Author Name:   meenakshi

what is foreign venture capital investment, how is foreign investment in capital ventures made, taxation of FVCI, exit strategies of FVCI...

"Foreign Venture Capital Investment In India"

"There is a tide in the affairs of men, which taken at the flood, leads on to fortune. And we must take the current when it serves, or lose our ventures." - William Shakespeare

In today’s global scenario of trade and communication, the tide of offshore investments is at a hike. There is an immense increase in the investments made by different countries to foreign countries to increase efficient trade and commerce relationship and to enhance the economy of one’s own country. Looking at the status of investments in India by foreign investors, there has been quite an increase in the venture capital investments resulting in favourable amendments in the rules governing these investments to enhance effective trade relationships between India and foreign countries.

The investments by a foreign investor in Indian Venture Capital Undertakings (VCU) and Venture Capital Funds (VCF)are governed by Foreign Exchange Management regulations and Securities Exchange Board of India regulations. The foreign country investing in the Venture Capital in India is called as the Foreign Venture Capital Investor (FVCI).

The term FVCI has been defined under the SEBI (Foreign Venture Capital Investor) Regulations 2000 to mean:

“an investor incorporated or established outside India, which proposes to make investments in venture capital fund(s) or venture capital undertakings in India and is registered under the FVCI Regulations”

Therefore it is mandatory for a foreign investor that it should have got itself registered with SEBI before it proceeds to make investment in Venture Capital Company of India. According to the definition given in Foreign Exchange Management (Transfer or Issue of Security by a person Resident Outside India) Regulations, 2000, FVCI means an investor incorporated and established outside India and which proposes to invest money in Venture Capital Funds or Venture Capital Undertaking in India and is registered with SEBI.

Thus, clearly from the above definitions, there are three requirements to be satisfied by a foreign investor before it can make investments in venture capital companies in India:

1. It should have been incorporated and established in any country outside India;

2. It should be willing to make investment in VCFs or VCUs in India in accordance with SEBI regulations; and

3. It should have got itself registered with SEBI as a FVCI.

Such a FVCI can be in form of a company including a body corporate or a trust.

Before a Foreign Investor can obtain certificate of recognition as FVCI from SEBI it has to satisfy certain eligibility criteria. Some of these criterions which are to be considered by SEBI are the applicant’s track record, professional competence, fairness and integrity of applicant, financial soundness of applicant, prior experience, whether applicant is fit and proper person in accordance with SEBI (Criteria for Fit and Proper Person) Regulations, 2004, etc. Further it has to be seen that whether the applicant has got necessary approvals from RBI for making investments in India or not.

Once the SEBI is assured that applicant satisfies all conditions under Regulation 4 it can proceed to grant registration to the applicant as FVCI allowing him to make investment in Indian VCUs and VCFs in accordance with applicable rules and regulations. This depends upon the discretion of SEBI which can impose suitable terms and conditions upon the applicant before it is recognised as FVCI.

After an investor has been recognized and registered as FVCI by SEBI it has to seek further approval of RBI under FEMA Regulations before making investment in India. Such an FVCI can apply to RBI for general permission through SEBI to invest in IVCU or VCF or in a scheme floated by such VCF.

The definitions of VCFs and VCU are given both in FEM (Transfer or Issue of Security by a person Resident Outside India) Regulations, 2000 and SEBI (Foreign Venture Capital Investor) Regulations 2000. The definitions are almost similar in nature except the fact that SEBI Regulation uses the term VCU whereas FEM regulations use the term IVCU. Joint reading of both these regulations explains the terms VCFs and VCU in following manner:

Indian Venture Capital Undertaking (IVCU): IVCU means a company incorporated in India whose shares are not listed on a recognized stock exchange in India and which is not engaged in an activity specified under the negative list specified by the SEBI. IVCU is generally a new born private company which is yet to establish itself and is in need of funds and experienced advice and support.

Venture Capital Fund (VCF): It is a fund established in the form of a trust or a company including a body corporate and registered with SEBI under SEBI(Venture Capital Fund) Regulations 1996 and which has a dedicated pool of capital raised in manner specified in regulations and which invests in VCU in accordance with said regulations. A VCF is also allowed to make investments in VCU subject to provisions in SEBI(Venture Capital Fund) Regulations.

Therefore a FVCI that has got registered with SEBI as such and has been permitted by RBI to make investments in India can make investment in either IVCU or VCF or both. FVCI that has been permitted by RBI to make investment in IVCU or VCF can make investment by purchasing equity or equity linked instruments or debt instruments or debentures of an IVCU or of a VCF. Equity linked instruments means and includes instruments that are later convertible into equity shares or share warrants, preference shares or debenture convertible into equity. These investments can be through Initial Public Offer or Private Placement or in units of schemes/funds set up by VCF. But a FVCI registered with SEBI and permitted by RBI can make investment only in those IVCU and VCF that are also registered with SEBI under respective SEBI regulations.

Investment conditions
A FVCI registered with SEBI is permitted to make investments in following manner:

1. An FVCI can invest all of its funds in a domestic VCF- a registered FVCI is allowed to invest 100% of its funds in a VCF registered under SEBI(Venture Capital Fund) Regulations.

