CHAPTER 9: TAXATION — PART 3: GST, DISTRIBUTION, REDEMPTION & TRANSFER OF UNITS

9.4 GOODS AND SERVICES TAX (GST)

Chargeability of GST on AIF Management Fees

In the indirect tax regime, the services provided by an Alternative Investment Fund (AIF) Manager to the fund are classified as a "supply of services" under Section 7 of the Central Goods and Services Tax (CGST) Act, 2017. Specifically:

• Classification: The investment management services rendered by the Asset Management Company (AMC) or Fund Manager are categorised under "Financial and related Services" (Heading 997153 as per Notification 11/2017 – CGST (Rate)).
• Applicable GST Rate: A flat rate of 18% is levied on the gross Management Fees, Trusteeship Fees, and other administrative fees charged to the Category III AIF by the manager, trustee, and external service providers.

The Input Tax Credit (ITC) Bottleneck

Because Category III AIFs are pooled investment vehicles rather than commercial trading entities selling taxable physical goods or services to end consumers, they face a severe structural bottleneck regarding Goods and Services Tax:

• No Output Liability: Since the fund’s primary activity is investing in securities, derivatives, and debt, it does not generate any outward supply that attracts GST. Thus, the AIF has no output GST liability.
• Unusable Input Credits: Under GST laws, input tax credits (ITC) can only be set off against output tax liabilities. Because the fund has no output liability, it is unable to obtain any benefit of input tax credits for the GST paid on input services (such as management fees, trusteeship fees, audit fees, and legal charges).
• Cascading Cost: Consequently, the GST paid by the fund on its inputs becomes a direct, unrecoverable incremental cost for the Category III AIF, which directly reduces the fund’s Net Asset Value (NAV) and is indirectly borne by its unit holders.

GST on Off-shore vs. Domestic Pooling

The application of GST differs significantly depending on where the Category III AIF is domiciled and where its investors are located:

1. Domiciled in Offshore Jurisdictions

• When a fund is established in an offshore tax-friendly jurisdiction (such as Mauritius, Singapore, or Luxembourg) to pool capital from global investors and invest in India, the management fees charged by the offshore manager are treated as "export of services".
• Under Indian GST laws, exports of services are classified as zero-rated supplies and are completely exempt from GST.

2. Domiciled in India (Domestic AIFs with Foreign Investors)

• If a Category III AIF is domiciled in India but pools capital from overseas investors, the Indian tax authorities levy 18% GST on the management fees.
• This treatment violates the global principle of GST as a destination-based consumption tax, as the services are consumed by offshore investors. This inconsistency creates a strong disincentive, leading foreign investors to prefer investing through offshore hedge funds rather than Indian-domiciled AIFs.

AIPAC Recommendations on Foreign Capital Pooling

To eliminate this competitive disadvantage and encourage the on-shoring of fund management operations in India, the SEBI-formed Alternative Investment Policy Advisory Committee (AIPAC) submitted the following recommendations to the Ministry of Finance:

1. 100% Foreign Capital Exemption: AIFs that have 100% foreign investment (excluding the domestic sponsor/manager commitment) and locate their fund management operations in India should be entirely exempt from GST on the management services provided by the Indian manager. These services should qualify as an "export of services".
2. Pro-Rata or Lower GST Rates: AIFs that have at least 50% foreign investment should qualify for a zero rate of GST or a significantly lower rate. This would incentivize global managers to establish domestic desks and co-mingle domestic and foreign capital efficiently.

Performance Fees and GST Debates

There is an ongoing industry debate and lack of explicit guidance in the current GST framework regarding Performance Fees (Incentive Fees / Additional Returns):

• The Position of the GST Regime: The current statute is silent on whether GST is leviable on "Additional Returns" or "Preferred Returns" distributed to the manager.
• The Argument Against GST: Industry experts argue that Performance Fees are a profit-sharing mechanism (or reward for taking market risks) rather than a payment for a specific service. In a partnership or Limited Liability Partnership (LLP) structure, the distribution of profits to partners is outside the purview of GST. Therefore, performance fees should be treated as long-term capital gains accrued to the AIF rather than taxable service revenue.

