IT Taskforce
Basic Background  Report
(BR-2)
8th August 1998



VIII. OTHER BANKING ISSUES

A number of other banking issues have to be addressed for possible inclusion in the final set of policy recommendations. A list of these are given below:

1. ESOP for Hardware

A large hardware company engages in:

Hardware Manufacturing

System Integration

Hardware Design Services

Hardware Support Services

Software Services

Test and Repair

• Majority of people currently engaged in hardware are re-employable in software.

• All Hardware related activities can be/already exported

• Integrated H/W companies should qualify for ESOP, not linked to GDR

2. Bank Guarantee/LUT

Though the condition of Bank Guarantee for duty free imports has been deleted from both the EPCG and Advance License Scheme vide para 4.19 of Exim Policy there is a provision for such Guarantees to be given to customs. It is recommended that the Bank Guarantee should be waived for quality manufacturer and exporters with a proven track record. For others, a legally valid undertaking for the guarantee amount shall be given.

In accordance with Para 7.15 (b)(i) of the hand book of Procedures, manufacturer exporters and units holding ISO 9000 series certificates are permitted to execute LUT in lieu of Bank Guarantee. However, there is no corresponding notification in this regard from the Ministry of Finance and as such the above facility of LUT is not applicable to the manufacturer- exporters and the units holding ISO 9000 certification. Ministry of Finance may issue necessary notification in this regard.

3. Working Capital

(i) As the traditional method of asset-based funding of working capital would not meet the adequate and timely requirements of fund of the Hardware export sector, a differential and flexible approach shall be adopted by giving special dispensation towards working capital requirements of this sector in view of the unique nature of the industry. Accordingly, RBI shall issue by 2 October 1998 new guidelines with regard to working capital requirements for the IT Hardware and related services sector which would be based on simple criteria such as turnover. Banks shall be advised to give 25 per cent of the contract value for 18 months, with the first six months as term loan(without collaterals) and from the 7th month onwards annualized Cash Flow Statements shall be accepted instead of collaterals.

(ii) From an amount of Rs.200 crores of working capital for the Hardware industry during 1998-99, the amount shall be increased to Rs.500 crores by the year 2000 subject to the broad criteria of pro-rata increase for the prospective requirements 24 months ahead as compared to the actuals of the current requirements at any given time. A system will be put in place which would enable substantial increase in working capital provided by the banks.

(iii) IT Hardware products and related IT industry shall be treated as a Priority Sector by banks for the next five years. This would help to meet the requirements of IT Hardware and related service exports, and also the IT industry and applications within the country. Major banks will be advised to create specialised IT financing cells in important branches, where IT units are sufficiently large in number. Performance in this dimension will be monitored by the Ministry of Finance.

4. Venture Capital

On the basis of the proposals made by the Indian Venture Capital Association(IVCA) the following policy guidelines are recommended:

(i) The banks shall be allowed to invest in the form of equity in dedicated venture capital funds meant for IT industry as part of the 5 per cent of increment in deposits currently allowed for shares.

(ii) Banks like IDBI and SBI shall set up joint ventures with Indian or foreign companies for setting up at least two different venture capital dedicated funds of a corpus of not less than Rs.50 crores each to cater to the credit need of the Hardware industry.

(iii) Venture capitalists shall be allowed to set off losses in one invested company and profit in another invested company during the block years for the purpose of income tax.

(iv) In the absence of any incentive it is extremely difficult for domestic venture funds to raise money. Initially the funds were raised either from multilateral agencies like the World Bank or all-India Financial Institutions. In the US and other developed countries, Pension Funds and insurance companies invest in the venture capital funds. During 1997-98, the corpus mobilised by the VCFs was in excess of US $10 Billion. In India too, Government could consider asking the Pension Funds, Insurance Companies and Mutual Funds to invest a small percentage of their corpus to VCFs with proven track record, which would go a long way in providing a boost to the domestic venture capital industry, which would ultimately help IT companies.

(v) There is a great anomaly in the treatment among VCFs and offshore funds. While offshore funds (which mainly cater to existing large companies) do not pay any tax, domestic funds which provide equity assistance to small and medium enterprises have to pay maximum marginal tax. Even among domestic funds, funds settled up by UTI are totally tax-exempt. Mutual Funds participate in the secondary capital market, whereas VCFs fill the void by providing promoters equity and nurturing the companies in their formative stage. VCFs take far more risk. It is anomalous that VCFs are required to pay maximum marginal tax, while incomes of Mutual Funds are totally tax-exempt under Section 10(23) D.

Section 10(23)F of the Act as it presently stands requires that investments are made by VCC/VCF only in equity of Venture Capital Undertakings. This is highly restrictive in the present economic milieu.

Normally, venture capital investments are made in startup undertakings based on innovative technology/concepts/products/markets or services, or in small to medium-scale companies which have established their technology/market, but do not possess the funds to finance growth. None of these companies can raise money through the public markets. Such entrepreneurs require a package of financial assistance in the form of equity or convertible instruments. This financial package has to be structured, specifically keeping in view, the future profitability, cash flows, requirement of funds, and such other factors which lead to enhancement of wealth of the company /shareholders.

Venture capital firms carry out substantial financial engineering to provide enough flexibility to meet the requirements of investee companies, which vary from case to case. Throughout the world, convertible instruments such as convertible preference shares, convertible debentures and fully/partly convertible are used more frequently than equity alone. SEBI has taken this into account, and therefore, SEBI definition permits investment in equity and equity-like instruments.

(vi). Section 10(23)F and the allied rules and circulars envisage that the benefits of Section 10(23)F are available only if VCC/VCF provide assistance to VCUs engaged in the manufacturing sector. Service sector barring 'computer software. has not been made open to the VCC/VCF. Due to liberalisation and globalisation, the service sector will play an increasingly important role. In the IT sector, Hardware design and related services have to be treated on par with manufacturing and included as an eligible area for VC investments.

The following areas should be considered eligible for exemption under section 10(23)F of the Act for venture capital investment:

(a) Data communications and related services

(b) Computer hardware-related services

(c) IT Project consultancy, design and testing services

(vii) Rule 2D of the Income Tax Rules, 1962, stipulates that investment in unlisted securities should be as per the following schedules:

(a) At least twenty percent in the initial year,

(b) At least fifty percent in the second year and

(c) At least eighty percent in the third year.

The percentages are reckoned on the funds raised. The foregoing schedule for completing investments in a major handicap given the fact that VC investments typically take some time to consummate. It is, therefore, urged that the schedule for completing investments be dropped and only an overall cap of eighty percent be retained. Further, a time period of three years should commence from the end of the financial year in which an application in form 56A is made. Additionally, computation of the eighty percent limit will be on the basis of gross original investment. Disinvestment made by the Fund should not be taken into account, because it would generally not be possible to reinvest the funds thus received on disinvestment, on account of the fact that the close-ended funds have a pre-determined short life span.