Vocabulary refers to the body of words used in a particular language or a range of artistic forms, techniques or movements. A vocabulary is usually developed with age and serves as a fundamental tool of communication for acquiring knowledge. You can enhance your vocabulary by reading, listening, speaking and writing. An extensive vocabulary helps a lot in expressing and communicating in a better manner. The size of your vocabulary is directly related to reading comprehension. So, one should always make efforts in honing your comprehending skills.
Article: Startups: Rationalise taxation of AIFs for greater flows, remove discriminatory policies
The funding of start-up enterprises and unlisted companies in India largely takes place through SEBI-registered Alternative Investment Funds (AIFs) and direct investments. The AIFs provide the much required long-term and high-risk capital to start-up and growth oriented enterprises. AIFs had received over R70,000 crore of capital commitment from its investors and have raised over R33,000 crore from them, till the end of December 2016. In the listed segment, the investments take place through Initial Public Offerings, Mutual Funds (MF), Portfolio Management Schemes (PMS) and directly by investors. But the tax regime for AIFs and MFs is different and discriminatory against AIFs. The finance minister in his Budget 2017 has not addressed the concerns of the AIF industry.
MFs are exempt from payment of income tax on any income earned by them. However, non-equity oriented MF schemes in India are required to pay Dividend Distribution Tax (DDT). Equity oriented schemes are liable to pay Securities Transaction Tax (STT) and not DDT. Dividends received by investors from all MF schemes in India are tax-free.
MF investors are not subject to a pass-through taxation on income earned by the MFs. Instead, they are only required to pay income tax on capital gains arising from the redemption/transfer of their MF units. The rate of capital gains tax differ based on the type of schemes (equity or debt) and the period of holding (short-term or long-term). Expenses incurred by the MFs are subsumed in the computation of the Net Asset Value (NAV) of the MF schemes resulting in lower taxation to the investor to that extent.
Under the present income tax regime, Category I and II AIFs (defined as “investment fund” under the Income tax Act) are exempt from payment of income tax on any income earned by them other than business income. As a corollary, investors in Investment Funds are tax exempt on business income earned by such funds and are subject to pass-through taxation on interest, dividends and capital gains earned by them, on an accrual basis. This concept of partial pass-through taxation is unique to India. It is baseless to expect investment funds to earn business income.
Category III AIFs are the ones that employ diverse or complex trading strategies and leverage, including through investment in listed or unlisted derivatives. They include funds such as hedge funds, PIPE Funds, etc. Category III AIFs are not included in the definition of an “investment fund”, and are consequently not granted pass-through taxation. In its absence, majority of these funds, organised as trusts, are taxed at the maximum marginal tax rate of 30%, since they fail to qualify as a determinate trust. Most such funds are, thus, domicile overseas.
Investment Funds (Category I and II AIFs) are required to withhold income tax at 10% on non-business income payable to domestic investors. The tax regulations do not indicate if the withholding tax is applicable on gross income of the fund or on income after netting off expenses incurred by it. Shareholders earning dividend income from domestic companies are tax exempt up to R10 lakh per annum. Long term capital gains arising from sale/transfer/redemption of listed equity shares or equity oriented MF schemes are also tax exempt. Thus, any requirement to withhold tax on such exempt income would make it suffer taxes without cause. It is absurd to expect an investment fund to withhold income tax on exempt income, which is against the cardinal principle of taxation.
This will lead to needless harassment of investment funds resulting in litigation. The biggest challenge for investment funds, and its investors, is the categorisation of income. Generally, income earned from the conduct of a trade or business is considered as “active” or “business” income and investment activities generating interest, dividend, rental income and capital gains are considered as “passive income”. Investment activities are considered passive since the investor does not actively participate in the day-to-day operations of the business. The distinction between active and passive income is important as capital gains is subject to a concessional rate of taxation in India compared to business income.
The entire income of all categories of AIFs (including Category III) can only be considered as passive income in view of the intent, activities, functioning and the definition of AIFs as per SEBI (Alternative Investment Funds) Regulations, 2012 and the Income tax Act, 1961. By providing that business income of investment funds will be taxable at the fund level, the tax regulation provides ample scope to the assessing officers (AOs) to characterise income earned by an investment fund as business income. The I-T authorities have not issued any specific guidelines on how to determine business income of an AIF.
What is considered to be passive income by an AIF could be re-characterised as business income by the tax authorities during an assessment and taxed accordingly. This causes uncertainty in income characterisation for an AIF and its investors, and thereby its taxation. As tax assessments happen with a lag, this exposes investors to uncertain liabilities.
