Investment fund taxation: a platter of ambiguities

The regulations governing venture capital funds have been revamped and a new regime has been formulated for registration of an alternative investment fund (AIF) with the Securities and Exchange Board of India. The new regulations are much wider in scope.

A category I AIF has been equated with a venture capital fund and given a tax pass-through status whereby the income will be taxable in the hands of the investors directly.

This taxation position, which was only an interpretation when the AIF regulations were introduced, will obtain the effect of law on the Finance Bill, 2013, attaining the status of the Finance Act, 2013.

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Two kinds of trusts

If an AIF takes the form of a trust, its taxation will be based on tax law provisions which lack clarity, giving rise to ambiguities.

The taxability of a trust depends on whether the trust is determinate or indeterminate. A determinate trust is one where the beneficiaries and their respective shares are ascertainable. An indeterminate trust is one where the beneficiaries and their respective shares are unknown or unascertainable.

If the trust is characterized as determinate, the trustees will be taxable as a representative assessee and any income distributed to the beneficiaries will not be taxable in their hands, as the trustees are statutorily required to discharge the tax liability on behalf of the beneficiaries. Conversely, if the trust is characterized as indeterminate, the income of the trust is charged at the maximum marginal rate (MMR) and any distribution to the beneficiaries is not taxable in their hands.

This is the general tax position in relation to taxation of a trust, however, when this is applied to taxability of an AIF, the issues vary, depending on whether the AIF is a “closed-end fund” or an “open-end fund”.

Closed-end fund

If the AIF is a closed-end fund and treated as a determinate trust, the tax implications of sales/redemptions of investments by the fund and any transfers made by the investor before the maturity need to be evaluated. On the sale of investments by the fund in a portfolio company, the fund/trustees will be taxable as representative assessee on the profits earned and any distribution to the investors should be tax free.

While this tax position appears to be clear, an issue which requires consideration is: will the investor be able to claim credit of the taxes withheld at the time of sales of investments by the fund which are subject to deduction of tax and tax is deducted by the investee company?

As regards taxation on transfers before maturity, a similar tax position cannot be applied, as it needs to be evaluated whether the fund or the investor or both will be taxed and, if both, will that lead to double taxation of the same income.

No set tests

The above discussion applies only where the fund is treated as a determinate trust. The law does not expressly set out tests to determine in what situations a trust is to be treated as determinate or indeterminate.

Courts have held a trust to be determinate if on the date of settlement of the trust deed, the names of the beneficiaries and their respective shares are ascertainable. However, this test cannot be satisfied even in the case of a closed-end fund, as such funds have multiple closings, with the addition of investors at every closing.

Also, an investor always has the option to transfer its units to a third party. In such a situation, whether the trust will continue to be treated as a determinate trust is an issue which needs to be evaluated on the facts of each case.

Other gaps

Turning to the taxation of an open-end fund, which is likely to be an indeterminate trust, the fund will be taxed at the MMR and any distribution made to the investors is tax free.

However, there is no express provision under the law to treat the distribution made by a trust as tax free in the hands of the investors. The situation could be further complicated where the redemption or transfer of a fund’s units is undertaken at net asset value built up by unsold underlying investments.

Thus, the AIF regime continues to present a platter of ambiguities, at times leading to double taxation of income. It was expected that the Finance Bill would either provide a tax-pass through status to the category II and III AIFs as well or provide clarity as to their taxation. Instead, these funds along with their investors will have to continue to rely on the tax interpretations to ascertain their tax liabilities.

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Economic Laws Practice is a full-service law firm with headquarters in Mumbai and offices in New Delhi, Pune and Ahmedabad. Pranay Bhatia is a partner at the firm and Vidushi Maheshwari is an associate.