CHAPTER 9: TAXATION — PART 1: TAX REGIMES & TRUST STRUCTURES

9.1 COMPARISON OF TAX-REGIME AMONG ALL CATEGORIES OF AIFS

Introduction to AIF Legal Structures and Taxation

Under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012, a Category III Alternative Investment Fund (AIF) can be registered in India under multiple legal structures. These permissible legal structures include:

• Trust: Established under the Indian Trusts Act, 1882.
• Company: Incorporated under the Companies Act, 2013.
• Limited Liability Partnership (LLP): Registered under the Limited Liability Partnership Act, 2008.
• Body Corporate: Set up under central or state legislatures.

To prevent the cascading effect of double taxation (taxing the same income both when earned by the fund and when distributed to the investors), the Income Tax Act, 1961 outlines specific taxation principles. Taxation of gains is either paid directly by the investors, or paid by the AIF on behalf of its investors.

The Concept of "Tax Pass-Through"

A "Tax Pass-Through" status means that the income generated by an investment vehicle is not subject to tax at the fund level. Instead, the tax liability is passed directly to the ultimate investors (unit holders), who pay tax on such income in their individual capacity based on their respective tax slabs and pro-rata holdings.

Category I & Category II AIFs (The "Investment Funds")

Under Section 115UB of the Income Tax Act, 1961, Category I and Category II AIFs are officially classified as "Investment Funds" and enjoy a statutory tax pass-through status for all income streams except business income:

• Exemption at Fund Level: Section 10(23FBA) provides that any income of an Investment Fund (Category I & II AIF), other than "profits or gains from business or profession," is completely exempt from tax at the fund level. This includes Capital Gains, Dividend Income, and Interest Income.
• Taxation in Investor Hands: This non-business income is taxed directly in the hands of the unit holders under Section 115UB in the identical manner as if the income had accrued to or been received by the unit holder directly.
• The Business Income Exception: Any income earned by Category I or II AIFs that is characterized as "profits or gains from business or profession" (Business Income) is taxable at the fund level.
• Section 10(23FBB) Protection: To prevent double taxation, Section 10(23FBB) ensures that once the fund pays tax on its business income, any distribution of this business income received by the unit holder is completely exempt from tax in their hands.

Category III AIFs (No Pass-Through Status)

Category III AIFs are not classified as "Investment Funds" under Section 115UB and, therefore, are not accorded tax pass-through status.

• The entire income generated by a Category III AIF (including Business Income, Capital Gains, Dividends, and Interest) is taxable at the fund level.
• The tax liability is discharged by the AIF (either through its corporate/LLP structure or through its Trustees as representative assessees), and the net post-tax income is distributed to unit holders.

Tax Applicability Based on the Fund's Legal Structure

Because Category III AIFs are taxed at the fund level, the applicable tax rates depend entirely on the legal structure selected during registration:

1. Company or Limited Liability Partnership (LLP) Structure

• Where the Category III AIF is structured as a Company or an LLP, the total income of the fund is charged to tax as per the statutory corporate tax rates or partnership tax rates applicable to Companies or LLPs under the Income Tax Act, 1961.

2. Trust Structure

• Where the Category III AIF is structured as a Trust, the total income of the fund is charged to tax at the Maximum Marginal Rate (MMR), which is currently 30% plus applicable surcharges and health & education cesses.

Detailed Surcharge Rates & Health and Education Cess

The final effective tax rate of a Category III AIF structured as a Trust is determined by adding surcharges and cesses to the base MMR of 30%:

Surcharge Rates for Trust Structure (Individuals / HUFs / AOPs / BOIs)

Under the tax regime, the surcharge calculated on the base tax liability of the Trust is as follows:

• Total Income up to Rs. 50 Lakh: 0% Surcharge.
• Total Income > Rs. 50 Lakh to Rs. 1 Crore: 10% Surcharge.
• Total Income > Rs. 1 Crore to Rs. 2 Crore: 15% Surcharge.
• Total Income exceeding Rs. 2 Crore: Capped at 25% maximum surcharge under the new tax regime.

Surcharge Rates for Corporate Structures

If the AIF is structured as a company, the corporate surcharge is as follows:

• Total Income exceeds Rs. 1 Crore but does not exceed Rs. 10 Crore: 7% Surcharge.
• Total Income exceeds Rs. 10 Crore: 12% Surcharge.
• Companies opting for lower tax rates (Section 115BAA or 115BAB): Flat surcharge of 10% regardless of income.

Health and Education Cess

• A Health and Education Cess is levied at a flat rate of 4% on the aggregate of the base tax and the calculated surcharge.

