The government may also consider according a tax pass through status to Category-III AIFs.
By Daksha Baxi and Surajkumar Shetty
Alternative Investment Fund is an investment pooling vehicle, according a significant opportunity to sophisticated investors to make medium to substantial investments. Typically, it is a pooling vehicle, permitted to be established or incorporated in India as a trust, company, limited liability partnership or a body corporate which is a privately pooled investment vehicles with Indian or foreign investors (Contributors) and registered with SEBI under the SEBI (AIFs) Regulations, 2012.
The AIF Regulations contemplate 3 categories of AIFs: (a) Category-I AIF, which generally invests in start-up or early stage ventures; (b) Category-II AIF, which is an AIF that does not fall in Category I or III such as private equity fund, debt fund, etc.; and (c) Category-III AIF, which employs diverse or complex trading strategies and may employ leverage (eg hedge fund).
The Indian tax law grants special tax pass through status to Category-I and Category-II AIFs. In effect, this means that the AIFs are ignored as entity for the purposes of taxation of income from investments. There is a legal presumption that the investor directly makes such investment, and, hence, the income received by the AIF is taxed in the hands of the investor, based on the tax provisions applicable to such investor. However, since legally the investment is made by the AIF entity and the income from the investment is actually received by the AIF, the law requires that the AIF withhold appropriate tax from the amount of income credited or distributed to the investor at the rates applicable to the investors. The investors are required to offer such income to tax in their annual tax returns and claim credit for the taxes withheld by the AIF. This pass through status is not given in respect of ‘business income’ of the AIF. In case of business income, the AIF itself is taxed on it and then there is no withholding when such income is distributed by the AIF to the investor.
Previously, the AIF was not permitted to pass on its losses to the investors. This lead to an anomaly where investors were being taxed on the income, but were not given benefits of losses incurred from the investments. This has now been rectified. Category I and II AIFs can now pass on their losses to investors, subject to conditions.
Despite the intention of the law being to grant a pass-through status, it is to be noted that there is an anomaly as a result of which this is not achieved. This arises from the fact that the AIF would have expenses in the form of fees to the fund manager and other administration expenses. Commercially, and legally the fund manager is permitted to deduct these from the income of the AIF and if the balance after such deduction is negative, not make distribution.
However, the investor is not given the benefit of this expense (unless such an expense is related to transfer or acquisition of the relevant asset being transferred). The investor is taxed on the income received by the AIF from the investment, disregarding the fees paid to the fund manager, which is allocated to her in the proportion of her investment in the AIF. This results in the investor paying tax on income which she does not receive where the fund management expenses are more than the income. To this extent, no pass through is achieved. It is desirable that an appropriate change be made to the provisions to permit availability of fund management expenses to the investor on pass through basis so that the investor can claim deduction for them while filing returns.
As stated earlier, any income of Category I and II AIFs which is in the nature of ‘business income’ is taxable at the level of the AIF. Characterisation of income, from sale of investments, as ‘business income’ or ‘capital gains’ has historically resulted in tax disputes. While the tax department has issued circulars laying down principles to be applied for classification of income, there still remains a certain level of ambiguity. The government had clarified this stance in the context of FPIs, and amended the law to reflect the understanding that all investments in securities by FPIs would be considered as capital assets and therefore, income from such investments would be classified as ‘capital gains’. A similar clarification is needed so that the characterisation of income from transfer of investments by AIFs is NOT treated as ‘business income’.
The government may also consider according a tax pass through status to Category-III AIFs. Currently, the Indian tax laws do not contain any specific provisions governing taxability of Category III AIFs. Typically, these are structured as trusts and the laws governing taxability of trusts are used for determining taxability of Category-III AIFs and their investors. The government has, time and again, stated that its agenda is to bring certainty in tax laws and avoid litigation. Combining Category III AIFs with Category I and II AIFs, will help the Government in achieving these objectives. Investment in AIFs can be a major mobiliser both for foreign investors as well as high net worth individuals and family offices.
The recent downturn in the market and the increased risk of NPAs may to some extent be doused by increased investments by AIFs. With enough clarity and push for investments, AIFs may become a major mode of sourcing funds for investments.
Baxi is Head, International Taxation and Shetty a Principal Associate (Direct Tax), Cyril Amarchand Mangaldas. Views are personal