No pass-through status for alternative investment funds

The exemption is currently enjoyed only by venture capital funds, and other AIFs such as hedge funds

The income tax department said on Monday that alternative investment funds (AIF) such as private equity funds with unknown investors would not be given the pass-through status and the income will be taxed in the hands of the trustees of such funds at maximum rate of up to 30 per cent.

The exemption is currently enjoyed only by venture capital (VC) funds. Other AIFs such as hedge funds, private equity funds, and infrastructure funds have also asked for a similar treatment where the income arising in the hands of the fund is treated as tax exempt, while investors are liable to pay tax.

A pass-through status means the income generated would be taxed in the hands of the investor, and the fund itself would not have to pay tax on the same.

In a circular issued on Monday, the Central Board of Direct Taxes stated that in cases where the trust deed neither names the investor nor specifies the beneficial interests, the entire income of the fund would become liable to be taxed at the maximum marginal rates in the hands of trustees.

"In the situation, where the trust deed does not name the investors or does not specify their beneficial interests, the entire income of the fund shall be liable to be taxed at the maximum marginal rate of income tax at the hands of the trustees," the circular said.

The domestic fund will need to be appropriately structured as per the relevant provision of the trust taxation of the Income Tax Act in order to get a pass through status,  Punit Shah, co-tax head of KPMG India said.

However, in funds such as private equity, investors come after deed is made and it is difficult to re-structure them as per the needs of the I-T Act, another expert said.

Even if the names of the investors are given in the trust deed, the trustees will still have to cough up the tax at the maximum rate, if the Fund’s income is assessed as business income and not capital gains.

Experts said this will have huge impact on private equity funds and others qualified as AIFs. .

This is because if these funds are given a pass through status, tax will be levied at investor level. Now, on listed entities it will come at nil for the long term and 20 per cent for unlisted entities.  Now, if pass through certificate is not given, maximum tax at the hands of trustees could be imposed at the rate of 30 per cent. 

Unlike VC funds, other funds including small and medium enterprise, social venture, infrastructure, private equity, debt, and hedge funds are not recognised under the I-T Act and their income is liable to tax depending on legal status of the fund - company, limited liability partnership or trust.

More than 90 AIFs are registered with markets regulator the Securities and Exchange Board of India (Sebi). Most of these AIFs are set up as non­charitable trusts and the identity of their investors is not known at the date of creation of the trust. Under the law, if the name of the beneficiary is not specified in the trust deed, then the trust is subject to tax and not the investor.

This gives advantage to VC funds over other AIFs. The industry had asked the finance ministry to remove this tax disparity and provide a level-playing filed so that more investors could be drawn toward AIFs.

The issue emanated from introduction of Sebi regulations in May 2012 about AIFs bringing all investments under one roof and repealing the earlier venture capital regulations issued in 1996. In Finance Act 2013, the government made changes to the existing provisions of the I­T Act to harmonise them with Sebi's norms, but the pass-through status was allowed only to VC funds and not other AIFs.