In order to encourage the development of venture capital funds, the Income Tax Act, 1961 exempts the income of a venture capital fund from income tax. Any income by way of dividends (other than dividend from domestic companies, dividend from mutual funds and UTI dividend, which are exempt for all assessees) or long term capital gains of a venture capital fund or a venture capital company from investments made by way of equity shares in a venture capital undertaking will be exempt from income tax.

However for claiming the benefit of this exemption, the venture capital fund or venture capital company is approved for the by the Central Government on application made to it in accordance to the rules made for such purpose and satisfies the prescribed conditions. This approval by the Central Government shall at one time have effect for not more than three assessment years specified in the order of approval.

For the purposes of the Income Tax Act, 1961, venture capital fund means a fund operating under a trust deed, registered under the provisions of the Indian Registration Act, 1908 and established to raise money by the trustees for investments, mainly by the way of acquiring equity shares of a venture capital undertaking in accordance with the prescribed guidelines.

Venture capital company means a company which has made investment by way of acquiring equity shares of venture capital undertaking in accordance with the prescribed guidelines.

Venture capital undertaking means such domestic company whose shares are not listed on a recognized stock exchange in India and which is engaged in the business of software, information technology, production of basic drugs in the pharmaceutical sector, bio-technology, agriculture and allied sectors or such other sector as may be notified by the Central Government in this behalf or in the production or manufacture in any article or substance for which patent has been granted to the national research laboratory or any other scientific research of institution approved by the department of science and technology.

In other words, the funding agency has been called the venture capital fund or venture capital company and the new enterprise has been called the venture capital undertaking.

It is noteworthy that SEBI guidelines do not prescribe the industries or sectors in which a venture capital fund has to operate. Whereas under the Income Tax Act, 1961, tax exemption will be available only if the venture capital undertaking is engaged in the aforesaid industries only.

The CBDT has prescribed certain guidelines for approval of a venture capital fund or company for claiming tax exemption. The concerned authority to whom application for approval is to be made and which grants the approval is the Director of Income Tax (Exemption) having jurisdiction over the venture capital fund or the venture capital company.

Briefly, these guidelines are as follows :-

• The application for approval shall be made in Form 56A by the venture capital fund or venture capital company to the concerned Director of Income Tax (Exemption).

• Every application must be made in any previous year in which any income by way of dividend or long term capital gains is earned by a venture capital funds or a venture capital company from investments made by the way of equity shares in the venture capital undertaking.

• Every application for approval shall be accompanied by the following documents:-

• A copy of trust deed or certificate of incorporation under the company act.

• Balance Sheets and Profit and Loss Accounts for three previous years immediately preceding the year in which the application is made.

• Form 56B and 56C duly filled in by and signed by the applicant.

• A copy of the certificate of registration from SEBI.

• The Director of Income Tax (Exemption) shall approve the venture capital fund or the venture capital company, as the case may be, subject to the following conditions:-

(a) The venture capital fund or the venture capital company must be registered with SEBI. 

(b) Every venture capital fund / company invests an amount of not less than 80% of his total money raised for investment by way of acquiring equity shares of the venture capital undertaking in the following manner :

• 20% or more of such money must be invested during or before the end of the previous year which the application is made by way of acquiring equity shares of the venture capital undertaking.

• 50% or more of such money shall be invested during or before the end of the previous year succeeding previous year in which investment of 20% referred to in sub-clause 1 has been made by way of acquiring equity shares of the venture capital undertaking.

• 80% or more of such money shall be invested during or before the end of the previous year immediately succeeding the previous year in which 50% investment referred to in above sub-clause 2 has been made by acquiring equity shares of the venture capital undertaking.

(c) A venture capital fund or venture capital company, as the case may be, shall not invest more than 20% of his total money raised or total paid up capital in one venture undertaking.

(d) A venture capital fund or a venture capital company, as the case may be, shall not make an investment of more than 40% of the equity capital of one venture capital undertaking.

(e) Every venture capital fund or venture capital company shall maintain books of accounts and shall get books of accounts audited by a chartered accountant and furnish audit report duly signed and verified by the chartered accountant to the Director of Income Tax (Exemption) before the due date of filling return under section 139(1).

The Director of Income Tax (Exemption) shall pass an order in writing granting approval or refusing approval of venture capital fund or venture capital company as the case may be. However, before refusing to grant approval, the capital fund or venture capital company, as the case may be, shall be given an opportunity to make its representation. Refusal to grant approval can be made only with the concurrence of the Director General of Income Tax (Exemption).

The Director of Income Tax (Exemption) shall withdraw the approval granted if the venture capital fund or venture capital company violates any of the aforesaid guidelines or violates the provisions of the Income Tax Act or rules there under or if the certificate of registration granted by SEBI is suspended or cancelled by SEBI.