CESTAT Bangalore decision will impact VCs

In a recent decision that could have wide ramifications to time-tested tax positions, the Customs Excise and Service Tax Appellate Tribunal (CESTAT) Bangalore, in the case of ICICI Econet Internet and Technology Fund has upheld service tax on ‘Carried Interest’ and ‘Expenses reimbursements’, in the hands of the Asset Management Company (AMC) (or Investment Manager) and VCF.

These investment vehicles undertake the risk of investing primarily in unlisted or illiquid securities as per the defined investment policy, using the professional services of an AMC that undertakes investment and other strategic decisions to maximise returns.

As investments are made on behalf of investors, trusts are floated under the Indian Trusts Act, 1882, (Trusts Act) to manage the funds and generate returns. The operational and administrative matters are defined in the Charter documents. Investors receive returns in proportion to the units held by them. Funds issue varied classes of units to regular institutional investors and also to the AMC and its employees/nominees (Specified class of investors).

Carried interest

The trustee receives trusteeship fees from the trust and the trust pays a management fee to the AMC for their services, besides bearing all costs/expenses associated with management of the fund.

The net reserve, being capital appreciations less expenses, is distributed to investors as may be prescribed for each class of investors. The regular investors generally get a pre-defined return (the ‘hurdle’ rate) and the remaining surplus is shared between the regular investors and a specified class of investors in a pre-defined proportion. The AMC/nominees/employees get a significant return, often higher when compared with the regular investors and in disproportion to the units they hold.

In practice, the entitlement of a share in a fund’s profit by a specified class of investors is called ‘Carried interest’. Carried Interest is typically treated as a return on investment by the specified class of investors.

The AMC discharges applicable indirect taxes on the management fee, while the trust discharges income tax on behalf of the investors in representative capacity. Further, the actual expenses incurred by the AMC are reimbursed/adjusted from the corpus/returns of the trust, on which indirect tax is not levied by the fund, being a reimbursement.

The CESTAT judgment probed into the portfolio management activities of a trust, to hold that there exists a relationship that of a ‘Service provider’ and ‘Service recipient’ between the trust and the investors; thus, expenses incurred by the trust, out of the contributions/profit earned, is service income liable to service tax in the hands of the trust. Further, the discretionary powers of the trust to distribute higher return (Carried interest) to a specified class of investors has been held as a ‘performance fee’ (instead of return on investment) for services rendered by the AMC, liable to Service tax.

Pure agent

The CESTAT refused to follow the doctrine of ‘mutuality of interest’ by citing the activities of the Trust being commercial in nature; the tribunal disregarded the argument that the Trust is not separate from its beneficiaries and there is no consideration received by the Trust as amplified in the underlying documents.

Further, reimbursements received in the capacity of ‘Pure Agent’, cannot be characterised as service income under indirect tax laws. As per the Trust Act, a trust can engage in any lawful activity and the trust and beneficiaries inter se do not engage in any business or trade nor have an intention to earn profit on such transactions. The Trust acts as a pass-through entity and merely adjusts/reimburses expenses incurred.

Under the lens

This decision, which is relevant under GST too, has unsettled historical practices of the industry and assumes significance, being the first time a VCF has come under the service tax lens.

The amendments through the Union Budget 2021, according to which activities/transactions, by a person to its members for consideration is ‘taxable’, further raises the scope of levy of tax on Carried Interest.

Indian tax laws and reforms are interlinked, and it is imperative that the impact of this decision needs to be evaluated under the income tax law as well.

One cannot disregard the possibility of revenue authorities taking a similar position on the ‘concept of mutuality’; and argue the taxability of ‘Carried interest’. CESTAT Bengaluru’s decision, which may be challenged, is not likely to be the last word.

Until a final view emerges, it is important to keep a tab on the progress and eventual outcome, as it may have a major impact on returns/distributions of a fund’s surplus to investors.

(The authors are Associate Partner and Director respectively at BDO India, a tax consultancy)

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