Pooled investment funds likely to attract service tax: Check details here

GST on expenses charged by REITs, InvITs and MFs may result in tax levy of hundreds of crores

A wide reading of a recent ruling by an indirect tax tribunal pertaining to venture capital funds could open Pandora’s box for all forms of pooled investment vehicles structured as trusts, including real estate investment trusts (REITs), infrastructure investment trusts (InvITs), mutual funds (MFs), and even provident funds.
 
MFs, for instance, might have to pay about Rs 1,500 crore in additional taxes annually for equity schemes alone, assuming a 2 per cent expense ratio, one per cent management fee on an equity asset base of Rs 10 trillion.
 
This follows a ruling last month by the Customs, Excise and Service Tax Appellate Tribunal, Bengaluru, which held that since trusts were treated as juridical persons for the purposes of Securities and Exchange Board of India (Sebi) regulations, there was no reason why they should not be treated as such for the purpose of taxation. It said that taxation law, being a specific legislation just as the Sebi Act, 1992, should prevail over the general Trust Act (Indian Trusts Act, 1882).
 
Going by the ruling, trusts could be seen as entities providing fund management services to contributors or unit holders, implying that the expenses incurred by them would be subject to goods and services tax (GST). These expenses typically include fund management fees, trustee fees, legal fees, and audit fees, which are deducted from the investments made by the investor.
 
GST on expenses charged by these vehicles could translate to a tax levy running into hundreds of crores. This could jack up costs significantly for investors as well as funds, and pave the way for a host of tax litigations, said experts.
 
“The ruling, if unchallenged, can cut across any form of pooled investments including REITs, InvITs and even mutual funds. You could see GST being applied on the expenses charged by these vehicles, which could push up costs significantly for investors,” said Siddharth Shah, partner, Khaitan & Co.
 
“Applicability of GST on all expenses would result in additional cost to investors and the fund itself. Funds will now need to examine whether GST would be applicable on all categories of expenses (on application of principles of composite supply) or whether it would apply in respect of those categories that are ‘cash expenses’,” added a tax expert.

In general, a trust is a special purpose vehicle created under Sebi guidelines and serves as a pooling vehicle. These vehicles are structured as trusts to avail of tax pass through status, which is the global standard for taxation of investment funds.
 
“A lot of these funds are created on the premise that these vehicles are pass-throughs or passive investment vehicles. Going by the ratio from this ruling, any form of differential distribution of profits among contributors would always be open for challenge and lead to tax litigations, which would be undesirable for the asset management industry,” said Shah.
 
This can impact the profitability of asset management companies, said a senior MF official.
 
According to him, providing services requires an entity to have people, system, processes, and technology, and a standalone entity, such as a trust, which does not have any of these and is taking the help of a third party, cannot be deemed as providing services. “We have discussed the matter at AMFI and are monitoring the situation closely,” he said.
 
At present, GST is paid on management fees. This means expenses that are debited where GST is not paid could potentially be subject to the additional service tax. The additional GST, if charged, will need to be within the total expense ratio (TER) limit set by Sebi. TER is an annual expense that is capped at 2.25 per cent for equity-oriented schemes and 2 per cent for other schemes.
 
Interestingly, the Central Board of Excise and Customs had in a 2007 circular clarified that entry and exit load charges by MFs were not subject to service tax, as they were in the nature of initial issue expense.
 
REITs, InvITs, and MFs all operate within a trust structure, with a few common entities such as the sponsor, who creates the trust and pools in the initial capital; trustees who manage the trust and supervise the asset management company; and, the asset manager appointed by the trust to invest the pooled money.