CHAPTER 13: TAXATION (PART 2 — NON-RESIDENT INVESTOR TAXATION, TDS MECHANICS, LOSSES, AND ADVANCED STATUTORY PROVISIONS)

2.1 Non-Resident Investor Taxation & Treaty Benefits

Non-resident taxation under the Income Tax Act, 1961 (ITA) is highly structured, focusing on the source of income and treaty benefits. Category I and Category II Alternative Investment Funds (AIFs) that have foreign unitholders must navigate distinct tax rates and compliance requirements.

1. Scope of Taxable Income

Unlike resident investors who are taxed on their worldwide income, non-resident investors (including Foreign Portfolio Investors - FPIs, and Non-Resident Indians - NRIs) are subject to tax in India only on income that is sourced, received, or deemed to be received, accrued, or deemed to accrue in India.

2. Retaining the Original Character of Income

Under the statutory pass-through status of Category I and II AIFs, all streams of income (other than business income) retain their original character and proportion when passed through to non-resident unitholders. The tax implications in the hands of non-resident unitholders for each income stream are detailed below:

• Dividend Income:
  • Tax Rate: Under Section 115A, dividends distributed by Indian portfolio companies to non-resident unitholders are taxable on a gross basis at a flat rate of 20% (plus applicable surcharge and cess).
  • Treaty Option: Non-resident investors can opt for tax rates specified under the relevant Double Taxation Avoidance Agreement (DTAA) if they are more beneficial than the domestic tax rate of 20% (often ranging from 5% to 15% under various tax treaties).
  • No Deductions: No deductions for any expenditure (such as interest or management fees) are allowed to non-resident investors against dividend income under Section 115A.
• Interest Income:
  • Tax Rate: Interest earned on debt securities or loans passed through to non-residents is generally taxable at 20% under Section 115A (plus applicable surcharge and cess).
  • Treaty Option: Non-residents may claim lower withholding rates if beneficial under the respective DTAA.
• Capital Gains on Listed Equity Shares:
  • Long-Term Capital Gains (LTCG) [Section 112A]: W.e.f. transfers on or after 23-07-2024, LTCG is taxed at 12.5% (plus surcharge and cess) for aggregate gains exceeding Rs. 1,25,000, provided Securities Transaction Tax (STT) was paid on acquisition and transfer.
  • Short-Term Capital Gains (STCG) [Section 111A]: W.e.f. transfers on or after 23-07-2024, STCG is taxed at 20% (plus surcharge and cess), provided STT is paid on the transfer.
• Capital Gains on Unlisted Equity Shares:
  • LTCG [Section 112(1)(c)(iii)]: For non-residents, LTCG on unlisted shares is taxed at 10% without the benefit of indexation and without exchange rate fluctuation adjustments, provided the holding period is more than 24 months.
  • STCG: Taxed at the applicable rates in force for the non-resident (corporate rates for foreign companies, ordinary slab rates for non-resident individuals).
• Capital Gains on Debentures (Debt Instruments):
  • Listed Debentures (LTCG): Taxed at 12.5% without indexation benefits if held for more than 12 months.
  • Unlisted Debentures & Bonds: W.e.f. transfers, redemptions, or maturities on or after 23-07-2024, any gains are deemed to be short-term capital gains (STCG), irrespective of the period of holding, and are taxable at the applicable rates in force.
• Business Income:
  • Since business income is taxed at the fund level (at the corporate rate, firm rate, or MMR for Trusts), once the tax is paid by the fund, the passed-through portion is fully exempt in the hands of non-resident unitholders.
• Transfer of Units of the AIF:
  • If the gains are characterised as capital gains, units of listed AIFs held for more than 12 months, and unlisted AIF units held for more than 24 months, are classified as LTCA and taxed at 12.5% without indexation benefits.
  • If characterized as business income, the net income (after deducting the cost of units and related transfer expenses) is taxable at the normal rates in force applicable to the non-resident investor.

3. Double Taxation Avoidance Agreement (DTAA) & Tax Residency Certificate (TRC)

To avail themselves of beneficial tax rates under a DTAA, non-resident investors must satisfy the following statutory conditions:

• Obtain a Tax Residency Certificate (TRC) issued by the government of their home country.
• Submit Form 10F electronically to the Indian tax authorities, along with relevant supporting documentation (if the TRC does not contain all the prescribed details).

2.2 Withholding Tax (TDS) Mechanics for Category I & II AIFs

Under the Indian tax regime, Category I and II AIFs have explicit statutory obligations to withhold tax (TDS) on income paid or credited to unitholders. The primary governing section is Section 194LBB of the ITA.