Formula for Maximum Marginal Rate (MMR) Calculation:

MMR = Base Tax Rate * (1 + Surcharge Rate) * (1 + Cess Rate) MMR = 30% * (1 + 0.25) * (1 + 0.04) = 39%

Treatment of Losses: Category I & II vs. Category III

The tax efficiency of an AIF is highly influenced by how the tax laws treat business and investment losses:

Category I & II AIF Loss Rules (Section 115UB)

• Business Losses: Business losses incurred by Category I & II funds are retained at the fund level and are not passed through to unit holders. The fund can carry forward and set off these business losses against its future business income.
• Non-Business Losses (e.g., Capital Losses): These are passed through directly to the unit holders, provided they have held the units for a minimum period of 12 months. These losses cannot be set off or carried forward at the fund level.
• Accumulated Losses (as on March 31, 2019): Losses (other than business losses) accumulated as of March 31, 2019, are deemed as individual losses of the unit holders who held units as of that date. Investors can carry forward these losses in their personal tax returns for up to 8 years from the year the loss was first incurred by the fund.

Category III AIF Loss Rules (The Retained Loss Bottleneck)

• Because Category III AIFs are not granted pass-through status, all losses (whether business losses or capital losses) are retained strictly at the fund level.
• These losses cannot be passed through to unit holders. The fund must carry forward and set off these losses against its own future taxable income under the respective heads of income. This acts as a primary bottleneck for Category III AIF structures.

9.2 TAXATION PRINCIPLES APPLICABLE TO TRUST STRUCTURE

Rationale for Selecting the Trust Structure

The majority of AIFs in India are established as private trusts registered under the Indian Trusts Act, 1882. The primary enablers for this preference are:

1. High Operational Flexibility: Private trusts allow the Sponsor and Manager to incorporate bespoke (customised) terms of governance, investment strategies, and fee arrangements directly into the trust deed.
2. Tax Pass-Through Benefits for Non-Business Income: Under specific conditions of determinacy, trusts allow non-business income to flow directly to investors without fund-level taxation.

Essential Parties in a Trust

A private trust is constituted of three essential entities:

• Settlor (or Contributor): The entity or individual who indicates the intention to create the trust and transfers the "Trust Property" (initial capital) to the trust.
• Trustee: The person or corporate body to whom the property is legally transferred and who is charged with administering the trust property in accordance with the Trust Deed.
• Beneficiary (or Unit Holder): The individual or institution for whose benefit the trust is created and who holds beneficial interest in the trust assets.

9.2.1 Determinate Trust vs. Indeterminate Trust

From a direct tax perspective, private trusts are classified as either Determinate or Indeterminate. This classification alters the tax assessment of the Trustee.

Determinate Trust

• Definition: A trust is considered a "Determinate Trust" if the individual beneficiaries and their exact beneficial shares (pro-rata entitlement) are clearly specified, ascertainable, and identifiable in the 'Indenture of Trust' (Trust Deed) at all times during the existence of the trust.
• ITAT Clarification: The Income Tax Appellate Tribunal (ITAT) has ruled that the beneficiaries and their shares must be capable of being ascertained on the date of the trust deed itself. However, if the trust deed permits the addition of subsequent contributors at different points of time, this clause does not make the trust indeterminate or the beneficiaries unknown.

Indeterminate Trust

• Definition: A trust is classified as an "Indeterminate Trust" if the ultimate beneficiaries or their respective beneficial interests are not explicitly defined, ascertainable, or specified in the Trust Deed.
• Discretionary Nature: The Trustee exercises absolute discretion regarding the utilization of trust assets and the distribution of income to beneficiaries.

Taxation of Determinate Trusts

If an AIF is established as a Determinate Trust, the Trustee is assessed as a "Representative Assessee" under Section 161 of the Income Tax Act, 1961:

1. Business Income (Section 161(1A))

• If the income of a Determinate Trust includes "Profits or Gains from Business and Profession" (e.g., gains from derivatives trading or high-frequency stock trading treated as stock-in-trade), the entire business income is taxed at the Maximum Marginal Rate (MMR) of 39%.
• This tax must be paid by the Trustee in their capacity as a representative assessee.

2. Non-Business Income (Section 161(1))

• If the Determinate Trust earns income other than business income (such as Long-Term or Short-Term Capital Gains, Interest, or Dividends):
  • The Assessing Officer (AO) can assess this income in the hands of the Trustee as a "representative assessee" of the beneficiaries.
  • In this case, the MMR of tax does not apply to capital gains. Instead, the tax is recovered from the Trustee in the "like manner and to the same extent" as it would be leviable upon the beneficiaries directly.
  • Section 166 Route: Alternatively, the tax department has the option to assess this non-business income directly in the hands of the ultimate beneficiaries (unit holders).
  • Tax Credit: Any income tax paid by the Trustee as a Representative Assessee is available as a tax credit to the beneficiaries against their personal tax liability.

