Pass-through status

A fund is a container. The money inside it belongs to the investors. So should the tax bill be raised on the container, or on the people?

Pass-through status is the answer that says: on the people. The income is treated as though each investor had made the investment directly. The fund itself pays nothing on it.

For a Category III AIF, the workbook's answer is blunt. No pass-through status has been accorded to a Category III AIF under the Income Tax Act. So the paper falls back on the ordinary rules for taxing a trust.

That does not mean the fund always pays the tax. It means the fund cannot rely on a statutory pass-through. It has to earn a similar result through the way the trust is written.

The statutory pass-through, and who gets it. Section 224 read with section 11, schedule V (Table Sl. No. 1) of the ITA exempts any income other than business income in the hands of an Investment Fund, and charges it directly in the hands of its investors — as if the investments had been made directly by them. The workbook's footnote is the examinable part: section 224 applies to Category I and Category II AIFs registered with SEBI or IFSCA.

Business income goes the other way. Under Table Sl. No. 2, business income accruing to an Investment Fund is taxed at the fund level — at the rate in the Finance Act of the relevant year where the fund is a company or firm, and at the maximum marginal rate in other cases — and is exempt in the investors' hands.

What a Category III AIF gets instead. With no pass-through, the general trust taxation principles apply, and three things decide the outcome:

A trust is determinate only if both conditions hold on the date of the indenture of trust: the beneficiaries of the income are identifiable, and each beneficiary's individual share of income is ascertainable.

Once income has been taxed in the trustee's hands as Representative Assessee, there should be no further tax on the later distribution to beneficiaries, subject to MAT for corporate beneficiaries. That is how a determinate irrevocable trust reaches a pass-through-like result without a statutory pass-through.

The catch on business income. If any portion of a trust's income is characterised as business income, the whole of the trust's income could become chargeable at MMR in the trustee's hands.

Losses do not pass through the same way. Under section 224, a fund-level business loss is not allowed to be passed through to investors, but may be carried forward for set-off against later years' business income. Any other loss is allowed to pass through — and to be carried forward and set off in the investors' hands — only where the investor has held the units of the AIF for at least 12 months.

In practice. The workbook records that most Category III AIFs take a practical approach and discharge taxes at the fund level, using the fund's own PAN, at the maximum rate applicable to the income stream.

The fund and amounts are illustrative; the sections, rates and rules are the workbook's.

Meridian Absolute Return Fund is a Category III AIF set up as an irrevocable determinate trust. The trust deed names the classes of beneficiaries and prescribes how each share is worked out, so both determinacy conditions are met. In the tax year it earns:

The capital gains. LTCG on listed equity sold on a recognised exchange with STT paid is taxable at 12.5% plus applicable surcharge and cess under section 198. The trustee pays as Representative Assessee under section 304, in the like manner and to the same extent as the beneficiaries would — so the base tax is Rs 5 crore on Rs 40 crore. When the money is later distributed, there is no second charge.

The business income. Rs 10 crore of business income makes the fund's position dangerous, not merely dearer. The workbook says that where any portion of the trust's income is business income, the whole of the income could be chargeable at MMR in the trustee's hands. The fund does not get to keep the 12.5% treatment on the Rs 40 crore as of right.

Now change one fact. Suppose the deed had not made each share ascertainable on the date of the indenture. The trust is indeterminate, and the trustee is taxable at MMR under section 307 on the entire Rs 50 crore. The workbook notes a taxpayer may argue, on a judicial precedent, that the concessional capital gains rates take precedence over MMR — an argument, not a rule.

And compare a Category II AIF with the same Rs 40 crore of capital gains. Section 224 exempts it at the fund and charges it directly to the investors as if they had invested directly. The Category III fund has to reach the same place through its trust deed.

Chapter 14, section 14.1.1 states flatly that no pass-through status has been accorded to a Category III AIF, and sections 14.1.1.1 and 14.1.2 set out the trust taxation principles that replace it. Chapter 14's first sample question is exactly this: which of the following Trust structures are eligible to pass-through income in the nature of Capital Gains — the answer is the Determinate Irrevocable Trust, and the three distractors are the other combinations.

Expect also: which categories section 224 covers (I and II, not III), whether business income passes through (no — taxed at the fund, exempt for investors), and the 12-month holding condition for passing a non-business loss to investors.

• A Category III AIF has no statutory pass-through. What it can achieve is the effect of one, through a determinate irrevocable trust taxed on the trustee as Representative Assessee. Do not answer that Category III enjoys pass-through status.
• Section 224 is a Category I and Category II provision. The workbook says so in a footnote, which is exactly where a question is set from.
• Business income never passes through. For an Investment Fund it is taxed at the fund and exempt for investors. For a trust, business income can pull the whole income to MMR.
• Determinacy is tested on the date of the indenture of trust, not on the date the income arises, and needs both limbs — identifiable beneficiaries and ascertainable individual shares.
• Revocable is about the document, not the intention. A contribution agreement that lets the transferor get the income or asset back, or reassume power over it, makes the transfer revocable under sections 97 and 98.
• Losses split two ways. Business loss stays at the fund and is carried forward there; other losses pass through only if the investor held the units at least 12 months.
• Other papers use the same phrase for other vehicles. A mutual fund is a pass-through vehicle in a structural sense, and a REIT is a hybrid pass-through entity — both are other workbooks' pages, and neither describes a Category III AIF.