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Wednesday, March 03, 2021

Budget 2021: Creating a vibrant financing ecosystem through impact funds

The current year’s Budget is indeed a challenging task for the government as it has to meet the dual objective of getting the economy back on the growth trajectory, while simultaneously being mindful of the mounting inflationary pressures and fiscal slippages.


Updated: January 29, 2021 10:36:48 am
Social impact investing drives entrepreneurs to build self-sustaining systems to serve a wider cross-section of the population and provide returns, both social and capital. (Representative image, source: Pixabay)

Written by Rajesh Gandhi

As the countdown for the Union Budget 2021-22 has begun, the atmosphere among India Inc and the general public is fraught with anxiety. Apprehensions about the declining growth rate, reduced private investment, jobs crisis and rising inflation, have set the tone for the present economic discourse. Successive economic disruptions caused by demonetisation, GST bottlenecks and the Covid-19 pandemic, have led to a slowdown in the Indian economy. This has led to heightened expectations on reformative government policies in Union Budget 2021-22 to halt the slowdown and increase the growth rate.

The current year’s Budget is indeed a challenging task for the government as it has to meet the dual objective of getting the economy back on the growth trajectory, while simultaneously being mindful of the mounting inflationary pressures and fiscal slippages. One of the areas worth the government’s attention is encouraging investment through impact funds in the economy, by providing few reforms to fuel growth and achieve sustainable development.

Social impact investing drives entrepreneurs to build self-sustaining systems to serve a wider cross-section of the population and provide returns, both social and capital. The ability to deliver benefits on a large scale is the wellspring of impact investment. With appropriate scale, scope and focus, impact investment in social entrepreneurial approaches, can go a long way in complementing social sector organisations in ushering sustainable development. Given the priority sector requirements and significant deficiencies in public spending, there are multiple market opportunities for investments, collaborations and exits for social entrepreneurs, to develop innovative and differentiated businesses to foster inclusive growth. Thus, a suitable policy impetus in the forthcoming Budget for impact funds will have a significant positive effect on the Indian economy.

To begin, the company law in India places Corporate Social Responsibility (CSR) requirement on all companies meeting minimum net worth, turnover and profit criteria. These companies are required to deploy 2 per cent of their average net profits in approved CSR activities. The rules permit companies to undertake their own CSR activities in specified areas or contribute to government funds such as PM’s Relief Fund. The category of Social Venture Funds under Category I AIFs is designed for social impact through curated CSR projects, with strict controls such as periodic disclosures and external audits. It is suggested that CSR rules in the Companies Act permit investments by companies in Social Venture Funds of Category I AIFs (Schedule VII of the Companies Act, 2013). These funds can be allowed to recycle their capital through debt funding, with the proceeds donated to the PM’s Relief Fund or other social causes.

Another amendment required is to Section 11(5) of the Income-tax Act, to include investment in social venture fund as one of the forms and modes of investing in specified instruments. Presently, a large majority of charitable trusts can only invest in eligible and safe instruments such as RBI bonds. To spur financial innovation in the social sector, public trusts should be allowed to invest in social venture fund of Category I AIFs which in turn will invest in recognised social enterprises.

While the aforesaid incentives seek to open avenues for increased capital inflow into social venture funds, allowing few tax deductions would also help increase the investor’s return on investments in impact funds. Typically, an impact fund would incur 15-20 per cent of the investors’ capital commitments towards fees payable to the investment manager, bankers, advisers, lawyers, accountants, administrators, and other service providers. Therefore, the amount actually invested by the impact fund stands reduced by this amount and only 80-85 per cent of the capital commitments are actually invested. Such expenses are not allowed as deduction for computing capital gains from an income-tax perspective. This means that the impact fund will have to write-off the expenses, which further means that neither the impact fund nor its investors are able to offset the expenses against income/gains from the investment. This issue is now further aggravated by the fact that a number of services sought by the impact fund are liable to GST at the rate of 18 per cent. Therefore, it is recommended to allow such expenditure as a deduction either at the fund level or at the investor level.

Since impact funds are only pooling vehicles and do not provide any service, there is no output GST liability on them, and hence they are not able to obtain any benefit of input credits. Consequently, the GST paid becomes an incremental cost to be borne by investors. In the context of foreign investors, this violates the taxing principle of destination-based consumption tax, as services rendered to the impact funds are ultimately for the benefit of its underlying investors who include foreign investors as well. The services rendered are effectively consumed outside India to the extent that there are foreign investors. Therefore, an exemption from GST to impact funds which have foreign investors, would provide much-needed tax clarity to such investors, bringing certainty on tax outcomes and ensuring greater consistency in extending export-related incentives. Another tax incentive in the form of a concessional tax rate of 5 per cent on interest and dividend on income of the social enterprises (similar to tax incentive to foreign investors on interest from bonds/debentures under section 194LC/LD), should be made available to investors in the category of Social Venture Funds under Category I AIFs, which will boost investments in impact funds and on the Indian economy.

The central government is aware of the power of social businesses and taking the aforesaid steps in the Union Budget 2021-22 will create a favourable environment of huge capital inflows in impact funds. This in turn, will bring in investments in social venture enterprises for maximum impact in priority sectors such as education, health, housing, agriculture, waste management, financial services, skill development etc.

The author is a Partner at Deloitte India. Views expressed are that of the author.

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