1. Section 194LBB Mechanics

Section 194LBB mandates that any income (other than business income) paid or credited by a Category I or II AIF to a unitholder is subject to withholding tax at source:

• Resident Payees: The fund is liable to deduct TDS at a flat rate of 10% on the passed-through income.
• Non-Resident Payees: The fund must deduct TDS at the rates in force under the ITA or the relevant DTAA, whichever is more beneficial. Surcharge and Health & Education Cess apply over and above the base tax rate for non-resident deductions.
• Timing of Deduction: TDS must be deducted at the earlier of:
  1. The actual payment of the income to the unitholder, OR
  2. The credit of such income to the account of the unitholder (including deemed credit under Section 115UB(6) on the last day of the financial year).

2. Annual Compliance timelines & Forms

• Form No. 64C (Statement of Income Paid/Credited to Unitholder): The AIF must provide a detailed break-up of the income streams (interest, dividend, capital gains) and the corresponding TDS deducted to each unitholder in Form No. 64C by the 30th day of June of the following financial year.
• Form No. 64D (Annual Electronic Return): The AIF must electronically file an annual return of details of all income paid or credited and the TDS deducted to the jurisdictional Commissioner of Income Tax in Form No. 64D by the 15th day of June of the following financial year under digital signature.

2.3 Set-off and Carry Forward of Losses Under the ITA

The treatment of losses incurred at the fund level is governed by Section 13.2 of the index and Chapter XII-FB of the ITA.

1. Pass-Through of Non-Business Losses

If the net computation of total income at the Category I or II AIF level (other than business income) is a loss (such as short-term or long-term capital losses), these losses are passed through to the unitholders:

• Set-Off: Unitholders can set off these passed-through capital losses against their other capital gains in their personal income tax returns.
• Carry Forward: If the passed-through losses cannot be fully set off in the same year, the unitholders are entitled to carry forward the unadjusted losses to subsequent years.
• Holding Period Prerequisite: To be eligible to claim a pass-through of any non-business loss, the unitholder must continue to hold units in the AIF for a minimum period of 12 months.

2. Carried Forward Loss rules for Unitholders

The unitholder's set-off and carry-forward of passed-through capital losses are subject to the standard provisions of the ITA:

• Long-Term Capital Loss (LTCL) can be set off only against Long-Term Capital Gains (LTCG).
• Short-Term Capital Loss (STCL) can be set off against both Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG).
• Unadjusted capital losses can be carried forward for a maximum of 8 Assessment Years immediately succeeding the assessment year in which the loss was first incurred.

3. Business Losses Retained at the Fund Level

Unlike capital losses, any business losses incurred at the fund level (under the head "Profits and Gains from Business or Profession") cannot be passed through to the unitholders.

• These business losses are retained at the AIF level.
• The fund is allowed to carry forward these business losses to subsequent years to set them off against future business income of the fund, subject to a maximum period of 8 Assessment Years.

2.4 General Anti-Avoidance Rules (GAAR) & Multilateral Instrument (MLI)

With alternative assets becoming a preferred route for foreign inbound investments, statutory anti-avoidance measures are strictly applied to AIF structures.

1. General Anti-Avoidance Rules (GAAR)

Effective from 1st April 2017, GAAR is governed by Chapter X-A of the ITA.

• Objective: GAAR empowers the Indian tax authorities to declare any business arrangement as an "Impermissible Avoidance Arrangement" (IAA) if its main purpose is to obtain a tax benefit, and it lacks commercial substance.
• Recharacterisation Powers: If GAAR is invoked, the tax department can ignore, recharacterise, or combine steps of an arrangement, recharacterise debt into equity (or vice versa), or deny tax treaty benefits.
• Implications for AIFs: Complex pooling structures, such as specific parallel or master-feeder arrangements in offshore jurisdictions, are scrutinized to ensure they possess genuine commercial substance and are not set up solely for tax arbitrage.
• Applicability Threshold: GAAR rules apply only if the aggregate tax benefit to all the parties involved in an arrangement exceeds Rs. 3 Crores in a financial year.

2. Multilateral Instrument (MLI)

The MLI is an international convention developed by the OECD to modify bilateral tax treaties (DTAAs) to prevent base erosion and profit shifting.

