This year?s Budget came with a number of reforms that were announced for alternative investment funds (AIFs). The Finance Minister, in his budget speech, announced that foreign investment will be allowed in AIFs going forward. Although this is a positive development, one has to wait and watch as to how this measure will be implemented.
Globally, funds have been accorded pass through status to ensure fiscal neutrality whereby funds do not discharge tax at an ?entity-level?. Instead, tax liability should fall on the investors in a fund depending on their respective tax statuses. True pass-through tax treatment is accordingly an integral aspect for the fund economics to work.
In response to a long-standing demand of the investment funds industry in India, the Finance Minister sought to extend pass through status to AIFs that are registered with the Securities and Exchange Board of India (SEBI) as Category I AIFs or Category II AIFs under the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations).
Prior to the Finance Minister?s announcement, pass-through status was only available to Category I AIFs under the venture capital fund sub-category and venture capital funds that were registered under the erstwhile SEBI (Venture Capital Funds) Regulations, 1996 (VCF Regulations).The Bill includes a proviso to section 10(23FB) of the ITA pursuant to which Category I and Category II AIFs that are registered under the AIF Regulations will be taxed according to the new rules set forth in the newly introduced Chapter XII-FB of the ITA. Consequently, venture capital funds registered under the erstwhile VCF Regulations will continue to be eligible to claim the exemption under section 10(23FB) in respect of income from investments in venture capital undertakings.
The Bill defines an ?investment fund? to mean a fund that has been granted a certificate of registration as a Category I or a Category II AIF and provides that any income accruing or arising to, or received by, a unit-holder of an investment fund out of investments made in the investment fund shall be chargeable to income-tax in the same manner as if it were the income accruing or arising to, or received by such person had the investments made by the investment fund been made directly by the unit-holder. In other words, the income of a unit-holder in an investment fund will take the character of the income that accrues or arises to, or is received by the investment fund.
However, the Bill contemplates that income chargeable under the head ?Profits and gains of business and profession? will be taxed at the investment fund level and the tax obligation will not pass through to the unit-holders. In order to achieve this, the Bill proposes to introduce two provisions:
- Section 10(23FBA) which exempts income of an investment fund other than income chargeable under the head ?Profits and gains of business or profession?; and
- Section 10(23FBB) which exempts the proportion of income accruing or arising to, or received by, a unit-holder of an investment fund which is of the same nature as income chargeable under the head ?Profits and gains of business or profession?.
Where the total income of an investment fund in a given previous year (before making adjustments under section 10(23FBA) of the ITA) is a loss under any head of income and such loss cannot be, or is not wholly, set-off against income under any other head of income, the Bill allows such loss to be carried forward and set-off in accordance with the provisions of Chapter VI (Aggregation of Income and Set Off or Carry Forward of Loss). Further, the Bill provides that the loss will not pass through to the unit holders of an investment fund and accordingly, the unit holders will be precluded from off-setting their proportionate loss from the investment fund against other profits and gains that they may have accrued. This is unlike under the current rules for taxation, where a trust is regarded as being a determinate trust or where an investor?s contribution to the trust is regarded as a revocable transfer, in which case the investor retains the ability to off-set its proportionate losses against its other profits and gains.
If the income of an investment fund in a given previous year is not paid or credited to the account of its unit-holders at the end of the previous year, such income will be deemed to have been credited to the account of its unit-holders on the last day of the previous year in the same proportion in which the unit-holders would have been entitled to receive the income had it been paid in the previous year.
An important feature of the pass-through framework is the requirement to deduct tax at 10% on the income that is payable to the payee as outlined in the newly proposed section 194LBB of the ITA. In view of the rule mandating the deemed credit of income to the accounts of unit-holders, the Bill extends the requirement to deduct tax to scenarios where income is not actually paid or credited but only deemed to be credited.
A welcome move provided for in the Memorandum to the Bill is that income received by investment funds would be exempted from TDS by portfolio companies. While a separate notification would be issued in this respect, when implemented, this should be helpful in case of interest / coupon payouts by portfolio companies to such funds. Previously, it was administratively difficult for investors to take credit of the TDS withheld by portfolio companies.
While the proposed pass-through regime is a welcome development, it is not without its set of difficulties. For example, the withholding provision in its current form would apply to exempt income such as dividends and long-term capital gains on listed equity shares. Further, no clarity has been provided on whether the withholding obligation would also apply in respect of non-resident investors who are eligible to treaty benefits. While section 195(1) of the ITA casts a withholding obligation only on sums that are chargeable to tax under the provisions of the ITA, it would have been preferable if the Bill clarified that section 194LBB would not be applicable in connection with the credit of income to an investor that is eligible for treaty benefits.
About the author
This article is written by Nishith M. Desai