Industry group pitches for removal of surcharge on category III AIFs

An industry association, comprising private equity, venture capital and institutional investors, is lobbying for a pass-through status for category III alternative investment funds (AIFs), which are usually targeted at wealthy investors. 

Indian Private Equity & Venture Capital Association (IVCA), the apex association for PE and VC firms, has shot a letter to this effect to the finance ministry a few days back, said two people familiar with the matter. 

Pass-Through status for category III funds has been a long-pending industry demand, but gains significance in the backdrop of the additional surcharge introduced in the Union Budget this year. 

Pass-through implies that income would be taxed in the hands of the investor, and does away with the need for the fund to pay tax, effectively helping it sidestep the higher surcharge. 

If a pass-through status is not feasible, IVCA wants the government to define a tax code for category III AIFs, wherein tax is levied at the fund level, but minus the additional surcharge.

Category III funds, especially long-short funds that do derivatives trades and earn 'business income', remain impacted by the surcharge hike. Such funds will see an increase in tax rate to 42.7 per cent from 35.9 per cent, if income earned exceeds Rs 5 crore.

“The chief reason the surcharge hike impacts category III AIFs is taxation at the fund level. Once a pass-through regime, similar to category I and II AIFs, is introduced, individual investors can pay tax based on their own tax position,” said Subramaniam Krishnan, partner, private equity & financial services, EY India. 

“Investors and fund managers of category III AIFs have been asking for tax clarity for years; the additional surcharge has only added to their woes. A pass-through status will not only address the surcharge issue but also bring in clarity on how such funds are taxed,” added Tushar Sachade, partner- tax and regulatory services, PwC India.

For categories I and II, the pass-through status is available only for non-business income. This means the fund is liable to pay tax at 30 per cent, plus surcharge if it earns business income. For category III funds, however, IVCA wants all income, including business income, be made pass-through, according to the sources.

Taxing individuals in a pass-through regime may be a complicated affair for category III funds. This is because these funds, unlike category I and II, typically invest in listed shares and redeem their holding periodically. 

“The pass-through framework for category III funds will have to be granularly defined as these are open-ended and investors can redeem their investments whenever they want. So, allocating the pass-through income to individual investors could become cumbersome,” said Krishnan.

A viable option, according to some experts, therefore, would be to tax category III funds at the fund level, but minus the additional surcharge. This will also help clear the air on the current tax regime for category III AIFs, especially the lack of clarity on whether tax ought to be levied simply at the fund level or both at the fund and the individual level. 

Category III AIFs have seen their investments rise over 60 times over the past five years to Rs 30,801.8 crore as of March 2019, data from the Securities and Exchange Board of India (Sebi) shows. This makes it the fastest-growing of the three categories of AIFs.

Some of these funds are now toying with the idea of restructuring to limited liability partnerships or registering anew in GIFT City, a tax-friendly zone, to avoid paying the higher surcharge.

Total investment commitment of AIFs put together reached Rs 1.09 trillion as of March 2019, more than a three-fold jump from Rs 35,099 crore two years ago. The surge in assets is a function of the easing regulatory framework, options for customisation and robust returns.