The Alternative Investment Funds (AIF) in India are an important building block of the economy of the country. The AIF Regulation of 2012 differentiates these AIFs into three categories: Category I, Category II, and Category III based upon the different investment objectives. These fund houses are taxed differently based upon the category in which they fall. Lately, there have been calls for an overhaul of the tax regime of Investment Funds and to bring in more parity among different pooled funds. This article is an attempt to flag important issues surrounding the present tax regime for the Investment Funds industry and also propose viable solutions to the same. This article primarily addresses two key issues: one that focuses on the need for parity of “pass-through” among all the three AIFs, and the other that talks about the need for percolating the expenses of AIFs as well to its investors.
Need for parity in “Pass-Through”
AIFs work on a ‘pooling’ concept whereby the commitments of investors are pooled together. Therefore, the pooled amount is generally not considered a different entity from that of the investors themselves. Recognizing this principle, Category I and II AIFs have been accorded a ‘pass-through’ status for any income which is other than a business income pursuant to Section 10 read with Section 115UB of the Income Tax Act. Simply speaking, the obligation to pay tax is ’passed through’ the investors of the AIFs as if these investments were made by them directly without any presence of an Investment Fund.
The issue lies in the fact that Category III AIF, which has a total investment of more than sixty-six thousand crore Rupees and forms an integral part of the AIF industry, is excluded from the “Pass-Through” provision without a reasonable explanation. The income or capital gains that accrue out of the investments by this category of AIFs are taxable in the hands of these fund houses themselves. This leaves a burdened shoulder on the AIFs for tax calculation and payment obligations along with their already existing bunch of other regulatory and operational burdens. Category III AIFs are usually registered as “determinable trusts’ under the Trust Act. The trustee of a Category III AIF established as a determinate trust is considered a representative assessee under Sections 160 to 162 of the Income Tax Act and must pay off the tax liabilities of its beneficiaries. Therefore, the trustee is required that they be aware of the beneficiaries’ i.e. the investors’ tax status, and pay off the relevant tax liability. This complexity and burden of tax liability are some of the primary reasons why a number of foreign investors get registered as Foreign Portfolio Investors instead of opting for the Category III AIF route of investment owing to the special tax benefit provided to the former under Section 115AD of the Income Tax Act.[1]
Another major reason which calls for a “Pass-Through” provision for Category III AIF is the possibility of double taxation in certain cases. An income accrued/earned may be taxed twice in the way that first it may be taxed when it accrues in the hands of the fund; secondly, this income may be taxed when it reaches down to the hands of an investor pursuant to Section 166 of the Income Tax Act.
In order to address this issue and to simplify and ease the taxation provisions of AIFs, a ‘pass-through’ for Category III AIF is required that allows the income, other than the business income of Category III AIF be “passed- through” the investors. The “Pass-Through” provision will ensure that the amount received by investors through these Category III Investment Funds is taxed as per the tax brackets applicable to their income level without the chance of any double taxation of the same income by the fund house and the investor. This not only eases the taxation and operational burdens of the fund house but also simplifies the determination of the tax liability upon the income earned. The present tax regime only provides a clearer and lighter tax provision for the Foreign Portfolio Investment (“FPI”) Route which thereby gives a green corridor for more FPI investment by offshore hedge funds. The suggested “Pass-Through” for Category III AIFs will accord competitive strength to the domestic fund managers by reducing the differential tax treatment of the domestic fund houses and the offshore fund houses (especially offshore hedge funds). Not only that but the suggested solution of “Pass-Through” for Category III AIF has also been espoused by the Alternative Investment Policy Advisory Committee Report in light of its benefits in avoiding double taxation and increasing global competitiveness among Indian AIFs.
Pass Through of expenses: Extending the Percolation Depth
A fund runs on the fuel operating expenses that sometimes amount to crores of Rupees in real (around 30% of the AIF’s corpus).[2] This may be in the form of trusteeship fees, investment manager’s fees, office administration, and data management expenses to list some. The present regime does not allow either the AIF or its investors to offset these expenses against the capital gains or income accrued owing to the investment by the AIF. Presently, only income and losses are factored in while determining the “passed through” of liability for tax calculation and payment.
An easy expense pass-through in other jurisdictions adds up to chagrin by incentivizing more and more investment through their jurisdictions instead of the Indian market. One of the major reasons why fund houses run behind tax havens like Mauritius or Singapore is the affordable pass-through of expenses of the fund houses to the investors of the fund, thereby increasing their net profits. This not only reduces the prospects of the Indian AIF industry but also places them on an uneven playing field of differential tax structures and makes them bear the brunt of regulatory differentials. Therefore, in order to incentivise more and more onshore fund houses and also parity in the global funds market, it is suggested that the AIFs be given the benefit of “Pass-through” of not only incomes and losses but also the expenses incurred by them in order to make them stand on a fair playing global investment funds industry. This is required, more so, for the funds established in the GIFT IFSC region of India owing to the financial and tax benefits they ought to receive.
Concluding Remarks
With each day passing by, the AIF industry is seeing an unprecedented growth in terms of its investments and total contribution to the Indian economy. A flourishing industry like this, therefore, requires a liberal tax regime in order to provide strength to its rising legs. On the same note, the pass-through provision, which allows the fund houses to pass through the tax liability onto its investors, needs to be eased for Category III AIF which holds a significant chunk of the overall AIF investment quantum. Allowing “pass-through” for Category III AIF will not only ease the burdens of the fund houses, but also it would avoid double taxation of the income on AIF and investors. Further, such a “pass-through” would allow fair standing to the Category III AIF by giving them tax parity with their offshore counterparts.
Another key issue that needs to be addressed is the need for “passing through” of expenses of the fund houses to its investors to increase the profitability of the funds and also to provide global competitive strength to the domestic funds. These expenses eat up the major chunk of fund’s corpus. In such a case, if the expenses are allowed to be “passed through” the investors, this will make sure that fund’s tax liability is minimized and its investment avenues are strengthened. Therefore, it is concluded that the suggested solutions be placed in to ensure increased profitability and global footing for the thriving Indian AIF industry.
[1] Vinod Joseph et al.,Tax treatment of Alternative Investment Funds, TAXINDIAONLINE, available at https://taxindiaonline.com/RC2/inside2.php3?filename=bnews_detail.php3&newsid=43093
[2] Id.
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Authors: Parv Pancholi (3rd Year student at National Law University Odisha), and Ishita Khandelwal (3rd Year student at National Law University Odisha)
Author Bio
There is no denial in the Income Tax Act to claim expenses against the income earned from AIF. We are claiming these expenses regularly and the department has allowed these as such even while assessing u/s 143(3) of the Act. Sorry to say but the article needs to be further reviewed.