Special Provisions Relating to Pass-Through Entities in Venture Capital Structures : Clause 222 of Income Tax Bill, 2025 Vs. Section 115U of Income Tax Act, 1961

Clause 222 Tax on income in case of venture capital undertakings.

Income Tax Bill, 2025

Introduction

The taxation of income arising from investments in venture capital undertakings has long been a subject of legislative focus, given the unique structure and economic importance of venture capital (VC) investments in fostering innovation and entrepreneurship. Clause 222 of the Income Tax Bill, 2025, seeks to consolidate and update the legal framework governing the taxation of income derived by investors from venture capital companies and funds. This clause is a successor to the existing Section 115U of the Income Tax Act, 1961, and is operationalized in practice through procedural rules such as Rule 12C of the Income-tax Rules, 1962.

This commentary provides a comprehensive analysis of Clause 222, examining its objectives, provisions, and practical implications. It further undertakes a detailed comparative analysis with Section 115U and Rule 12C, highlighting continuities, departures, and the evolving policy rationale. The analysis is structured to offer both a granular legal interpretation and a broader policy perspective on the treatment of pass-through entities in the Indian tax regime.

Objective and Purpose

Legislative Intent and Policy Framework

The primary objective of Clause 222 is to provide clarity and certainty in the taxation of income generated by investors through investments in venture capital companies and funds. The legislative intent, as reflected in both Clause 222 and its predecessor Section 115U, is to ensure a "pass-through" tax treatment for such income. This means that the income is taxed in the hands of the ultimate investors as if they had invested directly in the venture capital undertaking, thereby avoiding double taxation at both the fund and investor levels.

The policy rationale for such a regime is rooted in the recognition that venture capital funds serve as intermediaries, pooling resources from multiple investors to invest in high-growth, high-risk companies. Taxing the income at the fund level and again at the investor level would create inefficiencies and disincentivize the flow of capital to the start-up and innovation sectors. The pass-through framework aligns with international best practices and seeks to promote the growth of the venture capital ecosystem in India.

Clause 222 also aims to streamline compliance and reporting requirements, establish clear rules for the timing and nature of income inclusion, and carve out exceptions for certain categories of investment funds that are subject to separate tax regimes.

Detailed Analysis of Clause 222 of the Income Tax Bill, 2025

Sub-section (1): Pass-through Taxation Principle

The opening sub-section of Clause 222 lays down the fundamental principle: "Irrespective of anything contained in any other provision of this Act, where a person, out of investments made in a venture capital company or venture capital fund, receives any income, or any income accrues or arises to him, such income shall be chargeable to income-tax in the same manner as if, it were the income accruing or arising to, or received by, such person, had he made investments directly in the venture capital undertaking."

This provision enshrines the pass-through character of VC investments. The phrase "irrespective of anything contained in any other provision" gives it overriding effect, ensuring that the special regime for VC income prevails over conflicting provisions elsewhere in the Act. The income is taxed in the hands of the investor, mirroring direct investment, thus achieving tax neutrality for the intermediary entity.

The use of "receives any income, or any income accrues or arises to him" covers both actual receipt and deemed accrual, plugging potential timing mismatches and tax deferral strategies.

Sub-section (2): Reporting and Compliance Obligations

This sub-section imposes a dual obligation on (a) the person responsible for crediting or making payment on behalf of the VC company or fund, and (b) the VC company or fund itself, to furnish a statement in the prescribed form and manner to both the investor and the prescribed income-tax authority.

The statement must detail the nature of the income paid or credited during the tax year and any other relevant particulars as prescribed. This ensures transparency, facilitates tax administration, and enables the investor to report the income correctly in their return.

The language "within such time, as prescribed" delegates the specification of deadlines and procedural details to the rule-making authority, allowing for flexibility and periodic updating.

Sub-section (3): Nature and Proportion of Income

This provision clarifies that the income distributed or credited to the investor retains the same character and proportion as it had in the hands of the VC company or fund. For example, if the fund earns capital gains and interest, the investor is deemed to have received capital gains and interest in the same proportion.

