Recently, the Indian government has requested private equity and venture capital industry to explain how other countries tax fund managers, particularly in relation to the application of GST to 'carry earnings' that are part of the share of profits fund managers and key employees. This subject, which has been topical in the recent period, can potentially affect the development and functioning of AIFs in India.
International Analysis of the Taxation of Carried Interest
Currently, none of the developed markets such as US, UK, and Singapore taxes carried interest in the form of indirect taxes such as the GST. In these countries such income is captured under 'capital gains' which is worse than business income as far as tax rates are concerned. This is viewed as a profit on investment rather than management fees which set it outside the remit of VAT or GST in most countries.
The Indian fund managers who have actively participated in funding startups and other unlisted businesses have appreciated the government’s attitude toward considering comparability of tax regimes internationally as a positive move. This could pave the way for clearer tax policies that treat carried interest similarly to capital gains, potentially providing much-needed certainty for the AIF industry.
Court Rulings Offer Mixed Relief
The Supreme Court’s recent decision to uphold a Karnataka High Court ruling that trusts set up for funds should not be considered ‘persons’ under tax law has provided some relief to the industry. This ruling reaffirmed that AIFs, as pass-through entities, do not generate profit or provide services, thereby shielding them from GST liability.
However, the ruling remains silent on the application of GST to the carried interest earned by fund managers. If carried interest is classified as a 'performance fee' for services provided, it could attract 18% GST and up to 30% income tax, pushing the overall tax burden for fund managers above 40%. This outcome would be a major blow to the industry, as investors would resist having GST deducted from the fund's profits.
Industry Concerns on Potential GST Burden
The AIF industry, which has grown over 25% annually, relies on favorable tax treatment for carried interest to attract and retain talent. Fund managers already pay GST on fixed management fees, but if carry is treated as a performance fee, the tax burden could discourage further investment. Tax experts argue that India should adopt international best practices by taxing carried interest as capital gains, not service fees.
The Supreme Court’s affirmation of the HC order could play a pivotal role in ongoing negotiations between the industry and the government, potentially steering tax policy toward more globally aligned practices for taxing carried interest.
Conclusion
As the government continues discussions with the private equity and venture capital sectors, the outcome of these talks could determine the future of AIFs in India. Fund managers are hopeful that India will follow global norms, treating carried interest as capital gains and providing a clear tax structure that promotes growth in this rapidly expanding sector.
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