Category III AIFs eyeing Budget for clarity on taxation

Category III AIFs usually operate in the form of determinate trusts to avoid double taxation. However, current regulations mandate these funds to be set up as indeterminate trusts

Hedge funds, which fall under category III of alternative investment funds (AIFs), are looking at the Budget for the “pass through” status for their investments in AIFs.

Even the committee, headed by Narayana Murthy, which was constituted by the Securities & Exchange Board of India (Sebi) has suggested the same in its recommendations. Finance minister Arun Jaitley in the previous Budget had granted the ‘pass through’ status for category I and II AIFs.

Category III AIFs usually operate in the form of determinate trusts to avoid double taxation for investors. However, current regulations mandate these funds to be set up as indeterminate trusts.

As per the CBDT circular on AIF taxation, a trust will be liable to be taxed at the maximum marginal rate if its beneficial interest are not specified in the trust deed.

“The biggest challenge faced by some of the AIFs is the discrimination in tax treatment between various categories of AIFs, as Category I & Category II are treated as pass- through entities while Category III is subject to tax at the maximum marginal rate,” said Riaz Thingna, director, Grant Thornton Advisory.

Hemal Mehta, partner at  Deloitte India, said in the present structure, the trustee of the AIF has the advantage to deduct withholding tax on behalf of investors who can claim tax deduction on the same.

Tax experts said this framework becomes more  challenging in case of an open-ended fund, as trustees have been known to be averse to liability that arises with this responsibility.

“Close-ended nature would limit the fund manager’s ability to time the market and take positions to maximize gains. Also, typically hedge fund investors prefer the freedom of entering or exiting the fund as per their convenience. The binding investment tenure would also make multiple iterations in the trust deed impractical for every investor addition or exit that takes place,” Mehta added.

AIFs are special investment vehicles established to pool in funds for investing in real estate, private equity and hedge funds. Sebi had released regulations for AIFs in 2012.

AIFs have witnessed a significant jump in inflows in the last two years. The cumulative funds raised via AIFs was Rs 14,031.39 crore in Q3FY16 – triple the value of Rs 5,874.5 in Q1FY15, data compiled by Sebi showed.

This article was published in the Financial Express on 23 February, 2016.