In 2012, the Securities and Exchange Board of India (SEBI) introduced Alternative Investment Funds (AIFs) as a new class of investment vehicles. These funds provide a regulatory framework for private equity and venture capital funds, real estate funds, and other types of funds that do not fit within the existing regulatory framework for mutual funds. The goal of introducing AIFs was to help promote and develop the alternative investment industry in India, and to provide investors with additional investment options.
AIFs have played an important role and have served as a growth driver for the Indian economy by providing an avenue for long-term investments in various sectors including private equity, venture capital, real estate, and infrastructure. As per a recent report, there is optimism that AIF commitments shall cross INR 7 trillion mark soon[1].
As the industry has grown, tax and regulatory laws related to AIFs have also evolved. Given the importance of AIF’s the government has been continuously working towards creating a more favorable tax and regulatory environment for these funds.
The prospects and expectations from Union Budget 2023-24
Every Union Budget brings its own set of expectations. This year is no different. This article encapsulates a few key expectations which the funds industry is seeking from this year’s budget.
Pass through status for business income earned by Category I and II AIFs
- As per the special provisions for taxation of income earned by Category I and II AIFs, limited tax pass-through is provided to Category I and II AIFs. All income other than business income, is exempt in the hands of Category I and II AIFs and is liable to be taxed directly in the hands of the investors on a pass-through basis.
- On the other hand, all income (including business income) earned by a Securitization Trust is provided pass through status and is directly liable to tax in the hands of its investors.
- This year, therefore, one hopes that the budget will bring about rationalization of provisions for taxation of business income earned by Category I and II AIFs in order to bring about parity with taxation of business income earned by Securitization Trust.
Need for special tax provisions for domestic Category III AIFs
- Income-tax law has special provisions in place to pass through status to business trust, securitization trust and Category I and II AIFs. Further, the Finance Act, 2021 introduced tax pass-through status to certain Category III AIFs incorporated in the IFSC subject to the fulfilment of specified conditions.
- However, no separate tax code exists for Category III AIFs. This results in uncertainties and taxation of Category III AIFs as traditional trusts. In most situations, this ultimately results in tax complexities and liabilities at maximum marginal rate for Category III AIFs.
- Introduction of special provisions for Category III AIF would not only reduce the tax uncertainty but would also attract domestic and global investments in Category III AIFs in India.
Concessional tax regime on interest income for investments in debt AIFs
- As per the existing laws, interest income earned by Foreign Portfolio Investors (FPIs) from specified debt instruments including rupee denominated bonds and Government Securities, is taxed at a concessional rate of 5%.
- It is possible that the Government may consider extending this concession to interest income earned in all categories of Alternative Investment Funds (AIFs). This would help in creating tax parity for FPIs on interest income from debt AIFs and may attract more investment into India.
Tax deductibility of set-up and ongoing expenses incurred by the AIFs
- AIFs incur significant expenditure on set-up and ongoing activities. Such expenditure includes regulatory fees, professional fees, management fees, carried interests, trusteeship fees, and fees paid to various service providers. Typically, these expenses are not tax deductible for AIFs/ their investors.
- An amendment to the income-tax Act enabling deductibility of the set-up and ongoing expenditure against the income earned by the AIF or its investors could be beneficial. This could help reduce the overall tax liability for AIFs and their investors.
Clarity regarding characterization and taxability of carry interest
- The characterization and taxability of carry interest has historically been a matter of concern for the fund managers and the funds. To add to it, in 2021, the Bangalore bench of the CESTAT passed a ruling in the case of ICICI Econet Internet and Technology Fund and other funds wherein it was held that venture capital funds (VCFs) set-up as a trust is a separate legal entity. The CESTAT upheld the levy of service tax on carried interest distributed by the VCF, equating it to performance fee earned by the management company. While the CESTAT decision pertained to the erstwhile service tax regime, it did create uncertainty and stir up issues regarding taxability of carry interest under GST and income-tax regime on all pooling vehicles in general. The Ruling resurfaced the ambiguity regarding characterization of carried interest as business income (instead of capital gains).
- Internationally, the rules for taxation of carried interest are evolving. While the Indian Government has not issued any clarification / guidance since the CESTAT ruling, it is imperative to watch out for the Indian Government’s approach on this issue and to see if it is in line with global best practices.
Clarity on carry forward of losses by Business trust and Securitisation Trust
- Certain income earned by the following categories of entities enjoy pass through status under income-tax:
- Category I and II AIF.
- Business trust
- Securitisation trust
- The intention to allow the pass-through status was to simplify the taxation at the entity level while at the same time allowing investors to take benefit of the lower rate of taxation applicable to them. A drawback of the entire scheme of pass-through status was that it did not allow pass-through of losses, which could arise at the entity level. This proved to be a hurdle for set-off losses at investor level.
- Finance Act 2019 amended the provisions relating to pass through and set off of losses at investor levels to allow pass through of losses in case of Category I and II AIF. However, no such clarity has been provided in the case of business trust and securitization trust. Clarity in this regard is much awaited.
