Time for tax clarity in Category III Alternative Investment Funds

Clarity in the taxation of funds are pivotal for the growth of the Asset Management industry.

By Tushar Sachade and Nehal Sampat

It may sound a bit incredulous that a segment of the Asset Management industry which has garnered commitments of more than Rs 1.8 lakh crores from investors, does not have a specific tax regime. Instead, the taxation of this segment (including its investors) is governed by the generic rules of taxation as applicable to private trusts. That is largely the case with SEBI-registered Category III Alternative Investment Funds (AIFs) which invest in listed securities.

Backdrop

In the Asset Management industry, where fund managers deal with investors’ money in a fiduciary capacity, clarity in taxation of pooling vehicles/funds and investors is imperative. There are specific regimes in the tax law for taxation of Asset Management products such as mutual funds, Category I/II AIFs, REITs and InvITs. These regimes largely provide for a single level of taxation, usually in the hands of investors.

Category III AIFs, which have been around for more than a decade, however, suffer the ignominy of lack of a specific tax regime dealing with the taxation of these funds and their investors.

Taxation of Category III AIFs – Current practice

In the absence of a separate tax regime, taxation of Category III AIFs depends on the form in which they are set-up. For various commercial and operational considerations, these funds are usually set-up as trusts and are taxed in accordance with the rules which apply to taxation of private trusts. While these rules classify trustees/trust as a ‘representative assesse’ and seek to recover taxes as if the income was earned by the beneficiaries, it is, unfortunately, not so straightforward.

Challenges in Taxation

When the law with respect to taxation of private trusts is applied to taxation of an investment funds, the following challenges emerge:

# Computation of Income/Tax Thereon

• The tax law classifies trusts as either ‘determinate’ or ‘specific’ trusts, and ‘indeterminate’ trusts depending upon the ‘identifiability’ of beneficiaries. How should an open-ended fund, which provides the flexibility of investor entry and exit, be treated for tax purposes-- as a ‘determinate’ or an ‘indeterminate’ trust?
• A majority of Cat III AIFs adopt ‘long only’ strategy and maintain long holding periods. These AIFs offer their gains as ‘long term capital gains’ which are taxable at lower rates as compared to ordinary income. If these AIFs are deemed as ‘indeterminate’ trusts, can their ‘capital gains’ continue to be taxed at lower rates, or could the gains be taxable at the higher ‘maximum marginal rate’?
• If the funds are classified as ‘determinate’ trusts, how should tax/surcharge rates be applied? For instance, if the investors are partnerships or individuals who have opted for the new tax regime, can the lower surcharge rates be considered?

• Who should pay the taxes-- the trust/fund or the investors?
• Where the taxes are payable by the trust, can they be recovered from the investors?
• Where the taxes are payable by the trust, can the investors seek refund of those taxes if their tax incidence is lower?
• Can taxes be levied on payment of redemption proceeds paid to the investors?
• In case of a shortfall in payment of taxes or subsequent tax demand, who bears the liability?

Borrowing from some familiar phrases:

If ‘wishes were horses’ … A tax regime similar to the one applicable to mutual funds, which has worked well for the industry, could be extended to Cat III AIFs. Alternatively, an express tax pass through mechanism could be introduced for such funds making investors liable to pay taxes on income earned by them.

‘Low-hanging fruit’ …A couple of things could be expressly clarified:

1) Cat III AIFs should be deemed/regarded as ‘determinate’ trusts.

2) Investment income earned by funds, which is categorised as ‘capital gains’, should be taxed at the capital gains tax rates and not the ‘maximum marginal rate.

3) If taxes are payable by the fund, there should be no double taxation of the income in the hands of the investors.

Clarity in the taxation of funds and investors, along with single level of taxation are cornerstones in, and pivotal for, the growth of the Asset Management industry. Simplification of tax code is high on the agenda of the current government.

It may be time for us to be guided by the mantra of clarity and simplification and motivating Category III AIF managers to join the chorus to sing a tune different from their current anthem “apna time aayega”!

(Tushar Sachade and Nehal Sampat, Partners, Price Waterhouse & Co. LLP.)

Views are personal, and do not represent the stance of this publication.