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Indirect Tax Alert - Taxability of Performance fee, Carried interest and other expenses of Venture Capital Fund Trusts under service tax

15 July 2021

The CESTAT, Bangalore vide order no:20372-20402/2021, dated 01 July 2021, in the case of M/s. ICICI Econet Internet and Technology Fund (Taxpayer) has confirmed demand of Service tax on ‘Performance fee/Carried Interest/other actual expenses’ in the hands of Venture Capital Fund Trust.

Brief facts of the case

  • The taxpayer trust established under the Indian Trusts Act, 1882, (Trusts Act) is registered with SEBI as a Venture Capital Fund (VCF). The trust is represented and managed by a trustee and the terms and conditions pertaining to the formation and management is contained in Indenture of Trust (IOT) and Private Placement Memorandum (PPM), which is an Offer Document for inviting contributors or subscribers to be part of trust set-up by the settlor.
  • Money contributed by investors are held in a trust by the trustee on behalf of the beneficiary contributors.
  • The trust deed lays-down the objectives, establishment, and manner of management of the trust.
  • The trustee receives trusteeship fees for its services from the taxpayer.
  • The trustee appoints an Investment Manager (or Asset Manager) to manage the assets/investments, the terms of which is contained in ‘Investment Management Agreement’ (IMA), and it receives management fee. The trust is responsible for holding, use for gaining the monies received from the investors during the lifetime of the Scheme, 
  • As per PPM, the trust will (i) pay Asset manager annual management fee of 2.50% of aggregate capital commitments of the Fund, and (ii) bear all other costs and expenses associated with the organisation, establishment, operation, expenses, and cost associated with the management of fund.
  • The fund had three class of investors ‘A’, ‘B’ and ‘C’ - ‘A’ being regular institutional investors besides their employees. ‘B’ and ‘C’ Class unit holders were AMC, Investment Manager, and its employees/nominees.
  • The service tax department made investigation into the affairs of the taxpayer to ascertain taxability of the services of the fund/manager under ‘Banking and other Financial Services’ (BoFS) under Section 65(12) of the Finance Act, 1994, resulting into issue of series of notices demanding Service tax, which came to be confirmed by adjudicating authority. Aggrieved, the taxpayer approached CESTAT.

Given below the gist of grounds under which the taxpayer tried to defend the demand against them, and the conclusions arrived at by the CESTAT:

A. Existence of ‘Mutuality of Interest’ between the Trust and Contributors; absence of relationship that of a Service provider and Service Recipient, to levy Service Tax:

Rejecting defence put forth by the taxpayer, the CESTAT concluded that -

The principal object of taxpayer is to achieve capital appreciation through investment of contributions and gain profit, which is a commercial activity. The trust has an independent identity and distinct personality of its own as is evident from registration with SEBI, investment in various companies, managing capital contributed by subscribers to the fund. The trust also collects KYC forms from the contributors, thus acts as a commercial concern.

The trust is essentially a Mutual Fund engaged in portfolio management etc. The documents establishing that fund shall be managed by the trust and the object of the trust is to carry on the activity of a VCF. For the distribution of dividends in respect of units, a PPM and/or scheme document is created. Thus, the profit motive of the trust is evident. The service tax law being a specific legislation just as the SEBI Act, 1992 should prevail over other legislations like the Trust Act and the definition given thereof. VCFs do not bear comparison to that of a club and its members. Thus, there exists a relationship that of a Service provider and service recipient between the trust and the contributors and the consideration (expenses incurred by the trust, out of the contributions/profit earned from investment) would be liable to the tax in the hands of the trust.

B. No tax liability as the taxpayers are VCF entities, which invest monies belonging to contributors and AMCs pay service tax; circular issued by Board clarifies that Entry load and Exit load are not liable to service tax

CESTAT rejected the contentions put forth by the taxpayer and concluded that -

The trust manages monies invested by contributor investors and the trusts are not amorphous entities; mutuality of interest is no longer applicable in the instant case. They are rendering the service of Portfolio Management or Asset Management under BoFS to the contributors investors and the consideration is in the form of withholding of the dividends/profits otherwise distributable to the contributor Investors.

