Tax ruling: PEs, VCs seek advice on impact on past investments

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Fearing that a recent tax ruling could impact their returns, several private equity and venture capital funds have rushed to their advisors to find a way around this. The funds want to figure out the extent of cost they could incur on their past investments and returns and whether they can pass this on to their investors, said people in the know.

ET had first reported on July 6 that a tax tribunal has held that indirect taxes are applicable on expenses incurred by venture capital, private equity and mutual fund firms, even under the trust structure. This means expenses such as ‘carry fees’, legal fees and salaries incurred by a fund that is held in a trust structure could face indirect tax.

As of now no PE, VC or any other alternative investment fund (AIF) pays indirect taxes on such expenses.

Tax experts say following the ruling, the taxman could start demanding indirect taxes on expenses incurred by funds—including carry fees in the last few years.

“Pursuant to the indirect tax exposure basis of the recent ruling, spats of discussions are happening amongst PE/VC funds on the way forward for existing structures and future set-ups,” said Yashesh Ashar, partner at Bhuta Shah & Co, a tax advisory firm. “For existing structures, fund managers are exploring sharing of additional tax costs with investors on an overall fund basis.”

The ruling was under the erstwhile tax regime—service tax—and so only past deals or investments carried out by funds will be covered. Service tax was subsumed in Goods and Services Tax (GST). However, tax experts say the principles of the service tax regime can also be applied under GST.

“Although the decision is in the context of the venture capital fund space and relates to the erstwhile service tax regime, the ruling that the concept of mutuality of interest cannot be applied between the trust and investors would make it necessary for all funds to re-examine their positions in the GST regime as well,” said MS Mani, partner, Deloitte India.

Tax experts point out that unlike the direct tax regulations—income tax, international tax—the indirect tax regime doesn’t recognise or define the ‘pass through’ structures. Most funds tend to borrow money from various investors and invest in different ways. They return the money and the profits/returns made from that to investors after a few years or months.

In almost all cases, the funds tend to take certain fees—management fees or carry fees. In some cases the fees are payable to fund managers—carry fees—for instance. The tax department argued that the carry fee is nothing but a “variable pay” or variable performance fees and indirect taxes should be levied on that.

Funds are also re-looking at their existing structures to figure out the problem.

“For future funds, the LLP structure could become the first choice for many. However, funds which have got the trust structures registered with Sebi and are in the midst of road shows have got into a fix,” said Ashar.

Insiders say for the past deal most fund managers are adopting a wait and watch approach. In the past, the revenue department had started demanding taxes following an advance ruling.

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