Jul 16, 2019

Taxman Rationalises The Tax Pass Through Regime For Category I AND II AIFS:Creases Around Set Off Losses And Taxability Ironed Out

The recent reforms to the tax pass through regime applicable to Category I and II AIFs:

› permit the set off of unabsorbed losses (other than business losses) of such AIFs, in the hands of the AIF’s investors who have held the units of the AIF for at least 12 months; and

› clarify that the income arising to non-resident investors of such AIFs, derived from their overseas portfolio investments, are not subject to tax in India. It is also clarified that the losses arising from investments in overseas portfolio investments, corresponding to the non-resident investors of such AIFs, cannot be set off against the income of the AIF.


Presently, domestic funds registered with the Securities and Exchange Board of India (“SEBI”) as Category I or Category II AIFs1 (“AIFs”) are eligible for the tax pass through regime under Section 115UB of the Income Tax Act, 1961 (“ITA”). Accordingly, the income arising to investors of AIFs from their investments in such AIFs, other than income from business or profession, is deemed to be arising to their investors, as if the investments made by the AIF were held by the investors directly.

However, the said ‘tax pass through’ regime for AIFs had certain peculiarities associated with it, when compared to the tax pass through treatment accorded to funds globally. To elaborate, the ITA does not permit investors of an AIF to carry forward or set off the unabsorbed losses arising to the AIF against their individual income. Separately, in respect of the non-resident investors of AIFs, since the investors would typically receive income as distributions from or against redemption of their interest in, the Fund; there was a lack of clarity as to whether the income of an AIF’s non-resident investors from overseas portfolio investments of the AIF could be taxed in India.

The above two issues have now been addressed and are analysed below in detail.

Permitting Set off of Losses for Investors

The Finance Bill, 2019, which has been introduced before the Parliament as a part of the Union Budget, proposes to amend Section 115UB of the ITA such that the unabsorbed losses of Category I and II AIFs (other than business losses), may be set off by the AIF’s investors against their own income, provided that they hold the units of the AIF for at least 12 months. Further, as per the proposal of the Finance Bill, unabsorbed losses arising to Category I and Category II AIFs, not being business losses, as on 31 March, 2019, will be deemed to be the losses of investors who hold units of such AIFs as on the said date and will be allowed to be carried forward and set off by the investors as per the provisions of the ITA.

¹Category I and II AIF registrations are conducive to a wide range of domestic funds including venture capital funds, private equity funds, debt funds, infrastructure funds, SME funds, social venture funds etc.

AZB Analysis

The above proposal, once enacted, would bring about the much awaited efficiency in the tax pass through regime applicable to Category I and Category II AIFs, and would be a shot in the arm for the domestic funds industry. Currently, many HNIs and corporate investors shy away from AIF structures due to the tax inefficiency on account of their inability to set off unabsorbed losses of the AIF against their individual incomes. Such investors typically prefer to invest through portfolio manager accounts, which are not always ideal from a manager’s perspective. The proposed tax efficiency AIFs should bring back AIFs in focus for such investors and should benefit the domestic funds industry.

Clarifying Taxability of Income of Non Resident investors from Overseas Investments by AIFs

The Central Board of Direct Taxes has vide a recent Circular2 clarified that any income earned by non-resident investors of Category I and Category II AIFs registered with SEBI, from overseas investments of such AIFs, is at par with income of such non-resident investors from direct investments made outside India; and thus not liable to taxation in India. The Circular further clarifies that losses arising to non-resident investors of Category I and Category II AIFs, from the offshore investments of the AIFs, will not be allowed to be set-off, or carried forward and set-off, against the income of such AIFs. Notably, this clarification applies to Category I and Category II AIFs which enjoy a tax pass through status under the India tax laws in respect of income, other than business income.

The clarification comes in the backdrop of Section 5(2) of the ITA, which provides that any income of a person who is a non-resident investor is liable to be taxed in India, if it is received or is deemed to be received in India in such year by or on behalf of such person, or accrues or arises or is deemed to accrue or arise to him in India. Since, the investors of an AIF receive distributions and income from the AIF situated in India, it could be argued that such income is taxable in India as income received, accrued, or accruing in India. However, the Circular clarifies that the income arising to non-resident investors from overseas investments of Category I and II AIF is at par with the income earned by such non-residents from their direct investments outside India, and hence not liable to be taxed in India.

AZB Analysis 

The clarification provided by the Circular is certainly a welcome step and will benefit non resident investors of such Category I and Category II AIFs which have made overseas portfolio investments. Presently overseas investments by AIFs, other than AIFs set up in the International Finance Service Centre (“IFSC”), can be made only with SEBI’s specific approval for up to 25% of the investible funds of an AIF. Thus, the Circular should immediately boost the set up of Category I and II AIFs in IFSC which seek to raise capital from overseas investors and intend to allocate a portion of their capital for investments outside India.

  ² CBDT Circular No 14/2019 dated 3 July, 2019




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