AIFs stare at higher tax outgo on investment manager's performance fees

Tax uncertainty could dissuade global players from setting up funds in India

A recent ruling by an indirect tax tribunal pertaining to alternative investment funds (AIFs) has put the industry on tenterhooks.

The Customs, Excise & Service Tax Appellate Tribunal, Bengaluru, in the matter of ICICI Econet Internet and Technology Fund (ICICI Funds) versus Commissioner Of Central Tax, has ruled that 'carried interest’ or performance fee--a share of the profits of an investment paid to the investment manager if the fund’s returns meet a certain threshold or hurdle rate --ought to attract service tax in the form of GST at 18 per cent.

Suppose a fund has a hurdle rate of 10 per cent and charges a carried interest of 20 per cent. If it returns 25 per cent on a corpus of Rs 100 crore, it will take away Rs 3 crore as carried interest (20 per cent of Rs 15 crore).

Structuring the carried interest as a return on investment is a common practice in India and across the globe.

Legal and tax experts fear that if the ruling is upheld, such interest may also be reclassified as 'business income' by direct tax authorities, leading to a further tax outgo of 35-40 per cent for the fund. Currently, carried interest is treated as capital gains and is taxed at 20 per cent.

The uncertainty around taxation and the significant tax outgo could potentially dissuade global general partners (GPs) from setting up such funds in India, and even prompt Indian GPs to relocate to offshore locations. Several industry bodies, including the Indian Venture and Alternate Capital Association, are in the process of making representations to the government seeking clarity in this regard, said people in the know.

"The ruling may undo a lot of good that has been done by policymakers over the past few years for AIFs if it is not addressed comprehensively by the government," said Siddharth Shah, partner, Khaitan & Co. "You could take away a significant portion of carried interest in taxes which would misalign the interest of the GPs with the LPs and dissuade global GPs from setting up such funds in India."

Instead of seeing these funds as passive, pooled investment vehicles, the tribunal is seeing them as entities rendering services to investors under the GST law, added Shah.

"Sebi treats these funds as pooled investment vehicles, direct tax authorities view them as pass through vehicles and indirect tax authorities want to treat it as entities rendering services. You cannot treat these funds differently under different laws," he said.

While the tribunal has questioned the taxability of carried interest for service tax purposes under this ruling, direct tax authorities could start treating it as business income instead of capital gains, which could add 35-40 per cent as taxes on carried interest, said experts.

Globally, carried interest is taxed as capital gains because of the risk involved, the amount of investment and the strategic value it brings.

"In case the carried interest is classified as taxable services by the service tax or GST authorities, it will be interesting to see whether this also creates corresponding exposure under the Income-tax Act. Consequently, such carried interest may be characterized as income under the head ‘Profits and gains of business or profession’ instead of ‘Capital gains’ increasing the importance of structuring the carried interest suitably based on the underlying commercial necessities," said Hardik Mehta, deputy manager, Deloitte Haskins & Sells.

According to him, it will be important for the AIFs to reconsider their position of whether or not to discharge GST on carried interest until the matter is taken before the courts or some clarification is provided by the tax authorities.

Key aspects of Bengaluru Tribunal's verdict

• The funds have been paying huge amounts in the form of performance fee and carried interest to the AMCs or their nominees. They have not adhered to the principle of mutuality of interest

• It appears that carried interest is an additional income to special unit holders other than pro rata income. Thus, trusts are floated for drawing Contributors and to facilitate such persons to earn profits or gains out of the acquisition, holding and subsequent disposal of assets by the trust/fund

• Any amount retained out of income distributable to Contributors is nothing but charge or fee for the services rendered. It is gross consideration in service tax parlance

• Carried interest is neither interest nor return on investment and is a portion of the consideration retained by the funds for services rendered by them to the Contributors and passed on, in the disguise of return on investments, to the AMC, settlor and its nominees

• Fund has devised its structure in a manner that the AMC and/or their nominees would get huge sums of money in the guise of performance fee, carried interest, with the twin motives of benefitting the AMC and/or their nominees at the expense of the subscribers and avoiding the taxes.