Budget 2019: Rise in taxes to take a toll on category-III alternative funds

Budget 2019 mentioned an increase in the taxation of trusts and associations of persons

Sophisticated investment funds marketed to the rich will now have to pay higher taxes. New norms introduced in the Budget are effective from April 1 but several investors may have sold units in the category III AIFs in the past three months. It is unclear who would have to bear the brunt of the higher tax for this period, said experts.

The Union Budget on July 5 mentioned an increase in the taxation of trusts and associations of persons. This would bring most category III AIFs within the higher tax net as these are structured as trusts.

This includes funds that follow a long-only strategy and those that are long-short in nature. The latter comprise 65-70 per cent of the funds in the AIF III category and are likely to take a bigger hit as their income is categorized as business income and charged in the highest tax bracket.

Long-short funds take long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline. Such funds -- wherever income earned is over Rs 5 crore -- will see an increase in tax rate to 42.7 per cent from 35.9 per cent.

Fears over the effect on similarly structured foreign portfolio investors led to a 792.82 point decline in the S&P BSE Sensex on Monday. The benchmark index ended down 2.01 per cent to close at 38,720.57.

Like foreign investors, category-III AIFs follow strategies which mean that any income over Rs 5 crore will see a 6.8 percentage point increase in tax rate from 35.9 to 42.7 per cent. “The increase in surcharge will impact investors’ net returns as the net asset value of funds will get impacted because of the higher tax outgo. Long-short funds may resultantly lose their attractiveness among investors because the question for investors is whether they are better off investing in other investment products that provide comparable or better after tax returns,” said Subramaniam Krishnan, partner, EY Private Equity & Financial Services.

Vaibhav Sanghavi, co-chief executive officer at Avendus Capital Public Markets Alternate Strategies, runs a category-III AIF. He said such funds were already at a disadvantage tax-wise, and this would further affect end-investor returns.

“We are hopeful that the Centre would consider the implications of this and address the situation,” he said.  Tax experts said the norms are effective from April 1. This would also mean that there is a cloud over the taxes owed by investors who exited after the date, but before the Budget announcement.

Rajesh H Gandhi, partner at Deloitte Haskins & Sells, said this could create a headache for foreign and local fund managers where investors exited after April 1 but before the Budget announcement. Recovery of additional taxes from such investors would be challenging. 

“If the investors have already exited, their tax burden will have to be borne by other current investors. It is unlikely that the fund manager would absorb the cost. AIFs will face a similar situation,” said Gandhi.

AIFs under category-III had investments of Rs 30,801.8 crore as of March 2019.