• The Principal Purpose Test (PPT): The MLI introduces the PPT, which states that tax treaty benefits (such as lower withholding taxes on dividends or capital gains exemptions) will be denied if it is reasonable to conclude that obtaining that treaty benefit was one of the principal purposes of any arrangement or transaction, unless granting that benefit is in accordance with the object and purpose of the treaty.
• Anti-Treaty Shopping: For offshore feeder funds (e.g., in Mauritius or Singapore), the PPT ensures that treaty benefits are denied if the offshore fund lacks commercial presence, adequate staff, and operational substance in its resident country.

2.5 Other Applicable Taxes: Goods and Services Tax (GST) & Stamp Duty

Alternative Investment Funds are also subject to indirect tax frameworks in India.

1. Goods and Services Tax (GST)

• Taxability of Fees: Professional fees paid by the AIF, including the Management Fees paid to the Investment Manager, Trusteeship Fees, Fund Administrator Fees, Custodian Fees, Audit Fees, and Advisory Fees, are subject to GST at the standard rate of 18%.
• Impact of Unrecoverable GST: Since Category I and II AIFs are investment pooling vehicles, they do not collect GST on their output services (i.e., distributing returns to unitholders is not a taxable service).
• Therefore, the AIFs cannot claim input tax credits (ITC) on the GST paid on their expenses.
• The unrecoverable GST is charged directly to the fund's income, increasing the overall indirect costs and lowering the net returns (NAV) of the investors.

2. Stamp Duty

Under the Indian Stamp Act, 1899, stamp duty is systematically levied on transactions involving AIF units:

• Issue of AIF Units: Stamp duty is levied at 0.005% on the value of the units issued to investors.
• Transfer of AIF Units: Stamp duty is levied at 0.015% on the transfer value of the units sold on a secondary basis.
• Redemption: No stamp duty is payable at the time of redemptions of units.
• The stamp duty must be paid by the Fund on behalf of the investors.

2.6 Practical Worked-out Tax Examples

The following worked-out examples illustrate the application of statutory tax provisions on Category II AIFs and their unitholders.

Example 1: Withholding Tax (TDS) Computation for Fund WT

Background: Fund WT is a close-ended Category II AIF structured as an Irrevocable, Determinate Trust. It is launched with 100% resident investors.

• Committed Capital: Rs. 60,00,00,000
• Number of Units Issued: 6,00,000 units
• Face Value per Unit: Rs. 1,000

The financial data of Fund WT over three years is as follows:

Scenario:

• Interest income and dividend income are distributed/credited on a yearly basis to investors.
• On March 31, 2025, the NAV of the fund is Rs. 1,195.00, and the investors redeem all their units.

Step-by-Step Solution:

1. Computation of Net Pass-Through Income & TDS (FY 2022-23 to FY 2024-25): Under Section 194LBB, the fund is liable to deduct TDS @ 10% on the net income (other than business income) credited or paid to the resident unitholders.

• For F.Y. 2022-2023:

  • Gross Income = Dividend (3,50,00,000) + Interest (1,95,00,000) = Rs. 5,45,00,000
  • Total Expenses = Management Fees (1,53,80,000) + Fixed Expenses (25,00,000) = Rs. 1,78,80,000
  • Net Pass-Through Income = Rs. 5,45,00,000 - Rs. 1,78,80,000 = Rs. 3,66,20,000
  • TDS under Sec 194LBB @ 10% = 3,66,20,000 * 10% = Rs. 36,62,000
  • Net Amount Distributed to Unitholders = 3,66,20,000 - 36,62,000 = Rs. 3,29,58,000

• For F.Y. 2023-2024:

  • Gross Income = Dividend (3,80,00,000) + Interest (1,95,00,000) = Rs. 5,75,00,000
  • Total Expenses = Management Fees (1,59,35,000) + Fixed Expenses (25,00,000) = Rs. 1,84,35,000
  • Net Pass-Through Income = Rs. 5,75,00,000 - Rs. 1,84,35,000 = Rs. 3,90,65,000
  • TDS under Sec 194LBB @ 10% = 3,90,65,000 * 10% = Rs. 39,06,500
  • Net Amount Distributed to Unitholders = 3,90,65,000 - 39,06,500 = Rs. 3,51,58,500

• For F.Y. 2024-2025:

  • Gross Income = Dividend (3,95,00,000) + Interest (1,95,00,000) = Rs. 5,90,00,000
  • Total Expenses = Management Fees (1,65,20,000) + Fixed Expenses (25,00,000) = Rs. 1,90,20,000
  • Net Pass-Through Income = Rs. 5,90,00,000 - Rs. 1,90,20,000 = Rs. 3,99,80,000
  • TDS under Sec 194LBB @ 10% = 3,99,80,000 * 10% = Rs. 39,98,000
  • Net Amount Distributed to Unitholders = 3,99,80,000 - 39,98,000 = Rs. 3,59,82,000