It is a global practice that venture capital (VC) funds and private equity (PE) funds (both are AIFs by definition) generally assist the management of an investee company in addition to providing capital. They also have a seat on the board of the investee company to mentor the management team, closely monitor the growth of the company and participate in various strategy and decision making process. The I-T authorities in India could view these activities as the carrying on of a trade or business by that fund, and consequently categorise the income generated by the fund on the sale of its shares as business income instead of capital gains. The CBDT, supersedingits earlier order, recently advised its officers that transfer of unlisted shares along with ‘control and management of the underlying business’ by investment funds should be treated as capital gains. The need for issuing such an order clearly indicates the approach taken by the tax authorities in this regard.
In the United States, a VC or a PE Fund is usually organised as a limited liability partnership (LLP) which is a tax pass-through entity. A US partnership that elects an “investment partnership” status in its income tax filing, is not considered to be engaged in trade or business merely because of buying and selling of its investments and providing some ancillary management services in the formation, capitalisation, or offering of interests in a corporation. This safe harbour prevents the income of an investment partnership from being categorised as business income. Similar guidelines have not been issued by the I-T authorities in India, thereby exposing investment funds to the risk of being categorised as a business entity rather than an investment entity.
The nature of income determined by the investment fund would pass-through to its investors. If the fund determines its income to be capital gains, it is tax exempt on such capital gains (other than its obligation to withholding tax). Instead, the fund investors would pay income tax on their share of capital gains income. If the income tax authorities during an assessment procedure reclassify the capital gains income as business income, it would result in double taxation—as business income for the fund and as capital gains for its investors. This uncertainty in income characterisation would remain till the proper classification of income is resolved under a judicial process, which is an unduly time consuming process.
In the case of dividend income earned by a fund which was passed through to its investors, the income tax authorities contended that the dividend income was taxable under “Income from Other Sources” in the hands of the investor since DDT tax was not paid by the fund while distributing the dividend. The Delhi ITAT opined that AO and CIT (A) had taken a wrong view by holding that the assessee cannot claim exemption unless additional tax was paid. This case relates to FY06 and FY07, and the order was pronounced on January 29, 2016, a decade later. The time taken to resolve this issue, caused uncertainty to AIFs and its investors.
There is no clarity on the deduction of expenses incurred as well. Investment funds incur annual expenditure in the form of management fees paid to fund managers, office rent, legal, accounting and other operational expenses. Over the life of the fund, these expenses could be about 18-20% of the capital commitment of the investors. The income generation of Investment Funds is back-ended as majority of the income is earned as capital gains on exit of its investments. It generally takes more than five years to generate capital gains.
During this investment period, funds earn tax-exempt dividend income or low amount of taxable income which is inadequate to offset the annual expenditure, resulting in losses. The tax regulations do not clearly indicate if the investors are entitled to a pass-through expense deduction. The amount of annual pass-through taxable income in the initial years is lower than the corresponding expenditure incurred, resulting in a high quantum of unclaimed expenses. Foreign portfolio investors or foreign institutional investors (FIIs) are subject to only capital gains taxation in India since any securities held by a FPI/FII, which has invested in such securities in accordance with Sebi regulations, qualify as capital asset.
In summary, all gains made from investments in financial instruments by investors in public markets in India are taxed under the head “capital gains” for domestic investors and FPIs/FIIs.
The Alternative Investment Policy Advisory Committee (AIPAC), set up by Sebi under the chairmanship of NR Narayana Murthy to advise on various issues related to the alternative investment industry and development of the start-up ecosystem has rightly suggested in its report that investments in PE and VC funds are risky, commonly illiquid, and relatively longer term in nature. Accordingly, PE and VC funds should, at the very least, have a tax regime that is on par with that applicable to investors in public markets. Investment gains of AIFs should be deemed to be ‘capital gains’ in nature, is another recommendation of AIPAC Report.
The FM should stop the inefficient litigation prone pass-through taxation regime applicable to Category I and II AIFs, which could lead to tax terrorism by tax authorities. There would be equity in taxation if all categories of AIFs (including Category III) are completely exempt from taxation similar to MFs, and investors in AIFs are subject to capital gains taxation similar to investors in MFs. The tax authorities should impose STT on all categories of AIFs at the time of their investments and divestments.
This tax regime would ensure that there is no loss of tax revenue as investors would be liable to payment of capital gains tax on sale/maturity of AIF units and the AIFs would be subject to payment of STT on investment and divestment of its investments. This will ensure that the risk of mis-categorisation of capital gains as business income vanishes and expense deduction is subsumed in the NAV computation. This tax regime will bring in uniformity in taxation of all financial risk bearing instruments in India, regardless of whether the investment is in a MF or an AIF. In the absence of a pass-through mechanism, there would be no requirement to withhold tax on tax-exempt income paid by AIFs to its investors, resolving some of the challenges currently faced by AIF investors.
