The Central Board of Direct Taxes issued a clarification on 28 July, 2014 dealing with taxation of Alternative Investment Funds (AIFs) registered with SEBI. The circular notes that AIFs have been accorded tax pass-through status under the Income Tax Act, 1961.
The tax department has now clarified, through the circular, that in a scenario where the trust deed of an AIF, when set up as non-charitable trust, does not set out the names of the investors or their respective beneficial interests as on the date of creation of trust, tax pass through will not be available for the fund. This clarification will lead to the entire income of the Fund to be taxed at the ‘Maximum Marginal Rate’, in the hands of the AIF Trustees, in their capacity as ‘Representative Assessee’. Therefore, such income shall not be assessed in the hands of the investors.
The position taken in the circular is at variance from that taken by the Authority for Advanced Rulings in the AIG case (In Re: Advance Ruling P. No. 10 of 1996), wherein it was held that it is not required for the trust deed to state the exact names or shares of all beneficiaries for a trust to be considered a determinate trust. The primary issue that arises is that AIFs almost never have a ready set of investors at the time of fund formation and various investors enter at the subsequent or final closings. This circular differs from the entire edifice of AIF taxation built upon the AIG ruling, based on which merely class of beneficiaries and formula/ methodology for calculation of shares/distributions were sufficient to make the trust determinate.
Further, the circular inflicts more pain on the bruised AIF industry, by imposing tax at the Maximum Marginal Rate on the Trustees of the AIF, i.e., the rate applicable to highest slab of income for individuals, should the income of the AIF be ascertained to be earned through profits, income or other gains of business, even where the AIF is determinate. The circular may have been issued with the objective of clarifying the tax position for onshore funds established as AIFs, however it has the potential of having a detrimental effect on a sunrise source of capital for cash-strapped enterprises, jeopardizing the commercial viability of AIFs in the first place.