Chapter 13: Taxation

Statutory Pass-Through Status under the Income Tax Act, 1961

By virtue of the Finance Act, 2015, the Government of India enacted Section 115UB within Chapter XII-FB of the Income Tax Act, 1961, establishing a statutory tax pass-through regime for Category I and Category II Alternative Investment Funds:

Pass-Through Tax Mechanism under Section 115UB:
┌─────────────────────────┐
│   Investee Company      │
└────────────┬────────────┘
             │ Income Generated (Capital Gains, Dividends, Interest)
             ▼
┌─────────────────────────┐
│     Category I & II     │  TAX NEUTRAL PASS-THROUGH
│       AIF Scheme        │  (No tax paid at the Fund level for non-business income)
└────────────┬────────────┘
             │ Distributions Net of TDS (Sec 194LBB)
             ▼
┌─────────────────────────┐
│      Unit-Holders       │  TAX PAID BY INVESTOR
│       (LPs / CAs)       │  (Taxed in the hands of the investor as if earned directly)
└─────────────────────────┘

Core Principles of the Pass-Through Architecture

1. Character of Income Preservation:
   • Under Section 115UB(1), any income received by an investor from a Category I or II AIF is deemed to be of the same nature and in the same proportion as if it were received directly by the investor from the underlying investee company.
   • Long-Term Capital Gains (LTCG), Short-Term Capital Gains (STCG), interest, and dividends retain their exact statutory character in the hands of the unit-holder.
2. Fund-Level Exemption:
   • Under Section 10(23FBA), any income (other than business income) earned by a Category I or II AIF is completely exempt from tax at the fund level.

The Critical Exception: Business Income Taxed at the Fund Level

• Under Section 115UB(4), if any portion of the income of a Category I or II AIF is classified as Profits and Gains of Business or Profession (Business Income):
  • That specific business income is taxed directly at the fund level at the Maximum Marginal Rate (MMR) (currently ~39% to 42.74% depending on surcharge).
  • Once taxed at the fund level, that income is exempt in the hands of unit-holders under Section 10(23FBB).
  • To preserve pure pass-through, Category I and II managers structure investments as capital assets (equity shares, debentures) rather than trading assets.

Tax Deduction at Source (TDS) under Section 194LBB

To guarantee tax collection, the Income Tax Act imposes a statutory withholding obligation on Category I and II AIFs when making distributions to investors:

Withholding Tax Rates under Section 194LBB:
┌─────────────────────────────────────────────────────────────────────────────────┐
│ RESIDENT INVESTORS:                                                             │
│ • Flat TDS rate of 10% on all income credited or paid (excluding business income│
│   already taxed at the fund level).                                             │
├─────────────────────────────────────────────────────────────────────────────────┤
│ NON-RESIDENT INVESTORS (Foreign LPs):                                           │
│ • Withholding at "Rates in Force" (relevant statutory rates under domestic law  │
│   OR applicable Double Taxation Avoidance Agreement (DTAA) treaty rates,        │
│   whichever is more beneficial, subject to TRC and Form 10F).                   │
└─────────────────────────────────────────────────────────────────────────────────┘

Annual Tax Reporting: Form 64C and Form 64D

• Form 64D: The AIF must file an annual electronic statement with the Income Tax Department detailing all income distributed or credited to each unit-holder during the financial year (due by June 15).
• Form 64C: The AIF must issue an individual tax certificate to each unit-holder by June 30, detailing their proportional share of LTCG, STCG, interest, dividends, and TDS deducted.

Pass-Through of Investment Losses

Under Section 115UB(2), capital losses incurred by a Category I or II AIF are passed through to unit-holders:

• Condition: The investor must have held the units of the AIF for at least 12 months.
• Execution: The investor can set off the passed-through capital loss against their personal capital gains and carry forward unabsorbed losses for up to 8 assessment years in accordance with standard Income Tax provisions.

General Anti-Avoidance Rules and Indirect Taxes

1. General Anti-Avoidance Rules (GAAR) & Multilateral Instrument (MLI)

• GAAR: Invoked by the Indian tax authorities if an arrangement is deemed an Impermissible Avoidance Arrangement (IAA)—an arrangement whose main purpose is to obtain a tax benefit and which lacks commercial substance.
• MLI and Principal Purpose Test (PPT): Cross-border feeder structures investing into Indian AIFs from treaty jurisdictions (Singapore, Mauritius, Netherlands) must satisfy the PPT and demonstrate genuine economic substance (local directors, commercial operations, decision-making autonomy) to claim DTAA treaty benefits.

2. Stamp Duty on AIF Transactions

Under the amended Indian Stamp Act, 1899:

• Issue of Units: Stamp duty of 0.005% is payable on the issuance of units upon capital calls.
• Transfer of Units: Stamp duty of 0.015% applies to secondary transfers of AIF units between investors.

3. Goods and Services Tax (GST)

• Management Fees: Investment management fees charged by the Manager to the AIF attract standard 18% GST.
• Carried Interest Debate: If carried interest is structured as a fee or performance allocation rather than a return on capital (Class B units), tax authorities may seek to levy 18% GST. Consequently, AIFs structure carried interest as a distinct class of partnership or trust units entitled to statutory return of capital and profits.