A recent Karnataka High Court ruling in an appeal filed by ICICI Econet Internet and Technology Fund and others may ease the potential service tax burden of private equity and venture capital funds (VCFs). But are the funds out of the woods, yet? businessline takes a closer look. 

What is the issue all about? 

In 2021, the Customs, Excise and Service Tax Appellate Tribunal, Bangalore (CESTAT) held that the ICICI Econet funds managed the money of investors like a banking or financial institution, making them liable to pay service tax. The amount held by the funds for their own expenses was considered as consideration towards performance of services. The carried interest paid to unit holders was deemed to be a “performance fee”, and not a return on investment. The CESTAT noted that VCFs are treated as juridical persons under the VCF Regulations. It also held that the funds violated the principle of mutuality by carrying out commercial activities and using discretionary powers to benefit a certain class of investors. 

What was the likely impact of the CESTAT decision?

The ruling would have impacted all pooling vehicles. GST on carried interest would likely have become a fund expense and been passed on to investors as an additional cost. The risk of income-tax authorities challenging the capital gains characterisation of carried interest would have increased. Several funds had started receiving notices from the GST department asking them to take registration under the CGST Act for provision of services to investors. 

What does Karnataka High Court ruling on February 8 say? 

The High Court order stated that VCFs set up as trusts cannot be considered as a person for levy of service tax. This is because the Finance Act does not consider a trust to be a juridical person. Further, the trusts are pass-through in nature wherein funds from contributors are consolidated and invested by the investment manager. The order said the doctrine of mutuality must apply to a contributor investing into a fund as the two cannot be dissected as two different entities. 

Is the matter all settled now? 

The characterization of the carried interest in the hands of the fund manager was not discussed by the Karnataka High Court. So, the question of applicability of GST on carried interest does not get ruled out by this decision completely. What’s more, the tax authorities may choose to appeal against the order in the Supreme Court. 

What is carried interest? 

Carried interest is the percentage of profit that will be paid to the fund manager. The carried interest paid to the fund manager is directly impacted by the performance of the fund and a pre-decided hurdle rate. The amount of carried interest cannot be determined upfront.

Why is the characterisation of carried interest so important? 

This could have implications both from an income-tax and GST perspective. Carried interest will be subject to tax at applicable corporate tax rate of 25-30 per cent if such income is considered as service fee. While GST will be a deductible expense from an income-tax perspective, this may increase the effective tax rate on carried interest to 43-47 per cent (instead of 20 per cent in case where carried interest is considered as a return on investment).

“Such a high tax incidence can make India potentially an unfavourable jurisdiction for raising and managing of funds,” said Parul Jain, Head of Fund Formation Practice at Nishith Desai Associates. “Taxation of carried interest has been an issue globally. Considering the size and contribution of the fund management industry to the Indian economy, it is imperative that the Indian government provides clarity and certainty on this issue.”