Indirect Tax Liability On Venture Capital Funds Operating As Trusts

Hon’ble Bangalore Tribunal 1 has passed a recent judgement in relation to the Venture Capital Funds wherein the VCFs are established as trusts, managing the funds of the contributors. The tribunal has pronounced a view that the VCFs are rendering services to the contributors by concerning themselves in commercial activities and violating the principles of mutuality. A summary of the judgement is explained below:

Facts and issues of the case

1. The Venture Capital Funds (VCF) were established as a trust under the Indian Trusts Act, 1882, (“Trusts Act”) and registered with the Securities and Exchange Board of India (“SEBI”)
    
2. The VCF is a vehicle established to undertake sizeable investments in portfolio companies based on contributions received from various investors. The VCF is managed by a trustee for the benefit of its contributors/subscribers. The trustee typically appoints an Asset Management Companies (AMC) to manage pooled investments and take investment / divestment decisions. The fund incurs certain expenses like fees paid to the AMC, trusteeship fees etc.
    
3. Against the contributions received from investors, the Fund had allotted various classes of units. While Class A units were ordinary units, Class B/C units carried special privileges and were issued to the AMC, which in this case was ICICI Venture Limited, and its nominees belonging to the ICICI group.
4. The management fees were being paid to the AMC and the AMC was also a contributor to the VCF against which they were paid a carried interest as return on Investment.
    
5. The revenue contended that the Carried Interest paid to Class B/C unitholders (which included the AMC and its nominees) was deemed to be a “Performance Fee” and not a return on investment.
    
6. The Department launched investigation into the taxability of the services rendered by ICICI Econet Internet and Technology Fund floated by the Settlor (ICICI Ltd.) under the entry Banking and other financial services” in Sec. 65 (12) of the Finance Act, 1994. The said investigation resulted in the issue of series of notices demanding Service tax on the said activities, which were confirmed by the adjudicating authority.
   
    
7. Below are the few questions to be decided by the Tribunal:

• Whether, VCF and its contributors are the distinct persons. Does the Principle of Mutuality apply to the instant case or not?
• Whether the funds be called a “person” for the tax purposes?
• Whether the VCF are providing services to its contributors?
• What would be the consideration charged by the funds for the services provided, if any?

Observation of the Tribunal

• The Tribunal observed that the trust is established with pecuniary interest and the objective is to earn profits. Therefore, the Services rendered by the VCF established as trust to its contributors get squarely covered under the banking and other financial services category. Therefore, the expenses which are retained from the profits of investors would qualify as a consideration against such services and would be liable to service tax.
   
• Reliance was placed on the decision of the Hon’ble Supreme Court in Bangalore Club Vs. CIT & Ors. reported in 2013-5-SCC-509, wherein the following three conditions have been laid down
  There must be a complete identity between the contributors and participators;
• The actions of the participators and contributors must be in furtherance of the mandate of the association, and;
• There must be no scope of profiteering by the contributors from a fund made by them which could only be expended or returned to themselves.
• Furthermore, the VCF distributes unequal profits to its investors as per its own discretion. Also, the trust received contributions from its contributors, but, unlike clubs, it invested the money in third party companies, rather than spending the money directly for the benefit of the contributors.
• Though the investors/contributors received capital appreciation on their investment, and also received a surplus, the special class of investors with a very small contribution got disproportionately large benefits purportedly as 'income from investment' though the payment was in the nature of performance fee.
• Hence, the principle of mutuality does not apply to the trust in the present case.

Verdict by the Tribunal

1. Based on the above contention and observation, the Tribunal held that the VCF could not be treated as a “trust” for the purposes of service tax law, since it was involved in commercial activity pertaining to investment and capital appreciation, thereby vitiating doctrine of mutuality. The Tribunal termed the concept of a trust in the present case, as merely a façade.
    
2. Revenue argues that the VCF has registered themselves under Venture Capital Fund Regulations, 1996 issued under SEBI Act, 1992; SEBI Act being a special law, the provisions should prevail over the general law i.e. Indian Trusts Act, 1992. Therefore, VCF is a Trust only in form and not in content and shall be regarded as a “Person”.
    
3. The VCF disbursed profits/dividends upon redemption to Class A unit holders, net of expenses incurred while managing the fund. The Fund, on the other hand, disbursed an additional amount to Class B/C unitholders (i.e. the AMC and its nominees) as Carried Interest even without redemption. Amount distributed as carried interest was not return on investment but an extra amount received. The Tribunal referred carried interest as performance fee and included in consideration for taxable value.
    
4. The Revenue contended that the Fund is providing Asset or investment management services to its investors and liable to pay service tax on such services. Therefore, the case was remanded back to the adjudicating authority for the purpose of re-computing the tax amount after considering eligible input tax credits, provisions for losses and cum-tax benefits.
    
5. The Tribunal Bench affirmed the contention of revenue and imposed the penalty under Section 77 and 78 of Finance Act, 1994 for not obtaining registration and not performing compliances under the Service tax laws and suppression of material facts wilfully from the department. However, the decision is likely to be appealed against.

Impact on Industry: This judgement would impact the GST liability on fund managers and could negatively affect the fund structures in India. This could potentially have a far-reaching impact on the future growth of such investment vehicles in the country. The above decision of the Tribunal is being closely watched by the Indian private equity industry as to how this finally settles at higher levels.

1. [2021] 128 taxmann.com 281