Venture Capital’s Tryst with Tax: Revisiting the Debate on Carry

[Bhaskar Vishwajeet and Abhinav Shankarraman are final year law students at Jindal Global Law School]

The Karnataka High Court recently overruled a Customs, Excise, Service Tax Appellate Tribunal (“CESTAT”) order (page 4) on the service tax status of venture capital trusts (“VCTs”), declaring that service tax is not applicable to VCTs as they are pass-through structures. The authors argue that the judgement has given some direction to a clear and nuanced understanding of an increasingly popular investment structure for venture capital by clarifying fundamental questions concerning venture capital trusts. However, the authors further propose that the order could have done more by characterising the concept of carried interest and providing clarity on its tax treatment in India. This is because a global debate persists on the nature of carried interest and different jurisdictions view the payment structure through different lenses thereby translating into different treatment in taxation.

Stakeholders and Structure

Before delving in this dispute, it is pertinent to understand the various participants involved in this matter. The issue at hand concerns a subset of alternative investment funds (“AIFs”). AIFs are funds established or incorporated in India as privately pooled investment vehicles that collect funds from sophisticated (experienced) investors, Indian or foreign, to invest in accordance with a defined investment policy for the benefit of the fund’s investors. The SEBI (Alternate Investment Fund) Regulations, 2012 (“AIF Regulations”) allow AIFs to be incorporated in the form of a trust, company, limited liability partnership or a body corporate. Additionally, the AIF Regulations stipulate fund categories to distinguish structures on the basis of their organization and investment purpose. Venture capital funds come under ‘Category-I’ AIFs, i.e., funds which invest in, among others, start-ups, early-stage ventures or other sectors or areas which the government or regulators consider as socially or economically desirable.

To begin with, a VCT is essentially a trust created under the Indian Trust Act, 1882, to pool resources as a fund to invest in various financial instruments. According to market data and FAQs on the AIF Regulations, a VCT is the most common fund structure preferred by venture capitalists in India. The most common reasons to opt for such a structure are the favourable tax treatment of the structure (for the asset managers) and the relative ease, in comparison to companies and limited liability partnerships, with which the profits (if any) can be distributed.

VCTs are typically structured in such a manner that the income earned is distributed among the investors, with the trust retaining no money at the end of an investment cycle. The distribution of the returns is not uniform: investors are differentiated based on the class of units that are issued. An investment manager, tasked with the management of funds, is usually allocated a separate class of shares. It is pertinent to note that unlike their counterpart in the United Kingdom (“UK”), Indian VCTs are privately pooled vehicles of investment and regulation 4(b) of the AIF Regulations specifically prohibits the entity, i.e., VCT, from making an invitation to the public at large for investments.

Profit Distribution

Venture capital funds distribute profits after accounting the “carried interest” or simply — “carry”. Profit distribution takes place according to a distribution waterfall mechanism, which requires investors (limited partners, or “LPs”) to receive their dividends first, after which the carry may be considered for the investment managers (general partners, or “GPs”) of the fund. The carried interest rate typically hovers around 20% of the profits of the fund. Quite often, the carry is applicable only after the GPs manage to cross a pre-determined hurdle rate of return for the fund.

Tax Treatment

Category-I AIFs are designated as tax pass-through structures. Such a designation means any income earned by such AIFs is exempt from taxation at the structural level, i.e., fund level. As a result, the gains (profits) made by a VCT will be taxable in the hands of investors, viz., the LPs. Thus, the tax is paid by the investors in their personal capacity, despite the VCT (fund) making the investments for them. Briefly put, the tax liability passes through the VCT on to the contributing investors, aligning with the principle of taxing income only once, ultimately avoiding double taxation.

Observations from the Karnataka High Court Order

On the Doctrine of Mutuality

The impugned order of the CESTAT, which was overturned by the Karnataka High Court, held that the structure of the VCT in question does not attract the doctrine of mutuality. It observed that the money retained by the fund manager was not a return on investment, but a form of service fee paid for managing the fund. The doctrine of mutuality states that persons cannot make a profit out of themselves or trade with themselves. As an exemption carved out by common law with respect to the taxability of a VCT instrument, the doctrine distinguishes a VCT’s income based on the structuring of the investment. Thus, the income generated from such transactions is not considered to be taxable profit but rather a return on the contributions made by the members (LPs) to the fund.

Transposing the doctrine to the venture capital scenario, mutuality would dictate that the contributors to the fund are the eventual beneficiaries. This means that the LPs are viewed as both investors and recipients of the fund’s return. Since the investment managers are invested in the trust itself, it was held that the nature of income or carry earned by the asset manager was not a service fee for managing the trust, but an income earned on account of being a unit holder of the trust. Globally, VCTs enjoy significant tax incentives and most jurisdictions recognise the sum earned by the asset manager, i.e., the carry, to be an income earned on account of the underlying security in which an investment is made.

