Budget 2015: Bold reforms to boost entrepreneurship in India
Budget 2015 presents a unique opportunity to policymakers to accelerate the flow of capital to take entrepreneurship to the next level.
India is a country of entrepreneurs. If you count number of farmers and shopkeepers as entrepreneurs, India has more entrepreneurs than any other country in the world. By the same logic, about 70 per cent of country’s population can be classified as entrepreneur.
Last decade has seen emergence of new-age entrepreneurs from sectors such as IT, e-commerce, technology, education, healthcare, consumer and agribusiness. The success stories of Flipkart, Snapdeal, Zomato, and Housing.com etc., have inspired many more to take a dig at entrepreneurship like never before.
I am surprised by the bulging numbers of entrepreneurs in the 25-35 age group, who have quit their cushy and high-paying jobs with blue chips to chase their dreams. Majority of professional-turned entrepreneurs have unique business models, good teams and are committed to work hard to get there. However, the single biggest bottleneck for budding entrepreneurs continues to be “Capital”.
With budget just about a month away, there are expectations of higher reform quotient. In the context of a highly-qualified and experienced team at the Ministry of Finance working on budget, the expectations are bound to go up further. This budget presents a unique opportunity to policymakers to come up with bold reforms, which can accelerate the flow of capital to take entrepreneurship to the next level.
Three bold reforms on top of my list are as follows:
A. Zero capital gains on unlisted securities
Majority of transactions in the VC & PE (Venture Capital & Private Equity) industry are in the unlisted entities. The taxation on returns from these investments depend on tenure of holding as short term vs. long term (> 36 months holding is classified as long term), tax residency status of the investor, classification of income as business vs. capital gain.
The ideal solution to attract capital is to make capital gains arising out of investments in unlisted entities as tax-exempt irrespective of the above factors. The benefits are as follows:
• Increase attractiveness of private equity vis-a-vis public equity. This will bring parity (vis-a-vis listed entities) as well as clarity to all investors in VC/PE fund.
• Likely increase in the participation from domestic investors (including institutions and individuals) in investing in VC/PE.
• Incentivise foreign investors to domicile their funds in India. This will help them in close monitoring of the capital without worrying too much about the tax implications. There is good chance that over a period of time, they may increase India allocations.
• Saving of time, money and energy for fund managers lost in grappling with taxation and structure issues - which can be productively used to focus on portfolio management.
What are the pitfalls of exemption on capital gains on unlisted entities? Yes, the government will forego tax revenue. But loss of tax to the government arising out of capital gains should be seen in the following context:
• Capital gains on international money is anyways (mostly) taxed outside India in the hand of investors.
• Majority of the domestic money is from the government institution (likes of SIDBI, LIC, GIC, PSBs). So in a way, income tax's loss will be gain to other government organisations.
• Profitable exits in the industry are few limiting capital gains and to that extent have not been contributing much to tax revenue of the government.
• One way to reduce tax outgo is to put some nominal STT (securities transaction tax) on unlisted entities (like public traded companies on the stock exchange). Since the number of investments are far more than number of exits, STT despite nominal in nature will have much larger volume of transactions than capital gains situations.
I believe that benefit of capital gain tax exemption is far too higher than the pitfall of loss of tax revenue. It will trigger flow of capital to capital-starved entrepreneurs, which would contribute to the growth of economy as well as drive much-needed job creation.
B. Review of AIF regulations
In 2013, Sebi has issued norms for Alternative Investment Funds (AIFs). AIFs are a newly created class of pooled-in investment vehicles for private equity, real estate and hedge funds for change in their categories. The AIFs have been divided into three categories. The Category I AIFs includes those investing in start-ups, social ventures, SMEs etc. The Category II AIFs includes private equity funds and debt funds, which do not get any incentives or concessions from the government and do not undertake leverage or borrowing other than to meet day-today operational requirements. And the Category III includes hedge funds or funds which trade with a view to make short-term returns.
The three categories have some specification with respect to definition, use of funds, commitments, ticket size, taxation etc. AIF regulations are important and can play an important role in driving governance and compliances among fund managers. However, “flexibility” in investing needs to be left market-driven given the evolving nature of this industry. Investors in all three categories are investing risk capital so let the fund managers and the investee companies mutually decide the most suitable deal structure as permitted by the law.
C. Continuity and predictability of tax regime
All investors whether domestic or international; institution or individual do not want surprises on regulations and taxation. One niggling issue for the industry for a long time is applicability of put options. There has been ambiguity on this issue for a long time. Put option is one of the key down-side protection rights, so clarity on this issue will go a long way in boosting investor confidence.
The asset class in long-term and illiquid in nature, so the continuity in policies over a longer period of time is key to attract and keep investors invested in VC/PE. Any promise or step on this front will go a long way in building investor confidence.
The writer of this article is Hemendra Mathur, Managing Director, SEAF India Investment Advisors. He has about 18 years of experience in PE, management consulting and investment banking. He is also associated with many mentoring and incubator networks advising startups across a range of sectors. The views expressed here are personal.