Ten years ago, the typical investment instruments for retail investors were Mutual Funds (MFs) and fixed deposits (FDs), while High Net Worth individuals (“HNIs”) and other sophisticated investors generally used Portfolio Management Services (“PMS”) to manage their wealth. Sensing a need to have a regulatory framework for investment vehicles to pool money from investors, the Securities and Exchange Board of India (“SEBI”) introduced the SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”) to regulate the market of pooling investments in India.
Each investment avenue such as mutual fund, PMS, REIT, InVIT and AIF may differ in terms of minimum investment objective, profile and size, fee structure, portfolio diversification norms, pooling of funds etc. However, investors often lay emphasize on tax simplicity and efficiency as one of the primary decision factors prior to making an investment.
Under the existing tax framework for MFs, PMS, REITs/InvITs, the income is taxed in the hands of investors on a “pass through” basis, at tax rates applicable to such investors. However, with respect to AIFs, particularly those making public market investments, there exists a disparity in tax treatment.
AIFs have grown significantly in size, scale, depth of investments and investor profile and continue to show much greater potential in the years to come. AIFs are categorized into three main categories: (i) Category I AIFs invest primarily in start-up or early-stage ventures or social ventures or SMEs or areas which the government or regulators consider as socially or economically desirable, (ii) Category II AIFs are the ones which does not fall in Category I and III AIFs and invest majorly in unlisted securities, (iii) Category III AIFs employ diverse or complex trading strategies and may employ leverage.
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While Category I and II AIFs have been accorded a pass-through status for tax purposes (similar to other investment vehicles), there is no specific tax regime for Category III AIFs. Accordingly, Category III AIFs (which are usually setup as trusts) are taxed as per the general principles of trust taxation, which is complex and open to interpretation. The tax pass through framework for Mutual Funds, PMS, Category I and II AIF helps investors as the income is directly taxable in their hands; however Category III AIFs investors are put to a disadvantage as they do not have a tax pass through status which creates uncertainty in the amount of tax payable, risk of double taxation in some cases and complexity in tax calculation and reporting.
Category III AIFs usually discharge taxes at the AIF level due to the complexity in taxation. Further, there are no express provisions under the Act which provide that once the income arising at the AIF/trust level is assessed to tax in the hands of the trustee, it cannot be assessed again in the hands of the beneficiaries (investors). Also, since Category III AIFs are not accorded pass through status, foreign investors in the AIF are not able to avail the beneficial provisions available under the tax treaty. Foreign investors are often not eligible to claim a tax credit for the taxes paid by the Category III AIF in their home country.
To resolve this anomaly, tax pass through should be accorded to Category III AIFs as well which will provide parity in tax framework to investors.
Additionally, there is lack of clarity in terms of characterization of income in the hands of Category III AIF specially those which either have a long-short strategy or which churn their portfolio frequently, resulting in added complexity and risk of further tax outflow along with interest and penalties.
Another area where there is disparity is in terms of liability to pay Goods and Services Tax (“GST”) on the management fees, especially in case of foreign investors. While a PMS entity providing management services directly to the foreign investors is not liable to GST, if the monies from foreign investors are pooled into a domestic AIF which is managed by a domestic Fund manager, GST is applicable even if all investors are non-residents. Thus, there is a case to remove this disparity and exempt GST on management fees charged by the AIF Manager to the AIF, especially to the extent of foreign investments in the AIF. Even in case of domestic investors, the investors would be eligible to claim input tax credit of the GST on management fees charged by the PMS entity, while the AIF would generally not be eligible to claim input tax credit of the GST, as AIF would generally not have any output services.
Setting up an AIF in the GIFT City can solve many of the issues; however the GIFT City route is workable only for non-resident investors.
AIFs have emerged as a popular investment fund vehicle for Indian Fund Managers, as evidenced by the recent growth of the AUM of the AIFs. It would be in the interest of our economy to promote AIFs, as they offer a higher degree of capital commitment from investors as compared to a portfolio investment. Thus, parity in taxation of AIFs with other forms of investment vehicles is of paramount importance.
(By Rajesh H. Gandhi, Partner, Deloitte India; Vijay Morarka, Senior Manager and Hardik Mehta, Manager, Deloitte Haskins and Sells)