Foreign Portfolio Investment

Tax Implications of Foreign Venture Capital Investments in India

Foreign Venture Capital Investment is an important source of funding for Start-ups and technology-related projects. It is an unconventional source of funding, and it finances unconventional and innovative ideas that have a high growth potential. Venture Capital is risk capital provided to businesses for their expansion. Foreign Venture Capital Investments are funding provided by a foreign investor to new and emerging businesses in need of capital. As it is an important source of funding, it becomes crucial to understand the tax implications.

Under the Indian Tax system, the taxable income is determined by the Income Tax Act of 1961^[1]. Where there exists a Double Taxation Avoidance Agreement (DTAA) with a country, the taxability will be determined by the Income Tax Act read with the DTAA. The taxability of venture capital is determined as per section 10 (23FB) read with section 115U of the Income Tax Act of 1961. India has also entered into Double Taxation Avoidance Agreements (DTAAs) with several countries. Further, section 90(2) of the Income Tax Act prescribes that whichever is beneficial to the taxpayer among the two, will be applied.

Application of Income Tax Act on Foreign Venture Capital Investments

As per section 5 of the Income Tax Act of 1961, non-residents are taxed on their income received or deemed to be received, accrued, or deemed to have accrued or arisen in India. It covers any income arising or accruing from either directly or indirectly from India or any business connection in India. Business connection means any relationship between the business of the assessee and any business activity in India which directly or indirectly contributes to the earning of profits and gains by the assessee from his business. It is a broad definition and renders almost every activity of a non-resident business taxable in India. However, if there exists a DTAA between India and the respective country(s), then it should be read along with the Indian Income Tax provisions.

Tax on Venture Capital is determined under section 10 (23FB), read with section 115U of the Income Tax Act. In India, the Foreign Venture Capital Investments enjoy the tax pass-through status. Section 10 (23FB), read with 115U, makes venture capital exempt from tax in the hands of the investment fund and makes it taxable in the hands of the investors at the time of distribution. In simple words, the venture capital company or the venture capital fund is not taxable rather, the tax will be imposed in the hands of the foreign investor registered with SEBI. The income earned is taxed at the time of distribution of income to the investors. Further, the tax pass-through status is granted depending on the nature of the income. If it is dividend income, it is exempt from tax in the hands of the shareholder, but dividend distribution tax at the rate of 16.99% is imposed on the company distributing the dividend. In the case of capital gains, capital gains tax is imposed on the sale of shares of the investee companies.

Application of DTAA on Foreign Venture Capital Investors

In India, no specific tax exemption applies to Foreign Venture Capital Investors (FVCIs). It depends on the jurisdiction from where the FVCI invests in India. For example, India-Mauritius DTAA is one of the most beneficial DTAAs which India has with any country. It has attracted several foreign venture capital investments in India. India-Mauritius DTAA exempts tax on capital gains earned by a Mauritius resident in India. So when an FVCI transfers an Indian capital asset, the gains from such transfer are considered taxable in Mauritius only. As tax is paid only in the country of residence of the investor, it is a preferred option for investments in India.

This brings us to a question as to whether an investor in Foreign Venture Capital Investment is liable to pay income tax in India on the income they receive from the Foreign Venture Capital Investment as business profits despite the FVCI being exempt from tax. The answer to this is section 115U will override all provisions relating to the taxability of individual items of income, but it cannot override section 90(2) of the Income Tax Act, which is the DTAA provision. This is so because India is a signatory to the Vienna Convention of Law of Treaties, which gives tax treaties a special status as compared to domestic tax legislation. So the Tax treaty would prevail, having a special status as compared to domestic tax legislation unless there is an express specific provision in domestic law overriding the treaty. Presently, the Indian law does not seem to have the intention to override section 115U over section 90(2). A foreign investor in Foreign Venture Capital Investment receiving dividends from the investment fund is entitled to characterize the same as a dividend under DTAA by opting to be taxed under the DTAA instead of Indian Income Tax Act.

Conclusion

Foreign Venture Capital investments are high-risk and high-return investments due to this, it becomes crucial to understand their tax implications. Foreign Venture Capital Investments are governed by the provisions of the Income Tax Act of 1961 or the DTAA, whichever is more beneficial. Provisions of both the Income Tax Act and DTAA have to be read together.

Read our Article: Tax Implications of Foreign Portfolio Investors