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Tax Cheer For Private Equity!

Published on Sat, Nov 08,2014 | 10:15, Updated at Sat, Nov 08 at 10:18Source : CNBC-TV18 |   Watch Video :

In July a CBDT circular clarifying taxation of Alternate Investment Funds upset how the private equity industry structures funds. That’s because the Department clarified that PE funds structured as Trusts must name the investors and their beneficial interest upfront- a tall order as private equity funds have multiple closings with investors coming in at different points in time. But maybe there is a reprieve in sight? A recent Bangalore ITAT decision in the ICICI India Advantage Fund case said funds- structured as Trusts- can get a pass through status for tax purposes. Payaswini Upadhyay asks experts if that Tribunal ruling comes as a relief for the private equity industry?

The Bangalore ITAT ruling, for the first time, deals with 3 important principles of Trust taxation.
- One, revocability provisions and consequent tax implications
- Two, when can a Trust qualify as a determinate trust
- And three, whether an investment fund is an Association of Persons subject to a higher tax rate

The case pertains to the India Advantage Fund that was set up as a Trust. The Trust declared an income of Rs 1.8 cr and made a case before the tax department that the beneficiaries will offer the income for tax and not the Trust. The Assessing Officer concluded that the Trust was in the nature of a discretionary or non-determinate trust and hence taxable at Maximum Marginal rate of 30% at the trust level. The AO’s order was reversed by CIT Appeals who held that since the Trust was a revocable Trust, it cannot be taxed at the Trust level. The tax provisions for a revocable trust say that the income will be taxed at the hands of the contributor and not the trust. The Tribunal upheld the view of CIT Appeals on grounds that the Trust Deed gave the investors the power to revoke their contributions and so the income earned by the trust is taxable only in the hands of the contributors.

Punit Shah
Partner- Tax, KPMG
“Fortunately, if you look at the ruling, it says that any revocability within the document is good enough. So it need not be that 100% of the fund should be revocable; it need not be that 1% can revoke it. Revocability in any form by any agency involved is good enough to make the Trust or the fund revocable and therefore avail of the tax pass through benefits.

The revocability principle assumes importance because if a Trust doesn’t permit revocability, it needs to qualify as a Determinate Trust to get a similar tax pass through status. For a Trust to be Determinate, the names and individual shares of the beneficiaries should be spelled out on the date the trust deed is signed.  If a Trust doesn’t pass these two tests, it is taxed at the Maximum Marginal Rate of 30%. The cause of Determinate Trusts was helped by the 1996 AAR ruling in the matter of AIG. The AAR ruled that the exact share of the beneficiaries need not be specified. Even if there is a pre-determined formula by which distributions are made, the trust could still be considered a determinate trust.

This ruling prevailed till July this year…when CBDT dropped a bombshell. The Board issued a circular saying where the trust deed does not name the investors or specifies their exact beneficial interest, the entire income of the fund will be taxed at the Maximum Marginal Rate of 30% plus surcharge.

Prakash Nene
Managing Director, Multiples Asset Management
“First of all, everybody was surprised with that circular because the circular overrules a laid down position since 1996 by the AAR in the case of AIG. The way people have been working since this Circular is can we do one single closing rather than multiple closings and put all the names. But again there will be issues on transfers from one individual to another that would vitiate the whole thing. Some people are thinking can we have an alternate structure which is not a Trust but a Limited Liability Partnership – that’s one way of overcoming this. People are trying different things but I don’t think anyone has come out with a perfect structure as yet.”

Nishith Desai
Founder, Nishith Desai Associates
“There are two concepts under the Income Tax Act-one is straight forward revocability and second is what is called deemed revocability. So under the deemed revocability, in the placement memorandum for example, you provide that 75% of investors can come together, dismiss the investment manager, blow off the Trust and get back the money. So the Tribunal has very wisely stated that there could be direct or indirect revocability. But if you understand the business, then we will go more under the deemed revocable provisions rather than direct because direct will cause lot more problem to the investment manager and the other people involved.”

By interpreting the revocability provisions in a wide manner, the ITAT has given the PE industry an additional structure to work with.

Additionally, it has also grandfathered Trusts set up before CBDT’s July circular. The Tribunal ruled that the maximum marginal rate will not apply to a Trust even if doesn’t name all the beneficiaries and since the Circular came out after the India Advantage Fund was set up, it has no application.

Prakash Nene
Managing Director, Multiples Asset Management
“I think the precedent value of the case would be more for the past- people who have exited or assessments going on for 2007-08-09-10 and which are similarly structures as the India Advantage Fund and I believe a lot of funds are similarly structured. It definitely has a positive value; we still have to see if the Department appeals this ruling. As far as future structures, exits are concerned, I doubt one can derive too much of comfort from this.

The third principle in this ruling that has brought cheer for the private equity industry is the way the Tribunal has ruled on the concept of Association of Persons or AOP. In the case of India Advantage Fund and many such structures, the tax department has been alleging that the investment fund is an AOP. Once a fund gets classified as an AOP, it is taxable at the Maximum Marginal rate of 30% plus surcharge. Now, the tribunal has ruled that since the contributors of India Advantage Fund made contributions to the Trust under individual Contribution Agreements, it cannot qualify as an AOP.

Punit Shah
Partner- Tax, KPMG
“If one looks at the situation of funds where several contributories come together at the instance of the investment manager, they are investing their funds and getting their gains, I don’t think that gives rise to a situation of AoP because in an AoP certain people come together on their own for a common objective, there are common resources, there are common expenses, there are common gains to be made. In this situation, one investor may not even know the other investor because it’s the investment manager who getting all this activity together of investing and then passion on the gain. And so the Bangalore tribunal has rightfully held that this is not an AoP kind of situation and therefore Maximum Marginal rate of tax should not apply.”

Taxation principles for revocable trusts, what makes a Trust determinate and what constitutes Association of Persons - experts say the Bangalore ITAT has taken a very wide and pragmatic view on 3 three very important aspects of fund taxation. Some experts say that the ruling helps not just pre-CBDT circular structures but future ones too as a Circular is not binding on the taxpayers. And so the industry can continue to benefit from the favorable interpretations in the AAR’s AIG and Bangalore ITAT’s ruling. If that view stands in court- we’ll know once the CBDT’s new circular is tested in the court.

In Mumbai, Payaswini Upadhyay


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