Taxing the Fund Managers: The Future of Pass-Through Status of Trusts

[Shambhavi Sinha is a final year B.B.A.,  LL.B. (Hons.) student at Symbiosis Law School, Pune]

The Securities and Exchange Board of India (“SEBI”) allows an Alternative Investment Fund (“AIF”) to be constituted as a trust, a company, a limited liability partnership (“LLP”), or a body corporate under the SEBI (Alternative Investment Funds) Regulations, 2012 (the “AIF Regulations”). In India, the AIF business has grown tremendously, contributing to our country’s capital needs. The reasons for such a fast pace growth in the AIF sector lie in the tax certainty offered by the policy makers. The Finance Act, 2015 provided a separate tax pass through for Category I and Category II AIFs, regardless of the legal form in which they are established. Incorporating fund structures in the form of a trust has always been a preferred mode of incorporation of an AIF because of the principle of mutuality, according to which the trust is not distinct from its beneficiaries.

However, a recent judgement by the Customs Excise and Service Tax Appellate Tribunal (“Tribunal”), Bangalore bench, passed on 1 July 2021 in the case of ICICI Econet and Internet Technology Fund v Commissioner of Central Tax has challenged the premise of this long age industry practice. It held that a venture capital fund (“VCF”) is liable to pay service tax on expenditure incurred in administration of fund and carried interest. In the present case, ICICI Econet and Internet Technology Fund (“Appellant”) was a VCF under the SEBI VCF Regulations, 1996. The VCF is a vehicle created to make large investments in portfolio companies using contributions from a variety of investors. A trustee oversees the VCF on behalf of its contributors/subscribers. The trustee appoints an investment manager, also referred to as asset management company to oversee pooled investments and make investment and divestment decisions. The fund raises money through issuance of different classes of units. In this regard, the fund issued class B and C units to the investment manager, the Appellant and class A units to other ordinary investors. As per the fund documents and the process of disbursement of profits, class A unit holders received a payment equal to the capital plus a promised rate of return. On the other hand, class B and C unitholders received an amount equal to the capital, a promised rate of return and a percentage of the fund’s surplus profits, known as carried interest.

According to section 65(12) of the Finance Act, 1994, the tax department undertook an inquiry that resulted in an order confirming the taxability of services purportedly supplied by the Appellant under the category banking and other financial services (“BoFS”). The main question before the Tribunal was whether the Appellant’s operating expenses, along with the carried interest paid to holders of class B and C units, constituted payment for the services it provided to contributors. The Tribunal affirmed service tax liability on expenses, including payments of carried interest to the investment management company other expenses paid by the fund in the course of its operations.

This post aims to analyse the far-reaching implications of the judgement.

Analysis

The Tribunal held that i) the VCFs breached the principles of mutuality by engaging in commercial operations and utilising their discretionary powers to benefit a specific group of investors. As a result, the VCFs created arrangements to act in a manner that is contrary to the interests of the investors/contributors when it comes to the distribution of profit arising out of the investments, ii) the carried interest is not interest or returns on investment, but a portion of the consideration kept by the VCFs for the services they provided to the investors, iii) the fund’s structure in the form of the trust was a mere facade so that the investment managers and their nominees would earn large quantities of money in the form of performance fees and carried interest, with the dual aims of benefiting themselves at the expense of the investors and evading taxes.

Taxation of Trust in India

A trust does not have its own legal personality under Indian law. A trust is also not considered a person under the IT Act’s definition of the term. The IT Act, on the other hand, reflects the concept of a “representative assessee” for taxing income of assessees who are not subject to tax because their income is received by someone else, such as in a trust situation where the trustee receives the income for the benefit of the beneficiaries. The IT Act allows the tax officer to reclaim the tax from either the trustee or the beneficiary directly. The money earned for and on behalf of the beneficiary is taxable to the trustee. The same income cannot be brought to taxation twice, once it has been taxed in the hands of the trustee or beneficiary. Therefore, the direct tax regulations, such as the income tax and international tax afford pass-through status to trust. However, the indirect tax regime does not afford this status to trust because such taxes cannot be passed on to the investors. This is different from the position in the USA and Japan wherein a trust has been given the status of a distinct legal entity under their respective separate business trust laws. Thus, in absence of such a specific law in India, trusts will remain subject to taxation under indirect tax.

Tax Treatment of Carried Interest

Carried interest which was earlier regarded as a return on investment has now been classified as a fee-based return and made taxable. The global regime of private equity treats the carried interest as return on investment. It provides an incentive to the investment manager and is well aligned with the interests of the other investors. This is because it also serves a risk of investment for the capital infused by the sponsors/fund managers into the fund. Any attempt to increase taxation in the hands of the investment managers would reduce their interest in sponsoring an investment vehicle. As a result of the lowered incentive, innovation may suffer, and private equity could become less attractive. Therefore, the argument to allow pass through status of carried interest is based on the sound principles of rewarding entrepreneurial labour and capital commitments. This judgement by the Tribunal will also pose challenges for the government’s “Manage in India” campaign, which incentivize national and international fund managers to carry out activities of the funds in India without incurring any tax related adversity. Conclusion

The Tribunal’s decision is the first to address the taxability of operations performed by VCFs under the regime of service tax. The ruling and its reasoning could have ramifications for other ongoing investigations. Existing similar structures could be brought under the purview of scrutiny by the tax authorities. This can also adversely impact the taxpayers under the GST regime owing to the fact that provisions have mostly been carried forward. The judgement will disrupt the global standard of affording a pass-through status for investment vehicles. Hopefully, the Supreme Court or the policy makers will come into the rescue of fund managers and settle this controversy.

Shambhavi Sinha

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