The question before the Tribunal was whether a VCF set up as a “Trust” in India can be said to be providing services to its contributors/investors.
VCFs are pooled investment funds that manage investors’ money. These are investors who seek private equity stakes, typically in start-ups and small to medium-sized enterprises, with a strong growth potential. These investments are characterized as high-risk and high-return opportunities. It has been a common practice for the funds to be set up as trusts and hitherto; Trusts did not consider themselves covered under the ambit of the service tax law on grounds that they are a mere pooling vehicle with a pass through status in tax matters. Interestingly, while the Indian income tax laws provided for specific provisions that taxed the income of Trusts, no similar provision was included in the service tax laws.
In contradistinction to settled industry position, the ruling affirms applicability of service tax on Venture Capital Funds in India basis an interpretation that:
- A VCF-Trust is a “person” distinct from the investors
- A VCF-Trust can be said to be providing investment management services to the investors
- Amounts retained by the Funds to defray expenses incurred/deductions from the NAV computations of Investors are essentially consideration for the said services
The “doctrine of mutuality” affirmed in several judicial pronouncements in terms of which the fund or Trust should not be delineated from its contributors/investors has been disregarded primarily because the activity is commercial and there is no equality in the proportion of pay-outs to different classes of investors. In arriving at such a conclusion, the fundamental principle that different classes of persons can have a differential rights/ treatment has been disregarded and diluted by the Tribunal. Deviating from settled principles, the ruling has sought to treat expenses incurred by the Funds as income or revenue for services rendered. This interpretation and consequent taxation of VCFs is likely to inconvenience the industry, with no significant revenue potential for the government given underlying input tax credits that should be available on these expenses, to offset tax liability.
Another common phenomenon in VCF arrangements is that the Asset Management Company (AMC) or the investment manager typically invests in a class of high risk-high reward (Class B/C) securities such that they “have their skin in the game” and earn their return on such investment as “carried interest” or “carry income”. According to the ruling, carry income earned by the AMC is fundamentally in the nature of additional performance fees paid to the AMC, subject to certain contingencies. Carry income has therefore been held to be at par with the asset management fees charged by the AMC to the Trust and consequently by the Trust to the Contributors/ Investors. In essence, what has traditionally been regarded as capital gains is sought to be treated as operating revenue from a service tax standpoint, throwing open the door for potential implications under allied tax laws such as under income tax law provisions.
Overall, the ruling is contrary to two well established industry practices of: (i) treating the trust as a pass-through entity not liable to service tax, and (ii) considering carried interest as a return on investment/ securities not liable to service tax.
One could argue that this ruling has left the entire Funds (Private Equity Funds/ Venture Capital Funds/ Mutual Funds/ Alternate Investment Funds/ Asset Reconstruction Company) ecosystem vulnerable to similar tax, interest and penalty demands under service tax (subject to a look back period of five years). While this ruling has been issued in relation to the pre-GST (service tax) regime, it is likely to have an equal bearing under the current GST regime having regard to the overall similarities in the provisions of law.
While the ruling may be sudden for the industry at large, it is now imperative for all types of funds, AMCs and investors to carefully review the impact of this ruling on their past, current and future operations. In fact, any structure similar to a Trust or fund, being a pooled vehicle receiving contributions to effectuate a common goal, would now need to evaluate potential service tax/GST levy, at an entity level and in the hands of their managers and other stakeholders.
Commercial discussions on who bears a potential tax burden can be expected to assume importance. Further, mitigation strategies would need to be thought through in absorbing the impact of tax (by perhaps reserving the right to input tax credits), interest and possibly penalties. It would also been interesting to see if Gift City as a location becomes a more attractive destination for Funds and their AMCs given the GST exemptions it seeks to offer.
Given the unprecedented impact this ruling is set to pose, the lawmakers may need to step in to stem its imminent repercussions of similar tax demands across the funds ecosystem. This may be a fit case for the government to clarify the intent of the law to assuage industry apprehensions by: (i) exercise of its power of waiver to ensure a moratorium is put in place against recovery of past dues basis settled and undisputed industry practice on the issue and (ii) notify specific exemptions for the present and future periods.
(Jayashree Parthasarathy - Tax Partner, EY India also contributed to the article.)