1. Regime (noun) (दौर): Regime refers to a leadership of an organisation.
Synonym: Administration, reign, dynasty, incumbency
Antonym: Commotion, chaos, unauthorized, bad influence
Sentence: The training centers of armed forces follow quite a strict regime.
2. Redemption (noun) (उद्धार / दोबारा मोल लेना): Redemption is an act of purchasing back something previously sold or the act of making something better or more acceptable.
Synonym: Recovery, restitution, reclamation, atonement
Antonym: Captivity, imprisonment, surrender, blight
Sentence: In this sinful world, God has his own plans for the redemption of the world.
3. Subsumed (verb) (शामिल करना): Subsumed is to include something or someone as a part of a larger group.
Synonym: Classify, contain, include, incorporate
Antonym: Exclude, surrendered
Sentence: Success can only be subsumed with hard work.
4. Corollary (noun/adjective) (अनुमान): Corollaryis something that results from something else.
Synonym: Conclusion, analogy, upshot, deduction
Antonym: Beginning, commencement, opening, origin
Sentence: The liability of a person is a corollary of fault.
5. Accrual (noun) (बढ़ोतरी): Accrual, in finance, are adjustments made for the revenues/expenses that have been earned but are not yet recorded in the books of accounts.
Synonym: Growth, accumulation, buildup, increase
Antonym: Decrease, loss, depletion, shrinkage
Sentence: The accrual needs to be added via adjusting entries in the books of accounts.
6. Domicile (noun/verb) (निवास-स्थान): Domicile refers to the place where you make your permanent home or where you are considered to be a permanent resident.
Synonym: Abode, castle, condo, dwelling
Antonym: Office, forsaken, evict, public
Sentence: He is domiciled in the United States of America.
7. Cardinal (noun/adjective) (बुनियादी): Cardinal is something which is of greatest importance or fundamental in nature.
Synonym: Overriding, basic, central, essential
Antonym: Additional, inessential, inferior, outside
Sentence: In mathematics, you use cardinal numbers to count.
8. Ancillary (noun/adjective) (सहायक): Ancillary refers to providing necessary support to the primary activities of an organization or system.
Synonym: Additional, supplementary, accompanying, collateral
Antonym: Necessary, needed, central, primary
Sentence: The ancillary staff is quite helpful in providing smooth functioning of the organization.
9. Illiquid (adjective) (अद्रव): Illiquid refers to the set of assets which are not easily converted into cash.
Sentence: Illiquid assets are hard to sell quickly due to lack of willing investors to purchase it.
10. Ecosystem (noun) (परितंत्र): Ecosystem refers to the complex set of relationships among the living resources, habitats, etc.
Synonym: Environment, environs, habitat, atmosphere
Antonym: Chaos, pollution, exosystem
Sentence: Silicon Valley is known for providing an entrepreneurial ecosystem.
Question (1-5): Answer the following as directed.
1. Find out the words which mean the same as ‘exempt’(छोड़ देना)
- Other than those given in options
Solution: Option (1)
Explanation: The given word refers to excuse someone or something from a duty, payment, etc. From theabove-given options, option (1) is a right choice as the synonym of the word.
2. Find out the words which mean the same as ‘incurred’ (व्यय किया हुआ)
- Other than those given in options
Solution: Option (4)
Explanation: The given word refers to the charge for a product or service received or delivered. Hence, from the given options, option (4) is the correct choice as the synonym of the word.
3. Find out the words which mean the same as ‘computation’ (गणना)
- Other than those given in options
Solution: Option (2)
Explanation: The given word refers to an act of computing or calculating something. So, from the given options, option (2) is an apt choice as the synonym of the word given in the options.
4. Find out the words which mean the same as ‘partial’ (आंशिक)
- Other than those given in options
Solution: Option (3)
Explanation: The given word refers to something which is not complete or existing only in parts. So, from the given options, option (3) is the right choice as the synonym of the word given in the options.
5. Find out the words which mean the same as ‘diverse’ (विविध)
- Other than those given in options
Solution: Option (2)
Explanation: The given word refers to something which shows a great deal or variety of people or things. Hence, from all the above options, option (2) is the right choice as the synonym of the word given in the options.
Word of the Day
Meaning (English) – refers to the worst moment or the lowest point in a situation.
Meaning (Hindi) – पतन/ निम्नतम स्तर
Synonyms – Rock bottom, base
Antonyms – Zenith, apex
Example – Playing that role was the nadir of his career.
उदाहरण –उसकी यह भूमिका उसके पतन का मुख्य कारण बनी.