In the context of VCTs, the authors are of the opinion that the High Court has correctly applied the doctrine of mutuality. The judgement is consequential in so far as it directly addresses the specific legal question that has troubled the industry. While the service tax regime introduced through the Finance Act, 1994 may have been replaced by the goods and services tax (“GST”), the ambiguity on the taxation status of “carry” still remained.

From Service Tax to GST

Unlike the service tax regime, it may be pointed out that the Central Goods and Service Tax Act, 2017 (“CGST Act”) specifically defines a “trust” as a person (see section 2(84)(m) of CGST Act). This could be a challenge to importing the judgement in the present scenario as the judgement explicitly holds that a VCT is not a taxable person in the context of the service tax regime. However, it must be noted that the reasoning of the judgement centres around the application of the doctrine of mutuality to the trust and the role of the investment manager. Absent any clarification on the characterisation of carried interest in the GST regime, the doctrine of mutuality would appear to benefit investment managers with respect to tax liability arising from indirect taxation. However, recent reports concerning the Damodaran Committee’s examination of carried interest have reiterated that the industry is currently being charged GST on carried interest.

While the view presented in the judgment is largely in line with global standards there are some reasoned criticisms. Proponents of indirect taxation on investment managers and their compensation structures emphasise that the tax breaks for the VCT structure are merely “workarounds” to avoid taxation of what is fundamentally a service provided by the investment manager. The authors in the subsequent section will enumerate how jurisdictions such as the UK and the United States (“US”) have rationalised this by introducing conditionalities such as a minimum period for which an investment manager must operate a trust to avail tax benefits on carry. The authors posit that such conditionalities from foreign jurisdictions preserve the sanctity of the trust structure. Furthermore, other jurisdictions characterise carried interest in a far more detailed manner, thereby providing relevant stakeholders with certainty on the tax treatment.

Characterizing Carried Interest Across Jurisdictions

Weisbach observes, in an analysis of the nature of carry, that the general debate around carried interest’s characterization revolves around whether it should be taxed as capital gains income (as it currently is in the US) or as ordinary compensation income. Critics argue that treating carried interest as capital gains provides a preferential tax treatment to venture capital fund managers that is not justified. They contend that this income should be taxed similarly to other service providers’ compensation, such as stock options or royalties, which are taxed as ordinary income. Proponents of the current treatment argue that it aligns with partnership taxation principles and reflects the risk and return nature of the venture capital and private equity industries.


In the US, carried interest is typically taxed as a capital gain rather than ordinary income. This means that the GP pays a lower tax rate of 20% on long-term capital gains, rather than the top rate of 37% for ordinary income. The Tax Cuts and Jobs Act of 2017 curtailed the tax preference for carry by a slight margin by requiring an investment fund to hold assets for more than three years to treat any gains allocated to its investment managers as long-term. It must be noted that this concept has faced Congressional scrutiny; however, nothing has materialised.

European Union (“EU”) and the UK

Luxembourg: Carried interest is treated as capital gains and taxable at a progressive income tax rate of up to 45.78%, with a lower effective rate of 27% on receipt of the carried interest.

Spain: Spain has a specific tax regime for carried interest applicable to venture capital and buyout funds according to a recently introduced start-up law. The tax regime applies to Spanish venture capital entities, EU vehicles, and equivalent investment entities in other jurisdictions. The conditions attached to the specific tax treatment include having a negotiated minimum guaranteed return and holding the carried interest income for a minimum of five years.

UK: Carried interest is taxed under specific rules introduced in 2015 known as the Disguised Investment Management Fee (DIMF) rules and carried interest rules, supplementing general UK tax regulations. Carried interest holders in partnership investment funds, referred to as executives, are subject to capital gains tax and taxed akin to equity investments, with returns treated as capital gains. However, investment managers may face income tax on portions of their profit classified as fees from self-employment or employment income.


The jurisdictional analysis presents us with an interesting insight on how regulators choose to identify carried interest arrangements and, subsequently, tax treatment measures around the same. It is evident that a favourable taxation is a potent tool in the Government’s arsenal to promote investments. The Karnataka High Court’s judgment is just another reason for the government to deliberate and make suitable notifications on the subject matter to end the conflict relating to the ambiguous tax status at present. The Government would benefit from taking inspiration from other regimes and extend relief to VCTs albeit with sufficient conditionalities.

Bhaskar Vishwajeet & Abhinav Shankarraman

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