Education

Paying fund manager — the “taxing” question

Nehal D. Sampat Vishal S. Shah | Updated on July 31, 2011

In the interest of development of the Indian capital markets, it may be useful if appropriate provisions or, at least tenets, to address this issue are incorporated in the Direct Taxes Code.

The growth witnessed in the capital markets in the last decade or so has made available multiple investment avenues to investors. Investors with some sophistication can invest through a portfolio manager or invest in a venture capital fund. For rendering investment management services, the portfolio manager typically charges a recurring management fee to the investor. In addition, the investor may share gains with the portfolio manager if the returns from the investments exceed the pre-agreed ‘hurdle' rate.

Where the investor offers the gains from the underlying investments to tax as ‘capital gains', a question arises as regards the deductibility of the fees paid to the portfolio manager.

The genesis of the debate lies in the computational provisions which stipulate that in computing ‘capital gains', deduction would be allowed, namely, for (i) the cost of acquisition of the asset and the cost of improvement thereto and (ii) expenditure incurred wholly and exclusively in connection with the transfer of the asset. The post-tax returns for an investor would be higher if the fees paid to the portfolio manager are deductible in computing the ‘capital gains'.

DIFFERENTIAL TREATMENT

Interestingly, a couple of recent judicial precedents have examined the issue and arrived at contrary conclusions.

In the case of Devendra Motilal Kothari v. DCIT (Mumbai Bench of the Income-Tax Appellate Tribunal), reported in 136 TTJ 188, the tax-payer claimed deduction for fees paid to a portfolio manager where, apparently, the fees were paid on a quarterly basis and were based on the market value of the underlying assets or the net value of the underlying assets held at the beginning or the end of the quarter. Since the fees paid to the portfolio manager did not have direct nexus or weren't inextricably linked with purchase and sale of shares, the Tribunal held that the fees cannot be considered as incurred wholly and exclusively in connection with the transfer of securities or as the cost of acquisition / improvement. The Tribunal, therefore, held that such fees weren't tax deductible.

In the subsequent case of KRA Holding and Trading P. Ltd v. DCIT, (TS-251-ITAT-2011), the Pune Bench of the Tribunal has apparently taken a contrary view. In that case, the tax-payer had paid fees, which were termed as ‘termination fees', computed as a percentage of the net asset value of the portfolio to the portfolio manager. Before the Tribunal, the tax-payer, inter alia, relied on the decision of the Bombay High Court in CIT v. Shakuntala Kantilal, 190 ITR 56. In that case, the High Court held that the phrase “expenditure in connection with the transfer” is wider than the phrase “expenditure for the transfer” and, a payment which is absolutely necessary to effect the transfer is deductible.

The Pune Bench of the Tribunal sought to rely on the decision of the Bombay High Court (supra) and distinguished the decision of the Mumbai Bench of the Tribunal. The Tribunal reasoned that as the fees paid to the portfolio manager were genuine and were for the twin purpose of acquisition and sale of securities, they should be allowed as a deduction in computing the capital gains.

DIRECT TAXES CODE

The issue at the centre of the debate is the differential tax treatment of business income and capital gains and whether a tax-payer is entitled to claim deduction for various expenses incurred in the course of earning capital gains akin to business income.

Interestingly, both the decisions have common ground to the extent that they lay the onus on the tax-payer to demonstrate the nexus between the expenditure incurred and the investments made / the gains earned. Both the decisions provide useful guidance to the Fund Managers and the investor community alike.

A Fund Manager typically provides a gamut of services to the investors, including identification of investment opportunities, monitoring of the investments and successfully exiting from the investments. From the Fund Manager's perspective, the agreements with the investors may require thoughtful drafting to demonstrate that the fees charged by the manager have a clear nexus with the acquisition and sale of the securities. The decision, though in the context of portfolio managers, may be relevant for investments in venture capital funds as well.

From the investor community perspective, the conflicting decisions affirm that the matter is not free from doubt and it may be in their interest to keep their tax deductibility claims alive. Another pertinent issue would be deductibility of the expenditure in a year in which the investor may not have earned any taxable capital gains from the underlying investments.

The law is clearly far from settled on the issue. A new Direct Taxes Code to replace the existing Income-Tax law is on the anvil. Therefore, in the interest of development of the Indian capital markets, it may be useful if appropriate provisions or, at least tenets, to address this issue are incorporated in the Direct Taxes Code.

(The authors are Associate Director and Manager — Tax and Regulatory Services (Financial Services), PricewaterhouseCoopers India, respectively.)

Published on July 31, 2011

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