2. It has to invest atleast 66.67% of its investible funds in unlisted equity shares or equity linked instruments of Venture Capital Undertakings.

3. It can invest only 33.33% of its funds (and not more), by-

· Subscribing to initial public offer of adventure capital undertaking whose shares are proposed to be listed;

· Investing in debt or debt instrument of the VCU provided it has already invested by way of equity in such a VCU;

· Preferential allotment of equity shares of a listed company subject to lock in period of one year;

· Investment by subscription or purchase in the equity shares or equity-linked securities of a financially weak listed company or industrial listed company.

· Investment by way of subscription or purchase in Special Purpose Vehicles created for the purpose of facilitating or promoting investment in accordance with these regulations.

FVCI have a fixed life cycle. Every FVCI making investments in IVCU or VCF has to mandatorily disclose life cycle of its fund before making any investments. It has to further disclose all its investment strategies to the SEBI before it makes any investment in India.

General obligations and responsibilities
The following are the general obligations and responsibilities of the Foreign Venture Capital Investor:

· Every foreign venture capital investor shall maintain for a period of eight years books of account, records and documents which shall give a true and fair picture of the state of affairs of the Foreign Venture Capital Investor;

· He shall intimate to the Board, in writing, the place where the books, records and documents are being maintained;

· The Board may at any time call for any information with respect to any matter relating to its activity;

· Where any information is called for the same shall be furnished within the time specified by the Board;

· Foreign Venture Capital Investor or a global custodian acting on behalf of the foreign venture capital investor shall enter into an agreement with the domestic custodian to act as a custodian of securities for foreign venture capital investor;

· He shall ensure that domestic custodian takes steps for-

(a) Monitoring of investment of foreign venture capital investors in India;

(b) Furnishing of periodic reports to the Board;

(c) Furnishing such information as may be called for by the Board.

· He shall appoint a branch of a bank approved by the RBI a designated bank for opening of foreign currency denominated accounts or specified non-resident rupee account.

Taxation on FVCI
Under Section 90(2) of the Income-tax Act, a non-resident assessee based in a country with which India has a Double Taxation Avoidance Agreement (DTAA), may opt to be taxed either under the IT Act or the DTAA, whichever is more beneficial.

Under Section 10(23FB) of the IT Act, any income of a registered FVCI is exempt from income tax. The FVCI can carry on business in India through a permanent establishment in India, and yet its entire income would be tax free. On the other hand, if the FVCI opts to be taxed under the DTAA and it has a permanent establishment in India, its Indian income will not be tax free.

The tax exemption under section 10(23FB) has to be read with section 115U of the IT Act, which confers a pass-through status on SEBI-registered venture funds. Investors in such funds would be liable to tax in respect of the income received by them from the FVCI in the same manner as it would have been, had the investors invested directly in the venture capital undertaking. In other words, income earned by an FVCI by way of dividend, interest or capital gains, upon distribution, would continue to retain the same character in the hands of its investors.

This brings us to a question as to what is the nature of the income derived by an FVCI from its Indian investments. While dividend declared by an Indian company is tax free in the hands of any recipient, including an FVCI, the gains, an FVCI would make upon exit from an Indian investment, was so far regarded as capital gains. However, the Authority for Advance Ruling has held that profits made by a private equity fund or venture capital fund should be taxed as business profits and not as capital gains.

Are non-resident investors in an FVCI, therefore, liable to pay Indian income tax on what they receive from the FVCI as business profits, even though the FVCI itself does not have to pay any tax? Although Section 115 U begins with the words ‘Notwithstanding anything contained in any other provisions of this Act’, and it would override the normal provisions relating to taxability of individual items of income, it cannot override Section 90(2) relating to DTAA provisions. India is a signatory to the Vienna Convention on the Law of Treaties and, therefore, tax treaties have a special status as compared to domestic tax legislation and would prevail unless there is an express specific domestic provision to override the treaty. In the present case, it does not appear to be the intention of the legislature that Section 115 U should override Section 90(2).

Accordingly, a non-resident investor in an FVCI, who receives dividend from the FVCI, is entitled to characterize the same as dividend under the DTAA, by opting to be taxed under the DTAA and not the IT Act. Due to its very recent enactment, obviously, there is no precedent or case law and, therefore, it is not improbable that the Indian tax authorities may contend that the investor is not entitled to the DTAA benefit in view of Section 115 U and is liable to pay tax on business profits in India. Tax planning structures could be worked out to protect against such an eventuality, however remote it may be.

Exit strategy
Exit strategy is the method by which a venture capitalist or business owner intends to get out of an investment that he or she has made in the past. In other words, the exit strategy is a way of "cashing out" an investment. Examples include an initial public offering (IPO) or being bought out by a larger player in the industry. It is also referred to as a "harvest strategy" or "liquidity event"

A special exemption has been carved out for FVCI’s in as much that an FVCI may acquire or sell its Indian shares/ convertible debentures/units or any other investment at a price that is mutually acceptable to both the parties. Thus, there are no entry or exit pricing restrictions applicable to an FVCI. This could be a very significant benefit for FVCI’s, especially in the case of a strategic sale or buy-back arrangement with the promoters at the time of exit from unlisted companies.

