Foundation — Why Category III AIFs get no pass-through, and how trusts are taxed

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Key terms in this chapter

Determinate Trust

A trust whose beneficiaries and their respective beneficial interests are ascertainable from the trust deed at all times. Adding contributors later does not destroy determinacy, but leaving shares to be decided later by someone other than the settlor does.

Discretionary Trust

A form of indeterminate trust where the trustee exercises discretion over utilisation of assets, determination of beneficial interest and distribution of income, as against a non-discretionary trust administered per the deed.

Dividend Distribution Tax (DDT)

The tax under Section 115-O formerly paid by domestic companies on dividends from accumulated profits, withdrawn by the Finance Act, 2020 with effect from 1 April 2020, along with the Section 10(34) exemption for investors.

Equity-oriented Investment Fund

Under Chapter 97, a fund set up under a mutual fund scheme with at least 65 per cent of total proceeds in equity shares of domestic companies, computed on the annual average of monthly averages of opening and closing NAV. AIPAC has proposed extending the definition to Category III AIFs.

GAAR

The General Anti-Avoidance Rule in Chapter X-A, applicable from FY 2017-18 and not to investments made before 1 April 2017. It applies where the main purpose is a tax benefit and one of four tests is met, and can lead to denial of DTAA benefits.

Grandfathering

The protection given to investments made up to 31 March 2017 under the India-Mauritius Protocol of 10 May 2016, so that gains on their later sale remain outside Indian capital gains tax.

Health and Education Cess

A levy of 4 per cent on the aggregate of income tax and surcharge.

IFSCA

The International Financial Services Centres Authority, established on 27 April 2020 under the IFSCA Act, 2019 and headquartered at GIFT City, the unified regulator for financial products, services and institutions in the IFSC.

Impermissible Avoidance Arrangement

An arrangement whose main purpose is a tax benefit and which creates non-arm's-length rights, misuses or abuses the Act, lacks commercial substance, or is carried out in a manner not normally employed for bona fide business purposes.

Indeterminate Trust

A trust whose beneficiaries and beneficial interests are not ascertainable from the trust deed. Under Section 164 the trustee is assessed as representative assessee at the Maximum Marginal Rate, and Section 166 is not invoked.

Investment Fund

Defined in Section 115UB as a fund established in India as a trust, company, LLP or body corporate holding a certificate of registration as a Category I or Category II AIF. Category III AIFs fall outside this definition and so get no pass-through.

Maximum Marginal Rate (MMR)

The rate at which an Investment Fund formed as a trust is charged to tax on its total income, currently 30 per cent before surcharge and cess.

Minimum Alternate Tax (MAT)

The tax under Section 115JB at 18.5 per cent of book profits plus surcharge and cess, payable by corporate beneficiaries where it exceeds tax computed normally. For an IFSC unit deriving income solely in convertible foreign exchange the rate is 9 per cent.

Principal Purpose Test

The MLI test denying DTAA benefits where one of the principal purposes of an arrangement or transaction was to obtain a tax benefit, applicable also to a non-independent agent — one acting exclusively for closely related enterprises.

Representative Assessee

The capacity in which a trustee is assessed under Sections 161 and 164. Once the trustee has been taxed, no further tax arises on distribution to beneficiaries, and tax paid is in principle available as credit against their liability.

Revocable Trust

A trust the settlor can revoke at his discretion or with beneficiaries' consent. Under Section 61 income from a revocable transfer is taxed as the transferor's income, so no pass-through is available; partial revocation counts as revocation.

Section 10(23FBA)

Exempts the income of an Investment Fund other than profits or gains from business or profession, so capital gains and income from other sources are exempt at fund level.

Section 10(23FBB)

Exempts, in the unit holder's hands, income of the nature of profits or gains from business or profession earned by the Investment Fund.

Section 10(23FBC)

Exempts any income accruing to or received by unit holders from a Category III AIF located in an IFSC, and income on transfer of units of such a fund.

Section 111A

Taxes short-term capital gains on the same three assets at 20 per cent with 15 per cent surcharge and 4 per cent cess, and extends to sales through a recognised exchange in an IFSC in foreign currency even without STT.

Section 112A

Taxes long-term capital gains on listed equity shares, equity-oriented mutual fund units and business trust units held over 12 months with STT paid, at 12.50 per cent on the amount exceeding Rs 1.25 lakh, with 15 per cent surcharge and 4 per cent cess.

Section 14A

Disallows expenses incurred in relation to income not forming part of total income. Management fees, fixed expenses and performance fees are therefore not deductible when computing capital gains.

Section 166

The provision allowing the Assessing Officer to assess income directly in the beneficiaries' hands, provided the trustee has not been taxed on that income. It is not invoked for an indeterminate trust.

Section 194LBB

The withholding provision applying to distributions by an AIF other than business income — 10 per cent to a resident investor or domestic company at credit or payment whichever is earlier, and 20 per cent where a resident investor does not quote a PAN.

Section 195(3)

The provision under which a non-resident investor may apply to the Assessing Officer for a certificate authorising receipt of income without withholding or at a lower rate, or alternatively submit a chartered accountant's certificate.

Section 2(42A)

Defines a short-term capital asset as one held not more than 12 months for listed securities, equity fund units, listed bonds and debentures and REIT or InvIT units, or 24 months for unlisted shares. Market linked debentures, specified mutual funds and unlisted debentures or bonds are always short-term.

Section 47(viia)

Provides that a transfer by an IFSC fund of specified assets — GDRs, rupee-denominated bonds of an Indian company, derivatives, mutual fund units or business trust units listed on an IFSC exchange — is not regarded as a transfer, so no capital gains arise.

Section 80LA

Grants a unit of a Category III AIF set up in an IFSC a 100 per cent deduction from gross total income arising from AIF activities, for any 10 consecutive years out of 15, beginning with the year permission to operate was obtained.

Section 94(1)

Deems interest, dividend or other apportioned income attributable to units to be the income of an investor who sells or transfers units and later reacquires the same units.

Securities Transaction Tax (STT)

A levy on equity shares, derivatives and equity-oriented mutual fund units. It cannot be added to the cost of acquisition for capital gains, but is deductible as a business expense where income is treated as business income.

Tax Pass-through

The status under which an AIF is not obliged to pay income tax on income it generates, the investors instead paying tax on income distributed to them when filing their own returns.

Tax Residency Certificate (TRC)

The certificate a non-resident investor must obtain from his own tax authorities to claim DTAA benefits, supplemented where necessary by Form No. 10F prescribed by the CBDT notification of 1 August 2013.