Category III alternative investment funds use complex trading strategies including through investment in derivatives. Surcharge makes the business unviable
Finance Minister Nirmala Sitharaman, who announced a rollback of tax surcharge on various categories of foreign portfolio investors last Friday, has brought cheer to the market, but there is one exception. Some domestic AlFs (Alternative Investment Funds) may still continue to reel under the effect of higher tax (also called super-rich tax). This is also putting a question mark on the AIF model and its business viability.
AIFs, which employ diverse or complex trading strategies including through investment in listed or unlisted derivatives, are known as Category III AIFs. Various types of funds such as hedge funds, PIPE Funds, etc. are registered as Category III AIFs. As on March 31, 2019, this category of AIFs has raised Rs 34,237 crore from investors and deployed over Rs 26,700 crore. In fact, AIF Category-III has been an active participant to the disinvestment programme to an extent of 10% on CPSE and Bharat-22.
“While the announcements have cleared the air on the FPI categories, we believe that some of the domestic AIFs may continue to see an incidence of this surcharge unless further clarifications are issued,” says Sunil Tirumalai, head of research and strategist, Emkay Global Financial Services.
Bhavin Shah, partner & leader, FS Tax, PwC India explains that the removal of higher surcharge on capital gains will not apply to AIFs which deal in derivative securities. This is because the characterisation of income is business income.
As most of the AIFs are constituted as Business Trusts, the higher surcharges (tax rate 42.74%) and MMR (maximum marginal rate) still apply to a portion of their income streams. The income stream qualifying as LTCG also attracts a higher than the earlier tax rate. It is the trusts which bear the additional levy.
Unfortunately, most of the underlying investors who hold units of Category III AIFs won’t even be eligible for such surcharge. They nevertheless may have to suffer the higher tax.
See the tweet of Parth Patel, fund manager at Archer Capital LLP.
Ma’am, congratulations on measures announced today. Pleasantly surprised by depth of review of broad range of issues. However, would like to bring one unresolved issue to your notice. AIF Cat3 is still subject to HNI surcharge, even if the end investors are not earning above 2cr.
— Parth Patel, CFA (@parth699) August 23, 2019
The frustration is not without reason. Twitter user Ambikapathy says:
@nsitharaman mam. What abt home grown Cat-III AIF. Why do they have to suffer surcharge ? When HNI doesnt pay surcharge on Capital gains, When FPI doesnt pay surcharge on capital gains? No reason for AIF category III to pay higher surcharge. Pls clarify
— Ambikapathy (@Ambikapathy17) August 23, 2019
Following the increase in surcharge in the Budget, the effective income tax rate for individuals with taxable income of Rs 2-5 crore went up to 39% from 35.88% and for those above Rs 5 crore to 42.7%.
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