Direct Tax Alert

BACKGROUND

Alternative Investment Funds (‘AIFs’) are privately pooled investment vehicles regulated by the Securities and Exchange Board of India (‘SEBI’) under the SEBI (Alternative Investment Funds) Regulations, 2012. AIFs are classified into three categories: Category I, II, and III, based on their investment strategy and target sectors. Category III AIFs are permitted to employ complex and diverse trading strategies, including leverage through investment in listed or unlisted derivatives.

For taxation purposes, AIFs are governed by sections 10(23FBA), 115UB, 161, and 164 of the Income-tax Act, 1961 (‘IT Act’). While pass-through taxation is permitted for Category I and II AIFs under Section 115UB, Category III AIFs are subject to special treatment, particularly when structured as discretionary trusts.

In this regard, recently, the Delhi High Court has ruled on a significant issue in the case of Equity Intelligence AIF Trust¹, a Category III AIF, which challenged the applicability of CBDT Circular No. 13/2014. The circular mandates that unless the names and beneficial interests of investors are specifically mentioned in the original Trust Deed, the trust would be treated as “indeterminate” and taxed at the Maximum Marginal Rate (MMR) under Section 164 of the IT Act.

The ruling has major implications for the AIF industry, particularly in clarifying the interplay of SEBI regulations and tax treatment under the IT Act.
We, at BDO India, have summarised the above ruling and have provided our comments on the impact of this decision hereunder.

FACTS OF THE CASE

• The taxpayer, Equity Intelligence AIF Trust, is a Category III Alternative Investment Fund registered with SEBI, constituted under an irrevocable Trust Deed and sponsored by Equity Intelligence India Pvt. Ltd.

• The Trust launched an open-ended scheme titled "EQ India Fund", aimed at investing in listed equity shares. The scheme was registered with SEBI and issued units of INR 1,000 each to investors post registration, based on Contribution Agreements executed with them.

• The Trust did not disclose the names or beneficial interest of investors in the original Trust Deed, in compliance with SEBI (AIF) Regulations, 2012, which prohibits accepting investor funds prior to obtaining SEBI registration.

• Since inception in Fiscal Year (FY) 2017–18, the Trust has been filing separate income tax returns, claiming status as a determinate trust, with income allocation based on the number of units held by each investor as per the Net Asset Value (NAV).

• For FY 2017–18, the taxpayer filed an application seeking an Advance Ruling under Section 245Q(1) of the IT Act, to determine the applicability of taxation under Section 164 of the IT Act.

• Meanwhile, the Tax Officer completed assessment under Section 143(3) of the IT Act, accepting the returned loss and treating the Trust as a determinate trust. However, following the abolition of the AAR, the case was transferred to the Board for Advance Rulings (BAR).

• On 27 June 2024, the BAR issued an adverse ruling, holding that in the absence of names of the beneficiaries in the original Trust Deed, the Trust would be treated as indeterminate and hence, liable to tax at MMR under Section 164 of the IT Act, relying on CBDT Circular No. 13/2014.

• Aggrieved by the BAR’s ruling and the validity of Circular No. 13/2014, the taxpayer filed a writ petition before the Hon’ble Delhi High Court, challenging both the circular and the BAR’s order on the grounds of legal impossibility and inconsistency with SEBI regulations.

DELHI HIGH COURT’S RULING

The Delhi High Court allowed the writ petition filed by Equity Intelligence AIF Trust and struck down the adverse order passed by the BAR. The key observations laid down by the Court are as follows:

• CBDT Circular No. 13/2014, which mandates the disclosure of beneficiary names and their interests in the original Trust Deed, directly conflicts with SEBI (AIF) Regulations, 2012 and the SEBI Act, 1992. As per Regulation 3(1) and Section 12 of the SEBI Act, no AIF can accept funds or name investors until SEBI registration is granted.

• Compliance with both SEBI regulations and the CBDT circular is legally impossible, since investor names cannot be available at the time of Trust Deed registration. As per the doctrine of “lex non cogit ad impossibilia” (law does not compel the impossible), the taxpayer cannot be penalised for non-compliance with an impossible requirement.

• Reliance is placed on the Karnataka High Court’s ruling in India Advantage Fund-VII and the Madras High Court’s ruling in TVS Shriram Growth Fund, both of which upheld that subsequent identification of beneficiaries based on contribution agreements is sufficient to treat the trust as “determinate”.

• It is observed that CBDT Circular No. 13/2014 lacks legal reasoning and fails to take into account earlier binding Circular No. 281/1980, which clarifies that identification of beneficiaries at the time of income distribution is sufficient to qualify a trust as determinate.

• Exception to Paragraph 6 of Circular No. 13/2014 limits the circular’s applicability only to those jurisdictions where local High Courts have not ruled otherwise. This approach is termed as “baffling and contrary to settled legal principles”, i.e., judgements of Constitutional Courts cannot be applied selectively based on geography.

• It is further observed that no contrary argument was advanced by the tax authorities to refute the taxpayer’s submissions regarding SEBI’s procedural restrictions and regulatory compliance framework.

• Based on the above, it is held that non-mention of investors in the original Trust Deed, by itself, does not render the Trust indeterminate under Section 164 of the IT Act, as long as the shares are determinable through subsequent agreements or unit-based allocations.

BDO INDIA COMMENTS

This ruling establishes that, for the purpose of determining the taxability of income in the hands of Category III AIFs structured as discretionary trusts, substantive regulatory conditions must prevail over administrative circulars. Specifically, where regulatory frameworks such as the SEBI (AIF) Regulations mandate that investor details cannot be disclosed prior to registration, a circular issued by tax authorities requiring such disclosures cannot be enforced to the detriment of the taxpayer.

The Delhi High Court clarified that naming investors in the original Trust Deed is not a prerequisite for treating a trust as determinate under Section 164 of the IT Act, provided that the shares of the beneficiaries are otherwise ascertainable through contribution agreements and unit holdings. The ruling further affirmed that the CBDT Circular No. 13/2014 cannot override statutory law or compel compliance with conditions that are impossible under prevailing regulations.

Accordingly, the Trust in this case was held to be determinate and not liable to tax at the MMR and the impugned circular was read down to the extent it imposed such conflicting requirements. The judgment provides much-needed clarity and relief for Category III AIFs and is expected to set a binding precedent for similar cases across jurisdictions, reinforcing the importance of harmonising the tax administration with the regulatory framework.