🧠 Introduction

Micro-VC funds—smaller venture capital vehicles that invest in startups at the early stage—are rapidly growing in India. These funds typically raise between ₹20–100 crore and write initial cheques ranging from ₹50 lakh to ₹7.5 crore, depending on the stage and thesis. As this asset class matures, creating a tax-efficient business structure is not just a good-to-have—it’s essential for maximizing returns, ensuring regulatory compliance, and attracting quality limited partners (LPs).

This article walks through how Micro-VCs in India can build a structure that is legally sound, tax-efficient, and scalable.

⚖️ Regulatory & Legal Framework

SEBI AIF Regulations

Most micro-VCs register as Alternative Investment Funds (AIFs) under the SEBI (Alternative Investment Funds) Regulations, 2012. They fall under either:

• Category I AIF: Funds that invest in startups, early-stage ventures, social ventures, SMEs.
• Category II AIF: Private equity and debt funds with no specific incentives.

These vehicles must comply with regulatory minimums:

• Minimum fund corpus: ₹20 crore
• Minimum investment per investor: ₹1 crore (₹25 lakh for employees or directors of the fund)
• No leverage is allowed, and funds must adhere to specific investment concentration norms

Legal Forms: Trust vs LLP vs Company

Micro-VCs can operate under multiple legal structures, each with tax and operational implications:

🏛️ Trust (Common AIF structure)

• Trusts are typically used in Indian AIF structures.
• A determinate trust allows income to be taxed in the hands of investors, enabling tax pass-through.
• A discretionary trust, where the trustee decides distribution, may lead to maximum marginal rate taxation (~34%).

🏢 Private Limited Company

• Offers credibility and ease of dealing with institutional investors.
• Subject to corporate tax (~25%) on profits.
• Dividend payouts are taxed in the hands of shareholders, reducing post-tax returns.

📜 LLP (Limited Liability Partnership)

• Treated as a partnership for tax purposes.
• Profits taxed at 30% at LLP level.
• No Dividend Distribution Tax (DDT), and less compliance overhead.
• However, SEBI-registered AIFs generally prefer trust structures for pooled investments.

🧾 Tax Treatment & Planning Considerations

Capital Gains

• Long-Term Capital Gains (LTCG):

  • Listed shares held >12 months: taxed at 10% beyond ₹1 lakh.
  • Unlisted shares held >24 months: taxed at 20% with indexation benefits.

• Short-Term Capital Gains (STCG):

  • Listed securities held ≤12 months: taxed at 15%.
  • Unlisted securities held ≤24 months: taxed at slab rates or ~42% in some cases.

Dividend Income

• Dividends are now taxed in the hands of investors post-DDT abolition.
• Domestic investors pay tax as per slab rates.
• For non-residents, withholding tax may apply (typically 20%), subject to relief via tax treaties.

Withholding Tax (WHT) and DTAA Benefits

• Non-resident LPs are subject to WHT on gains or dividends.
• Tax treaties (e.g., with Singapore or Mauritius) can reduce withholding tax rates.
• Treaty benefits apply only if POEM (Place of Effective Management) rules are not triggered by India-based control.

Angel Tax Exemptions

• For Indian startups recognized by DPIIT, investments from SEBI-registered AIFs (Category I or II) are exempt from angel tax under Section 56(2)(viib).
• Effective FY 2025, this exemption has been extended to non-resident investors, eliminating a key deterrent to cross-border LP participation.

Pass-Through Status and Loss Sharing

• Category I and II AIFs enjoy pass-through status on capital gains.
• Losses incurred at the fund level can now also be passed through to LPs for offsetting their other gains.

💡 Optimal Structures for Micro-VCs

1. 🇮🇳 Domestic AIF Trust

This is the most commonly used structure by micro-VCs in India.

Benefits:

• Pass-through for capital gains and losses.
• Eligibility for angel tax exemption.
• Lower regulatory hurdles for domestic investors.

Key Point: Must ensure the trust is "determinate" to maintain tax transparency.

2. 🏙️ IFSC (GIFT City) AIF

Setting up the fund in the International Financial Services Centre (IFSC) can provide:

Benefits:

• Tax holidays for 10 years out of 15.
• No capital gains tax for non-resident investors.
• Regulatory light-touch compared to onshore structures.

Limitations:

• Not suitable for raising from Indian domestic investors.
• More complexity in governance and documentation.

