PE and VC funds – seek to solve the problem of indirect taxes on carry-on fee earned by managers – trying to create a step-down entity that will act as a buffer to absorb the fee before passing it on to the main company.
A performance fee is essentially a portion of the profits or investments that fund managers make.
Fund managers tend to earn millions in fees when they invest the money of PE or VC funds and also when they exit those investments.
Tax experts say it’s important to address this issue quickly as it can also lead to transfer pricing complications.
ET was the first to report on July 6 that a tax court had held that indirect taxes were levied on expenses incurred by VCs, PEs, and mutual fund companies, even if they were structure in the form of a trust fund. It basically means that expenses such as transfer fees, legal fees, and wages incurred from a fund organized as a trust can attract indirect taxes.
The tax court order relates to the service tax under the original tax regime, but experts argue that the same principles apply to the Goods and Services Tax (GST ).
If PE and VC funds operate through an organization registered outside of India, the problem will become bigger, tax experts said.
Typically, PE and VC funds operate on a “cost plus” structure in India.
This means that the Indian branch charges the actual cost plus a profit.
If tax authorities required GST for expenses, it would be difficult to calculate tax returns, experts say. This can attract transfer pricing, a tax framework that determines how costs are calculated in transactions involving units of the group.
So many PE and VC companies are thinking of setting up a non-banking buffer.
“Banking companies that receive the service will have to refund 50% of the credit, whereas if a non-bank company receives the same service, there may not be any reversal when such a company only provide taxable supplies,” said Abhishek Rastogi, Partner at Khaitan & Co.
If they create a non-bank step-down entity, then GST costs can be carried over there.
This means they can even claim a tax deduction – the 50% GST cost can be passed on to the invested company or limited partners, in some cases.
“The (tax court) ruling mentioned that the net interest paid to a particular type of investor would be essentially a performance fee, subject to prior service tax. This is likely to cause similar problems in the current GST regime and hence, venture funds are evaluating options…” said MS Mani, partner of Deloitte India.
Top fund managers in the past have earned hundreds of crores in transfer fees.
If the tax ruling is applied, not only will some of them have to increase the service tax on past transactions, but they may also have to pay GST on all future transactions.
The far-reaching impact of the ruling has led fund managers to turn to tax advisors to study its specific impact on transfer fees and their fund returns, experts say. Gia said.
“Global teams are really worried about creating an entity that steps down, or even shakes the boat in a way that triggers transfer pricing. Indirect taxes are a domestic issue, but transfer pricing is an international tax concern for most PE and VC funds,” said one person familiar with the development.
Tax experts point out that unlike direct tax regulations such as income taxes and international taxes, the indirect tax regime does not recognize or define a “pass-through” structure.
Most funds tend to borrow money from many different investors and invest in different ways.
They return money and profits/profits to investors after a few years or months. In most of these cases, the fund tends to charge a certain fee, such as a management fee or performance fee, while in some cases the fee is payable to the fund manager.
The IRS has argued that a transfer fee is nothing more than a “variable payable” or a variable performance fee, and an indirect tax should be imposed.
https://economictimes.indiatimes.com/news/economy/policy/pes-vcs-mull-recast-to-get-around-gst-on-carry-fee/articleshow/84622384.cms | gst: PEs, VCs mull recast to get around GST on carry fee