The Bangalore Customs Excise and Service Tax Appellant Tribunal, in a recent decision in the ICICI Econet Internet and Technology Fund and Others v Commissioner of Central Tax, Bangalore North case, has issued a position-altering judgment in the context of the relationship of a trust with its investors.
The issue for consideration before the CESTAT was whether venture capital funds provide services of asset/portfolio management, under the taxable category of ‘banking and other financial services’ to its investors. The service tax authorities had quantified the tax demand by taking into consideration the expenses incurred by the trust, the disbursement of carried income and carried interest and the provisions for losses and impairment of investments.
The CESTAT, while rejecting the arguments that a trust is not an independent juridical person, held that the trusts have violated the principles of mutuality by concerning themselves in commercial activities and by using the discretionary powers to benefit a certain class of investors or nominees or employees or subsidiaries. It was held that for this reason they cannot be treated as trusts for the purposes of taxation statutes and that the trust was a mere façade created to indulge in evasion.
The principles of the general trust law were discarded on the premise that tax law—being specific legislation just like the SEBI Act—would prevail over the general trust laws applicable in India. The element of profit motive and returns were given precedence to conclude that VC funds are not analogous to a trust as understood in the conventional sense and are in fact providers of portfolio/asset management services to the contributors/ investors and the consideration for such services is the retention by the trust/VC fund of dividends/profits towards performance fee, carried interest and other expenses.
Most VC Funds And AIFs Are Set Up As Trusts
There is no doubt that SEBI Regulations—be it the erstwhile 1996 VC fund regulations or the Alternative Investment Fund 2012 regulations—categorically permit the setting up or establishment of these funds in the form of a trust as per the Trust Act of 1882. In fact, most VC funds and AIFs registered with SEBI today are set up as trusts.
Until the introduction of the pass-through status for all Category I and Category II AIFs by the Finance Act 2015, all AIFs were set up as private trusts. Post the settlement of the Trust, the investors inter se agree to a waterfall distribution by individually entering into contribution agreements with the investment manager.
The trust model was and continues to be a preferred mechanism for AIFs, as by nature a trust is understood to be a pass through with no legal existence of its own. The finding of the CESTAT categorising the expenses and pay-outs in the books of the trust/VC funds as income earned by such trust/VC Funds erodes the concept of a pass-through vehicle and the waterfall distribution and the functions and role performed by the investment manager.
In a traditional VC fund structure, there is no retention of any service fee or income by the trust as it merely distributes the distributable surplus among various classes of investors, as per the waterfall agreed between the investors after deducting expenses that were incurred by or on behalf of the trust. In such distributions, no discretion is exercised by the trust and distribution is undertaken based on the agreed terms contained in the Indenture of Trust or Trust Deed and the Private Placement Memorandum or PPM. Thus, AIF trusts typically follow the fund documents such as PPM, Trust Deed and Contribution Agreements. They cannot at their discretion deviate from such fund documents. Any changes to documents such as PPM require investor approval and intimation to SEBI.
Trust Is A Veneer, Says CESTAT
Interestingly, the CESTAT has strongly based its decision on the notion that the trust is a veneer that is created to conceal the actual commercial transactions that are carried out for the investors with the intent to not pay taxes.
Contrary to this approach, the ITAT—in Escorts Benefit & Welfare Trust v. ITO ITA—while evaluating allegations by the Assessing Officer, where the validity of the trust was in question on grounds that the trust was invalid as it was merely a colourable device created for tax evasion purposes, the ITAT upheld the principle of representative assessee and the validity of the trust in line with the provisions of the Trust Act. The CESTAT has cast aside this basic principle.
The aspect that the trust is only a pooling vehicle and therefore is merely a pass-through entity and not a service provider in its own capacity has not been appreciated. In fact, if the arrangement is looked at in its entirety it is nothing but the distribution of proceeds from investment activity, distributed by the trustees (in a fiduciary capacity) amongst various classes of investors by way of waterfall distribution as has been agreed between the investors. Service tax cannot be made applicable to such distributions arising from profit on investments.
The view of the CESTAT is also contrary to the globally-accepted principle that carry income is in the nature of capital gains and therefore nothing but share of profits arising out of sale of investments. Once the carry income has been characterised as a share of profit arising from sale of investments under one legislation the same cannot be re-characterised for the purposes of another legislation.
Is Trust A Separate ‘Person’?
Taxability under the service tax law arises only where there is a provision of service by one ‘person’ to another. It may be interesting to note that the definition of ‘person’ under the service tax laws does not specifically include trusts.
However, this is not so under the GST laws. The definition of person under GST law, includes trusts for the purposes of determination of a supply exigible to GST. Though mere act of inclusion of trusts as person would not automatically establish a supply between the trust and the investors.
Challenges For The Industry
The CESTAT’s decision will encourage the tax authorities to issue demand notices for service tax and/or GST for the periods that are within limitation.
This is so even when the investment managers are the service providers appointed to manage the VC funds/AIF and for these services of asset management, they are already recovering service charges and charging service tax or GST on the same. Further, most of the expenses incurred by the VC funds/AIF is already service tax/GST paid.
The ruling does not only impact AIFs/VC funds, but could also have an impact on funds working under a similar structure such as asset reconstruction companies, etc.
While the CESTAT ruling will be challenged before the Supreme Court, it creates a lot of uncertainty in the interim for the industry players.
Ritesh Kanodia is Partner and Meetika Baghel is Principal at Dhruva Advisors LLP.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.