– Mukesh Butani and Shankey Agarwal

A recent ruling of the Customs Excise and Service Tax Appellate Tribunal ruling has a far-reaching impact on private equity and venture capital funds by substantially pushing up their service tax liability under extant law and Goods and Services Tax liability in the future.

PE and VC funds are normally organised as consisting of capital contributors or investors, general partners, and fund managers. PENC funds work on a high­risk/reward model by investing in nascent companies professing pioneering and innovative technology and in growth ventures. The fund is usually a pooling vehicle, which aggregates the investments, which could either be an onshore vehicle, offshore vehicle, or a special purpose vehicle. Similarly, the general partners and fund managers who manage the investments may be located on-shore or off-shore.

The Structure
The investment pooling vehicle is either organised as a limited liability company or partnership or a trust and depending on its legal form, the investors, general partners, and fund managers make up for beneficiaries and partners, respectively. The extent of power, including the manner of usage of the funds, is articulated and governed by various documents associated with the structure of the fund and captured in the trust deed or bye-laws. Further, in the case of a trust, they can sue or be sued only in the name of the said trustee, which creates a degree of mutuality of interest between the fund and its investors/beneficiaries.

The general partners and fund managers, besides charging a management fee, usually also get rewarded for their efforts by way of a share of profits above a certain threshold. This incentive is colloquially referred to as ‘carried interest’, which is essentially given as a return on investment and an added incentive to fund managers representing a reward for enhancing the profits. Further, should the profits not breach the agreed benchmark ‘hurdle rate’, such a share of profits does not kick in. The concept of carried interest can be traced back to the 16th century when the captain of a ship shared 20% share (usually the carried interest in PE and VC funds) of the carried goods, to pay for transport and risk of sailing over oceans.

On the primary question of taxability, the CESTAT has drawn a conclusion that such VC/PE funds are distinct from their investors/beneficiaries and are liable to discharge service tax on such carried interest. While the impact of tax ( service tax) should primarily be on the performance/management fee, which is charged irrespective of the fund performance, the tribunal observed that any expense deducted from the fund and specifically carried interest disbursed is a consideration for services and exigible for service tax. As noted earlier, this special disbursement made represents the profit above the hurdle rate of return to the investors. Such carried interest has no correlation with individual investments in the fund.

The contention of the fund before the tribunal was that these payments are a return on investment and must not be confused with consideration for services to the contributors/investors. The tribunal however held that carried interest is part of the consideration retained and that it was passed to the investors in the disguise of return on investments.
In coming to the conclusion, the tribunal viewed such arrangement as a tainted structure, consciously devised in a manner that large sums of money are distributed in the guise of ‘carried interest’, escaping tax.

Immediate Fallout

The tribunal ruling has come as a rude shock to PENC funds, as the ruling has a persuasive impact on all such structures until it is overruled.

In concluding, the tribunal has rushed to the tax avoidance angle without entirely appreciating the PENC model and the modus operandi of funds, particularly the relationship between the fund, fund manager, and the investor. Typically, such carried-interest allocation varies. In a PE deal, the standard carry-interest is 20%, though, greater variability prevails depending on the fund, and in some cases, the variability is as high as 44%. Besides, variability, which the fund documents lay down, an aspect not dealt with by the tribunal is that the distribution of carried interest is often directed by what is called a ‘distribution waterfall’ method by which the capital gained by the fund is allocated between the fund’s limited and general partners.

Secondly, returns are paid to investors other than the fund managers on an agreed ‘hurdle rate’. Not every fund may provide a hurdle rate. Returns to fund managers are not paid until they also reach the hurdle rate, if any, also called a ‘catch-up’ payout. Thereafter, begins a complex process of splitting the returns.

Funds usually distribute the carried interest upon successful exit from an investment, which takes years. In a typical risk situation, thefund manager and the investors carry the risk of loss in an investment portfolio.

As per well-established accounting practices, the carried interest is either deducted as an expense from the funds or redistributed as a net asset value to the fund managers.

Though, most jurisdictions classify such interest as a long-term capital investment for tax purposes, which are taxed at a lower rate, the underlying rationale for such characterisation is driven by considerations such as risk and long gestation for fructification of carried interest. Equally, there are critics of such interest being taxed at a favourable rate.

Be it the way it is, levy of service tax, which is a transaction tax raises a fundamental question – if such arrangements can be viewed as a rendition of a service – in light of the nature and the structure of the fund documents, an aspect the tribunal has sorely missed given its presumptuous tax evasion slant.

Larger Ramifications

The tribunal order has larger ramifications outside the service tax/GST realm. Firstly, it directly raises questions on the correctness of the GST position taken by the funds and the possibility of immediate precipitate action by GST authorities seeking to transpose the tribunal ruling.

Secondly, this occasions a head-on clash between different the two arms of taxation – one arm characterising it as capital gain and the other as income or service.

The tribunal’s order implies that such characterisation (for income-tax) is incorrect, and it should instead be treated as business income/salary depending upon the legal relationship of the recipient. Whereas such incongruous characterisation is common when one deals with separate principles of taxation under direct and indirect laws, it certainly leads to inconsistent tax consequences, given the international tax space.

The industry apprehends that direct tax authorities, being inspired by the tribunal’s order would open a fresh line of enquiry, a common phenomenon in our system.

Such apprehension could perhaps be misplaced, in as much as the structure of direct and indirect tax laws are fundamentally different and they work on differing underlying variables. Direct tax laws base the conclusions on the nature of income and returns whereas indirect tax laws apply to transactional  analysis. Furthermore, the key difference is that the text of the income tax law subsumes specific aspects and is replete with deeming fiction which fundamentally alters the ordinary meanings and settled legal analysis.

Therefore, in our view, the outcome of a direct tax analysis may not be directly transposed in indirect tax and vice versa.

This implies that the tribunal ruling must be viewed independently, no doubt with a pinch of salt before conclusions can be drawn.

Creating A Policy Muddle

Another aspect that seems to have been glossed over in the tribunal’s analysis is the fact that these funds, particularly VCs and AIFs, are a part of an extensively regulated industry and therefore the industry positions are driven by regulatory guidance. In such a scenario, de-hyphenating the analysis of the transaction as a pure vanilla scheme dehors the regulatory regime may not be an ideal approach to appreciate the finer nuances of the industry. Though the judiciary is independent of the executive to decide, such nuanced issues need deliberation and coordinated efforts. Given the impetus that the government accords in its fiscal and regulatory regime to private equity and venture as an important contributor to the growth engine, this development is bound to act as a party spoiler.

One hopes that there is immediate course correction with policy intervention and views of the regulator are sought to conclude on the correct legal position. The correctness of the tribunal’s order will certainly be examined by the Supreme

Court, which will have the last word, though, a timely policy intervention will enable curtail the damage.

Mukesh Butani is Managing Partner, Shankey Agrawal is Principal Associate, at BMR Legal. Views are personal.

The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.