Tax position clarified by a recent CBDT Notification
The Central Board of Direct Taxes
(CBDT) has vide a recent Notification1 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
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.
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 AIFs2 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.
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.
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.
1 Notification No 51/2015 dated 24 June 2015
2 Except income in the nature of profits and gains of
business or profession which is taxable at the maximum marginal
rate of tax.
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