The goods and services tax (GST) is, without doubt, the most significant tax reform ever undertaken in India. As this landmark change nudges Indian businesses to become more transparent, compliant and join the formal economy, it spells opportunity for the alternative investment fund (AIF) industry. The ‘one nation, one market, one tax’ regime is expected to significantly expand the investible universe for institutional investors looking to commit capital to India.
Indian firms that have already attracted AIF investments and play by the rulebook will immensely benefit too, as the tax arbitrage game grinds to a halt for their unethical competitors and provides them a level-playing field. All this is great news for private equity investors over the longer term.
But there is one wrinkle in the GST regime as it applies to private equity investors that appears to need ironing out. Under GST, AIFs that pool capital from foreign investors at an offshore location in order to invest in India do not pay GST, as export of services is clearly exempt. But such tax clarity is lacking for AIFs managed by India-domiciled asset managers. Such AIFs, even if they pool the same overseas dollars in India, haven’t been exempted from GST. As things stand, this adds a stiff 18% to the cost of management and creates significant barriers to creating more homegrown AIFs. This treatment can present a significant impediment to the ongoing ‘manage in India’ trend that is gaining currency.
Incentives towards ‘manage in India’ can have many spinoff benefits to the economy. More noted foreign investors in AIFs will mean more Indian institutions and high-net-worth individuals (HNIs) gaining confidence to invest in this vehicle. If foreign monies continue to be pooled overseas, that would represent a straight opportunity loss for India, as overseas fund managers are free to opportunistically pursue investments in other regions, rather than being firmly committed to India.
From a taxation perspective, the application of GST to the investment operations of domestic AIFs carries two shortcomings. Firstly, a domestic AIF is in essence pools contributions made by the investors and therefore should not be viewed as distinct entity separate from its investors. In fact, recognising the ‘pooling’ concept, income tax law has accorded ‘pass-through status’ to AIFs, and their income is taxed as if investors had made the investments directly. Under indirect taxation, however, making fund manager services and the services provided by others to Indian AIFs liable to GST, upends this pass-through status.
Secondly, as GST is intended to be a destination-based consumption tax, it appears anomalous that the services rendered by a service provider to AIFs are subject to the tax, given that all such services are ultimately for the benefit of the underlying investors. In an AIF which pools foreign money, the services, to the extent of foreign investments are, in principle, consumed outside India. A 5% GST rate for fund management of an AIF where a significant majority of capital comes from overseas, can give the much-needed impetus to the development of a deeper private equity ecosystem in India itself.
In fact, with appropriate taxation of such fund management services, private equity fund management hubs can mushroom in Indian cities like Mumbai, NCR Delhi and Bengaluru. This will, in turn, have significant collateral benefits for the Indian economy. When an offshore investor invests through an overseas fund, the investment remains contingent till it is actually invested in the country. On the other hand, in an onshore AIF structure, once an offshore investor commits the investment to the AIF, the foreign pool of capital is, in a sense, ‘earmarked’ and ‘locked’ for the tenure of the AIF, which runs into several years.
These commitments, being long term in nature, spur investments and economic activity in the country, leading to growth of portfolio companies and the overall Indian economy. Not only does the growth of portfolio companies support the larger ‘make in India’ initiative of the government; the increased fund management activity could create a ‘manage in India’ financial services ecosystem as well. In addition to accelerated growth and employment opportunities, companies with private equity investments are also more diligent in ensuring good corporate governance.
This government has already been quite proactive in providing more clarity and certainty to the private investor community and has maintained consistency in tax and regulatory laws. It has progressively liberalised foreign investments into domestic AIFs to encourage local asset management activities. Similarly, it has introduced safe harbour provisions in the income-tax law, making it potentially viable for fund managers to re-locate to India for India-focussed funds. The levy of a high GST rate of 18% on AIFs with foreign investors may set the clock back on these reforms.
Internationally, countries like Singapore are recognised as well developed asset management hubs. India competes with such countries for on-shoring both funds and fund managers, especially those investing here. Singapore provides benefits in the form of GST rebate to asset managers and thus mitigates the effective tax cost.
We hope the government continues with its visionary approach towards encouraging private equity flows into India through this proposed GST reform.
Padmanabh Sinha is vice chairman and Rajat Tandon is president at Indian Private Equity and Venture Capital Association. Views are personal.