Joint and Several Liability of Directors

• Under Section 89(1) of the CGST Act, if a Category III AIF is structured as a Private Limited Company and defaults on the payment of GST (including interest or penalties), a joint and several liability is cast upon all the directors of the company.
• The Safe Harbour Clause: This personal liability is not triggered if a director can prove that the non-recovery of taxes, interest, or penalty cannot be attributed to any gross negligence, misfeasance, or breach of duty on their part.

9.5 TAXATION ON DISTRIBUTION / REDEMPTION OF UNITS BY CATEGORY III AIFS

Representative Assessee Principle and Avoiding Double Taxation

• Assessment Mode: A Category III AIF structured as a Trust discharges its direct tax liability through its Trustee acting as a "Representative Assessee" under the Income Tax Act, 1961.
• Exemption on Distribution: Once the tax has been computed and paid at the fund level by the Trustee, no further tax is payable by the unit holders on the subsequent distribution of post-tax income. This ensures the avoidance of double taxation on the identical pool of earnings.

Early Redemption as a Taxable Transfer

• While the distribution of post-tax profits is exempt, if a unit holder decides to exit the fund prematurely by redeeming their units back to the Category III AIF, this transaction is treated as a separate taxable transfer.
• The redeeming investor may be liable to pay capital gains tax on the difference between the redemption payout and their cost of acquisition, over and above the tax already discharged by the fund on its underlying asset gains.

Dividend Stripping and Bond Washing (Section 94(1))

To prevent investors from buying units of an AIF just before a dividend or interest payout and selling them immediately after to claim artificial tax losses, Section 94(1) of the Income Tax Act, 1961 is strictly enforced:

• Provision: If an investor sells or transfers AIF units and subsequently reacquires the same units within a defined period, any interest, dividend, or other apportioned income attributable to those units will be deemed to be the taxable income of the investor (transferor) rather than the transferee.

Minimum Alternate Tax (MAT) for Corporate Beneficiaries

Corporate investors who invest in Category III AIFs must evaluate the impact of Minimum Alternate Tax (MAT) under Section 115JB:

• Trigger: If the income tax calculated on the corporate investor’s normal taxable income under the standard provisions of the Income Tax Act is lower than 18.5% (plus applicable surcharge and cess) of its book profits, the company is liable to pay MAT.
• Distribution Impact: Corporate beneficiaries must include the distributions received from a Category III AIF in their book profits, which can trigger an additional MAT liability.

Tax Deducted at Source (TDS) and Withholding Tax Obligations

Under the Income Tax Act, a Category III AIF has specific statutory obligations to withhold tax on distributions:

1. Withholding on Non-Business Income (Section 194LBB)

• Any income distributed by a Category III AIF to its investors—other than income in the nature of "Profits or Gains from Business or Profession"—is subject to withholding tax at source under Section 194LBB.

2. Deemed Distribution of Dividends (Section 194)

• Following the abolition of the Dividend Distribution Tax (DDT) by the Finance Act, 2020, dividend income received from domestic companies is taxable in the hands of the fund.
• Under Section 194, any dividend income earned by the fund is deemed to be distributed in the identical year in which it is received. Consequently, TDS must be deducted in that financial year, regardless of whether the dividend is physically distributed to the unit holders or retained/reinvested in the fund.

TDS Rates for Resident vs. Non-Resident / PAN-less Investors

A Category III AIF is liable to deduct tax at source at the following rates:

• Resident Investors / Domestic Companies: 10% at the time of credit or payment of such income (whichever is earlier). The threshold for trigger is an aggregate distribution exceeding Rs. 5,000 in a financial year.
• Resident Investors without PAN: 20% if the resident investor fails to quote their Permanent Account Number (PAN) to the fund.
• Non-Resident Investors (Section 195(3) concessions):
  • A non-resident investor can apply to the Assessing Officer (AO) for a lower withholding or nil withholding certificate.
  • Alternatively, they can submit a certificate issued by a Chartered Accountant in a prescribed format.
  • Upon receiving these valid certificates, the AIF will make the distribution payment either without any tax deduction or at the lower rate specified in the certificate.

