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TAX PASS THROUGH STATUS OF CATEGORY III AIFS: STILL LOOKING FOR A CLEAR PASSAGE?

Updated: Sep 22, 2020

[Dhruv Dinesh Jain and Gayatri Puthran are third-year students at Jindal Global Law School, Sonipat]


Introduction


The concept of alternative investments in India was introduced by the Securities Exchange Board of India (SEBI), vide its notification of the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations). Notably, an Alternate Investment Fund (AIF) is defined as a ‘privately pooled investment vehicle’ with a specific investment policy. The AIF Regulations provide for the AIFs to be registered under three different categories. While Category I AIFs are mandated to invest in start-ups/ SMEs/ social ventures/ sectors considered socially important and having a spillover effect on the economy, Category II AIF includes real estate funds, private equity funds, debt funds etc. While these categories are closed-ended and are not allowed to borrow except for the purposes as stipulated therein the AIF Regulations, Category III AIFs are open-ended and allowed to undertake complicated strategies, engage in leverage, borrow capital and invest in derivatives. Taxation of such AIFs has always been a determining factor for the investors and investment managers. Section 115UB of the Income Tax Act, 1961 (ITA) accords pass-through status to Category I and II AIFs, exempting them from the application of Chapter XII-D/Chapter XII-E of the ITA. However, Category III AIFs are not eligible for this exemption leading to taxation at the fund level instead of the investor, thereby being a major drawback for the investors.


Background

When SEBI first classified venture capital funds, only Category I AIFs were granted pass-through status as thereunder the Finance Act of 2013. A tax pass-through status signifies that income accrued from investing in the units of an AIF will be taxed at investor-level, i.e. according to the tax provisions applicable specifically to an individual investor. In other words, there is no taxation at the fund level. Since Category III AIFs have been excluded from the tax pass-through status, a majority of them are taxed as trusts (majority of the AIFs prefer trust structures for ease in legal, regulatory and tax compliances). Such AIFs are thereby subject to taxation under Sections 161 to 164 of the ITA, which places the tax burden on the representative assesses of the trust (since a trust is not a separate taxable entity). Section 164 states that if the beneficiaries of the trust are ‘indeterminate or unknown’ tax shall be charged on the relevant income or part of relevant income at the Maximum Marginal Rate (MMR). The beneficiaries of a Category III AIFs are rarely determinate for multiple reasons, including their open-ended structure. The Central Board of Direct Taxes in its Circular No. 13 / 2014 in 2014 provided that the Category III AIFs will be taxable at MMR if the names of the beneficiaries of the AIFs are not reflected in the trust deed as on the ‘date of its creation’. In a Category III AIF, the identification of investors generally happens after the execution of the trust deed. Hence, the current regime provides for the Category III AIFs to be taxed at the MMR, i.e. 42.7%. In essence, this leads to the trust as a whole being taxed at the highest possible rate without taking into account the tax bracket applicable for the underlying investors.

Such a provision leads to an unusual situation giving rise to a differential tax regime applicable for Foreign Portfolio Investors (FPIs) and investors of a Category III AIF such that the former is entitled to a special tax rate under Section 115AD of the Act but the latter are taxed at the MMR. The difference in the tax rates somehow favours the offshore hedge funds over the domestic ones. Especially when the hedging of instruments is treated as business income for such AIFs, they are taxed at an effective rate of 42.7%. Investors are in favour of the pass-through status for Category III AIFs, since it would eliminate the risk of double taxation as discussed in detail below. Despite this, the Budget 2020 has remained silent on this treatment of Category III AIFs.


AIPAC Recommendations: Signs of Change?


The Alternative Investment Policy Advisory Committee (AIPAC) constituted by SEBI has submitted four reports analysing the current regime of AIF taxation, as well as appending recommendations to streamline and resolve uncertainties within this regime. First, the foremost benefit of according a tax pass-through status for Category III AIFs would be the elimination of risk of double taxation. Currently, there is a risk of double taxation: at the level of the trust through the representative assesses, and also at the level of the individual beneficiary. This is due to Section 166 of the Act, which allows the authorities to directly tax the individual beneficiaries of the trust. Also, as reported by the 4th AIPAC report, there is no provision for credit to beneficiaries on tax paid by the representative assesses adding to the risk of double taxation. If a pass-through status were allotted, only the amount received from the trust by individual investors would be taxed at the investor level. An added benefit of this would be that the tax charged would be based on the tax bracket of each individual investor ensuring the satisfaction of the canons of equity.