Elimination of categorization of AIFs in IFSC and amendment to the definition of specified fund
- Finance Act 2021 brought in specific beneficial provisions to remove tax on capital gains on relocation of overseas funds to IFSC. The said provisions are applicable to all categories of AIFs (including Category I and Category II).
- On the other hand, the definition of ‘Specified Fund’ for the purpose of certain other exemptions and benefits, includes only Category III AIFs located in IFSC with investments from non-residents. This results in a disadvantageous position for Category I and Category II AIFs located in IFSC.
- To achieve the desired output from the amendment by Finance Act 2021 and to remove difficulties for Category I and Category II AIFs located in IFSC, the Government should consider elimination of categorization of AIFs in in IFSC.
Need for incentivizing the domestic investors to invest in IFSC
- The Reserve Bank of India (RBI) allows domestic investment up to USD 250,000 in IFSC based Category III AIFs by a resident Indian under Liberalized Remittance Scheme (LRS). However, IFSC based Category III AIFs are treated as specified funds eligible for tax benefits only if such funds have investment from “foreign investors”.
- Hence, IFSC based Category III funds receiving domestic investments may not be treated as specified funds and would not be eligible to claim tax benefits. While attracting investments from Indian HNIs, this tax disparity puts them in a disadvantageous position when compared with the overseas jurisdictions like Singapore, Mauritius, etc.
- An amendment in this space is something to look out for given the recent overseas investment trend by Indian HNIs.
Pillar 2 impact on concessional tax MAT and AMT rates for businesses in IFSC
- Businesses carried out from International Financial Services Centre (IFSC) in India enjoy a tax holiday under normal tax provisions for a specified period. Such businesses are eligible to claim concessional rate of 9% under Minimum Alternate Tax (MAT) and Alternate Minimum Tax (AMT) if they are deriving its income solely in convertible foreign exchange.
- OECD’s 2 Pillar solution imposes a global minimum corporate tax of 15% on multinational enterprises (MNEs) that meet the EUR 750 million threshold.
- The OECD’s 2 pillar solution is expected to impact the concessional MAT/AMT rate extended to the units/companies in IFSC. It will be interesting to see how the Indian Government balances retaining the IFSC tax holiday while also meeting the requirements of the Pillar 2 proposal.
Indirect Transfer in case of IFSC based Category III AIFs
- As per the existing provisions, transfer of shares or interest in an offshore company that derives its value, whether directly or indirectly, substantially from assets located in India is subject to Indirect Transfer Provisions in India. The said provisions do not apply to non-resident investors investing in Category I or II AIFs. In the absence of any specific exemption the indirect transfer provisions apply to Category III AIFs.
- Category III AIFs (expect specified Category III AIFs located in IFSC) are not provided pass through status and are hence, taxed at the AIF level with an exemption at the investor level. If an investor in such a taxable AIF is a feeder fund, then the investor in that feeder fund could be exposed to tax liability as a result of indirect transfer provisions.
- To bring uniformity for AIFs, it is suggested that the Indian government should clarify that the Indirect Transfer Provisions are not applicable for non-resident investors, directly or indirectly, in all Category III AIFs located in IFSC. This would ensure that non-resident investors in AIFs located in the GIFT IFSC are not subject to any potential tax liability as a result of the Indirect Transfer Provisions. This would align the tax treatment of AIFs located in the GIFT IFSC with the tax treatment of AIFs located outside of India and would attract more investment in the GIFT IFSC, helping to promote the development of the IFSC as a global financial hub.
Conclusion
In conclusion, the upcoming budget presents an opportunity for the Indian government to address the concerns of the AIF and IFSC funds industry by providing clarity on the tax and regulatory laws related to these funds. This includes providing tax parity to non-resident investors, clarifying the applicability of Indirect Transfer Provisions for AIFs in IFSCs, and providing guidance on the tax implications of carried interest earned by fund managers and much more. Such steps would not only provide a boost to the Indian economy but also attract more foreign and domestic investment and promote growth for the funds industry.
We hope you have found this information useful. For any queries/clarifications please write to us at insights@elp-in.com or write to our authors:
Nishant Shah, Partner – Email – NishantShah@elp-in.com
Rahul Charkha, Partner – Email – RahulCharkha@elp-in.com
Arpita Choudhary, Senior Associate – Email – arpitachoudhary@elp-in.com
Disclaimer: The information contained in this document is intended for informational purposes only and does not constitute legal opinion or advice. This document is not intended to address the circumstances of any individual or corporate body. Readers should not act on the information provided herein without appropriate professional advice after a thorough examination of the facts and circumstances of a situation. There can be no assurance that the judicial/quasi-judicial authorities may not take a position contrary to the views mentioned herein
References
(1)https://www.business-standard.com/article/markets/less-than-a-decade-since-launch-aif-commitments-to-cross-rs-7-trn-mark-122103000428_1.html#:~:text=It%20has%20Rs%206.9%20trillion,lag%20on%20a%20quarterly%20basis.
