On May 27, 2020, the CBDT issued a notification which has far-reaching implications for offshore funds. The notification has amended Rule 10V of the Income Tax Rules, which provided that Indian Fund Managers would have to be remunerated on atleast at an arm’s length price. Furthermore, the amendment has also affected transfer pricing compliances of offshore funds by requiring maintenance of transfer pricing documentation and furnishing transfer pricing reports under the Income Tax Act. Through this article we shall explore the key changes introduced and the consequent implications these changes would have on offshore funds.
Key changes under the notification
Following Key changes have been brought about by the Notification:
A. Deletion of sub-rules 5 to 10 of Rule 10V
Sub-rule (5) to sub-rule (10) of Rule 10V are deleted with effect from April 1, 2019. The application of Sub-rule (5) pre-empted the existence of an international transaction and deemed the eligible investment fund and the eligible fund manager to be associated enterprises. The deletion of these provisions means that the funds would no longer be required to comply with the transfer pricing requirements.
B. Methods of calculation of Remuneration to Eligible Fund Managers
Section 9A(1) does not designate the association of an eligible investment fund and an eligible fund manager as a business connection. This leads to the eligible investment fund getting a substantial tax relief. Section 9A(3) outlines various criteria for a fund to be classified as an eligible investment fund. One of them was remuneration to be paid at an arm’s length price to eligible fund managers. The amendment has changed this and has introduced a new method by which the remuneration of eligible fund managers would be now calculated. This method is as follows:
• When EIF is a category-I Foreign Portfolio Investor (“FPI”), the minimum remuneration is to be 0.10 percent of asset under management (“AUM”).
• When the EIF is not a category-I FPI, the minimum remuneration must be at least either of
i. 0.3% of the AUM
ii. 10% of the profit of the fund which is in excess of the specified hurdle rate from the fund management. This applies when the fund manager when is entitled only to income or profit of the EIF
iii. 50% of the management fee, reduced by operational expenses when there is more than one fund manager
EIF is to be a Category-I Foreign Portfolio Investor as defined under regulation 5 of the Securities and Exchange Board of India (Foreign Portfolio Investors) Regulations, 2019. The institutions covered under the regulation must be registered as a central bank, sovereign wealth funds, pension funds, university funds, banks, appropriately regulated entities such as investment advisors, portfolio managers, broker/ swap dealers, other Government related funds with at least 75% direct or indirect Government ownership. It can also be an entity from Financial Action Task Force (FATF) member countries with the same ownership requirements as under an Indian institution.
The AUM as per the notification would be the average of the monthly average of the opening and closing balance of the value of such part of the fund which is managed by the fund manager.
Specified hurdle rate as per the notification would be a pre-defined threshold beyond which the fund agrees to pay a share of the profits earned by the fund from the fund management activity undertaken by the fund manager.
The minimum remuneration to an EFM can also be lower than what is determined under the above-mentioned methods if it is approved by a member of the CBDT. This can be done by applying the procedure under sub-rule 2 of rule 10VA under the Income Tax Rules.
C. New Reporting Requirement
The notification provides for the eligible fund manager to obtain a single report in the filing of Form No. 3CEJA which is to be signed and duly verified by an accountant in line with the procedure applicable under Section 92E of the Act.
The annexure to form No. 3CEJA prescribes certain details and documents that are to be furnished, some of them including details of the EIFs the EFMs have undertaken fund activities, particulars of remuneration received by the EFMs for fund activities and other transactions undertaken on behalf of the EIFs.
If the EFMs undertake transactions which are otherwise between Associated Enterprises, and beyond the purview of the notification, the report would have to be filed following all transfer pricing regulations that apply when two related parties transact.
Implications of the notification
The changes brought about may have the following implications:
• Eligible investment funds and eligible fund managers are not viewed as associated enterprises anymore and no longer are the transactions inter se them treated as international transactions. This would free the eligible investment funds of a number of transfer pricing compliances.
• Earlier, the remuneration was supposed to be at an arm’s length price. Such a calculation was subjective in nature and resulted in vexatious litigation. Having a specific calculation method in place leaves no room for any errors or flaws to be adjudicated later on.
• Reduced compliance requirements would ease out the administrative obligations of eligible fund managers and would hence reduce costs.
• Hassles such as choosing comparables would also be done away with a specific formula for calculation in place.
The new amendment brought through the notification is going to be highly beneficial as it clears the air around the applicability of transfer pricing provisions and arm’s length price to eligible investment funds and eligible fund managers. It has introduced an objectivity which would prevent unnecessary litigation. It is a welcome move and would help in reduction of compliances and simplification in calculation of minimum remuneration by offshore funds.
Co-authored by: Sumanth Sudharshan