AIFs may accelerate switch to LLPs, sans respite on FPI surcharge

Sophisticated investment funds for the rich are likely to speed up on structural changes after failing to get relief on higher taxation.

Finance Minister Nirmala Sitharaman rolled back the additional surcharge on foreign and domestic investors on Friday. The relief is provided only to tax payable on long-term and short-term capital gains as far as alternative investment funds (AIFs) are concerned. 

The higher surcharge would still apply to domestic entities such as category-III alternative investment funds that do derivatives trades and earn income under the head business income, even as a post-announcement clarification eased the pain for FPIs on a similar issue over the weekend. 

“There is relief for long-only funds since the higher surcharge on long-term and short-term capital gains arising from transfer of equity shares has been done away with. However, long-short funds would remain at a disadvantage as they earn business income arising from derivatives trades,” said Vaibhav Sanghvi, co-chief executive officer at Avendus Capital Public Markets Alternate Strategies.

Subramaniam Krishnan, partner, Private Equity & Financial Services, EY India, said business income for category-III AIFs will continue to be taxed at 42.7 per cent, since there is no relief on the surcharge for them, unlike the FPIs who will benefit from the surcharge relief on gains from shares and derivative transactions.

Long-short funds comprise 65-70 per cent of the funds in category-III, primarily hedge funds, according to those in the know. Such funds often have exposure to derivatives and follow strategies that can seek to make money when markets are going up, as well as by betting on a fall when they sense weakness in the market. Such funds could opt for a different structure called a Limited Liability Partnership (or LLP) to reduce their tax liability, despite the change coming with the possibility of a higher compliance burden and confidentiality issues, according to experts.

“Some closed-ended funds could consider implementing the LLP structure, though it will not be easy,” said Krishnan.

Tushar Sachade, partner, Tax and Regulatory Services at Pricewaterhouse Coopers, said many were going slow on implementation of an LLP structure on hopes of some relief from the government. They are likely to push through now after the latest announcements.

“Funds may decide that it is better to deal with higher compliance than higher taxation,” he said.

The LLP structures comes with its own restrictions. This includes curbs on non-banking financial companies (NBFCs) investing in them. Many family offices (which can be a source of investments into the fund) are structured as NBFCs, Business Standard had reported earlier. Other issues include confidentiality since the LLP structure requires investor details (once admitted as partners) to be made public.

The route was explored after the Union Budget sought to raise taxes on the wealthy. The Budget had raised the surcharge on those earning between Rs 2 crore and Rs 5 crore from 15 to 25 per cent. It increased it for those earnings over Rs 5 crore from 15 per cent to 37 per cent.

The move applied to individuals and other non-corporate entities. This meant that it also applied to investment vehicles structured as non-corporate entities. Both foreign portfolio investors and AIFs were affected. An alternative investment fund pools money from the wealthy for investments. It has a minimum ticket size of Rs 1 crore.

Category-III AIFs saw their tax rate increase from 35.9 per cent to 42.7 per cent.

Category-III AIFs have seen their investments rise by over 60 times over the last five years to Rs 30,801.8 crore as of March 2019. This makes it the fastest growing of the three categories of alternative investment funds.

Meanwhile, foreign investors were net sellers by around $3 billion in the market after the surcharge was announced.

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