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The income tax department might turn down the demand of alternative investment funds (AIF) such as hedge funds, private equity funds and infrastructure funds to exempt them from tax and impose it at the hands of investors. Such an exemption is currently enjoyed only by venture capital (VC) funds, also an AIF, through a "pass-through" status.
The tax department is likely to issue a circular to clarify that AIFs, other than VC funds, may not get pass-through status as investors in most of them are not known at the time of setting up of these funds.
"Since the share of beneficiaries is not known in other AIFs set up as noncharitable trusts, they would be taxed at maximum marginal rate," said an official.
Unlike VC funds, which are recognised and tax-exempt under the IT Act, income of all other funds, including small and medium enterprise, social venture, infrastructure, private equity, debt, and hedge funds, is liable to tax. Their taxation depends on legal status of the fund; that is, company, limited liability partnership, or trust.
More than 90 AIFs are registered with market regulator Securities and Exchange Board of India (Sebi) as on date. 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. As income of foreign investors can't be taxed in India, those investing in VC funds become totally exempt. However, if the income is taxed in the hands of trustees as the representative assesse of a beneficiary, the tax liability will be passed on to the investors.
"Since investors of these funds in most cases are foreigners, their income can't be taxed in India. As there is a pass-through status in the case of VCs, their income becomes totally exempt in the hands of the fund as well as foreign investors," said another tax official.
Domestic investors, too, are at a disadvantage. Under the current tax treatment, the entire income of the fund would be taxed at a maximum marginal rate of 30 per cent. This gives huge disincentive to domestic investors, because if they were to invest directly in the listed equity space, they would end up paying only zero tax (subject to securities transaction tax and one-year holding).
Although there is no double taxation, issues arise as the investor has to take a tax credit for the taxes paid by AIFs if he is either tax-exempt or subject to lower rate of tax compared to the maximum marginal rate of 30 per cent paid by AIF.
"If the income is taxed in the hands of the fund, the investor gets tax credit. But if the primary shareholder gets taxed directly, instead of the fund, it eases a lot of things," said Abizer Diwanji, partner, EY.
According to experts, this issue is because of judicial and other rulings interpreting a 130year-old trust law, which was never meant for these funds.
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 the Finance Act 2013, the government made changes to the existing provisions of the IT Act to harmonise them with Sebi's guidelines, but the pass-through status was allowed only to VC funds and not other AIFs.
Recently, Sebi chairman U K Sinha had also asked for a pass-through status for the proposed real estate investment trusts. The government will have to amend the law to provide this status.
