A setback for alternative investment funds
Tax Partner, EY
Senior Tax Professional, EY
The Securities and Exchange Board of India (Sebi)—recognising the need for long-term, cost-effective funding source from the private sector, capital markets or private pool of capital for start-ups, small & medium businesses and infrastructure—notified the alternative investment fund (AIF) regulations in May 2012 after extensive stakeholder consultation. As of May 2014, Sebi had granted registrations to over 100 AIFs and, until March 2014, AIFs had raised net commitments totalling R13,465 crore.
Currently, there is a provision in the tax law that provides a pass-through tax status on specified income to AIFs that are registered under the venture capital fund (VCF) sub-category of category 1 AIFs. The same status is also available to VCFs registered under the erstwhile Sebi (VCF) Regulations, 1996. However, funds registered as category 1 (other than VCF), category 2 and category 3 AIFs—which include small & medium enterprises, social ventures, private equity, debt and hedge funds, majority of which have been formed as a trust—have to deal with ambiguities and uncertainties of the trust taxation provisions in the Indian tax laws.
The Central Board of Direct Taxes (CBDT) may have compounded the uncertainty by issuing a circular on July 28, 2014, to clarify certain tax aspects for AIFs (other than VCFs). The circular addresses that if a trust deed does not either name the investors or their beneficial interest, the provisions dealing with taxation of trust whose beneficiaries’ share is unknown would come into play and the entire income of the fund shall be taxable at the maximum marginal rate (MMR, 30% plus applicable surcharges) in the hands of the AIF’s trustee. In such cases, the income tax authorities should not seek to directly assess the AIF’s investors. Further, where the trust deed contains the names of the investors and their beneficial interest, the tax on whole of the income of the AIF, consisting of or including business profits, shall be taxable at MMR in the hands of the AIF’s trustee.
Conceptually and by regulation, AIFs raise funds from investors by issuing units which represent the investors’ beneficial interest in the AIF. The manner and timing of distribution of invested capital and returns thereon by the AIF to its investors is discernible from the AIF’s trust deed and associated documentation, which are legally binding. Typically, there is no discretion on this matter granted to the AIF’s trustee. However, due to the manner in which AIFs raise funds, it is not always possible to ensure that the names of the investors and their beneficial interest are identifiable on the date of the trust deed.
Courts have examined this matter, albeit not specifically in the context of AIFs, and have held that the names of the beneficiaries need not be mentioned in the trust deed so long as the trust deed gives details of the beneficiaries and the description of the person who is to be benefited. It has also been held that the requirement of specifying individual shares of beneficiaries would stand fulfilled where the basis and mechanics of sharing is specified in the trust deed, although some computation may be needed to find out the individual shares.
Clarifications issued by the CBDT in the past indicate that the intention of imposing a requirement that the name and share of the individual beneficiaries should be stated in the trust deed on its execution date was to prevent misuse of the trust tax provisions. On this issue, it would have really benefited the sector if, in addition to the clarification provided, the CBDT had stipulated that so long as the AIF’s constitution documents clearly provide a mechanism for the trustee to identify beneficiaries and their respective share, the AIF should be regarded as a specific trust (i.e. trust taxed on pass-through basis). Without this clarity, there is a clear risk that, armed with the circular, the tax authorities regard AIFs as not being specific trusts and tax their income at MMR, leading to avoidable litigation.
The second issue dealt with by the circular relates to the characterisation of income earned by the AIF and the resultant tax consequences. In essence, the circular states that if an AIF earns profits and gains of business, the whole of the AIF’s income shall be taxable at MMR. The predominant source of income for AIFs, depending upon the strategy adopted by the AIF, could be gains from sale of investments in shares and other securities. Characterisation of income as capital gains or business income has always been a vexed issue for financial investors. The recent Budget, in order to impart certainty to the foreign portfolio investors, has provided a deeming provision that income from securities transactions will be characterised as capital gains. It would have been useful if the circular provided guidance on this aspect. In its absence, on this issue as well, the circular can be used by the tax authorities to characterise the AIF’s income as business income and thereby tax the same at MMR.
AIFs are a vital source of risk capital and significantly contribute to nurturing investment activity across many sectors which, in turn, promotes employment and growth. The tax law provides a specific tax code for mutual funds, securitisation trusts and the recent Budget has also introduced a tax code for real estate investment trusts and infrastructure investment trusts. The AIF sector has been operative for more than a decade and has faced tax uncertainties with flip-flops in tax approaches. The sector has sufficient scale and potential to warrant a specific tax code consistent with the recommendations of various committees and global practices, i.e. AIFs should be granted an automatic tax pass-through at the fund level on registration with Sebi, while maintaining taxation at the investor level without any other requirements under tax laws. To restore investor confidence in this asset class, the CBDT should relook at the circular and engage in a constructive dialogue with all the stakeholders.