Tax position clarified by a recent CBDT Notification

  • The Central Board of Direct Taxes (CBDT) has vide a recent Notification[1] exempted Alternative Investment Funds (AIFs) from the obligation to deduct tax at source  (TDS) at a rate of 10% from distributions made to fund of funds (FoFs) registered as AIFs.
  • Obligation to deduct TDS at a rate of 10% continues to apply to income distributed by FoFs to their underlying investors.
  • FoFs are permitted to register as AIFs under SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations). FoFs registered as Category I AIFs are permitted to invest in other Category I AIFs of the same sub-category. FoFs registered as Category II AIFs are permitted to invest in other Category I AIFs and Category II AIFs.

Introduction

Earlier this year, the Finance Act, 2015 had brought about the much awaited tax relief for domestic funds industry by granting a tax pass through status to Category I and II AIFs registered with the Securities and Exchange Board of India (SEBI) under the provisions of the AIF Regulations. As per the existent regime, while the income of such AIFs[2] is not subject to the levy of tax at the AIF’s level; AIFs remain saddled with the obligation to deduct TDS at a rate of 10% from the distributions made by them to their investors. Considering that FOFs registered as Category I or II AIFs are permitted to invest in other AIFs, the TDS obligation placed on AIFs could have led to levy of TDS at the level of both the investee AIF and the FoF. This anomaly has been swiftly brushed away by the timely Notification which now exempts income paid by AIFs to FoFs from the levy of the TDS.

Clarification

In their strive to receive a tax pass through status, domestic funds in India saw much success earlier this year with the Finance Act 2015 finally amending the Income Tax Act, 1961 (ITA). This amendment effectually extended the beneficial tax pass through regime (previously available only to venture capital funds) to all Category I and Category II AIFs. Such AIFs are classified under the ITA as ‘investment funds’, and the income of such investment funds, other than income chargeable under the head of ‘profits and gains of business or profession’, is exempt from levy of tax at the level of the investment fund or AIF. The income is directly chargeable to tax in the hands of the investors of the AIFs at the applicable rates of tax. However, the AIF is required to deduct TDS at a rate of 10% from the distributions made by it to its investors.

The provisions of the Finance Act, 2015 therefore led to a situation where, technically, a FoF investing in another AIF would be required to deduct TDS again inspite of the TDS being already deducted by the investee AIF before making distributions to the FoF. The TDS requirement could hence have placed FoFs at a disadvantageous position when compared to other AIFs for no justified reason. Anticipating this anomaly, the CBDT has released the Notification exempting Category I and II AIFs from the requirement of deducting withholding tax while distributing income to their FoF investors which are themselves registered as AIFs. Having said that, the FoF would in turn be required to deduct TDS at a rate of 10% while making distributions to its investors in the same manner as required by the Finance Act, 2015. Finally, tax would be levied in the hands of the underlying investor of the FoF. In effect, the Notification has maintained the pass through benefit for structures where investments are made using FoFs with such FoFs further investing in AIFs.

Khaitan Comments

The Notification has provided a level playing field for FoF structures which, but for the Notification, could have been amidst uncertainty on levy of TDS on the income distributed by their investee AIFs. The clarity brought about by the Notification is certainly a welcome move.