COMPREHENSIVE STUDY NOTES: NISM SERIES XIX-B AIF (CATEGORY III) DISTRIBUTORS

CHAPTER 9: TAXATION (FROM SECTION 9.7 TO END)

SECTION 9.7: TAX APPLICABILITY TO CATEGORY III AIFS IN IFSC

The International Financial Services Centre (IFSC), established at GIFT City in Gandhinagar, Gujarat, represents a special economic zone designed to provide world-class financial services to global and domestic participants under a unified regulatory framework overseen by the International Financial Services Centres Authority (IFSCA). Category III Alternative Investment Funds (AIFs) set up within the IFSC are granted a highly competitive and concessionary tax regime. This framework is structured to eliminate tax drag, avoid cascading tax effects, and offer an investment environment comparable to popular global offshore hubs like Mauritius, Singapore, or the Cayman Islands.

1. Core Direct and Indirect Tax Incentives under the Income Tax Act, 1961

IFSC-domiciled Category III AIFs benefit from several direct statutory exemptions and concessionary tax rates under the Income Tax Act, 1961:

1.1 Tax Holiday under Section 80LA

Any unit of an AIF set up in an IFSC can avail of a 100% tax deduction from its Gross Total Income.

• Duration: This deduction is available for any 10 consecutive years out of a total block of 15 years.
• Commencement: The fund can choose its tax holiday period starting with the financial year in which the requisite operating permission was obtained from the regulator.

1.2 Concessionary Minimum Alternate Tax (MAT) Rates

For corporate AIF structures or corporate unit holders, MAT is applicable at a highly reduced rate:

• IFSC Rate: 9% of book profits.
• General Domestic Rate: 18.5% of book profits.
• Condition: The concessionary 9% rate applies if the AIF located in the IFSC derives its income solely in convertible foreign exchange.

1.3 Exemption from Securities Transaction Tax (STT)

• Any transaction of sale or purchase of securities undertaken on a recognized stock exchange located in an IFSC is completely exempt from STT.
• Even though STT is not paid, these transactions remain eligible for the concessionary tax rates on capital gains, which normally require STT payment. Specifically, short-term capital gains are taxed under Section 111A, and long-term capital gains are taxed under Section 112A.

2. Special Concessions and Relaxations under the Taxation Act, 2020

The Taxation and Other Laws (Relaxation and Amendment of Certain Provisions) Act, 2020 (commonly referred to as the Taxation Act, 2020) introduced vital structural relaxations to encourage offshore fund aggregation within the IFSC:

2.1 Criteria for a Category III AIF to Qualify for Concessions

To claim the special exemptions under the Taxation Act, 2020, a Category III AIF must satisfy the following cumulative conditions:

1. Location: It must be physically located in an IFSC and registered with SEBI as a Category III AIF.
2. Legal Structure: It must be established as a trust, company, or Limited Liability Partnership (LLP).
3. Foreign Portfolio Investor (FPI) Registration: It must hold a Certificate of Registration as an FPI under the SEBI (Foreign Portfolio Investors) Regulations, 2019. Under exchange control guidelines, the IFSC-based AIF is treated as a "person resident outside India", and its downstream investments must comply with the National Debt Instrument (NDI) Rules.
4. Investor Profile: All units issued by the Category III AIF must be held strictly by non-resident investors, with the sole exception of units held by the fund's investment manager and the sponsor.

2.2 Income Exemptions at the Fund Level

For a qualifying IFSC-domiciled Category III AIF, the Taxation Act, 2020 exempts the following streams of income from tax at the fund level:

• Transfer of Non-Equity Securities: Any income accrued, arisen, or received from the transfer of specified capital assets (Global Depository Receipts, Rupee-denominated Bonds, derivatives, mutual fund units, or business trust units) listed on an IFSC stock exchange is fully exempt.
• Indian Derivatives and Debt Securities: Any income received from the transfer of derivatives or debt securities issued by Indian companies is fully exempt, irrespective of whether these securities are traded on an IFSC stock exchange or a domestic stock exchange.
• Overseas Securities: Any income received from the transfer of securities held in the form of offshore/overseas investments is fully exempt.

2.3 Business Income Exemption on Securitisation Trusts

Any income received by an IFSC-based Category III AIF from a Securitisation Trust under the head 'Profits and Gains from Business and Profession' is exempt from tax to the extent that such income is pro-rata attributable to the units held by non-resident investors in the AIF.

