Will Finance Minister Arun Jaitley provide some clarity on different and confused tax provisions, especially for investment vehicles such as mutual funds, trusts and private equities in the Budget 2015?
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. 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, especially when international investors are invariably flummoxed about tax uncertainty. 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).
CBDT circular and Bangalore ITAT ruling
A recent ruling of the Bangalore ITAT in the case of M/s India Advantage Fund –VII vs. Dy. Commissioner of Income Tax
, examined the general representative tax principles in India, conditions of taxation of an AOP, tests for determinacy of beneficiaries in case of a trust, and was particularly helpful is expanding/ extending the benefit of a CBDT circular issued recently on 28 July 2014.
The CBDT circular had the effect of laying down, as most assessing officers would have believed, that a trust will be taken having determinate beneficiaries only if the beneficiaries were named in the trust deed. On the contrary, the ITAT rules that even if beneficiaries are added later, as long as beneficiaries could be ascertained with the help of the trust deed, the trust will still be a determinate trust. As a corollary, it may be safe to hold that even where beneficiaries change hands subsequently, the determinacy test will still be satisfied.
The ITAT held on the issue that as long as the trust deed gives the details of the beneficiaries and the description of the person who is to be benefited, the beneficiaries cannot be said to be uncertain. Where the beneficiaries are determinable irrespective of the percentage share being prescribed at the inception, the business trust would be construed to be a determinate trust and the trust should be a pass-through.
The ruling came as a spite in the much ambiguous tax environment pertaining to business trusts. However, a ruling is, after all, is a ruling, and it comes from a tribunal. Grapevine is that the Department has already gone in appeal against the ruling. The High Court’s decision, which normally may take quite a few years, may be a cliff hanger. In the meantime, tribunals from different other places may have different rulings to offer. And who knows how many years will this whole process take?
In the meantime, many of the AIFs would have been redeemed. The trustees or the asset managers may still be around. The Department’s action, or even show causes, may cause shockwaves among the asset managers. After all, the Vodafone episode clearly indicates that what international investors are invariably flummoxed about is tax uncertainty. Therefore, the investments into the country suffer.
Securitisation distribution tax has killed securitisation transactions:
The Union Budget for 2013-14 introduced taxation regime for securitisation transactions by inserting Chapter XII – EA in the Income Tax Act, 1961. Pursuant to the insertion any income distributed by the securitisation trust/ SPV was to suffer distribution tax. The tax provisions were similar to those applicable to mutual funds. The distribution tax regime adversely impacted the securitisation industry. The distribution tax applicable on income distributed by securitisation trusts has the following drawbacks:
a. The distribution tax is on the gross income. The investors in securitised instruments are all leveraged entities, who have their own expenses, primarily interest. The net income of such investors is only a small fraction of the gross income received by such entity. Clearly enough, if an investor in securitisation has to pay tax on gross incomes, not only is the tax offensive, it is also outright inequitable, as it fails to take into consideration the leverage of entities. At the same time, a tax based on gross income ignores the profits or losses of the investor, and becomes particularly inequitable in case of losses.
b. In the Indian context, investors in securitised debt instruments have generally been mutual funds, banks, financial institutions, non-banking financial companies and insurance companies.
i. The chapter exempts mutual funds from the applicability of distribution tax.
ii. For investors such as banks, insurance companies etc. the gross income from the investment would be taxed at a flat rate of, effectively, 28% / 34% at the trust level. Further investors would also suffer disallowance of expenses incurred in relation to the income from PTC’s under section 14A of the Act.
c. Such distribution tax regime would, generally, hold good where there are a number of retail investors earning income, as in the case of Mutual Fund paying income or a company paying dividend. In such cases, admittedly, it is onerous to track if such income/ dividend is offered to tax by the investors. However, contrary to this, securities issued by the SPV are, generally, subscribed to by institutional investors. The number of investors in each SPV would, generally, range between 2 to 20. Therefore, it is highly unlikely that the income earned by such large investors will go unreported.
REITs are a non-starter:
REITs, supposedly initiated by the Budget 2014, have been a non-starter. SEBI came up with its final regulations in September, 2014; however, REITs are yet to make a debut. Our interaction with the potential sponsors clearly indicates that tax issues are keeping them on the hold.
In fact, REITs are clearly a model adopted from the USA, which allows full tax transparency to REITs, subject to a mandatory norm for distribution of a minimum 90% of the taxable income. Interestingly, SEBI regulations still follow the 90% mandatory distribution norm but the tax pass-through is only in case of interest income. This appears quite queer, because in view of the nature of an REIT, it is unlikely that an REIT will have an interest income. The most likely source of income is rentals – and there is no tax pass through on rental income.
Ideal structure for investment conduits: A conditional pass through:
The ideal structure for investment conduits is conditional pass-through. The SPV is called a see-through conduit, as the tax laws can see the investors receiving the income through the SPVs. Pre-conditions for see through approach:
• The SPV is a non-substantive body; investors are the real owners of the pool
• The SPV’s organisational form does not matter
• Trustees must have no discretion in application of income
• The share of income received by the participants must mirror proportionate share in the income of the SPV – proportionate to the interest of the investors
• See-through approach relates to gross income of the SPV and not residual income
• Tranching amounts to re-allocation of income and disturbs the parity between income received by the SPV and distributed by the SPV
• There must not be an equity class entitled to variable, residual income
If there conditions are satisfied with regard to any business trust, then the tax authorities must see through the SPVs to tax the ultimate investors making the funds structure more conducive for existence.
(Vinod Kothari is a chartered accountant, trainer and author. Nidhi Bothra is executive vice president at Vinod Kothari Consultants Pvt Ltd