This is crucial for determining the applicable tax rates, exemptions, or deductions for each component of income, and prevents the recharacterization of income at the investor level.

Sub-section (4): Exclusion from Certain Procedural Chapters

The sub-section provides that the provisions of Chapter XIX-B (which deals with settlement of cases) do not apply to the income paid by a VC company or fund under this Chapter. This exclusion is intended to streamline the tax treatment and avoid procedural complexities in the context of pass-through income.

Notably, this differs from Section 115U(4), which excluded Chapters XII-D, XII-E, and XVII-B (relating to dividend distribution tax, tax on distributed income, and tax deduction at source, respectively). The change in reference reflects the evolving legislative intent and possibly a reorganization of chapters in the new Income Tax Bill.

Sub-section (5): Deemed Credit Mechanism

This sub-section addresses situations where income has accrued to the VC company or fund but has not yet been distributed or credited to the investor. It provides that such income shall be deemed to have been credited to the investor on the last day of the tax year, in the proportion to which the investor would have been entitled.

This anti-deferral provision ensures that tax cannot be postponed simply by retaining income at the fund level. It aligns the timing of taxability with the accrual of income, promoting symmetry between economic accrual and tax recognition.

Sub-section (6): Exclusion of Double Taxation on Actual Payment

This provision prevents double taxation by stipulating that income already included in the investor's total income on an accrual basis shall not be taxed again when it is actually paid out by the VC company or fund.

This is an essential safeguard to ensure that the pass-through regime does not result in over-taxation due to timing differences between accrual and payment.

Sub-section (7): Carve-out for Specified Investment Funds

Clause 222 expressly excludes its applicability to income arising from investments in VC companies or funds that are "investment funds specified in section 224(10)(a)." This reflects the legislative intent to segregate the tax regime for certain categories of investment funds, such as Alternative Investment Funds (AIFs) covered under a different framework (possibly analogous to Section 115UB of the 1961 Act).

The rationale is to avoid overlapping or conflicting tax treatments for funds subject to a separate dedicated regime.

Sub-section (8): Definitions

The sub-section provides that the terms "venture capital company," "venture capital fund," and "venture capital undertaking" shall have the meanings assigned in Schedule V. This ensures consistency and clarity in interpretation, anchoring the provision to a defined universe of entities.

Practical Implications

Impact on Investors

Clause 222 ensures that investors in venture capital companies and funds are taxed in a manner that mirrors direct investment, conferring certainty and preventing double taxation. The deemed credit mechanism (sub-section 5) prevents deferral of tax, while the exclusion of double taxation on actual payment (sub-section 6) protects investors from being taxed twice on the same income.

Investors are also provided with detailed information on the nature and proportion of income through the prescribed statement, facilitating accurate tax compliance.

Impact on Venture Capital Funds/Companies

VC companies and funds are subject to rigorous reporting obligations, requiring timely and accurate furnishing of statements to both investors and tax authorities. The requirement to allocate income in the same proportion and character as received at the fund level adds administrative complexity but enhances transparency.

The deemed credit provision may necessitate careful cash flow management, as tax liabilities may arise for investors even before actual distribution of income.

Regulatory and Administrative Considerations

The pass-through regime simplifies tax administration by aligning the tax treatment of VC income with economic reality. However, it imposes significant compliance burdens on funds, especially in tracking and reporting the character and timing of various income streams for a potentially large number of investors.

The carve-out for specified funds mitigates the risk of overlapping regimes but necessitates careful identification and classification of funds.

Comparative Analysis with Section 115U of the Income Tax Act, 1961 and Rule 12C of the Income-tax Rules, 1962

Structural and Substantive Similarities

Clause 222 is, in substance, a re-enactment and modernization of Section 115U. Both provisions:

• Override other provisions of the Act to ensure pass-through taxation for VC income.
• Tax income in the hands of the investor as if received directly from the underlying undertaking.
• Require VC companies/funds to furnish statements to investors and tax authorities, detailing the nature and quantum of income.
• Deem income to be credited to investors at year-end if not actually distributed, preventing tax deferral.
• Exclude double taxation when income is actually paid after being taxed on an accrual basis.
• Exclude applicability to certain specified funds (Section 115U(6) refers to funds specified u/s 115UB; Clause 222(7) refers to those u/s 224(10)(a)).