Mathematical Case Study: Withholding Taxes on Distributions (Fund WT)

Fund Profile & Parameters:

• Committed Capital: Rs. 60,00,00,000
• Units Issued: 6,00,000 units
• Initial NAV: Rs. 1,000 per unit
• Legal Structure: Irrevocable, Determinate Trust
• TDS Rate (Section 194LBB & Section 194): Flat 10% (Assuming all investors are residents with PAN)
• Liquidation NAV (end of F.Y. 2023-2024): Rs. 1,195.00

Fund Income & Operational Metrics:

The fund recorded the following income and expense parameters across three financial years:

• Note: Interest income from debentures is distributed on a yearly basis. Dividend income is deemed as distributed in the identical year of receipt. All remaining assets are distributed on final redemption on March 31, 2024.

Year-by-Year Withholding Tax Calculations:

1. Financial Year 2021-2022

• Yearly Interest Income: Rs. 1,95,00,000
• Yearly Dividend Income (Deemed Distributed): Rs. 3,50,00,000
• Redemption Payout: NIL
• Yearly Gross Distributions (Interest + Dividend): 1,95,00,000 + 3,50,00,000 = Rs. 5,45,00,000
• Withholding Tax (TDS @ 10%): 5,45,00,000 * 10% = Rs. 54,50,000
• Yearly Net Distribution: 5,45,00,000 - 54,50,00,000 = Rs. 4,90,50,000

2. Financial Year 2022-2023

• Yearly Interest Income: Rs. 1,95,00,000
• Yearly Dividend Income (Deemed Distributed): Rs. 3,80,00,000
• Redemption Payout: NIL
• Yearly Gross Distributions: 1,95,00,000 + 3,80,00,000 = Rs. 5,75,00,000
• Withholding Tax (TDS @ 10%): 5,75,00,000 * 10% = Rs. 57,50,000
• Yearly Net Distribution: 5,75,00,000 - 57,50,000 = Rs. 5,17,50,000

3. Financial Year 2023-2024 (Liquidation Year)

• Yearly Interest Income: Rs. 1,95,00,000
• Yearly Dividend Income (Deemed Distributed): Rs. 3,95,00,000
• Redemption Distributions to Investors (6,00,000 units redeemed @ Rs. 1,195 Net NAV): 6,00,000 * 1,195 = Rs. 71,70,00,000
• Yearly Gross Distributions: 1,95,00,000 + 3,95,00,000 + 71,70,00,000 = Rs. 77,60,00,000
• Withholding Tax (TDS @ 10%): 77,60,00,000 * 10% = Rs. 7,76,00,000
• Yearly Net Distribution: 77,60,00,000 - 7,76,00,000 = Rs. 69,84,00,000

9.6 TAXATION ON TRANSFER OF CATEGORY III AIF UNITS BY INVESTORS

Transfer Mechanism and Capital Asset Classification

To allow investors to exit a closed-ended or lock-in scheme prior to the fund's maturity, Category III AIFs must disclose a unit transfer mechanism in their Private Placement Memorandum (PPM).

• The Charging Section: Section 45 of the Income Tax Act, 1961 dictates that any profit or gain arising from the transfer of a "Capital Asset" is chargeable to income tax under the head "Capital Gains".
• Transfer Definition (Section 2(47)): Includes the "sale, exchange, or relinquishment" of the asset.
• Capital Asset Definition (Section 2(14)): Includes shares, securities, and units of "equity-oriented investment funds".

SEBI AIPAC Recommendations on "Equity-Oriented Investment Fund" Definition

Under the standard provisions of the Income Tax Act, Category III AIF units were historically excluded from the definition of "equity-oriented investment funds", which applied only to mutual funds. This subjected AIF unit transfers to high tax rates.

