India funds suffer pass-through tax confusion

Indian private equity firms are using trust structures in order to stop double taxation after the country’s funds regulation removed a pass-through tax exemption for certain types of funds.

Investors in Indian private equity could face a being hit with extra taxes after the country’s fund regulations caused private equity funds to lose their pass-through tax status.

Pass-through status means a fund will not be subjected to tax on its income and only investors in the fund will be taxed when the money reaches their hands.

Under India’s Alternative Investment Funds (AIF) Regulation, which were launched in June, only funds that invest in start-up or early stage ventures, social ventures or infrastructure will benefit from the pass-through tax status.

“They [private equity funds] will be taxed twice, once at the fund and then the investors will be taxed too,” said Siddharth Shah, partner at Indian law firm Khaitan & Co.

Shah said the problem arose because under the old fund regulations, the Venture Capital Fund Regulations, there was a specific provision under the Indian income tax act whereby any income earned by a private fund was given a tax pass-through.

But under the new regulations funds have been categorized and the existing provision under the income tax act only provided tax pass-through for a specific category of alternative investment funds.

This has meant that most private equity funds are being organized as trusts in India, said Shah. Trust provisions in India essentially entitle the trust to pass-through status because only beneficiaries of the trust (the investors) are supposed to pay tax.

But Shah said there is still a risk that trusts will be challenged from tax officers. Private equity trusts will still fall under a category of the AIF regulation where the income tax act exemption does not come to their rescue and entitle them to pass-through status.

“It is up to the tax officer to decide where it wants to collect the tax; most likely they would say I would like to tax the trust itself because the law provides them the discretion to collect tax at either level,” said Shah.

This will be a problem for private equity investors as although tax has been paid at the trust level there is still a tax demand on the investors which creates double taxation.

Shah said the Indian Venture Capital Association has been lobbying the government to extend the pass-through status for other categories of funds under the new fund regulations. But Shah adds: “Unfortunately there is not much of a hope that the government would extend the pass-through to all categories of AIF.”

However, he remains confident the issue will be resolved in the tax bill, which is currently being deliberated by government, and trusts will gain a specific tax provision ensuring once a trust has paid tax then its beneficiaries will not be subjected to further tax.