Conclusion
The venture capital fund is a high risk and reward activity. The investments are made by high net worth individuals and institutions to reap high returns. The investor in venture capital funds does not involve himself in day-to-day management of the fund and the activities of the funds are managed by professionals. The investors therefore like to keep their liability limited to the contribution committed by them to the fund and are not willing to take on any other liability. The venture capital funds are set up for a limited life and on maturity the returns are distributed amongst the investors. The structure of venture capital funds should therefore protect the interest of investors and the liquidation process should be simple. There are some recommendations, which I strongly feel, are considerable for making the investment provisions much better to develop this sector of trade-

· Investments by VCFs in VCUs should not be subject to any sectoral restrictions except those to be specified as a negative list by SEBI in consultation with the Government which may include areas like real estate, finance companies and activities prohibited by Law.

· There is no need for any ceiling of investment in equity of a company. It is understood that the investment ceiling of 40% of paid up capital of VCU under the Income tax Act has already been removed. As a prudential norm, the investment in one VCU should not exceed 25% of the corpus of VCF.

· The investment criteria needs to be amended to provide for investment criteria whereby VCF invest primarily in unlisted equity and partly in listed equity, structured instruments or debts also. The investment in listed equity shall be through IPO or preferential offer and not through the secondary market route. The VCF shall invest atleast 70% of the investible funds in unlisted equity of VCU and 30%of investible funds may be used for investment through IPO, preferential offer, debt, etc. The investible funds would be net of expenditure incurred for administration and management of the funds.

***********************
# Quoted in the play Julius Caesar written by William Shakespeare
# Defined in Regulation 2(1)(m) of the SEBI (Foreign Venture Capital Investor) Regulations 2000
# Defined in Regulation 2(1)(l) of the SEBI (Foreign Venture Capital Investor) Regulations 2000
# Foreign Exchange Management (Transfer or Issue of Security by a person Resident Outside India) Regulations, 2000 and SEBI (Foreign Venture Capital Investor) Regulations 2000
# Regulation 2(1)(g)
# Regulation 2(iii)(a)
# Regulation 4(1)(c) of the SEBI (Foreign Venture Capital Investor) Regulations 2000
# Regulation 4 of SEBI (Foreign Venture Capital Investor) Regulations 2000
# See Regulation 4 and 4A of the SEBI (Foreign Venture Capital Investors) Regulations 2000 and SCHEDULE II - SEBI (Intermediaries) Regulations, 2008
# See Regulation 8 of the SEBI (Foreign Venture Capital Investor) Regulations 2000
# Reg. 5(5) and Sch. 6 of FEM (Transfer or Issue of Security by a person Resident Outside India) Regulations, 2000
# Regulation 2(xi) and Reg. 2(v)(a) respectively
# Regulation 2(1)(l) and Reg. 2(1)(m) respectively
# Regulation 11(c)(i)of the SEBI (Foreign Venture Capital Investors) Regulations, 2000
# Regulation 2(1)(f) of the SEBI (Foreign Venture Capital Investors) Regulations, 2000
# See Schedule 6 of Foreign Exchange Management (Transfer or Issue of Security by a person Resident Outside India) Regulations, 2000
# Master Circular on Foreign Investment in India No. 6/2004-05 Dated 1-7-2004
# Regulation 11 of SEBI (Foreign Venture Capital Investors) Regulations, 2000
# Regulation 11(a) of the SEBI (Foreign Venture Capital Investors) Regulations, 2000
# See Regulations 12, 13, 14, 15 of the SEBI (Foreign Venture Capital Investors) Regulations 2000
# Regulation 12(1) of the SEBI (Foreign Venture Capital Investors) Regulations, 2000
# Regulation 12(2)of the SEBI (Foreign Venture Capital Investors) Regulations, 2000
# Regulation 13(1) of the SEBI (Foreign Venture Capital Investors) Regulations, 2000
# Regulation 13(1) and (2) of the SEBI (Foreign Venture Capital Investors) Regulations, 2000
# Regulation 2(1)(d) of the SEBI (Foreign Venture Capital Investors) Regulations, 2000
# Regulation 14(1) of the SEBI (Foreign Venture Capital Investors) Regulations, 2000
# Regulation 14(2) of the SEBI (Foreign Venture Capital Investors) Regulations, 2000
# Regulation 15 of the SEBI (Foreign Venture Capital Investors) Regulations, 2000
# Section 90(2) of the IT Act provides the provisions for avoidance of double taxation of any income in India and any other country. The provision speaks about an agreement/treaty signed between India and any other country for Double taxation avoidance. The general rule is that the treaty prevails over the Income-tax laws, but if the law is more beneficial than the provisions provided in the treaty, the law will prevail over the treaty.
# Order dated March 7, 2001
# Retrieved on December 23, 2011 http://www.investopedia.com/terms/e/exitstrategy.asp#ixzz1hLMG8nZY

The  author can be reached at: meenakshiagrawal@legalserviceindia.com

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