2.4 Tax Exemption for Unit Holders under Section 10(23FBC)

Any income accrued to, arising to, or received by unit holders from their investments in an IFSC-domiciled Category III AIF, or any gain arising to investors on the transfer of their units in such an AIF, is completely exempt from income tax. This effectively establishes a complete "tax pass-through" for non-resident investors in the IFSC.

2.5 Exemption from Alternate Minimum Tax (AMT)

Under Section 115JEE of the Income Tax Act, 1961, Category III AIFs set up in an IFSC as trusts or LLPs are fully exempt from the provisions of Alternate Minimum Tax (AMT), ensuring that tax calculations are streamlined and predictable.

3. Comprehensive Tax Rates Applicable in IFSC (Table 9.2)

The tax rates applicable to various streams of income generated by a Category III AIF domiciled in an IFSC vary depending on the tax residency status of the investors:

Note: The tax rates listed above exclude applicable surcharge and health and education cess.

4. Withholding Tax (TDS) Obligations for IFSC Funds

The Taxation Act, 2020 lays down specific withholding tax (TDS) requirements for entities distributing income to, or paying income from, an IFSC-domiciled Category III AIF:

4.1 Base Withholding Rate

Any person responsible for paying any income, other than capital gains, to a Category III AIF located in an IFSC must deduct tax at source at the rate of 10% at the time of credit or payment, whichever is earlier.

4.2 Reduced Withholding Rate under Section 194LD

For interest income arising from rupee-denominated bonds of an Indian company, Government securities, or municipal debt securities, the withholding tax is deducted at a reduced concessionary rate of 5%.

4.3 Capital Gains TDS Exemption

Importantly, no withholding tax (TDS) is applicable on any capital gains accruing to an IFSC-domiciled Category III AIF upon the transfer of securities, protecting the fund's cash flows during portfolio rebalancing.

SECTION 9.8: TAX IMPACT ON PERFORMANCE OF CATEGORY III AIF

The performance of a Category III AIF is highly sensitive to the tax jurisdiction in which it is domiciled and the tax structures it utilizes. Direct tax liabilities (income tax, capital gains tax) and indirect tax liabilities (Goods and Services Tax) directly affect the fund's Net Asset Value (NAV), reducing the Net Internal Rate of Return (Net IRR) and actual payouts delivered to investors.

1. Strategic Jurisdictional Routing and Double Tax Avoidance Agreements (DTAAs)

To optimize returns and mitigate tax drag, fund sponsors often evaluate international routing options alongside domestic Indian structures. Offshore tax-friendly jurisdictions like Mauritius, Singapore, and the Netherlands are widely utilized due to bilateral Double Tax Avoidance Agreements (DTAAs) signed with India:

1.1 The India-Mauritius DTAA

• Historical Regime: Historically, the treaty exempted Mauritius residents from paying capital gains tax in India on gains derived from selling shares of Indian companies.
• The 2016 Protocol Amendment: A Protocol signed on May 10, 2016, revised this framework, granting India a source-based right to tax capital gains arising from the sale of shares of an Indian resident company acquired by a Mauritian tax resident on or after April 1, 2017.
• Grandfathering of Assets: All share investments made prior to April 1, 2017, were grandfathered. Any sale or transfer of these grandfathered shares, even if completed after April 1, 2017, remains fully exempt from capital gains tax in India.
• Interest Income Benefit: The India-Mauritius DTAA continues to offer a lower withholding tax rate of 7.5% on interest income earned by Mauritius investors from India. This is highly advantageous compared to the withholding rates under the Singapore DTAA (15%) and the Netherlands DTAA (10%).

1.2 The India-Singapore DTAA

• Similar to Mauritius, a Protocol signed on December 30, 2016, amended the India-Singapore DTAA to introduce source-based taxation of capital gains on the sale of Indian shares.
• This amendment aligned the treaty with the Indian domestic tax laws, removing the residence-based tax exemption on capital gains from shares.

1.3 The India-Netherlands DTAA

• The treaty provides relief against capital gains tax in India on the sale of shares of an Indian company by a Dutch resident, provided the sale is made to a non-resident buyer.
• Restriction: This exemption is lost, and the gains become taxable in India, if:
  1. The Dutch resident investor holds more than 10% of the share capital of the Indian company.
  2. The sale of shares is made directly to a resident of India.