To bring parity, the SEBI Alternative Investment Policy Advisory Committee (AIPAC) recommended expanding the definition of an "equity-oriented investment fund" to include any SEBI-registered Category III AIF that meets the following conditions:

Condition A: If the Category III AIF invests in units of another fund (Fund of Funds)

1. A minimum of 90% of the total proceeds of the Category III AIF must be invested in the units of the other fund.
2. The underlying investee fund must also invest a minimum of 90% of its total proceeds in equity shares of domestic companies listed on a recognized stock exchange in India.

Condition B: In any other case (Direct Investing)

• The investable funds must be invested in equity shares of domestic companies listed on a recognized stock exchange in India to the extent of more than 65% of the total proceeds of such fund.
• Method of Calculation: The percentage of equity shareholding must be calculated based on the annual average of the monthly averages of the opening and closing Net Asset Value (NAV) of the fund.

Capital Gains Computation Mechanism

The taxable capital gain on the transfer of Category III AIF units is calculated as follows:

Capital Gain = Full Value of Consideration - Cost of Acquisition - Cost of Improvement - Transfer Expenditure

Where:

• Full Value of Consideration: The transaction price or NAV at which the units are transferred to the new buyer.
• Cost of Acquisition: The price paid to purchase the units (usually Rs. 1,000 per unit at inception).
• Transfer Expenditure: Costs directly incurred in connection with the transfer (such as broker commissions or exchange fees).

Tax Rates for Equity-Oriented vs. Non Equity-Oriented AIFs

The tax rate on unit transfers depends on whether the Category III AIF is classified as equity-oriented:

Case A: If Classified as an "Equity-Oriented Investment Fund"

• Holding Period for Long-Term: More than 12 months preceding the date of transfer.
• Short-Term Capital Gains (STCG): Taxed at 20% (plus surcharge and cess).
• Long-Term Capital Gains (LTCG): Taxed at 12.5% (plus surcharge and cess).

Case B: If Classified as a "Non Equity-Oriented Investment Fund"

• Holding Period for Long-Term: More than 36 months preceding the date of transfer.
• Tax Treatment: Taxed at individual slab rates applicable to the investor.

Section 14A Expense Disallowance

• Under Section 14A of the Income Tax Act, any expenses incurred by the Category III AIF in managing its investments—including Management Fees, Performance Fees, and Operational Costs—are disallowed from being treated as "expenditure incurred in connection with the transfer" by the investor.
• Because no deduction is permitted for these operational expenses, the cost of management is directly borne by the unit holders without any tax relief, reducing their post-tax net returns.

Stamp Duty Framework and Collection by RTAs

• Under the amendments to the Indian Stamp Act, 1899 (effective July 1, 2020), a uniform stamp duty of 0.015% is levied on the issue, transfer, and sale of AIF units, whether executed on-market or off-market, and whether in physical or dematerialised form.
• The Central Government has authorized the Registrar and Transfer Agents (RTAs) of AIFs to act as the official collecting agents for this stamp duty.

Mathematical Case Study: Capital Gains on Unit Transfers (Fund TM)

Fund Profile & Parameters:

• Fund Name: Fund TM (Equity-Oriented Investment Fund)
• Total Capital Commitments: Rs. 60,00,00,000
• Fund Launch Date: April 01, 2020
• Fund Liquidation Date: March 31, 2025
• Liquidation NAV: Rs. 1,225 per unit
• Surcharge on Capital Gains Tax: Flat 15%
• Health and Education Cess: Flat 4%

Unit Class Setup:

• Class A Units: 3,00,000 units issued @ Rs. 1,000 per unit on April 01, 2020 (Held till Liquidation on March 31, 2025).
• Class B Units: 1,50,000 units issued @ Rs. 1,000 per unit on April 01, 2020 (Transferred on April 15, 2024 @ Rs. 1,150 per unit).
• Class F Units: 1,50,000 units issued @ Rs. 1,000 per unit on April 01, 2020 (Held till Liquidation on March 31, 2025).
• Class C Units (New): 1,50,000 units acquired on April 15, 2024 @ Rs. 1,150 per unit from the Class B sellers (Held till Liquidation on March 31, 2025).

