08 Mar 2024
The Karnataka High Court has set aside an order of the CESTAT and held that a venture capital fund is not liable to pay service tax on the expenses incurred by it either as performance fee paid to the asset management company or returns on investment disbursed to the asset management company, usually referred to as carried interest.
The Karnataka High Court, while ruling on a batch of appeals filed by ICICI Econet Internet and Technology Fund and others, has provided clarity on the applicability of service tax to the financial services sector. The Court held that service tax is not leviable on the expenses incurred by a venture capital fund (VCF), organised as a trust, on the administration of the fund. This decision is likely to impact not only VCFs but all other investment pooling vehicles that are organised as trusts, such as alternative investment funds, by exempting asset management activities from the ambit of service tax.
VCFs were established under the Indian Trusts Act, 1882, and registered with the Securities and Exchange Board of India. In the current case, institutional investors/contributors had made investments in the VCF. The VCF was represented by a trustee, who in turn appointed an asset management company (AMC) to manage the VCF. In exchange for these services, the VCF paid a performance fee to the AMC. Additionally, the AMC and its employees/nominees were also entitled to ‘carried interest’, which is a percentage of the gains earned by contributors.
Against this structural backdrop, an investigation was conducted by the Anti-Evasion Unit of the Jurisdictional Commissionerate into the activities of the VCF. It took the view that the VCF retained a portion of the income (i.e., carried interest) that would otherwise be distributed to the contributors, and it classified such portion as a service charge/fee for asset management. Consequently, a show cause notice was issued, proposing the imposition of service tax on the expenses incurred by the VCF (i.e., performance fee) and the returns paid to AMC (i.e., carried interest) by categorising them as ‘banking and other financial services’ under the Finance Act, 1994 (Finance Act).
This tax demand was challenged before the Customs, Excise and Service Tax Appellate Tribunal (CESTAT), Bangalore, which held that service tax should be imposed on the expenses borne by a VCF, as they amounted to payment for asset management services. Additionally, disbursements of ‘carried interest’ to the AMC and other operational expenses incurred by the VCF were also classified as service income of the trust by the CESTAT.
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