Alternative Investment

Budget 2023: Alternative Investment Vehicles expect tax clarity, relaxations

India has proved to be a nation of entrepreneurs and our fund management industry is no exception to the Indian growth story. Over the past few years, the alternative investment segment (like AIFs, REITs and InvITs) has witnessed significant growth in the assets under management and has provided investors with additional investment avenues beyond traditional direct investments such as equity, mutual funds and bonds.

While these investment avenues continue to grow, investors and fund managers currently face several tax issues which result in uncertainty, risk of interest and penalties, need for creating contingent reserves and varying tax treatment in the industry.

Recommendations for the Alternative Investment Vehicles (like AIFs, REITs and InvITs)

Granting pass-through status to Category III AIFs:

Unlike Category I and II AIFs which have been accorded pass through status, no specific tax regime is provided for a Category III AIF. Pass through status requires the investors to directly pay tax on the income, with no tax liability on the AIF. Category III AIFs have to rely on normal trust tax provisions, which is highly complex and has ambiguities. There is also risk of double taxation of the income earned by the Category III AIFs, once in the hands of the AIF and then again in the hands of the investors upon distribution. This puts Category III AIF at a significant disadvantage as compared to other investment vehicles (Category I and II AIFs, REIT, InvIT and Mutual Funds), which have tax clarity on one level taxation of income.

Accordingly, pass through status to Category III AIFs would go a long way in providing much needed clarity to the investors of Category III AIFs. It would also help foreign investors to claim foreign tax credit, which may not be possible if the tax is paid at AIF level.

Also Read: Recurring Deposit: How to get the best out of your RD account

Clarity on Characterization of income of Category III AIFs:

CBDT has issued various circulars providing clarity in terms of characterization of income on transfer of securities, viz. capital gains v business income. While gains arising on transfer of securities by Offshore Funds registered as Foreign Portfolio Investors (“FPIs”) are deemed to be capital gains, no such clarity is provided to Category III AIFs, leaving them susceptible to litigation specially long-short funds and those which churn their within a year. Given that both Category III AIF and FPI invest in listed securities, it is important for Category III AIFs to have clarity on characterization of income to have a level playing field with the FPIs.

Clarity on taxability of carried interest:

AIFs generally provide carried interest to the manager based on their performance. After providing the minimum assured return to the investors in the fund, the sponsor or manager may receive certain portion of the balance returns as pre-agreed with the investors through the offer document, known as carried interest. There is lack of clarity on whether the carried interest should be taxable as capital gains or business income in the hands of the manager.

In the US, for instance, carried interest is treated as long term and subject to a lower rate of tax if the asset is held for more than three years. A similar rule based concessional treatment could be considered.

Taxability of interest income distributed by REITs/ InvITs to FPIs:

Interest income distributed by a business trust to non-resident unit holders attracts a tax of 5% plus applicable surcharge and cess. For FPIs, interest on any security is taxable at the rate of 20% plus applicable surcharge and cess. Accordingly, there is ambiguity of whether interest income received by FPIs from REITs/ InvITs should be taxable at the rate of 5% or 20%.

While the legislative intent of introducing the lower rate of 5% for interest income distributed by REITs/ InvITs is clearly to give benefit to all investors, FPIs may end up paying more taxes on such interest income. Accordingly, clarification on this aspect could boost investment in REITs/ InvITs by the FPIs.

Reducing period of holding of units of REITs/ InvITs to consider as long-term capital asset:

While most of the listed securities have a holding period of 12 months to be classified as long-term capital asset, units of REITs/ InvITs are required to be held for 36 months to be considered as a long-term capital asset. Accordingly, these units may be taxed at the higher rate of short-term capital gains, even if they are held for more than 12 months, which makes them at a disadvantage with other listed securities. Accordingly, the holding period to classify units of REITs/ InvITs as long-term should be reduced to 12 months.

The industry expects that the Budget 2023-24 will provide the necessary relaxations and clarity on tax issues, which, if addressed in this upcoming Budget, will boost investor confidence in these instruments and further propel industry growth.

(By Rajesh H. Gandhi, Partner, Deloitte India; Vijay Morarka, Senior Manager and Hardik Mehta, Manager, Deloitte Haskins and Sells LLP India)

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