Step 1: Holding Period and Gains Characterisation:

• Class B Units: Held from April 01, 2020 to April 15, 2024 (48 months and 14 days). Since the holding period is more than 12 months, the gain is characterized as Long-Term Capital Gain (LTCG).
• Class A Units: Held from April 01, 2020 to March 31, 2025 (60 months). Characterized as Long-Term Capital Gain (LTCG).
• Class F Units: Held from April 01, 2020 to March 31, 2025 (60 months). Characterized as Long-Term Capital Gain (LTCG).
• Class C Units: Held from April 15, 2024 to March 31, 2025 (11 months and 16 days). Since the holding period is less than 12 months, the gain is characterized as Short-Term Capital Gain (STCG).

Step 2: Computation of Capital Gains and Tax Liability:

1. Class B Units (LTCG Payout on Transfer)

• Full Value of Consideration (1,50,000 units @ Rs. 1,150): Rs. 17,25,00,000
• Less: Cost of Acquisition (1,50,000 units @ Rs. 1,000): Rs. 15,00,00,000
• Long-Term Capital Gain (LTCG): 17,25,00,000 - 15,00,00,000 = Rs. 2,25,00,000
• Base LTCG Tax (@ 12.5%): 2,25,00,000 * 12.5% = Rs. 28,12,500
• Add: Surcharge (@ 15%): 28,12,500 * 15% = Rs. 4,21,875
• Add: Cess (@ 4%): (28,12,500 + 4,21,875) * 4% = Rs. 1,29,375
• Total Long-Term Capital Gains Tax Payable: 28,12,500 + 4,21,875 + 1,29,375 = Rs. 33,63,750

2. Class A Units (LTCG Payout on Liquidation)

• Full Value of Consideration (3,00,000 units @ Rs. 1,225): Rs. 36,75,00,000
• Less: Cost of Acquisition (3,00,000 units @ Rs. 1,000): Rs. 30,00,00,000
• Long-Term Capital Gain (LTCG): 36,75,00,000 - 30,00,00,000 = Rs. 6,75,00,000
• Base LTCG Tax (@ 12.5%): 6,75,00,000 * 12.5% = Rs. 84,37,500
• Add: Surcharge (@ 15%): 84,37,500 * 15% = Rs. 12,65,625
• Add: Cess (@ 4%): (84,37,500 + 12,65,625) * 4% = Rs. 3,88,125
• Total Long-Term Capital Gains Tax Payable: 84,37,500 + 12,65,625 + 3,88,125 = Rs. 1,00,91,250

3. Class F Units (LTCG Payout on Liquidation)

• Full Value of Consideration (1,50,000 units @ Rs. 1,225): Rs. 18,37,50,000
• Less: Cost of Acquisition (1,50,000 units @ Rs. 1,000): Rs. 15,00,00,000
• Long-Term Capital Gain (LTCG): 18,37,50,000 - 15,00,00,000 = Rs. 3,37,50,000
• Base LTCG Tax (@ 12.5%): 3,37,50,000 * 12.5% = Rs. 42,18,750
• Add: Surcharge (@ 15%): 42,18,750 * 15% = Rs. 6,32,813
• Add: Cess (@ 4%): (42,18,750 + 6,32,813) * 4% = Rs. 1,94,062
• Total Long-Term Capital Gains Tax Payable: 42,18,750 + 6,32,813 + 1,94,062 = Rs. 50,45,625

