such funding will be 50 – 20 = Rs. 30 per share, or Rs. 3,000,000 (three million). The startup will have to pay a tax of 30%, Rs. 900,000 (nine hundred thousand) on this.

How it affects angel investment in startups

For obvious reasons, startups have to sell shares above fair value of their shares – investors are not buying shares in a startup for the existing value of the share, which is only a small fraction of the amount they pay for each share – they are paying a premium to the face value in the hope that in the long run the fair value of these shares will grow a lot and exceed the price at which they are buying now. This is an investment they are making in low value assets, buying the assets at a higher price than their real price so that the company can use that money to grow itself. Issuing shares at a premium also enables the promoters to retain managerial control over the company, while being able to raise the necessary funding for expansion.

If money raised from investors is taxed, then a company will have lesser resources to grow – and the investor will be very unhappy that 30% of his money is not going to contribute towards the growth of the company. Investment in startups will become a significantly more expensive proposition if this tax applies to angel investor funding. Startups and investors stand to lose out a lot if this tax is applicable – and if a viable solution is not found, it is likely to affect the startup sector in a terrible way.

Registering a VC fund – the way to go for angel investors?

The only clear exception to this tax is in case of investment by a venture capital fund registered with SEBI. In case there is investment by such a fund, this tax would not have to be paid. Most individual investors and even many institutional investors do not register with SEBI in India as a fund. In most cases, money is invested in personal capacity or through closely held companies.

Other benefits of registration

Registration as a venture capital fund has other benefits under Indian law, apart from preventing the tax consequences arising from funding startups under the new budget. For example, registration exempts an investor from the elaborate lock-in requirements in an IPO under Indian law (for an exhaustive discussion of the advantages of registration with SEBI, see my post on the HeadStart Network blog). As per the lock-in requirement, when a company undergoes an IPO, the pre-IPO shareholding of non-promoters (including shares held by investors who have funded the company in investment rounds prior to the IPO) is subject to a lock-in of 1 year. These shares cannot be transferred, so an investor cannot ordinarily realize the value of his investment from an IPO for a further period of 1 year. A VC fund which is registered with the SEBI is exempt from this lock-in requirement. Angel investors who register as VCs with SEBI will be able to benefit from this exemption.

Critical considerations for angel investors before registration

Will it make sense for these investors to pool in some money into a fund first? The factors that will most strongly influence investors are the following:

– how much funds do they need to commit to the VCF at the beginning? How will pooling of funds work?

– how difficult/costly will it be to get a SEBI registration, and later on, to administer the fund/comply with SEBI regulation?

The newest problem in attempting to answer the two questions above is that the regulatory regime applicable to VC funds and other investment vehicles is transforming radically.

Overhaul of the regulatory regime applicable to VCs – which regulations apply?

VCs funds are governed by the SEBI (Venture Capital Funds) Regulations, 1996 (“VCF Regulations”). However, on 2^nd April, SEBI issued a press release approving the draft regulations for alternative investment funds (“AIF Regulations”) proposed through a concept paper earlier last year (on 1^st August, 2011). (See my post on Yourstory for a criticism of the draft AIF Regulations).

The AIF Regulations propose to revamp the framework applicable to investment vehicles, including VC funds. Finalized AIF Regulations have not been notified yet and are not presently in force, although they may be notified at any time. Once they are notified, venture capital funds will be covered by the AIF Regulations and the VCF Regulations would be automatically repealed. Funds registered under the VCF Regulations will continue to be governed by the same until the existing fund or scheme managed by the fund is wound up. Any registration or approval granted by the SEBI under the VCF Regulations will be presumed to have been granted under the corresponding provisions of the AIF Regulations.

Until the AIF Regulations are notified, VCF Regulations continue to be applicable. Therefore, we have provided a detailed comparison of the relevant provisions of the VCF Regulations and AIF Regulations below.

Is it feasible for angel investors register as VCs after the regulatory change?

SEBI has in its press release mentioned that venture capital funds have positive spillover effects on the economy, and that the it may, along with the government and other regulators, consider granting incentives or concessions based on the need of the funds.

The AIF Regulations have drastically increased the minimum fund size from INR 5 crores to INR 20 crores, and the minimum amount that can be accepted from an investor from INR 5 lakh to INR 1 crore. The increase is significant – angel investors in India cannot individually invest more than about INR 20-25 lakhs. They may not be able to constitute such a large fund, and to pool these amounts.

Further, there are additional restrictions on the tenure of the fund, disclosure and record keeping requirements that will significantly add to the costs of operating as registered entities. We are summarizing some key requirements which will be introduced by the AIF Regulations for the first time:

· The tenure of the fund shall be at least 3 years.

· Detailed information specified under the regulations needs to be disclosed to investors (such as financial, operational, risk management information relating to fund investments, details of regulatory proceedings or breach of information memorandum, etc.).

· The fund manager is required to address all investor complaints.

Conclusion: Registration with the SEBI as a VC fund is the solution for angel investors, to prevent falling under the net of the startup tax. However, SEBI’s announcement to overhaul the regulatory framework for VC funds could make it impractical for angel investors to register with it.