Taxation of Indeterminate Trusts (Section 164)

• MMR at Fund Level: Under Section 164 of the Income Tax Act, 1961, the Trustee of an Indeterminate Trust is assessed as a representative assessee and must pay tax on the entire income of the trust at the Maximum Marginal Rate (MMR) (currently 39%).
• No Investor-Level Tax: Because individual beneficial interests are unknown, the provisions of Section 166 (direct assessment of beneficiaries) cannot be invoked. No tax is payable on these earnings in the hands of the unit holders.

Revocable Trust vs. Irrevocable Trust

Trust deeds are also categorized by their revocability:

Irrevocable Trust

• A trust is "Irrevocable" if the Settlor does not retain any powers to revoke, cancel, or prematurely terminate the trust. The trust must continue its operations until its defined purpose is accomplished or its stipulated tenure is complete.
• AIF Standard: To safeguard investor interests and prevent abrupt fund dissolution, all AIFs structured as trusts are compulsorily set up as Irrevocable Trusts.

Revocable Trust (Section 61 Impact)

• A trust is "Revocable" if the Settlor retains the power to revoke the trust at their discretion, or with the consent of the beneficiaries.
• Revocable Transfer definition: Under Section 61 of the Income Tax Act, 1861, a transfer of an asset via a contribution agreement is deemed revocable if:
  1. It contains provisions for the direct or indirect re-transfer of the income generated by the asset back to the transferor (settlor/investor).
  2. It gives the transferor the right to re-assume direct or indirect power over the transferred asset or the income arising from it.
• Tax Consequence: If a trust is deemed revocable, Section 61 is triggered. All income arising to the trust from such assets is clubbed and charged to tax directly in the hands of the transferor (investor), rather than being assessed at the trust level.

Summary Matrix: Tax Pass-Through Status of Trust-Structured AIFs

This table outlines the final tax regimes applicable to private trusts depending on their determinacy, revocability, and source of income:

KEY EXAM TAKEAWAYS

1. Tax Pass-Through Discrepancy: Category I and Category II AIFs are recognized as "Investment Funds" under Section 115UB and possess tax pass-through status for non-business income. Category III AIFs do not have tax pass-through status; all income is taxed at the fund level.
2. Taxation of Business Income: For all three categories of AIFs, "profits and gains from business or profession" are taxed at the fund level.
3. Maximum Marginal Rate (MMR): For an AIF structured as a Trust, the MMR of tax is 39% (consisting of 30% base tax, 25% surcharge for income exceeding Rs. 2 Crore, and 4% health & education cess).
4. Loss Bottleneck: Unlike Category I & II where non-business losses flow to unit holders, Category III AIFs must retain all losses at the fund level. Unit holders cannot carry forward or set off Category III AIF losses in their individual tax returns.
5. Adding Beneficiaries: A determinate trust's status is not compromised or rendered indeterminate if the trust deed permits the addition of further contributors to the trust at different points in time.
6. Representative Assessee: Trustees are assessed as representative assessees of the unit holders under Section 161 (for determinate trusts) and Section 164 (for indeterminate trusts).
7. Revocable Transfer Penalty: If a contribution agreement allows the investor to re-assume power or re-transfer income, the transfer is "revocable" under Section 61, and all trust income from that asset is taxed directly in the hands of the investor.

AIF TAXATION DICTIONARY (IMPORTANT TERMS)

• Tax Pass-Through: A tax mechanism where a pooled investment vehicle's income is exempt from taxation at the entity level, and the tax liability is transferred to the ultimate unit holders.
• Maximum Marginal Rate (MMR): The highest rate of income tax (including applicable surcharge and cess) specified in the Finance Act for the relevant association of persons, individuals, or companies.
• Determinate Trust: A trust in which the beneficiaries and their respective beneficial shares are specified and ascertainable from the Trust Deed at all times during the trust's existence.
• Indeterminate Trust: A trust in which the beneficiaries or their pro-rata beneficial interests are not specified or ascertainable in the Trust Deed, making the distributions discretionary.
• Representative Assessee: An individual or corporate entity (such as a Trustee) who is legally assessed and pays income tax on behalf of another person (the beneficiary) whom they represent.
• Surcharge: An additional tax levied on the existing tax liability of an assessee once their total income exceeds specific threshold slabs.
• Health and Education Cess: A flat tax-on-tax (currently 4% in India) levied on the sum of base income tax and surcharge to fund national health and education initiatives.
• Section 115UB: The specific section of the Income Tax Act, 1961 that regulates the tax pass-through framework and treatment of income and losses for Category I and Category II AIFs.
• Section 61: The section of the Income Tax Act, 1961 governing revocable transfers of assets, which mandates that income from revocable transfers must be taxed in the hands of the transferor.