The Tale of Venture Capital Funds: A New Breeding Ground of Tax Evasion?

[By Aarushi Kapoor]

The author is a fourth year student at the Hidayatullah National Law University.

Introduction

The Customs Excise and Service Tax Appellate Tribunal (hereinafter ‘Tribunal’), Bangalore bench, in ICICI Econet and Internet Technology Fund v. Commissioner of Central Tax, has recently confirmed the service tax liability on the expenses incurred by the venture capital fund (hereinafter ‘VCF’), as the consideration received towards the asset management services which are employed for the administration of funds. The VCFs are incorporated as trusts. Such incorporation in the form of the trusts is always a favourable mode of incorporation because of the application of the principle of mutuality. According to this principle, a trust is not separate from its beneficiaries and hence, the activities pursuant to such an institution cannot be taxed. However, this judgment has challenged this long age industrial practice.

Pertinent Facts

In the present case, ICICI Econet and Internet Technology Fund was a VCF created to make large investments in portfolio companies using the contributions received from a variety of investors. For the management of these contributions, an investment manager or the asset management companies was appointed to analyse the investments received in the form of contributions and decide the future course of actions in the form of investment and disinvestment. The contributories were referred to as unit holders. It is imperative to mention that in the present case, the asset management companies in addition to providing advisory services also contributed to the fund and hence, were entitled to the payments which included a payment equal to the capital invested plus a promised rate of return like the other unit holders.

Issues which required consideration

This return on investment paid to the asset management companies in this instance was much more than the quantum of the investment made by them. It is here, where the bone of contention appeared. The main question before the tribunal was whether the enhanced amount being paid to the asset management companies comprised of the operating expenses and carried interest in addition to the legitimate return of investment. It was to this question, that the tribunal actually answered in affirmative by concluding that payments included payments of carried interests being made to the asset management companies in the disguise of return on investment, and hence this amount attracted the service tax liability in the hands of asset management companies.

Critical Analysis: An Insights into the Implications

After having discussed the background of the issue at hand, it now becomes essential to discuss the implications that this decision is likely to have on the equity industry.

  1. VCF is no longer a trust

The structure of the trust is based on the principle of mutuality. According to this doctrine, whenever there is an oneness of the contributors to the fund and the recipients from the fund and the fund has been constituted for the convenience and common benefits of the members backed by the impossibility that the contributors derive profit from such contributions, mutuality comes into play. As an implied conclusion, it follows that a person cannot make profit out of himself. Hence, this profit cannot be regarded as income and hence, it is not taxable.

However, accordingly to the decision of the Tribunal, the VCFs which were traditionally incorporated as trusts, have been denied to continue applying doctrine of mutuality. Accordingly to the reasoning of the Tribunal, the VCFs breached the principles of mutuality by breaking the closed circuit within which only the trust and the beneficiaries used to interact. In contravention, the VCFs made an attempt to engage in pure commercial operations in order to provide a favourable return to the contributories. In other words, it could be said that the contributions received from the contributories were invested in the portfolio companies and arrangements were created in a manner to ensure that a profitable return at the end is distributed. This resulted in the collapse of the closed circuit within which the doctrine of mutuality operated.

The tribunal instead warned that the structure of the VCF fund was a mere façade. The aim of such a foul play was to provide every opportunity and fortune to the investment management companies to avoid taxation. The intent was somehow to benefit themselves through earning performance fees in the form of carried interests.

  1. Fails to analyze the other factors

One of the most critical analyses of the judgment rendered by the tribunal is the fact that the order is very case specific. It is important to keep in mind that while making a judgment that is likely to have an impact on the entire private equity industry, a holistic consideration of the facts and circumstances in required. However, the judgment fails to analyse the status quo on such considerations. For instance, the detailed list of payments which the VCFs are legally entitled to make to the asset management companies as a consideration for the services rendered. The Chapter 10 of the Master Circular on Mutual Funds explains list of fees, charges and expenses which can be ideally charged by the collective investment schemes pursuant to the regulations and approval of SEBI.

However, under the same guidelines, there is a prohibition on the collective investment schemes like VCFs to charge the expenses related to the payment of performance or management fees to the investment management companies. So as a necessary corollary, it can be deduced that the logical reasoning of the tribunal is backed by the SEBI regulations and circulars.[1] However, what needs to be determined is the fact that whether the enhanced payment made to the asset management companies by the VCFs comprised of the lawful payments or the prohibited performance fees. The tribunal has failed to take into account the balance sheets of the VCFs and contractual arrangements between the VCFs and the asset management companies.

  1. Detrimental for Private Equity and Management Industry

The above decision of the tribunal is likely to have a very detrimental impact on the private equity Industry especially in India. The private equity industry in India has been an eye witness to the long drawn struggle surfacing the tax uncertainty. It was only around in 2015 that the policymakers offered tax pass-through status to the VCFs. It not only helped to provide a relief from the menace of double taxation but at the same time, simplified the tax based compliances and complications for the domestic and international fund managers, who were now encouraged to trigger their and their investors’ investments in collective schemes like VCFs. .

The above-mentioned ruling is likely to make the already established confidence an illusion in terms of consequences over the period of time that the fund managers may have to witness over the period of time. The taxability of the services in the hands of the fund managers is likely to disincentivize them from maintaining the same spark in the private equity industry in India. This is likely to uproot the shackles of the fund management industry in India which is still grappling with the aftermath of the lockdown.

Concluding remarks

It is acceptable that such a decision is likely to be appealed before the Supreme Court anytime soon. What is important to be brought to light is the correct interpretation of law. If in case, the tribunal has failed to holistically take into account other factors, then such a decision is likely to constitute the biggest threat towards the well-established private equity market in India. However, if in case the proper analysis of facts and circumstances boils down to the conclusion that the VCFs are masquerading themselves as trusts to avoid taxation and make unaccounted profits, then such a decision would be a welcoming step. This step would help to tighten the whip of compliance and disclosures over these acts. This decision is likely to bring a new direction to the existing investment preferences of the investors, both domestic and abroad.

[1] Clause 10.1.2.5, Chapter 10, SEBI Master Circular on Mutual Funds, SEBI/IMD/MC No.3/10554/2012

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