Even though the category is the second largest among the alternate investment fund (AIF) categories, with ₹1.29 trillion worth of investor funds raised so far, the tax rules are not clear.
“Unlike other investment products, which clearly fall under a specified tax regime, the category III AIF does not have a well-defined tax framework yet. These AIFs are mostly set up as trusts and therefore get taxed under trust rules,” explained Tushar Sachade, partner at Price Waterhouse & Co. LLP.
Here is a look at some of these tax issues and issues that already affect investors’ post-tax returns due to the lack of an investor-level tax regime.
No pass-through status
Category III AIFs do not have a pass-through status, which means that all taxes are levied at the fund level rather than the investor level.
As mentioned earlier, category III AIFs are set up as trusts. Hence, the various rules that govern the tax treatment of trusts also apply to category III AIFs. There is also some haziness with the court ruling that these AIFs can be treated as ‘determinate’ trusts. At the same time, the strict interpretation of tax rules implies that the open-ended structure of category III AIF is ‘indeterminate’.
More on that later.
Returning to the lack of pass-through status, why is this an issue for investors?
The investor may not always benefit from the long-term tax rate on capital gains (12.5% on listed stocks) despite holding the fund for more than a year, which is the threshold period to be eligible for long-term capital gains. Simply because the investor’s own holding period doesn’t matter due to the lack of pass-through, but the fund’s holding period is the deciding factor.
For example, if the fund buys and sells a stock within a year, any gains from the stock will be taxed at a 20% short-term capital gains (STCG) tax rate. This will impact the fund’s NAV (net asset value) and, thereby, the investors’ exposure to it. An investor holding the fund for more than one year will also be impacted by the same STCG rate.
Similarly, any gains from the derivatives strategies are treated as business income, and the fund is taxed at the maximum marginal rate of 39%. It is possible that the investor’s own slab rate is lower, but as the fund will be taxed at the maximum marginal rate, the investor will, by default, get taxed at the same rate.
The investor can’t benefit from the set-off or carry-forward of losses. “As the losses are booked at the fund level, the capital losses (if any) are not available to the investor,” pointed out Nalin Moniz, chief executive officer at Ionic Asset Management.
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Similarly, capital losses on other investments are not available for set off against the gains on category III AIF investments.
With other investments, an investor can book capital losses and use them to set off gains from other investments — stocks, real estate, bonds, etc. — and then pay taxes on the net capital gains after these deductions. The unabsorbed losses — when capital loss is more than capital gain — can be carried forward for eight subsequent financial years; after the year in which the capital loss is originally incurred.
Trusts
The issue is not so much that the AIFs are set up as trusts for operational ease as the lack of clear tax rules for category III AIFs.
“Mutual funds (MFs) are also set up as trusts, but they have a well-defined tax framework, wherein no taxes are payable by the mutual fund on the transfer of underlying securities (as the income earned by MF houses is exempt from tax) and taxes are paid by the investors at the time of transfer of MF units, depending upon the holding period of the said units by each investor,” pointed out Riaz Thingna, partner at Grant Thornton Bharat LLP.
“The first level of uncertainty comes from whether an open-ended category III AIF should be considered a determinate or indeterminate trust. According to the legal definition of determinate trust, the trust is determinate if the beneficiaries are named in the trust deed, and the share of the beneficiaries is also prescribed in the trust deed at the time of formation,” pointed out Sachade of Price Waterhouse.
However, past court rulings have stated that a trust can be considered determinate as long as the beneficiary and their percentage share can be identified at any time. Advance Authority of Rulings (AAR) made this observation in 1996.
The Central Board of Direct Taxes (CBDT) issued a circular in 2014, restating the original definition of a ‘determinate’ trust. However, the Karnataka High Court ruling in 2017 again held the view of AAR. More recently, Madras High Court held the same view in an order issued in 2020.
AIFs rely on these past court rulings, and the industry practice considers AIF a determinate trust.
The determinate trust rules state that it needs to be taxed at the same rate as the beneficiary would be taxed on their income. So, if it is capital gains income, the capital gains tax rates apply. The only condition is that if the fund has business income, i.e. income from derivatives strategy, the maximum marginal tax rate of 39% applies.
For ‘indeterminate’ trusts, all categories of income are taxed at the maximum marginal tax rate of 39%.
“There is also a risk of double taxation as the units are now classified as separate ‘security’ under SCRA — Securities Contracts Regulation Act,” said Sachade. The Finance Bill 2021 included AIF units as ‘securities’.
So, this has created another grey area on whether an investor can be taxed on capital gains on redeeming units after the fund has already been taxed on capital gains on underlying securities.
Industry seeks clarity
“As an industry, we have been seeking clarity on these things — clarity on considering cat III AIFs as ‘determinate’ trusts, once it is ‘determinate’ clarity on maximum marginal rate and special rates. It should also be clarified that there will not be double taxation if the tax has already been levied at the fund level,” said Rahul Shah, executive vice president of the industry body — Indian Venture and Alternate Capital Association (IVCA). Special rates refer to capital gains tax rates — short-term capital gains tax rate of 20% and long-term capital gains tax rate of 12.5%.
“We have also been seeking pass-through status so that taxation is at investor-level,” he added.
“Just to reiterate, the industry is not seeking tax concessions; it is asking for clarity and the appropriate amount of taxes being recovered from the right beneficiaries,” Sachade said.
Industry participants feel regulatory certainty will drive the industry’s next growth phase. “Clarity on the various tax issues and more regulatory certainty will also encourage more innovation in the AIF category, attract global investors, and lead to more job-creation and development for the industry,” said Vaibhav Sanghavi, chief executive officer of ASK Hedge Solutions.
Key takeaways
- Despite being established in 2012 and managing significant investor funds, Category III AIFs operate without a dedicated, well-defined tax regime, unlike other investment products like mutual funds.
- Taxes are levied at the fund level rather than the investor level.
- Fund-level taxation means investors may not benefit from lower long-term capital gains rates even if they hold the fund long-term, derivative income is taxed at maximum marginal rate within the fund, and investors cannot utilize losses generated within the fund to offset their other capital gains or carry forward those losses.
- Clarity needed on treatment of these AIFs as ‘determinate’ trusts.