These are huge amounts retained and distributed to the AMCs or their nominees subject to achieving certain levels of performance. Thus, it is a variable expenditure and cannot be equated to entry or exit load. Moreover, it is found that the taxpayer’s trusts are managing VCF and not the mutual funds, therefore the Circular is not applicable.

In a typical commercial activity various entities in the chain of activities need to pay service tax and the subsequent entity may avail the credit of tax paid by the preceding entity. Hence the claim that the entities, where the VCFs are investing, are paying service tax is not tenable. Thus, it qualifies as taxable services liable to tax.

C. Service tax not leviable on ‘Carried interest’ as it is in the nature of return on investments; expenses incurred are merely reimbursed which is not service consideration liable to tax.

Rejecting these contentions also put forth by the taxpayer, the CESTAT concluded that -

The taxpayer who manages the amounts invested by contributors investors have discretion over the distribution of dividend/profit to entities other than subscribers and they devised the structure of the fund in such a manner that the AMC and/or their nominees would get huge sums of money as ‘Carried interest’ which is nothing but a performance fee, with the motive of benefitting the AMC and/or their nominees, at the expense of the subscribers and avoiding the taxes. The fact that the AMC, settlors and trustees are all group concerns, would further give credence to the inference. It is also seen that the roles of different companies are rotated.

By way of Carried Interest, large amounts are paid in disproportion to the investment of a special class of investors, representing the same as ‘return on investment’. The tribunal observed that it is beyond doubt that the regular investor would not cede his/her gains to make good the gain of other class of investors unless such gains are on account of the performance parameters. Holding gains of Class B unitholders in Escrow to compensate any shortfall in performance parameters point to performance guarantee given by Class B investors. Thus, contention by taxpayer that ‘carry interest’ is return on investment cannot be maintained, it being fee for meeting performance parameter.

In terms of Rule 1, 2 and 5 of Service Tax Determination of Value Rules, all expenses incurred by the trust/fund in the course of providing taxable services to the contributor is to be treated as value of taxable service where value shall not be less than the cost of provision of taxable service; the exemption available to ‘pure agents’ and the Trust/Fund does not qualify as ‘pure agent’ in the light of Rule 5. While the initial expenses (Entry load, etc.) is not includible in the value of the service, the recurring expenses incurred by the taxpayer integral to the primary service, is not. Thus, the expenses incurred are also liable to service tax.

The CESTAT held that any amount retained out of income distributable to subscribers is nothing but charge or fee for the services rendered. CESTAT also rejected the contention of ‘Revenue Neutrality’ also taking into the account the requirement of all assesses paying their due share of tax, together with corresponding CENVAT credit.

As regards other contentions of the taxpayer, the CESTAT remanded the case back to the adjudicating authority to verify the documents and allow -

  • The claim that the amounts on account of “Loss of sale of investment‟, "Accrued interest considered doubtful", "Loss on revaluation of assets", etc., are not actual expenses but are only accounting adjustments.
  • Claim of the taxpayer on the admissibility of the CENVAT on input services with respect to the services provided by the taxpayer.
  • Claims of the taxpayer on the cum duty benefit.

BDO Comments

This decision assumes significance as it seems that this is the first time that VCF operating through a trust structure has come under the service tax lens. While this may not be last word on the issue as there is existence of possibility of challenge to this tribunal order, the historical industry practices/positions, such as existence of ‘Mutuality of interest between Trust and Contributors’, ‘Carried interest represents Return of Investments’, ‘Expenses are characterised as reimbursement’, etc. are under fresh scrutiny. This would upset the established practices and open-up litigation for players in this space/industry. If the tax authority is able to substantiate suppression/misstatement/collusion, etc. on the part of the taxpayer, the demand can go back to a larger period of 5 years, resulting in large tax demand, without corresponding reference to CENVAT credit, which is considered to be significant leaving little net tax liability.

The CESTAT order running into over 115 pages deals with multiple concepts and arguments advanced by the taxpayer, department’s views and final finding of the tribunal and it require careful analysis in the context of the fact pattern exists in respect of each taxpayer. It is important that the taxpayers examine these aspects and prepare well to defend demands, if any. This decision also opens-up an opportunity to revisit the existing arrangements to ring fence potential tax disputes.