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).

In 2021, the Customs, Excise and Service Tax Appellate Tribunal, Bangalore (CESTAT) had held that these 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 were 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.

‘Pass-through vehicle’

In its February 8 order, the High Court stated that VCFs set up as trusts cannot be considered as a person for levy of service. 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 High Court ruling suggests that the fund is not rendering any services, given the principle of mutuality and is only a pass-through vehicle pooling investors’ capital and putting it to work. This hopefully eliminates any future question about the nature of the fund and its relationship with its contributors,” said Siddharth Shah, Senior Partner, Khaitan & Co.

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. Since there cannot be any service to self, service tax cannot apply to the VCF. “The CESTAT ruling had caused quite a stir and while fund houses were not paying taxes upfront, they had become cautious and were preparing for an adverse impact. This ruling brings much needed respite, although a more detailed order on the issue would have helped,” said Ashish Sodhani, Partner, Parakram Legal.

Yashesh Ashar, Partner at Illume Advisory believes that any GST levied by such funds in future would have been passed on to the contributors as costs. Accordingly, various funds which were in an exit mode had started mulling different structures for creating reserves at the time of exit and informing the same to the investors. This position of the fund managers may be re-evaluated post the HC decision depending on the language adopted in the fund documents, he said.

Commercial arrangement

“The HC has acknowledged the commercial arrangement between the contributors and the investment manager. The trust is distributing the money as per the distribution waterfall mechanism agreed between the parties and this does not violate the principle of mutuality,” Ashar said.

The characterisation of the carried interest in the hands of the fund manager, however, was not discussed by the court. “The order has not settled the issue of levying GST on ‘carried interest’ or performance fees. That matter is still being examined by the tribunal and remains subjudice,” said Shah.

The tax authorities may choose to appeal against the order in the Supreme Court.