Second, the tax pass-through status would provide domestic fund managers, a competitive edge over the FPIs. The current tax regime indirectly favours offshore hedge funds investing in India through the FPI route. The Indian tax regime unexpectedly provides more clarity and benefits certain for FPIs as compared to the domestic Category III AIFs in terms of characterization of income, even though the regulatory regimes for both are similar. Such a differential approach incentivizes offshore funds, while imperiling domestic fund managers.

Third, not surprisingly, the 3rd AIPAC report also recommended investor-level taxation, wherein short term capital gains for transfer of units are taxable at MMR, while long-term capital gains are taxed at 20% for residents and 10% for non-residents. These rates are proposed to be inserted as ‘Section 111B’ of the Act. It is for this reason that AIPAC, in its draft of proposed amendments, recommended adding ‘any units issued by an investment fund’ under the definition of ‘capital asset’ in Section 2(14) and ‘a unit of an equity-oriented investment fund’ under the definition of ‘short term capital asset’ under Section 2(42A) of the Act. The 3rd and 4th AIPAC reports also recommend the addition of Section 10(23DB) to provide a pass-through status. The AIPAC advocated for the new sub-clause to exclude ‘income of an investment fund’ from total income with the proposed explanation defining an ‘investment fund’ as a fund having a certificate of registration as a category III AIF regulated by SEBI (AIF) Regulations 2012.

Demystifying The Mystery Around Category III AIFs


In what could be one of the primary reasons for the Category III AIFs not being offered such relaxations is their ability to turn the market upside down within a matter of hours. Given that the majority of Nifty 50 is overvalued (in Price to Book terms), incentivising speculative funds such as Category III AIFs would be a dangerous move amidst the pandemic’s effect on the investor sentiment, by hammering key stocks, affecting market credibility and stability. Events like these can quickly dry up the capital available to the company, leading to an eventual bankruptcy; this is especially true for companies relying heavily on borrowing to operate day to day operations (such as Airlines).


Furthermore, the Indian markets are not even deep enough for FPIs which dominate Indian Category III AIFs in terms of assets. The most common parameter to assess the financial depth of a country is to weigh its private credit to Gross Domestic Product (GDP) as a percentage. The World Bank GFD data indicates that: India’s ratio stood at 47.5% in 2017 compared to China’s 150.6%, Singapore’s 125%, UK’s 131.7% and Germany’s 75.5%. The data depicts that India lags far behind other high-income countries which have a strong positive correlation with private credit to GDP %. This weak positive correlation poses a great systemic risk to credit availability in the economy. Category III AIFs being allowed to borrow monies on a daily basis to fund their operations pose a risk of depriving other institutions from borrowing and funding their operations. This is apparent by the blanket ban on the FPIs to employ shorting in India, except in cases provided by the Securities Lending & Borrowing Scheme (SLB) or any other applicable framework decided by SEBI. (Shorting or Short Selling refers to the practice of investing in a way that the investor profits if the price of the underlying asset falls). Interestingly, FPIs seemed to be the most incentivised in terms of tax benefits and hold the most investments in the hedge fund space. However, they are not allowed to short sell which domestic funds are allowed to do which can be attributed to the fact that these techniques require larger and deeper markets to operate with less volatility.


Another possibility is the perceived bad reputation attached to the Category III AIFs for their shorting techniques having been historically blamed for stock crashes across jurisdictions. However, the advocates of short selling argue that it is an essential method for price discovery of inflated and overpriced stocks; and such a method only accelerates the process of a market downturn rather than initiating it.


The analysis throws open two potential reasons for the unfavourable policy against these funds: First, the Government may be trying to enlarge the depth of our financial markets so that one entity alone may not trigger a panic selling spree; Second, the Government seeks to avoid the possibility of an accelerated downturn in market caused by shorting techniques employed by such funds.

Conclusion


The Indian Category III AIFs industry has managed to capture only a small share (about 0.125%) of the equity markets owing to the unfavourable tax regime. Consequently, it generates mediocre returns at best, with higher risks as compared to other avenues of investments (such as Mutual Funds, Gold, Real Estate Investment Trusts, etc.). This is unfortunate, since incentivizing this alternative class of investments may present new opportunities to the experienced investor; to invest contrary to the markets, the possibility of higher returns and lead to new money flowing into the investment space: thereby aiding price discovery and hedging opportunities as the HNI population grow.

Allowing the Category III AIFs a level playing field with investment vehicles under other categories will incentivize the growth of these funds. Conversely, they pose a systematic risk to the credit system in our market, have a poor reputation due to their shorting-like techniques, and run contrary to the Government’s quest to promote financial growth without overdoing it. The need of the hour is to achieve a fine balance between these two objectives; so that the need to promote Category III AIF investments with more private credit does not create a systemic credit risk in the economy, while also laying out necessary guidelines for improving the taxation ambiguity and discrimination.

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