The Firm

Show Timings:

Friday: 10.30 pm, Saturday: 11.30 am

Sunday: 9:30am & 11.00pm


Tax Shocker For Private Equity

Published on Sat, Aug 02,2014 | 13:48, Updated at Sat, Aug 02 at 13:53Source : CNBC-TV18 |   Watch Video :

On Monday evening, this week, a circular from the tax department took the private equity industry by surprise.  The CBDT clarified the taxation of Alternate Investment Funds in a way that threatens the very basis of how the private equity industry structures its funds and raises capital. Payaswini Upadhyay reports on the CBDT surprise and its implications.

SEBI’s 2012 Alternate Investment Funds or AIF regime categorized funds based on their objective, investment restrictions and benefits that they’d like to avail. Category 1 includes Venture Capital funds, SME funds, infrastructure and social venture funds. Category II includes private equity and debt funds and domestic hedge funds fall under Category III.

The Budget next year brought taxation relief for AIFs but only for Category I. They were given a tax pass through status meaning the income is tax exempt at the fund level and is taxed in the hands of the investors.

Category II or PE funds are taxed based on how they structure the fund i.e. as a company, an LLP, or a Trust. So far, the industry has followed a Trust structure

Anish Thacker
Partner- Tax & Regulatory Services, EY.
“Private Equity funds have usually been structured as Trusts. As per the AIF regulations, you can structure them either as companies or as Limited Liability Partnerships or as trusts. Now companies have an issue in terms of dividend being distributed taxed once again. LLPs are regulated entities and require extensive compliances and therefore Trusts were the most popular route in terms of how they were structured because they are relatively easier to manage and you have to have only a Trustee and an asset manager and not too much of regulations around it.”

Prakash Nene
MD, Multiples Alternate Asset Management
“While there are several options, almost everyone structured as a Trust. First you make a Trust, you register it with the Registrar of Assurance, then go ahead and prepare a contributory agreement and ask investors to invest based on that contributory agreement and that is how all the PE funds are structured.”

The Trust structure came handy for tax benefits. Under the Income Tax Act, determinate trusts get a pass through status.

For a Trust to qualify as a determinate Trust, the names of the beneficiaries should be specified in the trust deed and the on the date the trust deed is signed, the individual share of the beneficiaries should be ascertainable. If a Trust doesn’t pass these two tests, it is taxed at the Maximum Marginal Rate of 30%.  

Prakash Nene
MD, Multiples Alternate Asset Management
“Most PEs fall under Category II and there is no pass through status there. Everybody hoped that while there is no specific pass through status available, you have what is called the Indian Trust Act, 1882 which provided that under certain Sections, you could still claim benefits on likewise-like manner and everybody assumed that we will continue to have some kind of status where the Trust itself is not taxed. If at all it is taxed, it will be taxed in the same manner as the ultimate investor would have been taxed. So that was the assumption by most funds.”

This assumption has its roots in the 1996 AIG order by the Authority for Advance Rulings. The AAR had ruled that for a Trust to be a determinate Trust, it is not required that the exact share of the beneficiaries be specified. And that if there is a pre-determined formula by which distributions are made, the trust could still be considered a determinate trust.
Anish Thacker
Partner- Tax & Regulatory Services, EY.
“If I look at it legally, an AAR ruling applies only to the taxpayer who sought it which is AIG in this case, but the ratio of that ruling- the principle of law that was laid down- when you have a formula determined for the allocation of the beneficiaries’ share in the total value of the fund, that should be sufficient to regard a Trust as a determinate Trust rather than a discretionary Trust. I think that was what the industry was relying upon based on past experience that the courts would take a view which would be consistent with that principle.”

This week, the CBDT burst this bubble via a clarificatory circular. It said that where the trust deed does not name the investors or specifies their beneficial interest, the entire income of the fund will be taxed at the Maximum Marginal Rate of 30% plus surcharge.

Prakash Nene
MD, Multiples Alternate Asset Management
“The whole Trust concept and the way Indian funds have been formed in the past will no more reimain valid because no one would like to pay 33% capital gains tax as against normal 10%, 20% or 0%. This is a completely different regime. So now everybody is back to the drawing board to see how to handle the situation.

Nishchal Joshipura
Partner, Nishith Desai Associates
“The challenge could be, for instance, in case of a defaulting investor, there is a provision in the fund documents that the fund can forfeit the units of the investor in which case the beneficial interest – percentage- of all the contributors change. Similarly, under new amendment of SEBI’s AIF Regulations which was introduced a few months back, SEBI has mentioned that in case there is a material change in the private placement memorandum, the fund needs to give exit option to the investor. Now if some of the investors exercise their investment option and the other investors don’t, then again there will be change in beneficial interest percentage in which case there will be a risk of pass through status benefit of the Trust going away.”

Add to that, the problem of tax credit. So far, it was possible for individual investors to offset capital gains from the fund against capital gains losses in their other investments. Now, if the tax is to be paid at the fund level, investors would not be able to get any credit by offsetting. So, what next? Experts told me that PE funds could consider the LLP structure but the tax department may tomorrow argue that since the LLP is formed for the purpose of business and not investment, the income should be taxed as business income. Seems like Private equity is caught between a rock and a hard place!

In Mumbai, Payaswini Upadhyay


Copyright © Ltd. All rights reserved. Reproduction of news articles, photos, videos or any other content in whole or in part in any form or medium without express written permission of is prohibited.