FEBRUARY 19, 2016

By Hemal Mehta, Pranav Turakhia & Tiya Jain, Deloitte Haskins & Sells LLP

THE last budget reformed the taxation structure for Category I and Category II AIFs to avoid double taxation on the returns to investors. A pass through status was awarded to both these categories with the introduction of sections 115UB and 10(23FBB) of the Income-tax Act, 1961. But Category III AIFs catering to investments through complex trading strategies in unlisted or listed securities by entities such as hedge funds are being given step treatments and are left out from the advantage extended to other 2 AIF categories. The rationale behind the move remains unknown but the Government should be urged to reconsider since several difficulties in implementation are being faced on ground.

Category III AIF are normally structured in the form of determinate trusts to avoid double taxation in the hands of the investors. But the major challenge that exists in the structure is that the trust will have to set up as an indeterminate trust. A Category III AIF can be structured either as an open ended or close ended fund, although a hedge fund can optimally function only as an open ended fund. A specific closing or close ended nature would limit the fund manager's ability to time the market and take positions to maximize gains. Also, typically hedge fund investors prefer the freedom of entering or exiting the fund as per their convenience. The binding investment tenure would also make the multiple iterations in the trust deed impractical for every investor addition or exit that takes place. Hence, an indeterminate trust would provide the ideal base had the taxation not been cumbersome on the investors and the Trustee of the fund. For an indeterminate trust, the trustee acts as the representative assessee and will bear tax at the maximum marginal rate on behalf of its investors thereby defeating the commercials of setting category III AIF.

Currently, this category of AIFs have been structured as close ended funds and determinate trusts. The trustee has the advantage to deduct withholding tax on behalf of the investors who can claim tax deduction on the same. This procedure becomes more challenging with an open-ended fund, as trustees have been known to be averse to the liability that arises with this responsibility. Also, practically many of the professional trustee are not yet open to provide trusteeship services to an open ended category III AIF thereby making it difficult to function as an independent fund.

Further, the suggested structure and policy confines for category III AIFs pose restrictions rather provide impetus to investments. The business rationale should govern taxation and not vice-a-versa.

With the Union budget coming up, we hope that Government gives due consideration to provide a pass through for category III to align benefits allotted to category I and II.