|The Finance Act, 2015 and Investment Funds: Well Begun but only Half Done?||Investments, PE, VC|| Bijal Ajinkya | Partner
Rohit Jayaraman | Associate
|01 June, 2015|
The election of the National Democratic Alliance (“NDA”) government in May 2014 with an absolute majority in the Lok Sabha was greeted with optimism by Indian business in general and the investment funds industry in particular. The industry had expectations that several long pending demands would be addressed by the government with the most prominent being clarity on the taxation of alternative investment funds (“AIFs”) set up as trusts and registered with the Securities and Exchange Board of India (“SEBI”) under the SEBI (AIF) Regulations, 2012. However, the first budget of the NDA in July 2014 did not address any of the these issues except for a clarification that any income earned by a Foreign Portfolio Investor (“FPI”) would be considered as capital gains and not as business income. The industry however took consolation from the fact that as the July 2014 budget was presented within two months of the government assuming power, the government may not have had sufficient opportunity to examine these issues in detail. The hopes of the industry accordingly shifted to the next budget of the government which was presented on 28 February 2015 (“Budget”). The proposals in the Budget passed into law through the Finance Act, 2015 (“Finance Act”). The Finance Act while undoubtedly representing a step forward still leaves certain questions unanswered and has even opened up a few new challenges for the industry.
From the perspective of the investment funds industry, the biggest positive from the Finance Act was the clarity obtained in terms of taxation of AIFs. Under the Income Tax Act, 1961 (“IT Act”) a pass-through status was provided for only one sub-category of Category I AIFs, namely venture capital funds and the taxation of other sub-categories of Category I AIFs and Category II and Category III AIFs set up as trusts were governed by the general principles of trust taxation. This position had led to considerable ambiguity which was further compounded by a circular on AIF taxation issued by the Central Board of Direct Taxes on 19 July 2014 (“Circular”) which had inter alia stated that the trustees of AIFs which are not considered to be determinate (i.e. whose trust deeds do not specify the names and beneficial interests of the investors) would be required to pay tax at the maximum marginal rate (“MMR”) on the entire income of the AIF as a ‘representative assesse’.
The Budget and the Finance Act have clarified this ambiguous position by extending the benefit of a tax pass through to all Category I and Category II AIFs. This means that any income earned by an investor in a Category I or II AIF shall be charged to tax directly in the hands of the investor, as if such investor has directly made an investment in the underlying portfolio company. Further, at the time of distribution of such income to the investor, a withholding tax of 10% shall apply for which credit can be claimed by the investor and no tax shall be payable at the fund level on such income. However, the Finance Act also only allows Category I and II AIFs to carry forward unutilized losses incurred at the fund level and set-off such losses against future income and does not permit such losses to be passed on to the investors as would be the case in a pure pass through structure. Further, the tax pass through is not available in cases where the income earned by the Category I or II AIF is categorized as business or professional income/gain. In such a situation, tax shall be payable at the fund level at the applicable rates in case the fund is setup as a company or a limited liability partnership and at the maximum marginal rate in case the fund is setup as a trust. As no clear guidelines have been laid down regarding the circumstances in which income would be considered as business income, this provision has the potential to lead to ambiguity and potential tax litigation.
A prime concern for the investment funds industry was the coming into force of the GAAR provisions in the IT Act from 1 April 2015. These provisions had the potential to impact India focussed offshore fund structures. The Finance Act by extending the date for coming into force of GAAR from 1 April 2015 to 1 April 2017 and by further clarifying that it would be applicable only to transactions completed after that date has managed to address these concerns to a large extent. However, concerns continue to remain on the wide discretion granted to tax officers under the current GAAR provisions and it is hoped that the government will utilize this two year window to iron out these remaining creases.
The applicability of Minimum Alternate Tax (“MAT”) to foreign companies had emerged as a major source of concern for all foreign investors including FPIs following the decision of the Authority for Advanced Rulings in the case of Castleton Investment Limited (AAR No. 999 of 2010). MAT applies under the provisions of the IT Act if the income tax payable by a company (including foreign companies) as computed under the normal provisions of the IT Act is less than its ‘book profits’ (calculated in a prescribed manner) and is chargeable at an effective rate of around 20%.
The Budget sought to rectify the situation by amending the IT Act and providing that no MAT shall be chargeable on capital gains earned by FIIs/FPIs on their transactions in securities (except short term capital gains earned on transactions on which no STT is chargeable). However, this proposed amendment did not provide any clarity on whether other offshore private equity funds which are not registered as FPIs are liable to MAT and as to whether FPIs were liable to pay MAT on non-capital gains income such as interest income. The Finance Act further clarified the position by exempting all foreign companies for the ley of MAT on income earned on their transactions in securities (except short term capital gains earned on transactions on which no STT is chargeable). However, as the amendment is effective only from 1 April 2015, judicial proceedings in respect of past demands made by the tax authorities will continue. However, the government has constituted a committee to look into the validity of these claims and has assured investors that there will be no further tax demands made on this aspect till the committee comes out with its findings.
A major source of uncertainty for offshore funds investing in India created by the Finance Act is the introduction of the concept of ‘Place of Effective Management’ (“POEM”). The Finance Act has amended the IT Act to provide a company shall be a tax resident in India in a given financial year if: (i) it is incorporated in India; or (ii) POEM during the year is in India. POEM is proposed to be based on the place where key management and commercial decisions of the entity as a whole are taken. While this represents an improvement from the proposal in the Budget which provided that a company shall be held to be tax resident in India if its POEM at ‘any time’ during the year is in India, the revised provision also lends itself to considerable ambiguity and India focused offshore funds would have to reassess their management structure once the POEM rules are notified by the CBDT to ensure that they are not held to be tax resident in India.
Therefore, to conclude while the Finance Act definitely represents a huge step forward in providing certainty and a favourable tax atmosphere for private equity investors, the feeling remains that the government could have gone much further than it did to iron out some of the teething issues like taxation of AIFs and MAT. This is especially true considering the key role private equity funds have to play as sources of capital in ensuring that the Prime Minister’s dream of ‘Make in India’ comes true.
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