2. Computation of Capital Gains Tax on Redemption (March 31, 2025):

• Total Redemption Proceeds = 6,00,000 units * Rs. 1,195.00 = Rs. 71,70,00,000
• Original Capital Contribution = Rs. 60,00,00,000
• Total Capital Gains on Redemption = Rs. 71,70,00,000 - Rs. 60,00,00,000 = Rs. 11,70,00,000
• Withholding Obligation: Because redemption represents an investment exit by resident investors, no TDS is deductible by the AIF on capital gains on redemption. The resident unitholders are liable to pay their capital gains tax directly as per their applicable tax rate.

Example 2: Multi-Fund Pass-Through & Loss Set-Off (A.Y. 2025-26)

Background: We compare the income computations for four different Category II AIFs (ABC, PQR, XYZ, LMN) and their respective unitholders. Each fund is structured as a determinate trust and has 20 unitholders, each holding 1 unit for more than 12 months. Unitholders have no other source of income.

The income details for each fund are as follows:

Step-by-step Solution:

1. Fund-Level Total Income Computation: Under the ITA, business income is taxed at the fund level, whereas other passed-through incomes are exempt at the fund level.

• Fund ABC: Has business income of Rs. 50,00,000. It is taxed at the fund level at the Maximum Marginal Rate (MMR) (assuming trust structure). Non-business income (Rs. 30,00,000) is exempt at the fund level. Total taxable income of the fund = Rs. 50,00,000.
• Fund PQR: No business income. All income is pass-through. Total fund-level taxable income = NIL.
• Fund XYZ: In XYZ, the business loss of Rs. -50,00,000 is set off against the income from other sources of Rs. 90,00,000. This leaves a net income of Rs. 40,00,000 (under other sources) to be passed through. Total fund-level taxable income = NIL.
• Fund LMN: No business income. Capital losses and other income are passed through. Total fund-level taxable income = NIL.

2. Individual Unitholder Level Total Income Computation (20 unitholders each):

• Unitholder of Fund ABC:

  • Business Income: Fully exempt in the unitholder's hands since tax was paid by the fund.
  • Income from Other Sources: Rs. 30,00,000 / 20 unitholders = Rs. 1,50,000.
  • Total Taxable Income = Rs. 1,50,000.

• Unitholder of Fund PQR:

  • Capital Gains: Rs. 30,00,000 / 20 unitholders = Rs. 1,50,000.
  • Income from Other Sources: Rs. 80,00,000 / 20 unitholders = Rs. 4,00,000.
  • Total Taxable Income = Rs. 1,50,000 + Rs. 4,00,000 = Rs. 5,50,000.

• Unitholder of Fund XYZ:

  • Income from Other Sources: Net passed-through other income is Rs. 40,00,000 (after fund-level set-off). Rs. 40,00,000 / 20 unitholders = Rs. 2,00,000.
  • Total Taxable Income = Rs. 2,00,000.

• Unitholder of Fund LMN:

  • Income from Other Sources: Rs. 30,00,000 / 20 unitholders = Rs. 1,50,000.
  • Capital Losses: Rs. -40,00,000 / 20 unitholders = Rs. -2,00,000 (Loss).
  • Loss Treatment: Under the ITA, capital losses cannot be set off against income from other sources.
  • Since the unitholders have held the units for more than 12 months, this capital loss of Rs. 2,00,000 is carried forward to subsequent years in the unitholder's hands to be set off against future capital gains.
  • Total Taxable Income = Rs. 1,50,000.

2.7 Key Terms & Definitions

• Double Taxation Avoidance Agreement (DTAA): A bilateral treaty signed between two sovereign nations to prevent double taxation of the same income in both countries and facilitate international investments.
• Section 194LBB: The specific statutory provision of the ITA that mandates the deduction of tax at source (withholding tax) by Category I and II AIFs on income distributed or credited to unitholders.
• Impermissible Avoidance Arrangement (IAA): Under GAAR, an arrangement whose main purpose is to obtain a tax benefit and which lacks commercial substance, thereby allowing tax authorities to deny tax benefits.
• Input Tax Credit (ITC): A mechanism in GST allowing a taxable entity to reduce the tax they pay on output services by the amount of tax they already paid on inputs. For Category I and II AIFs, ITC is typically unrecoverable.
• Principal Purpose Test (PPT): A core standard introduced under the MLI that denies tax treaty benefits if obtaining those benefits was one of the principal reasons for entering into a specific transaction or structure.