4. Class C Units (STCG Payout on Liquidation)

• Full Value of Consideration (1,50,000 units @ Rs. 1,225): Rs. 18,37,50,000
• Less: Cost of Acquisition (1,50,000 units @ Rs. 1,150): Rs. 17,25,00,000
• Short-Term Capital Gain (STCG): 18,37,50,000 - 17,25,00,000 = Rs. 1,12,50,000
• Base STCG Tax (@ 20%): 1,12,50,000 * 20% = Rs. 22,50,000
• Add: Surcharge (@ 15%): 22,50,000 * 15% = Rs. 3,37,500
• Add: Cess (@ 4%): (22,50,000 + 3,37,500) * 4% = Rs. 1,03,500
• Total Short-Term Capital Gains Tax Payable: 22,50,00,000 * (1 + 0.15) * (1 + 0.04) - principal = Rs. 26,91,000

KEY EXAM TAKEAWAYS

1. GST Rate on Fees: AIF management fees and trusteeship fees are subject to flat 18% GST. Since AIFs have no output tax liabilities, this GST represents an unrecoverable unusable input tax credit bottleneck that directly acts as an incremental cost to the fund’s NAV.
2. IFSC GST Exemption: Category III AIFs operating within an International Financial Services Centre (IFSC), such as GIFT City, are completely exempt from GST on management, trusteeship, and other third-party service fees.
3. AIPAC GST Recommendations: SEBI's AIPAC recommended that domestic AIFs with 100% foreign investment should be exempt from GST on management fees as "export of services".
4. withholding Tax under 194LBB: All non-business income distributed by a Category III AIF is subject to withholding tax under Section 194LBB at 10% for residents and 20% if no PAN is provided.
5. deemed Dividend Distribution: Following the Finance Act, 2020, dividend income received by the fund is deemed distributed in the identical year of receipt, requiring immediate withholding tax deductions under Section 194 regardless of actual payout.
6. Section 94(1) Anti-Avoidance: If an investor transfers units and reacquires them shortly after, any interest or dividend earned during the transfer period is deemed the income of the original transferor.
7. LTCG Holding Period for Units: If a Category III AIF qualifies as an "equity-oriented investment fund" (maintaining >65% domestic listed equity exposure), the holding period threshold for Long-Term Capital Gains on its units is 12 months.
8. Disallowed Expenses (Section 14A): Under Section 14A, all expenses incurred by the fund (management fees, fixed costs, performance fees) are disallowed from being treated as cost of transfer, meaning the investors cannot deduct these from their capital gains calculations.
9. Stamp Duty collection: A flat 0.015% stamp duty is payable on the issue, transfer, or sale of AIF units, collected systematically by the Registrars and Transfer Agents (RTAs).

AIF TAXATION DICTIONARY (PART 3)

• Export of Services: Services provided by an entity in India to a recipient located outside India, which are settled in convertible foreign exchange and are zero-rated (exempt) under GST laws.
• Input Tax Credit (ITC): The tax paid by a business on its purchase of inputs (goods or services), which can normally be used to reduce its tax liability on output sales.
• Dividend Stripping: A tax-avoidance practice where an investor buys securities just before a dividend payout, receives the tax-exempt dividend, and then sells the security at a loss to offset other capital gains.
• Withholding Tax: Tax systematically deducted at source by the payer (e.g., the AIF Trustee) before distributing income to the payee (the investor) and deposited directly with the government.
• Section 194LBB: The section of the Income Tax Act, 1961 that mandates a 10% withholding tax on all non-business distributions made by registered Investment Funds to resident investors.
• Equity-Oriented Investment Fund: A fund where more than 65% of the total proceeds are invested in listed equity shares of domestic companies, calculated using the annual average of monthly averages of opening and closing NAV.
• Section 14A: The section of the Income Tax Act, 1961 that disallows deductions for any expenditure incurred in relation to income that is exempt from income tax.
• Registrar and Transfer Agent (RTA): A registered intermediary appointed by the AIF to handle unit issuance, transfer, redemptions, and act as a collecting agent for uniform stamp duties.
• General Anti-Avoidance Rule (GAAR): An anti-tax avoidance framework designed to curb aggressive tax planning and re-characterize arrangements that lack commercial substance.