Union Budget 2016: Can It Be Entrepreneurial? Focus on attracting investments in "Startups" and "SMEs".

This is going to be the only leap year budget for the current government before the next elections – to that extent, can it be different from the last budget and set the agenda for budgets to come over next few years? More precisely, can it be more entrepreneurial? By entrepreneurial I mean – bold, fresh and visionary – a reflection of Modi's approach to governance.

I believe that the government has a never-like-before opportunity to push the reform agenda, precisely the reason for which it has been voted to power.

India needs to create about 20 mn jobs every year which is possible only by boosting investments in start-ups and SMEs.

An unprecedented policy booster to promote entrepreneurship at all possible levels is the need of the hour if we want ourselves to be closer to 20 mn jobs target.

In India, two important pillars or segments of entrepreneurship are – Start-ups and SMEs. Both are capital starved – despite developing VCPE funding (about USD 10 bn per annum) and numerous government initiatives to improving debt funding.

Union budget can a long way in policy reforms to attract more capital to these important segments of economy.

Focus on attracting investments in "Startups" and "SMEs"

It is heartening to see the government push for startups and the policy framework announced prior to the budget. Startups are finally getting the recognition they deserve for the disruptions to bring more efficiency in the system. The Startup policy is definitely is one of the rare example of government's commitment to promote entrepreneurship at the startup stage.

However, one must not forget the role of SMEs in creating employment across length and breadth of the country. Unlike majority of start-ups are "tech" and "service" focused, SMEs are conventionally more "manufacturing" focused – and most definitely the founding pillar for "make in India".

Thus a balanced approach towards start-ups and SMEs is also the key to give the balance to Indian economy in time to come.

Startup policy has many incentives for start-ups such as income tax break, ease of registration and exits. However, when it comes to attracting investments, the government should not differentiate between start-ups and SMEs. SMEs are nothing but start-ups in their teenage or adolescence. They are as capital starved as start-ups and as much policy support.

In my view, if we want to attract capital in a non-linear way, following reforms are essential with respect to attracting capital:

1. "Zero capital gains on gains from investing in start-ups / early stage companies / MSMEs (unlisted securities)"

Majority of investments in the VCPE industry are in the start-ups / early stage / MSMEs / unlisted entities. The taxation on returns form these investments depends 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 investment in these entities as tax-exempt irrespective of the above factors. The start-up policy has indicated this but made exemption conditional to the use of proceeds being invested in another long term assets (Sometimes the fine print kills the spirit of reform).

The benefits of capital gain tax exemption are as follows:

• It will increase attractiveness of private equity vis a vis public equity. This will bring parity of investing in this asset class (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. Domestic money not only gives confidence to foreign investors but also act as a hedge against depreciating currency.
• Incentivize 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 and exits.

What are the pitfalls of exemption on capital gains on start-ups / early stage / MSMEs /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 institutional money is from the government institution (likes of SIDBI, LIC, GIC, PSBs), so in a way tax's loss for the IT department will be gain to other government entities.

Profitable exits (as proportion to investments) are few thus limiting capital gains and to that extent have not been contributing much to tax revenue of the Govt.

One way to reduce tax's loss is to put some nominal STT (securities transaction tax) on investments in start-ups / SMEs / unlisted entities (like public traded companies on the stock exchange). This is also proposed by SEBI panel on VCPE reforms, headed by Mr. Narayana Murthy.

Since the number of investments are far more than number of exits, STT despite nominal in nature will have much larger volume of transactions to offset the tax foregone on capital gains.

I believe that benefit of unconditional 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.

2. "Under Legislate investments instart-ups / early stage companies / MSMEs"

Multiple regulations and multiple regulatory bodies have led to over-legislation pertaining to investments and exits. The legislations with respect to risk capital (with no collaterals) in the form of equity instruments should not be function of the size of the company (start-up / early stage / MSME / Growth) and type of funding (angel / venture / private equity). It is not prudent to design legislations on these parameters.

In 2013, SEBI has issued norms for Alternative Investment Funds (AIFs). AIFs is a newly created class of pooled-in investment vehicles for private equity, real estate and hedge funds, for change in their categories.

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.

At a macro level, key regulatory bodies like– Reserve Bank of India (RBI); Securities Exchange Board of India (SEBI), Foreign Investment Promotion Board (FIPB), Department of Industrial Policy &Promotion (DIPP) should work in tandem to formulate (or eliminate) legislations with respect to this asset class.

The much needed acceleration of flow of capital to the most vibrant sections of the economy – start-ups & SMEs – can be triggered with above reforms. The entrepreneurial spirt of the next union budget can take Indian entrepreneurship to the next level and set India on 10 per cent growth trajectory.