Contributed by: Khaitan & Co
A recent decision in the case of ICICI Econet and Internet Technology Fund [TS-290-CESTAT-2021-ST] from the Bangalore bench of the Customs, Excise and Service Tax Appellate Tribunal (the “Tribunal”) has the potential to unsettle long-established tax positions adopted by Venture Capital Funds (“VCF”) funds set up as a trust. In fact, the underlying logic behind this decision can extend the exposure even to private equity (“PE”) and mutual funds space.
Further, while this case pertained to service tax leviable under the provisions of Finance Act, 1994 (“Finance Act”), the reasoning adopted may be easily extrapolated to the GST regime as well, thus increasing the concern.
In this article, we have discussed the key points emerging from the ruling and the implications it may have in times to come from a tax perspective.
Key aspects of the judgment
ICICI Econet and Internet Technology Fund (“ICICI VCF”) is a VCF set up as a trust registered under the Securities and Exchange Board of India (Venture Capital Fund) Regulations, 1996 (“SEBI Regulations”). As per the objective of the indenture of trust document, the purpose of ICICI VCF was to pool in investments and generate capital appreciation for the contributors. To set up the whole structure of VCF, documents such as private placement memorandum, indenture of trust and contribution agreement were also put in place.
Various contributors pooled money and investment together in the ICICI VCF which, being a trust, was managed by a trustee. Further, in terms of an investment manager agreement, an Asset Management Company (“AMC”) was also appointed to provide investment management services to the trust.
The trust also undertook KYC of its contributors.
The money pooled in by the contributors was further invested by ICICI VCF in various portfolio companies. On the investments which were generated from such pooling, appropriate returns were distributed back to the contributors basis their contribution. ICICI VCF however deducted certain expenses like payments made to the AMC, custodians, other ancillary expenses, etc,. prior to such distributions to the contributors.
In some cases, the AMC was also a contributor (typically a Class B / Class C contributor). Against those funds, the AMC was paid certain amounts as “Carried Interest” apart from the fees which it was paid for its investment management services.
In these facts, the tax authorities initiated proceedings mainly alleging that ICICI VCF is providing Banking & Financial Services (“BoFS”) to the contributors and the consideration for the said services includes the amounts retained by ICICI VCF for various above-mentioned expenses like payments to custodians, AMC, etc., including the payment of carried interest to the AMC. This dispute ultimately reached the doors of CESTAT and the main issue pertained to the taxability of the alleged services being rendered by VCF.
The key arguments raised by ICICI VCF and what the Tribunal held on those points is summarised below:
In light of the above conclusions, the Tribunal held as under:
That ICICI VCF was providing the taxable service of facilitating the management of the fund and the same was classifiable as BoFS under Section 65(12) of the Finance Act. The retention of various expenses by ICICI VCF from the distribution to be made and the payment of carried interest in the nature of performance fee was in the nature of consideration received by VCF for its foregoing services.
The fact that the settlor, trust, beneficiary and the AMC were all ICICI group entities was emphasized upon to infer that ICICI VCF was set up as a mere façade to evade taxes.
Our comments on the judgment
With great respect, it is submitted that the Tribunal failed to take note of/give sufficient weightage to various crucial aspects as discussed below:
The Tribunal held that since the AMC was paid higher return on investment, the same was nothing but a form of performance fee and that ICICI VCF had acted unfavorably qua the various other contributors. The Tribunal failed to appreciate that a trust is not required to ensure that all the contributors are paid equally. Further, Doctrine of mutuality of interest does not necessarily connote that all the contributors have to be equally treated. Rather, the requirement is that the contributors are paid back in terms of the contribution made to the pooled in resources. The fact that the AMC was being paid carried interest does not negate the fact that there is oneness between the contributors and the participants. The AMC was being paid carried interest only from those funds in which it had made contributions. Further, the return on investment was decided as per the contractual arrangements in place.
The Tribunal rejected the applicability of mutuality doctrine since ICICI VCF was involved in commercial activity pertaining to investment and capital appreciation - but investment in portfolio companies was not for commercial purposes of the trust, rather for commercial purposes of the portfolio companies.
It has been a fairly settled position that contractual arrangements cannot be artificially bifurcated or disregarded so as to levy tax on a particular transaction. This judgment seems to have gone against this settled principle. Further, even assuming the existence of a service provider-service recipient relationship between the ICICI VCF and the contributors, no consideration has been agreed between these parties for such alleged services. A notional consideration seems to have been ascribed by holding that the expenses deducted, and the payment of carried interest are in the nature of consideration (the quantification of which has been left to the adjudicating authority). This aspect also seems contrary to the settled position that if the parties have not attached any consideration when there is none, to ascribe a notional consideration is unjustified.
The mere fact that ICICI VCF was registered under SEBI Regulations may have been wrongly interpreted to conclude that the VCF set up as a trust has a separate legal identity from the contributors.
Implications of this judgment and concluding remarks
All trust-based pooled-investment structures in the form of VCFs/PEs/mutual funds/alternative investment funds operate basis certain foundational principles of mutuality of interest, oneness of contributors to the common pool, and entitlement to the surplus apropos the said common pool. If these principles are disregarded, as has been done in this judgment, then all trust-based pooled-investment structures may be in for an unpleasant surprise in the form of demands of past service tax (for the 2016-17 period) and past GST (from 2017 until date and going forward), and not to forget applicable interest and penalties as well.
While this judgment is likely to be appealed against, it is imperative that relevant contractual and other documents are reviewed to assess the potential impact of this judgement and potential restructuring options, if any.
Further, given the potential disruptive impact, an industry-wide advocacy effort ought to be explored seeking suitable clarification from the Government.
Contributed by Khaitan & Co
The above article is authored by Sudipta Bhattacharjee (Partner) and Onkar Sharma (Principal Associate), with assistance from Arjyadeep Roy (Associate).