AIFs need tax parity in Budget 2024: BDO India

Over 1,350 Alternative Investment Funds (AIFs) are registered, with commitments totalling approximately ₹11 lakh crore. Since their establishment in 2012, AIFs have made significant progress due to regulatory amendments that consistently prioritise the investor community's view of India as a preferred market.

An increase in High-Net-Worth Individuals (HNIs) in India and their growing inclination to expand and diversify their wealth through personalised solutions have made AIFs a preferred choice for many affluent individuals. Given that AIFs are a sophisticated product class, clarity on the tax implications of investments in these funds is crucial.

Tax complexities within AIF categories

Under the Finance Act of 2015, a special tax regime was introduced granting pass-through status to Category I and Category II AIFs. This shift means that the tax obligation on income earned by AIFs (excluding business income) now falls on the investors of the AIF. Therefore, the investors are required to pay the tax on the income received from AIFs, as if they had earned the income directly through their investments. However, despite continuous deliberations, the pass-through status has not been extended to Category III AIFs under the Income Tax laws, resulting in disparity with the income earned by Category III that is subject to taxation at the fund level. Consequently, the taxation of Category III AIFs depends on their structure and incorporation status — whether they are Limited Liability Partnerships (LLPs), Trusts, or Companies — leading to differential tax rates and surcharges.

To give impetus to the International Financial Services Centre (IFSC), the pass-through status has already been granted to Category III AIFs incorporated within IFSC. It is important to bring tax parity among all the categories of AIFs. This extension will also align the tax treatment for the investors of Category III AIFs with those in Category I and II AIFs. Currently, at the fund level, the entire income is taxed at the highest applicable surcharge rate, whereas granting pass-through status would mean different surcharge rates could apply to each investor.

The taxation structure for capital gains on securities introduces complexities and challenges for AIFs and their investors. Currently, the tax rate on capital gains in the case of securities and mutual-fund units is different for short-term and long-term assets, typically ranging from 10% to 30%. These rates vary based on factors such as the nature of the financial asset, period of holding and whether the assets are listed or unlisted. The holding period is 12 months or 24 months for long-term assets and 36 months for short-term assets.

Expectations of Taxpayers

To reduce complexities and create a level playing field amongst equity and debt segments, it is anticipated that the law will be amended to consider all types of financial assets as long-term capital assets after a holding period of 12 months. Similarly, a uniform tax rate for both long-term and short-term capital gains should be introduced — whether it involves equity or debt, and whether the assets are listed or unlisted.

The existing TDS and TCS provisions, specifically under Section 194Q (TDS on purchase of goods) and Section 206C(1H) (TCS on sale of goods), have brought ambiguity in the AIF industry regarding their applicability. Since entities fully exempt from income tax are already excluded from these provisions, it is recommended to similarly exclude AIFs, given that a majority of AIF income is pass-through in nature. Alternatively, the issue and redemption of AIF units should be kept outside the purview of TDS and TCS provisions, as they do not constitute typical sales or purchases.

It is expected that the Finance Minister will uphold the legacy of positioning India as a financial hub, ensuring robustness and transparency from the tax and regulatory perspective by addressing the required clarifications and exemptions in tax laws in Budget 2024.

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