Govt stumps fund managers with conditional tax pass-through status for PE firms

A recent clarification note by the Finance Ministry to extend the benefit of tax pass-through status, which is currently available to venture capital firms, to private equity (PE) funds with a rider that the investors in such funds be identified right at the beginning has all but negated its usefulness, say experts.

The development relates to a Central Board of Direct Taxes (CBDT) circular, which states that if a private investment fund, registered as an alternative investment fund (AIF), is unable to disclose the investor's name on the date of creation of the trust the entire income of such AIF will be taxed at the maximum marginal rate of 30 per cent.

The niggling factor is that almost all funds raise money in tranches or multiple closings in industry parlance and the names of the prospective investors cannot be determined at the time of creation of the trust, which pools in the money for the fund.

While the industry was clamouring for clarification on this account ever since the government had previously provided tax pass-through status to only class of such AIFs—i.e., VC firms—the circular has come as a no-show.

“The domestic funds will be affected the most but the foreign LPs who invest in them will also be affected. The purely foreign non-SEBI registered funds will not be affected by these regulations. Pass-through status ensures taxing at the investor level and not the fund level,” says Arvind Mathur, president at Indian Private Equity and Venture Capital Association (IVCA).

However, some like Siddharth Shah, partner at legal advisory firm Khaitan & Co, have contrarian view.

“I think the circular is creating more noise than it is intended to. What it has stated as a principle is something which always existed in law and that has only been reiterated,” he says.

CBDT has reaffirmed that once tax has been paid, the beneficiary will not be considered under the purview of taxation. The circular states: in cases of funds where names of the beneficiaries and their interests in the fund are determined i.e. stated in the trust deed, the tax on whole of the income of the fund - consisting of or including profits and gains of business, would be leviable upon the trustees of such AIF, being 'representative assessee' at the Maximum Marginal Rate (MMR) in accordance with sub-section (1A) of section 161 of the Act.

“The circular clarifies that if the tax has been paid at the trust level then the beneficiary should not be further taxed,” points out Shah.

Historically, PE funds in India have structured their funds at determinate trust and claimed a pass through status. The circular now states that if the names of the investors are not mentioned at the time of registration, then the entire income of the fund shall be liable to be taxed at MMR.

“The only added complication that has come in is the fact that for a trust to be treated as a determinate trust you will have to ensure that the names of the beneficiaries are present in the trust document,” Shah of Khaitan & Co. said.

A determinate trust needs to have a full list of investors at the time of registration. At the time of first close, only the general partners and the anchor investors are known. The external limited partners come in at later stages.

It is here that interpretations of the circular vary. While Khaitan & Co.’s Shah says one can go on adding new investors and adding their names can be added in the trust deed, others beg to differ.

“In most cases, funds end up with multiple closing; you will never know the set of investors upfront. So, you will always register the fund because that is a pre-requisite and as the investors come in, you keep adding them on,” says Shah.

“All the LP names cannot be known on day one,” says Mathur of IVCA. “What the CBDT circular states is that if you have more investors coming in at later stages then you shall lose your determinate trust status,” he adds.

According to a 2012 SEBI regulation, AIFs were regulated into three broad categories depending upon the operational strategies, objectives and fund structure. A large number of AIFs registered with SEBI have been set up in the form of non-charitable trusts.

“The recent circular will severely damage the prospects of the domestic AIF industry. It goes against not just the long standing demands of the industry but also against the recent moves of the Finance Ministry and the Finance Minister to try and bring the fund management industry onshore. It is also completely out of line with the international practices,” says Gopal Jain, co-founder, managing partner and managing director at home-grown PE firm Gaja Capital Partners.

It is a norm that PE/VC structures get pass-through for taxation purposes and if such practices are not replicated then people will not set up onshore funds and the industry will remain offshore, adds Jain.

The PE industry was expecting clarifications on the pass-through status for AIFs and had clearly stated its disappointment when the same was not granted.

“It (CBDT circular) states that if an income comprises as business income then to that extent tax will be imposed based on maximum marginal rate. Industry was pushing for clarification on this around the Union Budget announcement. There was a negative reaction among the PE investors, but as they evaluated more carefully, the panic situation is not there,” Shah of Khaitan & Co stated.

Taxation and legal experts say there is a need for further clarity on multiple closings.

“What is required to be clarified now in the context of trusts is ‎if the beneficiaries can be identified ‘at any point in time’ and their shares are ascertainable, the trust should be considered pass through,” according to a note co-authored by Adhitya Srinivasan, Richie Sancheti and Rajesh Simhan of law firm Nishith Desai Associates.

They added that this would be in line with ruling laid down by the Authority for Advanced Rulings (AAR) in a previous case related to investment firm AIG.

“The requirement laid down in the circular of explicitly stating the names of the investors of the AIF and their beneficial interests on the date of creation of the trust creates ambiguity. In fact, the AIG ruling had specifically commented on each of these aspects in great detail which ought to have been replicated in the circular in order to remove all ambiguities on the issue,” they said.

(Edited by Joby Puthuparampil Johnson)

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