Financial markets are hopeful that the Budget will clarify different and confused tax provisions regarding investment vehicles such as mutual funds, trusts and private equities
All over the world, there are clear rules for being eligible for pass-through status, but unfortunately, the principles on representative taxation in India have never been designed to tax collective investment devices. These principles have been created over the years to tax trusts where tax payers may create pools of assets/ income which beneficially belong to a tax payer, but are not legally his. Therefore, there are situations where such a “representative assessee” is required to pay tax at maximum marginal rate (MMR) which defeats the purpose of these collective investment vehicles at the first place.
The least what Finance Minister Arun Jaitley should do, in Budget 2015, is to set right the highly distorted scene of taxation of investment vehicles. These vehicles include the private equity (PE) funds and venture capital funds (VCFs), collectively called alternative investment funds (AIFs), securitisation vehicles, real estate investment trusts (REITs) and infrastructure investment trusts (InvITs). Lest you should think these are some esoteric instruments that don’t matter to the country’s economy in general, you are actually mistaken. Each of these investment vehicles is crucial for the country’s economy:
A large part of the foreign direct investment into the country comes through these vehicles. Over years, private equity funds have brought billions of funds into the country.
The India Private Equity Report, 2014 states that in 2014, Indian PE industry did deals worth $11.8 billion -- lower than the 2011 levels which were at $14.8 billion. It is important to note that capital is much more important than debt- capital and is like the foundation of a business on which the edifice of debt is built.
• Securitisation activity is crucial for the business model of the non-banking finance companies in the country which supplement bankers’ access to the so-called priority sector lending market. NBFCs are instruments of financial inclusion, and their business model substantially hinges on securitisation.
• REITs have been proposed in the last Budget, but have not taken off at all. REITs are expected to be crucial in reviving or unlocking investments in commercial real estate. Commercial real estate has a substantial multiplier effect - it brings employment, affects core sector industries, and so on.
• Infrastructure investment trusts, another non-starter, was expected to revive the so-very-crucial infrastructure sector in the country.
Tax issues continue to baffle funds:
Currently, the tax law pertaining to taxation of investment conduits is either legislatively uncertain, or is lopsided. The different taxing principles under the Income Tax Act, 1961, for taxing different forms of investment vehicles in India are as follows:
• Mutual funds, taxed under Section 115 R
• Venture capital funds, taxed under Section 10 (23FB) read with Section 115U
• Alternative investment funds – no tax provisions, hence, taxed under normal tax principles of representative taxation
• Securitisation trusts – taxed under Section 115TA to 115TC (Chapter XII EA)
• Real estate investment trusts – Section 10 (23FC), 10 (23FD) and 10 (38) read with Section 115 UA
• All other collective investment vehicles – no tax provisions, hence, taxed under normal tax principles of representative taxation
The various fund structures existing in India are covered by different tax regime. Even though the fund structures are similar, the practice of applying different tax principles on them is not clear. This divergence creates much ambiguity on the whole. In some investment vehicles there is a partial pass-through and in some cases there is representative taxation made applicable. While the intent with which each of these vehicles is set up is similar, the tax implications vary across vehicles.
Most of these vehicles are set up in a trust form (a non-charitable business trust) and there have several issues with regard to such trusts being revocable, determinate, discretionary or otherwise. The tax treatment of these trusts has been dependent on the nature of these trusts.
The critical issue in taxation for consideration, for all these conduits is whether there will be a pass-through for tax purposes, or the fund is a tax-opaque entity. A pass-through taxation is the most convenient form of taxation, as the investors pay their own taxes, and the fund as a collective investment device is not required to pay any taxes at the fund level. All the more there is no duplication of taxes or leakage of taxes. On the other hand, if there is a claim to tax as an AOP, company, firm or as a representative assessee, the fund itself is not tax transparent. The tax officer taxes the fund; the distributions made by the fund may not be chargeable to tax.
Far from following a clean pass-through principle, the Indian system is extremely muddy, allowing for contradictory interpretations. A recent ruling of Bangalore Income Tax Tribunal has shown this. We explain that in the next part, and also how to clean things up.
is a chartered accountant, trainer and author. Nidhi Bothra
is executive vice president at Vinod Kothari Consultants Pvt Ltd)