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CBDT Circular: Blow For AIFs!

Published on Fri, Aug 01,2014 | 21:54, Updated at Fri, Aug 01 at 21:54Source : 

By: Prakash Shah, Associate Director - Tax & Regulatory Services, EY

The Central Board of Direct Taxes (CBDT) has in a recent circular dated 28 July 2014 (Circular) clarified its position in relation to tax treatment of Alternative Investment Funds (AIFs) which are formed as  non-charitable trusts.

The AIFs that are registered as Venture Capital Fund (VCF) Category I AIFs are exempt from tax under section 10(23FB) of the Income-tax Act, 1961 (Act) in respect of income earned by it from Venture Capital Undertakings (VCUs). However, the investors are taxed on the said income as if they had made investments directly in the VCUs. The ‘pass-through’ treatment under the said provisions is not available to other Category I AIFs (i.e. SME funds, Infrastructure Funds etc) as well as Category II and III AIFs. Thus, the taxation of these trusts is determined under the general provisions of the Act as applicable to non-charitable trusts.

As per the general provisions for the taxation of non-charitable trusts, the income of a determinate trust (i.e. trusts whose beneficiaries and shares are known) is taxable in the hands of the ‘trustee’ in the same manner and like extent as the beneficiaries. Thus, if the income would have been exempt from tax (for e.g. a foreign investor from a favourable jurisdiction) / taxed at a lower rate in the hands of the beneficiaries, the same treatment would apply in the hands of the trustee to the share of such beneficiaries’ income. However, a determinate trust whose income includes business income, then whole of the income of the determinate trust is chargeable to tax at the maximum marginal rate (MMR) i.e. 30% (plus applicable surcharge and education cess).

Further, the income of an indeterminate trust is taxable at MMR. The Act provides that a trust will be treated as indeterminate where the individual shares of the persons for whose benefit such income is receivable is not ascertainable on the date of the instrument. In the context of funds, it is not practically feasible to know the names of the beneficiaries at the time of formation of trust as the raising of money typically happens subsequent to the formation of trust/ registration with Securities and Exchange Board of India (SEBI).

The above matter has been examined by the Authority for Advance Rulings (AAR) in a particular ruling (AIG Ruling). The AAR observed that the requirement of specifying individual shares of beneficiaries would stand fulfilled where basis and mechanics of sharing is specified in the instrument even though the names of beneficiaries are not mentioned in the trust deed.

Dissenting from the above ruling, the CBDT has clarified that  in case the  trust deed does not either name the investors /their beneficial interest, then the trust would be regarded as a discretionary or indeterminate trust and the entire income of the AIF shall be taxable at the MMR in the hands of the AIF’s trustee. In such cases, the income-tax authorities should not seek to directly assess the investors of the AIF. The Circular further indicates that where trust is determinate but has any income consisting or including business income then the entire income would be subject to tax at the MMR.
It appears from the Circular that the intent of the revenue authorities is to grant pass through status only to those funds which qualify for exemption under section 10(23FB) of the Act (i.e. Category 1 VCF). Even where the AIF manages to have the names of the investors indicated in the trust deed and therefore it qualifies as a determinate trust in terms of the Circular, the revenue authorities are likely to closely examine the facts to determine whether the income earned by the Fund is ‘business income’ or ‘capital gains’. In one of the rulings rendered in the context of a Mauritius fund (TCW ICICI), the AAR held that since the fund was formed with the objective of acting as an investment company for buying and selling securities and the operations revealed large, intricate and systematic process from earning profits from trading in securities, the income earned by it was ‘business income’. The characterization of income is a very factual exercise and there have been number of judicial precedents on the subject and courts have adopted divergent views on seemingly similar kind of facts.

The above Circular would be a challenge to the AIFs which have treated the income earned by it on sale of securities as capital gains and have discharged taxes in the same manner as applicable to the investors. The trustees/ sponsors may have to assess how they would safeguard themselves against residual liabilities should there be any demand that arises on account of interpretation set out in the Circular. Having said that, it is important to note that the CBDT circular is binding only on the income tax authorities and not on the taxpayers and courts.

On a separate note, Budget 2014 has proposed that certain class of resident taxpayers (as may be notified by the Central Government) may file an application for ‘advance ruling’ on any transaction undertaken or proposed to be undertaken. It would be interesting to see the threshold/ categories of resident taxpayers that will be notified.

The Circular is certainly a blow for the AIF industry and ought to be withdrawn. Given the significance of the AIF industry to the economy as a whole and in order to provide a regime that gives a boost to the AIF Industry, the above Circular definitely needs a re-consideration.

(Kushal Parikh, Senior tax professional, EY contributed to the article)

(Views expressed are their personal)


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