However, SEBI has stated that it will consider giving exemptions for VC funds depending on their need. It may be easier for angels to get relaxations from SEBI to register as VCs, than it is to hope that the tax on startups is withdrawn altogether. Angel investors and startups would need to adopt a consistent stand on the matter, so that they can make a representation to SEBI. Your views as a startup/angel investor will play a significant role in taking this discussion forward.

We are presenting a detailed comparison between the VCF Regulations and AIF Regulations below, so that angels know how they can register as VCs with SEBI. Do you think the new requirements under the AIF Regulations will be difficult to meet for angel investors? You can mention your comments below.

Comparison of key provisions of the VCF Regulations and Draft AIF Regulations

Criterion	VCF Regulations	Draft AIF Regulations
Minimum total commitment	A firm commitment of INR 5 crores from investors before starting operations is required. This does not mean that the entire amount of INR 5 crore needs to be put up front – just a firm commitment to invest when investment opportunity arises is sufficient. If one investor does not have the intention to invest 5 crore alone, he will have to find other investors to join him to create a fund that can be registered.	Minimum size of the fund must be INR 20 crores.
Minimum investment per investor	A venture capital fund cannot accept less than Rs. 5 lakhs from any investor	Minimum investment amount shall be 0.1% of fund size subject to a minimum amount of Rs.1 crore. Sponsor must contribute a minimum of 2.5% of the fund corpus or INR 5 crores, whichever is lower.
Registration and Application process –Summary of information to be provided to SEBI	a. Application form (Form A) as per the First Schedule to the VCF Regulations b. Constitutional documents of the sponsor/ settlor, the investment manager, and the trustee company c. A write up on the activities their shareholding pattern/profile of the directors of the sponsor/settlor, the investment manager and the trustee d. Detailed investment strategy of the fund – This should disclose the investment style or pattern, preferred sectors/industries for investment, proposed corpus, the class of investors, life cycle of the fund and any other relevant information. e. Declarations and undertakings as prescribed under the VCF regulations.	Application form shall be specified by SEBI and is not provided under the Draft AIF Regulations. SEBI will consider the legal structure of the fund (i.e. whether it is a trust or LLP or company, whether the sponsor, asset management company or the fund manager have relevant experience in managing assets, a sound track record, are fit and proper persons, etc.
Manner of raising funds	The VC fund needs to prepare placement memorandums/ contribution agreements, which must be prepared in a fairly detailed manner. This also increases compliance cost. The placement memorandum must indicate the entitlements available on the units purchased by the subscribers of the fund, the manner in which the benefits accrue on the units, tax implications, investment strategy, details of the investment manager/ asset management company, investment horizon, details about the performance of other funds managed by the fund manager, etc.	The VC fund can raise funds through a placement memorandum only, which must contain information prescribed under the regulations, such as details of business, terms and conditions of investment services, investment policy, valuation, etc.
Cost of registration	Application fee of Rs. 1 lakh must be paid to the SEBI for making an application to register as a VC fund or company. Once SEBI approves the application, a registration fee of Rs. 5 lakhs must be paid. SEBI issues a registration certificate after payment of the registration fee	Similar to the VCF Regulations
Time taken to grant registration	The grant of registration by SEBI is discretionary under the VCF Regulations and the AIF Regulations – that is, SEBI will only issue a registration certificate if it is satisfied that all the requirements under the regulations are fulfilled, and all material information is adequately disclosed by the applicant. In relation to the VCF Regulations, SEBI officials have informally stated that if the application is complete in all respects and there are no further clarifications required by SEBI, registration as a domestic venture capital fund may take only 1 month. However, 6 to 8 weeks may be a more reasonable estimate.	Not known presently. SEBI may take more time initially to grant registrations, since some of the requirements stipulated under the AIF Regulations are different from the VCF Regulations.
Procedure in case of refusal to register	SEBI can reject an application that is incomplete, but is required to give the applicant an opportunity of being heard. Often, SEBI comes back with questions and requires the applicant to submit additional documents or information.	Similar to the VCF Regulations
Investment restrictions	A VC fund cannot invest more than 25% of its corpus in one unlisted company. At least 66.66% of its funds must be invested in equity or equity linked investments of unlisted companies. The remaining one third (33.33%) may be invested by way of: a. Subscription to shares of a company which is making an initial public offer; b. debt or debt instruments of an unlisted company (if the VC fund has also invested in its equity) c. Subscription by preferential allotment of shares of listed companies, or equity shares of financially weak or sick industrial companies d. SPVs created by the venture capital fund for facilitating or promoting investment in accordance with the VC Regulations.	Similar to the VCF Regulations
Record keeping and information	Record-keeping obligations add to costs and are somewhat onerous for VC funds. As per the VC Regulations, a VC fund must keep books of account, records and documents giving a true and fair picture of its affairs for a period of 8 years. It must furnish any information requested by SEBI from time to time.	Following records need to be maintained for a period of 5 years after the winding up of the fund: a. The asset under the scheme/fund b. Valuation policies and practices c. Trading practices or investment or trading strategies d. Particulars of investors and their contribution e. Analytical or research methodologies