Finishing Touches Needed for India’s Alternative Investment Fund Industry

In the recent past, Indian tax authorities and regulators have responded swiftly to the needs of the alternative investment fund (AIF) industry, and they have carried out significant changes with far-reaching impacts to remove hurdles faced by the industry and different investor classes.

Due to the dynamic nature of the AIF industry, rules and policies need to be updated all the time. This article focuses on the “last mile” finishing touches required in the short term for the industry.

Application of Indirect Transfer Provisions to Category III AIFs located in the GIFT IFSC

According to Section 9(1)(i) of the Income Tax Act, 1961 (the Act), transfer of shares or interest in an offshore company which derives its value, whether directly or indirectly, substantially from assets located in India will be subject to indirect transfer provisions in India.

Category III AIFs in the Gujarat International Finance Tec-City (GIFT) International Financial Services Center (IFSC) are taxed at the fund level and investors are exempted from tax on income from the Category III AIF. If an investor in the GIFT AIF is a feeder fund, then the investor in that feeder fund could be exposed to tax as a result of indirect transfer provisions.

Nonresident investors investing in Category I or II AIFs in India or Category I Foreign Portfolio Investors (FPIs) are outside the purview of indirect transfer provisions. To bring parity for AIFs in GIFT, it should also be clarified that the indirect transfer provisions are not applicable for nonresident investors, directly or indirectly, in Category III AIFs located in the GIFT IFSC.

This would be of relevance to AIF III funds investing in the international stock exchanges, because those investing on domestic exchanges are required to register as FPIs, and, as mentioned above, Category I FPIs are outside the purview of these provisions.

Loss Suffered by Unitholders in Case of Inheritance

The Finance Act 2019 allowed pass-through of net capital losses to unitholders for Category I and II AIFs. However, this benefit was restricted for unitholders which held the units of the AIF for a period of at least 12 months. This provision in a way is like loss-stripping provisions contained in Section 94 of the Act and is designed to discourage trading losses or misuse of losses for transfer of purchases of units by a loss-incurring investor.

While the restriction is fair in cases where parties consciously engage in transactions of transfer of units, such restrictions are not warranted where the act is involuntary, for example, due to death or inheritance.

Section 49 of the Act provides that when a capital asset becomes the property of a person under a will or inheritance, the cost of acquisition of the asset shall be the cost to the previous owner. Correspondingly, in computing the period of holding the asset by a person who has acquired the property under a will or inheritance, the period of holding by the previous owner shall be counted.

On similar lines, in case of transfer of units under a will or inheritance, a dispensation should be provided enabling the new unitholder to claim losses.

TCS and TDS on Unlisted Securities and Units of Funds

The Finance Act 2020 expanded the scope of tax collection at source (TCS) by introducing the provision for TCS of 0.1% on sale of goods worth 5 million rupees ($66,500) or more, with effect from Oct. 1, 2020. Further, the Finance Act 2021 introduced Section 194Q, which obliges certain buyers to withhold tax at source (TDS) on purchase of “goods” from resident sellers with effect from July 1, 2021.

The term “goods” is not defined in the Act and therefore raises doubts about the applicability of TCS/TDS to securities. Although “goods” include securities under certain laws, perhaps the intention was not to cover financial instruments. Further, under the Goods and Services Tax law, securities are not covered in the definition of “goods.”

The Central Board of Direct Taxes has issued circulars clarifying that TCS/TDS would not be applicable on transactions in securities carried out through stock exchanges. Thus, it could be argued that by implication all other transactions pertaining to off-market sale/purchase of shares and securities (AIF units, mutual funds), including shares of private and unlisted public companies, would be covered within the ambit of TCS/TDS provisions.

This would have a major impact on the funds and investors, and hence it is necessary to clarify that TCS/TDS provisions meant for transactions in goods would not be applicable to securities.

While in the case of transactions in goods, generally these are business-to-business transactions and the seller would make some profit, in the case of securities there could be no certainty that the seller would make a profit and hence a percentage of the gross sale proceeds could lock the funds in taxes when no tax is ultimately payable.

Taxation of Category III AIF Investors

There are currently no specific provisions governing the taxability of Category III AIFs. Typically, these are structured as trusts and the laws governing taxability of trusts are used for determining taxability of Category III AIFs and their investors.

However, Category I and Category II AIFs are granted a special pass-through status and are taxable in the hands of the investors. With the increase in surcharge rates for high-net-worth individuals, taxation at the fund level for category III AIFs would lead to disparity in net tax rates. At the fund level, surcharge at the highest rate would be applicable, which would adversely impact investors falling into a lower tax bracket but who would still be subject to a surcharge of 37%.

A pass-through status would ensure fairness in tax treatment for all investors.

Tax on Debt Investments by IFSC AIF Units

In accordance with Section 194LD of the Act, interest income arising to FPIs from government securities and corporate bonds is taxed at 5% (plus surcharge and cess). According to Section 194LC of the Act, interest income arising to foreign lenders on external commercial borrowing (ECB) loans and rupee-denominated bonds is subject to a lower tax rate of 5% (plus surcharge and cess) provided the ECB guidelines are met.

Currently, Category III AIFs set up in the GIFT IFSC have been extended the tax treatment of an FPI with certain additional benefits. However, the 5% tax rate on interest income has not been extended to them. Unlike for foreign lenders, there is no concessional tax rate provided in the Act for Category I and Category II AIFs to invest in Indian debt securities.

In line with benefits extended to FPIs and foreign lenders, the concessional tax rate of 5% should also be extended to interest income arising to AIFs (all categories) set up in GIFT IFSC from their investments in mainland India.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Sunil Gidwani is a Partner and Naitik Doshi is Associate Director with Nangia Andersen LLP.

The authors may be contacted at: sunil.gidwani@nangia-andersen.com; naitik.doshi@nangia-andersen.com