The ongoing power struggle between Ratan Tata and Cyrus Mistry to control sundry Tata companies should not distract attention from a more fundamental question. Should charitable trusts, which are exempt from income tax, be allowed to hold large (and often controlling) stakes in big business houses? Is this not bad corporate governance and misuse of tax breaks?
The Tata Trusts are justly famous for their excellent work in charitable, educational and other endeavours. They merit tax-free income for their good work. But the troublesome fact is that the Tata Trusts control two-thirds of the shares of Tata Sons, the holding company of the Tata group. Thus tax-exempt trusts, created for charitable purposes, are being used to control a large business group. This defies logic and ethics.
Decades ago, this was standard practice. Many old industrial groups held controlling stakes in their business empires via tax-exempt trusts. They argued this was okay since the trusts were indeed carrying out charitable activities. However, criticisms multiplied that this was misuse of tax-exempt status.
So, the government prohibited tax-exempt charitable trusts from holding equity stakes in companies. This prohibition was absolute for new trusts. However, an exemption was given to older existing trusts, including the Tata and Birla trusts. They were permitted to continue holding shares.
If Nandan Nilekani or Azim Premji sets up a new charitable trust today, it will be banned from holding shares in any company, big or small. Is this discrimination logical or ethical? Is there any reason to privilege the old trusts over the new ones? No, none at all.
Now, there is indeed a case for allowing charitable trusts to hold equity shares. If trusts invest only in interest-earning securities like bonds, the real value of these will erode over time with inflation, making it difficult to sustain or expand charitable activities. Many studies show that, in the long run, equities give far better returns than bonds or fixed deposits. So, it makes sense to allow charitable trusts to invest part of their holdings, maybe one-third, in equities.
Besides, we now have a new concept called social investment. For social reasons, the government forces banks to lend to certain priority sectors — agriculture, small-scale industries, education, microcredit, low-income housing, and disadvantaged groups like artisans or SC/STs. The government also urges trusts, corporations and individuals to give grants to non-profit NGOs in these fields.
However, in the last two decades many for-profit startups have come up in priority sectors. An enterprise dependent on grants cannot grow fast or reach many people. But an enterprise that is profitable can expand fast and help thousands, even millions of people. For instance, microfinance institutions once served just a few villages, but some have now grown into full-fledged banks like Bandhan with over a million clients. Other for-profit startups have come up in agriculture, education, low-cost housing and so on.
These enterprises need not just priority-sector loans from banks but equity finance too. Billions of dollars are now being provided by many foreign social investors that have entered India, such as the Dell Foundation and Omidyar Network. But Indian laws prevent tax-exempt trusts from investing in the equity of such ventures. The outrageous result, according to a McKinsey study, is that 85% of all equity investment in social impact ventures is foreign, and only 15% is Indian. This also sabotages Modi’s ‘Startup India’ policy.
The laws on charitable trusts must be amended. Trusts must be prohibited from holding more than 1% of the shares of any for-profit company or Rs 5 crore, whichever is more. This will ensure that tax-exempt trusts cannot be used to control big business, yet can make social equity investment in priority sectors.
Old trusts like the Tata and Birla trusts can be given five years to gradually reduce their equity stakes to a maximum of 1% in any company, subject to an overall equity limit of one-third of their assets. They can be allowed to invest in mutual funds owning shares, provided that the mutual funds are not controlled by the same group. For instance, the Reliance Trusts should not be able to invest in the mutual funds run by Reliance Capital, since this can lead to indirect control of a business empire.
Such reforms will end the misuse of charitable trusts even while providing much-needed equity to socially relevant ventures. That’s the way to go.