Saturday, January 12, 2008

Our taxmen will soon get this scent

In an increasingly flattening world, no new taxing strategy could slink under the taxman’s radar for long. They are always on the prowl picking up new excuses to tax the citizen. India’s Finance Minister P.Chidambaram borrowed the concept of Fringe Benefit Tax and Securities Transaction Tax not from US or Europe, but went all the way down under and picked it up from Australia. I am sure he will be closely watching the debate on “carried interest tax” on VCs that is raging in the US.

We had a similar row last year when the Government sought to restrict the “pass through” status for income streaming to VC firms around February 2007.

Steve Brotman of SAVP, a VC firm in New York has a detailed post here. I liked the interesting illustration Brotman has inserted in there.

Suppose a entrepreneur starts a corporation, and invests $50,000 in it. Then they raise $100,000,000 by selling 80% of it in preferred stock; preferred stock means the investors get paid first, and is quite typical structure with startups. Then the entrepreneur sells the corporation for $300,000,000 after 5 years. Should the entrepreneur who continues to own the 20% piece that he owns, pay capital gains tax of 15% or ordinary income tax of 35%?

Today the law is 15%, as these are long term capital gains.

Now change the word "entrepreneur" to "VC".

Is that OK in your book if a VC creates such a company, and generates capital gains this way?”

I haven’t read US tax law. But in the Indian context, VC firms registered with SEBI enjoy a conditional “pass thro” tax status so that the income is not taxed at the firm level. It is taxed in the hands of the investor when it gets distributed. So if the investor stations himself in a tax haven like Mauritius or Cyprus, they escape with nil taxes. But it is biased against India based VC firms like ICICI Venture since the Indian investors in the fund would be liable to pay tax on their income either by way of LTCG or income tax depending upon the nature of its receipt.

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