2. Global Anti-Avoidance Frameworks: BEPS, MLI, and PPT

To prevent aggressive tax planning, treaty shopping, and the artificial routing of funds through shell companies, global regulators have introduced strict anti-avoidance measures:

2.1 The Multilateral Instrument (MLI)

Developed by the Organisation for Economic Co-operation and Development (OECD) under the Base Erosion and Profit Shifting (BEPS) project, the MLI is an international treaty that sits on top of existing bilateral DTAAs to plug loopholes.

2.2 The Principal Purpose Test (PPT)

The PPT is the core anti-abuse test implemented under the MLI:

• The Rule: Tax treaty benefits (such as reduced withholding rates or capital gains exemptions) will be denied if it is reasonable to conclude that obtaining that tax benefit was one of the principal purposes of any arrangement or transaction, directly or indirectly.
• Impact on AIFs: Category III AIFs cannot simply use an offshore "post-box" office in Mauritius or Singapore to claim treaty benefits. They must demonstrate genuine commercial substance, including local operations, active fund management decisions, and independent commercial objectives.

2.3 Permanent Establishment (PE) and Dependent Agent Rules

The MLI has significantly tightened the criteria for determining whether an offshore fund has created a taxable Permanent Establishment (PE) in India, which would expose its global income to domestic tax rates:

• The Rule: If an offshore fund's activities are managed by an agent in India (excluding an independent agent) who plays a principal role in routinely concluding contracts for the fund, the fund is deemed to have a PE in India.
• The Independent Agent Test: An agent is not considered independent if they act exclusively or almost exclusively on behalf of one or more closely related enterprises.
• Fund Management Implication: Category III AIFs must ensure that their offshore managers or sub-advisors are structured correctly. If an Indian advisor acts exclusively for a single offshore fund, they may be classified as a dependent agent, creating a PE in India, triggering full tax liability, and severely hurting the fund's Net IRR.

3. Practical Portfolio Case Study: IFSC vs. Domestic Performance (Example 5)

The workbook provides a direct quantitative comparison of the tax impact on performance by analyzing two identical funds operating in different jurisdictions over a 5-year tenure:

1. Fund INT: Aggregates USD 14 Million from offshore foreign investors and operates from the IFSC (GIFT City).
2. Fund DOM: Aggregates INR 98 Crore from domestic investors and operates from Mumbai under the domestic tax regime.

3.1 Initial Parameters and Capital Structure (As of April 1, 2019)

At inception, both corpuses are exactly equal in value (USD 14,00,000 * 70 = INR 98,00,00,000).

3.2 Statement of Investments (As of April 1, 2019)

Both funds deploy 100% of their capital into identical assets listed on the IFSC Stock Exchange:

• Company I (IFSC Listed Equities): 10,000 shares @ INR 700 each.
  • Fund DOM Cost: INR 70,00,000 | Fund INT Cost: USD 100,000
• Company F (IFSC Listed Equities): 2,50,000 shares @ INR 1,260 each.
  • Fund DOM Cost: INR 31,50,00,000 | Fund INT Cost: USD 4,500,000
• Company S (IFSC Listed Equities): 6,00,000 shares @ INR 350 each.
  • Fund DOM Cost: INR 21,00,00,000 | Fund INT Cost: USD 3,000,000
• Company C (IFSC Listed Equities): 75,000 shares @ INR 2,240 each.
  • Fund DOM Cost: INR 16,80,00,000 | Fund INT Cost: USD 2,400,000
• Fund EQMF (Listed Equity-oriented Mutual Fund Units): 20,00,000 units @ INR 140 each.
  • Fund DOM Cost: INR 28,00,00,000 | Fund INT Cost: USD 4,000,000
• Total Portfolio Cost:
  • Fund DOM: INR 98,00,00,000 | Fund INT: USD 14,000,000

3.3 The Divestment Transaction (August 14, 2024)

On August 14, 2024, both funds liquidate their entire holdings in the equity-oriented mutual fund scheme of Fund EQMF at a harvested Fair Value of INR 183.75 per unit:

• Gross Sale Consideration:
  • Fund DOM (INR): 20,00,000 units * INR 183.75 = INR 36,75,00,000
  • Fund INT (USD): USD 5,000,000 (representing $5 Million at 1 USD = INR 73.50)
• Gross Long-Term Capital Gains (LTCG) Accumulated:
  • Fund DOM (INR): INR 36,75,00,000 - INR 28,00,00,000 = INR 8,75,00,000
  • Fund INT (USD): USD 5,000,000 - USD 4,000,000 = USD 1,000,000

