Taxation of Carried Interest of Indian Fund Managers and Rising Uncertainty

Taxation of carried interest in the hands of fund managers has recently been a matter of dispute and uncertainty, with the Tax Tribunal re-characterizing income by way of carry as service fees (instead of return on investment). With this decision, historical tax positions on carried interest may need to be re-examined, both under Income tax and GST laws.

Himanshu SinhaPartner

In India, taxation of 'carried interest' (or carry) in the hands of fund managers, both under Income Tax as well as Goods and Services Tax (GST), has until recently been an uncontested area of law. Carried interest is the share of a fund's profit allocated to its fund manager and is typically referred to as 'being carried by the investors', since the fund manager receives a share in profits disproportionate to the amount invested by it in the fund but proportionate to the performance and success of the fund.

Under Income Tax law, fund managers have historically treated their carry as capital gains arising from investment in securities (of a class, specially and exclusively designed for them). For the purpose of GST (and the old services tax regime), income by way of carry has traditionally been treated as income arising from securities (and not as consideration for services rendered), which is specifically exempt from GST (and service tax). This kind of tax treatment therefore permits fund managers to avail lower rate of capital gains tax (the difference between tax on ordinary income and capital gains burden can be as high as one-fourth of the gain) and allows investors not to bear any GST on the carry paid to the fund managers (the burden of GST can be as much as one-fifth of the gross receipt).

A recent decision of the Tax Tribunal in a case involving various venture capital funds managed by ICICI Venture has, however, upended the tax landscape of carried interest leading to uncertainties. The Tribunal, in its order, held that carried interest is neither interest nor return on investment, but consideration retained by funds/trusts for the services rendered by them to investors/contributors and passed on to asset management companies or their nominees in the guise of return on investment. The Tribunal was of the view that the structure of the funds was devised in a manner to avoid taxes and characterized the return on securities as service fee.

The venture capital fund, in this case, was organised as a trust and registered with the regulator under the venture fund regime. The Tribunal took cognizance of the fact that the fund manager, sponsor, and trustees were all ICICI entities and that the investment by the fund managers in special class shares had been made after returns had been distributed to the investors. Much of the debate before the Tribunal was focussed on the doctrine of mutuality, which does not permit taxation of transactions between persons acting in mutual interest who come together to provide services or goods to themselves (e.g., services provided by a club to its members). However, the Tribunal negated the applicability of the principle of mutuality on the ground that the investors had received services from the fund managers for their commercial benefit and the trust had provided portfolio management services to the investors.

Most countries that have adopted VAT have chosen not to impose any VAT on financial services that are margin based (like interest or carry).

Most countries (like those in the European Union) that have adopted value added taxes (VAT) like GST have chosen not to impose any VAT on financial services that are margin based (like interest or carry). Only fee-based services are subject to VAT. In fact, following a wide public consultation, the European Union is currently debating various proposals to strengthen and reform VAT on financial services.

On the income tax side, many countries where capital markets and fund management are well developed and vibrant, taxation of carry has been specifically dealt with under the law and carried interest of fund managers given varying degrees of concessional tax treatment, e.g., either wholly or partly treated as investment income or effective tax rates applicable on ordinary incomes reduced. In fact, the law in the UK and US has evolved over a period providing a nuanced approach to taxation of such income.

In the US, return on investment is considered a function of time, and therefore managing long term investments qualifies a manager for capital gains treatment rather than service fee. The underlying logic being that a service provider would ordinarily want to be compensated without waiting for the outcome of their service, and regardless of the nature of outcome. Accordingly, the US has provided for a bright-line test where return on investment that is held for a period less than three years is treated as ordinary income and taxed at higher rates, while carry arising from investments held for three years or more get concessional capital gains treatment.

The UK's approach is more aligned with the underlying premise of period of holding and is based on a sliding scale approach to take care of hybrid situations. The UK law provides that if the average holding period for the fund’s investments is forty months or more, none of the carry is income-based. On the other hand, if the average holding period is less than thirty-six months, all the carry is income-based and charged to income tax, even if funded out of capital sources. If the average holding period is between thirty-six and forty months, a percentage of the carry is income-based. Since the individual tax rates can be quite high, both in the US and the UK, there is a significant tax break available to fund managers who manage long term capital.

Any uncertainty of tax on fund managers creates uncertainty for investors as any post-factor tax burden erodes the basis on which investment decision is built.

There is therefore an immediate need for clarifications. The uncertainty created by the ICICI decision could discourage fund managers from setting up base in India, even though the law offers opportunities of tax arbitrage based on tax residency. For instance, certain tax treaties permit taxation of service fee only if services 'make available' technical know-how etc. to the service recipients. If the carry is therefore treated as a service fee rather than as investment income, a non-resident fund manager (not having any presence in India) can, relying on such tax treaty provisions, potentially earn a carry from an Indian fund without paying any income tax in India. Further, regarding GST in such a situation, GST on fund advisory services (provided by the non-resident fund manager) would have to be borne by the Indian fund. Such GST would therefore be a cost to the investors, as the Indian fund would not have any output tax liability that could be set-off against GST paid on import of fund-advisory services from the non-resident fund managers.

Any uncertainty of tax on fund managers creates uncertainty for investors as any post-facto tax burden erodes the basis on which the investment decision is built. Such uncertainty also discourages free movement of capital and erodes capital efficiency. Waiting for courts to settle the dispute or to lay down the law is not optimal to attain tax certainty, as court processes could be protracted. It would therefore be salutary for the Indian government to take an informed view in the matter in accordance with prevalent international norms, so that the nascent fund management industry in India does not suffer a setback.

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