3. 🌍 Offshore Fund with India SPV

Some micro-VCs targeting global LPs opt for an offshore fund (e.g., in Mauritius or Singapore) with an Indian SPV making investments.

Benefits:

• Treaty access can lower taxes on capital gains or dividends.
• Suited for USD-denominated capital pools.

Challenges:

• High setup and maintenance cost.
• POEM rules may classify the offshore entity as tax-resident in India if not structured carefully.

🛠️ Strategic Steps to Optimize Tax Efficiency

Step 1: Choose the Right Legal Vehicle

• Trusts offer tax pass-through and regulatory familiarity.
• LLPs offer cost savings and easier compliance but aren't always accepted for pooled investment structures.
• Companies are least preferred due to corporate taxation and dividend tax leakage.

Step 2: Design Your Investment Thesis Around Capital Gains

• Prioritize startup equity investments with high potential for long-term capital gains.
• Avoid heavy focus on dividend-generating strategies or interest-based investments.

Step 3: Segment Investor Base

• Domestic LPs: Prefer onshore AIF trust structures with angel tax exemptions.
• Foreign LPs: Can benefit from IFSC or offshore structures, leveraging treaty benefits and tax holidays.

Step 4: Minimize Dividend Distributions

• Fund distributions should ideally be structured as return of capital or profit share (capital gains), not dividends.
• Dividends face higher tax implications for both resident and non-resident LPs.

Step 5: Keep Offshore Funds Compliant

• Avoid triggering POEM by ensuring:

  • Key decisions are taken offshore.
  • Majority of directors are based outside India.
  • Documented governance is maintained offshore.

Step 6: Pass Through Losses

• Allocate startup investment losses transparently to LPs.
• Helps offset taxable income at the LP level.

Step 7: Use Venture Debt Judiciously

• Venture debt can provide tax-deductible interest for startups.
• Helps preserve equity upside while optimizing tax treatment for the portfolio.

🔍 Practical Scenario

Let’s say a micro-VC raises ₹30 crore and invests in six startups at ₹5 crore each. The fund is structured as a Category I AIF in the form of a determinate trust.

After five years:

• Three startups provide successful exits.
• The fund generates ₹40 crore in capital gains.
• ₹10 crore in losses from other investments.

Here’s how tax efficiency plays out:

• Capital gains passed directly to LPs, taxed at LTCG rate (10–20%).
• Losses from failed startups reduce taxable gains at LP level.
• No DDT or additional layer of corporate tax.
• No angel tax on investments, ensuring clean cap tables for startups.

This ensures more money returns to LPs, boosting IRR and improving the fund’s long-term credibility.

🎯 Summary of Best Practices

• ✅ Use a determinate trust to maintain tax transparency and ensure pass-through of gains/losses.
• ✅ Register as a Category I or II AIF to access regulatory and tax benefits.
• ✅ Avoid discretionary trusts and dividend-heavy structures.
• ✅ Explore IFSC AIFs or offshore structures only if foreign LP participation is significant.
• ✅ Prioritize capital gains-based exits, and avoid interest/dividend-heavy income streams.
• ✅ Keep governance clean and document investment decisions to prevent POEM risks.
• ✅ Utilize pass-through loss rules to enhance after-tax returns for LPs.

🌟 Final Thoughts

Building a tax-efficient business structure isn’t just about compliance—it’s about amplifying returns, inspiring investor confidence, and future-proofing your fund. The regulatory and tax environment for venture capital in India is becoming increasingly favorable, especially with recent exemptions for angel tax and greater clarity on capital gains treatment.

For micro-VCs, starting with a thoughtfully designed, tax-optimized structure can mean the difference between good and great fund performance. Whether you choose an onshore trust, an IFSC-based fund, or an offshore setup, what matters most is aligning your structure with your strategy and investor profile—while keeping taxes low and compliance high.

Accounts Executive at TAXAJ

TAXAJ is a consortium of CA, CS, Advocates & Professionals from specific fields to provide you a One Stop Solution for all your Business, Financial, Taxation & Legal Matters under One Roof. Some of them are: Launch Your Start-Up Company/Business, Trademark & Brand Registration, Digital Marketing, E-Stamp Paper Online, Closure of Business, Legal Services, Payroll Services, etc. For any further queries related to this or anything else visit TAXAJ

Watch all the Informational Videos here: YouTube Channel                                                                                               

TAXAJ Corporate Services LLP

Address: 1/3, UGF, Sulahkul Vihar, Old Palam Road, Dwarka, New Delhi-110078