The definitions of key terms are anchored in external provisions (Section 10(23FB) under the 1961 Act, Schedule V under the Bill), maintaining conceptual continuity.

Key Differences and Evolution

• Reference to Procedural Chapters: Section 115U(4) excludes Chapters XII-D, XII-E, and XVII-B (relating to DDT, distributed income tax, and TDS), while Clause 222(4) refers only to Chapter XIX-B (settlement of cases). This suggests a rationalization and possible reorganization of procedural chapters in the new Bill, or a deliberate narrowing of exclusions.
• Terminology and Definitions: Section 115U relies on definitions in Section 10(23FB), whereas Clause 222 refers to Schedule V. This reflects a move towards centralizing definitions in a schedule for greater clarity and legislative hygiene.
• Carve-out for Investment Funds: Section 115U(6) carves out income from "investment funds specified in clause (a) of the Explanation 1 to section 115UB," while Clause 222(7) refers to "investment fund specified in section 224(10)(a)." The cross-references reflect updated legislative architecture, but the substantive intent remains to exclude AIFs and similar vehicles from the VC regime.
• Language Modernization: Clause 222 employs updated terminology ("tax year" instead of "previous year," "prescribed" for forms and manner), reflecting modernization and harmonization with international standards.

Procedural Compliance: Rule 12C and Its Interface

Rule 12C operationalizes the reporting requirements u/s 115U(2) (and by extension, Clause 222(2)). It prescribes that the statement of income paid or credited must be furnished by 30th November of the financial year following the previous year, to the Chief Commissioner or Commissioner within whose jurisdiction the principal office of the VC company or fund is located.

The statement must be in Form No. 64, verified by an accountant, and filed electronically under digital signature. The Director General of Income-tax (Systems) is tasked with specifying filing procedures and ensuring data security.

The procedural framework is designed to ensure accuracy, traceability, and ease of compliance, while minimizing the risk of evasion or misreporting.

Clause 222(2) provides for similar reporting, though the specific forms, deadlines, and manner are to be "prescribed" under the new Bill's rules, suggesting continuity with potential for refinement.

Ambiguities and Potential Issues

• Deemed Credit and Cash Flow: The deemed credit mechanism can create cash flow mismatches for investors, who may incur tax liabilities on income not yet received. This is a necessary anti-deferral measure but may necessitate investor education and fund-level communication.
• Characterization of Income: The requirement to maintain the nature and proportion of income at the investor level can be complex in practice, especially for funds with diverse income streams. Detailed guidance and robust accounting systems are essential.
• Overlap with AIF Regime: The carve-out for specified funds reduces, but does not eliminate, the risk of jurisdictional overlap. The precise boundaries between VC funds and AIFs must be clearly delineated to avoid disputes.
• Procedural Delays: The reliance on prescribed forms and deadlines means that delays in rule-making or technical glitches in electronic filing could impede timely compliance.

Conclusion

Clause 222 of the Income Tax Bill, 2025, represents a continuation and modernization of the pass-through tax regime for venture capital investments. By taxing income in the hands of investors as if received directly from the underlying undertaking, and by imposing robust reporting requirements, the provision strikes a balance between tax neutrality, administrative feasibility, and anti-avoidance safeguards.

The comparative analysis with Section 115U and Rule 12C reveals substantial continuity, with updates in terminology, procedural references, and definitional anchors reflecting the evolution of the legislative framework. The carve-out for specified funds ensures coherence with the broader alternative investment fund regime.

Future areas for reform may include further harmonization of definitions across statutes, refinement of reporting procedures to minimize compliance burdens, and issuance of detailed guidance to address practical challenges in income characterization and timing.

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Full Text:

Clause 222 Tax on income in case of venture capital undertakings.

 

Dated: 7-5-2025