Tax Hotline: ITAT allows scheme of AIF to avail pass-through exemption despite having a separate PAN

ITAT allows scheme of AIF to avail pass-through exemption despite having a separate PAN

• An AIF scheme is entitled to exemption under section 10(23FBA) even if SEBI registration is in the name of the parent trust and not in the scheme’s own PAN.
• Differences arising due to statutory indexation cannot be taxed as business income in the hands of the AIF.

Background

Edelweiss Crossover Opportunities Fund (“Scheme”) is a scheme of Edelweiss Alternative Investment Opportunities Trust (“Trust”), a Category II alternative investment fund (“AIF”) registered under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”). The Trust and Scheme had separate permanent account number (“PAN”). The Scheme filed its income-tax return declaring ‘nil’ income claiming exemption granted to investment funds under section 10(23FBA) read with section 115UB of the Income-tax Act, 1961 (“ITA”).

During scrutiny, the Assessing Officer noted that the SEBI registration stood in the name of the Trust, while the Scheme had a separate PAN and no independent registration. On this basis, the exemption was denied on the ground that the Scheme did not qualify as an ‘investment fund’ under section 115UB of the ITA.

The lower tax authorities accordingly disallowed the exemption claimed by the Scheme, principally on the basis that the Scheme, having been allotted a separate PAN, was a distinct legal entity from the Trust and, not being independently registered with SEBI as an AIF, did not qualify for exemption under the pass-through regime under section 115UB of the ITA.

Ruling of the ITAT

Allowing the appeal, the Mumbai ITAT held that the Scheme was entitled to exemption under section 10(23FBA) read with section 115UB.

The key findings of the ITAT are summarized below:

• The AIF Regulations permit the launch of multiple schemes within the same trust registered as an AIF;

• A separate PAN, by itself, is not determinative of the existence of a separate trust. PAN is an identifier for tax administration. Whether an arrangement constitutes a separate ‘fund established in the form of a trust’ (as contemplated under section 115UB) is a matter of substance and governing documents, not of PAN alone;

• The Revenue had not demonstrated that the Scheme was constituted as a separate trust. The ITAT noted that once it is accepted that the Trust is permitted to float multiple schemes, the crucial test for availing exemption under section 115UB is whether the Scheme is indeed floated under the SEBI-registered Trust. In this regard, the ITAT noted that the trust deed and the private placement memorandum clearly established that the Scheme was a scheme of the Trust which is a SEBI-registered Category II AIF;

• The ITAT also relied on Explanation 1 to section 115UB, which recognizes ‘units’ of an ‘investment fund or a scheme of the investment fund’, thereby statutorily acknowledging schemes within an AIF structure.

• In relation to the difference between the amount reported as surplus in profit and loss account and the amount declared as distributed to investors, the ITAT held that once the Scheme qualified for pass-through treatment, the income had to be dealt with within that framework, and the character of income, including the computation leading to the distributable figure, cannot be altered merely because the book surplus reflects a different figure. The ITAT agreed with the Scheme’s submission that such difference arose on account of indexation benefit available under section 48 of the ITA in respect of long-term capital gains on unlisted equity shares.

Analysis

Under the AIF Regulations, a trust registered as an AIF is permitted to launch multiple schemes, subject to the filing of placement memorandum with SEBI.¹ While each scheme of the trust is managed by the same investment manager, it may have different set of investors and different portfolios. The primary advantage of launching a new scheme, as opposed to establishing a new trust or fund, is the relatively lower documentation burden and the ability to achieve a faster launch. The AIF Regulations also require the investment manager and the trustee of the AIF to ensure that the assets and liabilities of each scheme of an AIF are segregated and ring-fenced from other schemes of the AIF; and bank accounts and securities accounts of each scheme are segregated and ring-fenced.²

The ITA accords a tax pass-through status to ‘investment funds’ such that any income (other than income in nature of profits and gains from business or profession) is exempt at the fund level and taxable directly in the hands of the investors. Investment fund has been defined, inter-alia, to mean any fund established or incorporated in India in form of a trust which has been granted a certificate of registration as a Category 1/ 2 AIF by SEBI. Where a SEBI-registered trust launches a new scheme, SEBI does not issue a separate registration certificate to the new scheme, rather, the scheme operates within the registration granted to the trust.

The issue before the Tribunal arose primarily from this regulatory framework and the tax authorities’ lack of understanding of the interplay between the AIF Regulations and the ITA. In this regard, the decision by the Tribunal is welcome. It provides judicial clarity and should help prevent recurring disputes on the eligibility of schemes to claim pass-through exemption merely on account of holding a separate PAN.

Having said this, as rightly held by the Tribunal, it is crucial that the launch of subsequent schemes by SEBI-registered trust is appropriately in the fund documents. The trust deed should include specific clauses which, inter-alia, enable the trustee to launch multiple schemes, expressly providing that each of the schemes formed under the trust shall be a separate and independent trust obligation of the trustee under the Indian Trusts Act. The trust deed should clearly identify the various schemes launched by the trust. These aspects will be critical to demonstrate that the scheme is a ‘fund established in form of a trust’.

Lastly, the decision reinforces the principle that accounting outcomes and tax outcomes for AIFs may diverge. While taxable income is required to be computed in accordance with the provisions of the ITA, actual distributions to investors are often governed by cash availability and commercial considerations at the fund level. Differences arising on account of statutory adjustments, such as indexation, cannot, by themselves, justify adverse tax treatment. It is therefore important for tax authorities to recognize this distinction and not assess AIFs solely on the basis of their financial statements.

To conclude, the present litigation appears largely unwarranted and avoidable. It highlights the need for timely training and clear guidance to lower-level tax officers on the regulatory framework governing AIFs and the application of the pass-through regime. Such pre-emptive measures would reduce unnecessary disputes, and enhance tax certainty for AIFs in India.

Ipsita Agarwalla
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¹Regulation 12, AIF Regulations

²Regulation 20(16), AIF Regulations; While introducing the requirement of ring-fencing, SEBI in para 2.3.2 of the SEBI Board Meeting dated September 30, 2022 noted that, each scheme of an AIF is treated as a separate unit for taxation purposes, notwithstanding that all such schemes are established under the same AIF or trust