4. Step-by-Step Capital Gains Tax Computation

The capital gains tax liabilities arising from the divestment of Fund EQMF units are calculated as follows:

4.1 Fund INT (IFSC Domicile) Tax Computation

• Applicable Rule: Section 47(viia) of the Income Tax Act, 1961.
• Provision: Any transfer by a Category III AIF located in an IFSC of specified capital assets (including units of a mutual fund listed on an IFSC stock exchange) is not regarded as a "transfer" for tax purposes, provided the transaction is executed in convertible foreign currency.
• Tax Rate: EXEMPT (0%)
• Total Tax Payable by Fund INT: USD 0 (EXEMPT)

4.2 Fund DOM (Domestic Domicile) Tax Computation

• Applicable Rule: Section 112A of the Income Tax Act, 1961.
• Provision: Long-Term Capital Gains arising from the transfer of units of an equity-oriented mutual fund are taxable under Section 112A, provided the units were held for a period exceeding 12 months and Securities Transaction Tax (STT) was paid on the sale transaction.
• LTCG Tax Rate: 12.50% (excluding surcharge and cess).
• Surcharge Rate: Capped at 15% under Section 112A.
• Health & Education Cess Rate: 4% levied on the sum of base tax and surcharge.

Step-by-Step Mathematical Computation (Simple Line Format):

1. Long-Term Capital Gains (LTCG):
   • LTCG = Sale Consideration - Cost of Acquisition
   • LTCG = INR 36,75,00,000 - INR 28,00,00,000 = INR 8,75,00,000
2. Base LTCG Tax:
   • Base Tax = LTCG * Base Tax Rate
   • Base Tax = INR 8,75,00,000 * 12.50% = INR 1,09,37,500
3. Surcharge:
   • Surcharge = Base Tax * Surcharge Rate
   • Surcharge = INR 1,09,37,500 * 15% = INR 16,40,625
4. Health and Education Cess:
   • Cess = (Base Tax + Surcharge) * Cess Rate
   • Cess = (INR 1,09,37,500 + INR 16,40,625) * 4% = INR 1,25,78,125 * 4% = INR 5,03,125
5. Total Capital Gains Tax Payable:
   • Total Tax = Base Tax + Surcharge + Cess
   • Total Tax = INR 1,09,37,500 + INR 16,40,625 + INR 5,03,125 = INR 1,30,81,250

5. Summary of Tax Liability and Performance Impact

The direct tax outgo results in a significant performance divergence between the two funds:

Performance Analysis:

• Tax Drag: Because Fund DOM is not domiciled in an IFSC, it suffers a tax drag of INR 1,30,81,250 on the divestment of its mutual fund portfolio.
• Reduction in Net Returns: This tax liability represents a 14.95% reduction in net realized gains (INR 1,30,81,250 / INR 8,75,00,000). This cash outgo directly depresses the post-tax NAV of Fund DOM, reducing the Net IRR received by its unit holders.
• IFSC Superiority: Fund INT successfully retains 100% of its capital gains (USD 1,000,000), allowing the entire amount to be distributed to its offshore investors or re-invested, leading to a significantly higher Net IRR.

6. Key Exam-Relevant Terms

• Section 47(viia): The Income Tax provision that exempts specified capital assets (like listed mutual fund units, derivatives, or RDBs) transferred by an IFSC-based Category III AIF in convertible foreign currency from being treated as a taxable "transfer".
• Section 112A: The tax code governing long-term capital gains on listed equity shares and equity-oriented mutual fund units, imposing a 12.50% base tax on gains, a maximum 15% surcharge, and a 4% cess.
• Tax Drag: The reduction in a portfolio's return caused by tax liabilities. In Category III AIFs, tax drag directly lowers the scheme's net post-tax NAV and Net IRR.
• Principal Purpose Test (PPT): An MLI-based treaty shopping rule that denies tax benefits if the primary motive of a structure is to secure a tax advantage without genuine economic substance.
• Dependent Agent PE: A taxable presence created in a source country (India) when an offshore fund's local agent acts exclusively for closely related entities, exposing the offshore fund to full domestic taxation.