Fiddich Review Centre
Alternative Investment

Budget 2023: Why carried interest for alternative investment funds must be kept outside GST purview

By Pratyush Miglani
Ever since its introduction in 2012 by the Securities and Exchange Board of India or SEBI, alternative investment funds or AIFs have proven their indispensability to the overall growth of the Indian business ecosystem.
A CRISIL report revealed that AIF commitments saw a massive 42% increase in FY22 with private equity and debt funds accounting for the majority of the share, even as enormous potential still remains untapped. Among the key reasons behind the resounding success of AIFs in India has been a conducive and consistent taxation regime. Whether it is in the form of granting pass-through status to Category I & II AIFs or by providing exemption from angel tax, a supportive taxation regime has anchored rising investments.
However, a 2021 decision by the Bangalore bench of the Custom, Excise and Service Tax Appellate Tribunal or CESTAT in the matter of ICICI Econet Internet and Technology Fund and Others v Commissioner of Central Tax, Bangalore North (the Ruling), dealing with the taxation of ‘carried interest’ may have caused some serious trouble in paradise.
Taxation of Carried Interest- the historical position
‘Carried interest’ or ‘carry’ refers to such part of a fund’s profit that is allocated to its fund manager as is proportionate to the performance and success of the fund. The taxation of carried interest was a settled area of law under both the Income Tax and Goods and Services Tax (GST) laws. Under Income Tax, carried interest had always been treated as a ‘capital gain’ arising from investment in securities, whereas under GST & the erstwhile ‘services tax’ regime, it was treated as income arising from securities, exempt from both GST & service tax thusly. This allowed fund managers to avail a lower rate of capital gains tax and prevented investors from bearing any GST on the carry interest paid to the fund managers.
CESTAT Ruling rocks the ‘carrying’ boat
However, the CESTAT Ruling from 2021, in a case concerning multiple venture capital funds managed by ICICI Venture took a completely different position and held that carried interest is neither ‘interest’ nor ‘return on investment’. Instead, it is consideration retained by funds or trusts for ‘services’ rendered by them to investors or contributors and passed on to asset management companies in the guise of return on investment.
In the facts of the case, the fund in question was organised as a trust, and different ICICI entities inter se acted as the fund manager, trustees, and sponsors. Generally, such arrangement would be viewed as one where each entity acting in mutual interests came together to provide services or goods to themselves, and hence be exempt from taxation, commonly known as the ‘doctrine of mutuality’. The CESTAT, however, denied the applicability of the doctrine of mutuality on the premise that investors had received services from the fund managers for their commercial benefit and the trust had provided portfolio management services to the investors.
The law in other jurisdictions
Taxation of carried interest is considered as a tax loophole across the world, and several countries, like the USA under the Trump administration, have tried to plug in the so called ‘loophole’, but to no success. Currently, carried interest is taxed as a capital gain under US law.
In the European Union, where the tax treatment of funds was well established in the late 20th century, a well-distributed tax structure has been put in place. Many EU countries, where Germany and France are in the lead, have introduced special regulations for carried interest to qualify under the head of capital gains tax which entirely removes the difficulty of its taxation under the head of revenue or services. A recent amendment in the Italy tax regime of 2017 has also clarified that carried interest shall be treated as capital gains.
The UK’s strategy is built on a sliding scale method to handle hybrid scenarios, which is more in line with the fundamental idea of duration of holding. According to UK legislation, none of the carried interest is income-based if the average holding duration for the fund’s investments is forty months or more, which can be understood as the counterpart of long-term capital gains tax as charged in India. On the other hand, all carry is income-based and subject to income tax if the average holding duration is shorter than 36 months, i.e., short-term capital gains vis-à-vis India. A percentage of the carry is based on income if the average holding duration is between 36 and 40 months. The Hong-Kong approach is similar to that of the UK.
Interestingly, in 2013 the Sweden tax authority taxed carried interest under the head of salary declaring it as ‘performance bonus’. The Supreme Administrative Court of Appeal in Sweden, later, overruled the decision of the tax authority and upheld the taxation of CI under the head of capital gains.
Impact of the Ruling and the way ahead
The CESTAT Ruling has given rise to a wave of uncertainty which was, at the least avoidable and at best- unwarranted. It defies any cogent logic that carried interest is interpreted as a ‘service’ under the GST framework for the simple reason that carried interest is not a guaranteed payment or remuneration for services rendered, which is the sine qua non for an act to be taxable as a service. For this above reason, carried interest should be kept entirely outside the purview of GST.
Ample clarification to this effect is the dire need of the hour, whether through legislation by the Parliament or by way of a decision of the higher courts in appeal.
It is tacit that until the uncertainty surrounding the taxability of carried interest is addressed, the Ruling will have serious repercussions in the Indian business ecosystem. The Ruling, if stayed as is, creates heavy tax liability on carried interest, which may force existing funds in India to move their operations outside the country. Besides, the funds may also not be inclined to accept investors from India because that would come with GST implications.
It may prove as an exordium to a series of notices by tax authorities and subsequent litigations. The varied interpretation of the Ruling by tax authorities in different states may result in dubiety, especially when the fund functions inter-state, which is true for almost all cases.
The overzealous approach of the CESTAT may deal a severe blow to the otherwise growing investment ecosystem through AIFs, even before it could take off completely.
Pratyush Miglani is Managing Partner, Miglani Verma & Co.The author acknowledges the contribution of Prakhar Srivastava and Kritagya Agarwal in writing this article.

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