Over the previous three budgets, significant progress has been made towards introducing a simplified and uniform fund taxation regime. We shall learn about the uniformity in fund taxation.

1. UNIFORMITY IN
FUND TAXATION:
CLOSE, BUT NOT
THERE YET.

2. Over the previous three budgets, significant progress has been made towards
introducing a simplified and uniform fund taxation regime
Under the Indian regulatory framework, capital can be pooled under different fund
structures like mutual funds, infrastructure debt funds (IDFs), real estate investment
trusts (REITs), infrastructure investment trusts (InvITs) and alternative investment
funds (AIFs).Though each structure is taxed differently; the previous three Union
Budgets have introduced several changes that bring a certain degree of uniformity in
their taxation. This development needs to be reinforced in future policy changes so
that investors face broadly the same tax burden, irrespective of the fund structure.
This is important because lack of uniformity in taxation of different fund vehicles can
lead to tax arbitrage, which increases the risk of tax uncertainty. The sudden change
in the taxation of non-equity oriented mutual funds to bring them on par with other
debt investments is a case in point. Lack of certainty in tax rules also creates fear
among investors of retrospective taxation. Unwarranted differences in tax treatments
also lead to tax efficiency assuming the most important role in the choice of
investment vehicles, even though not all fund structures are suitable for investment
in every asset class.
Over the previous three Budgets, significant progress has been made towards
introducing a simplified and uniform fund taxation regime. In Budget 2014-15, partial
tax pass-through status was provided to REITs and InvITs. However, the taxation
framework introduced for these suffered from two problems. First, REITs and InvITs
had to pay tax on income earned from directly holding assets (the other, indirect way
to hold assets is to provide equity or debt to a special purpose vehicle, or SPV,
which in turn holds the assets). Second, these funds suffered dividend distribution
tax (DDT) when the asset holding SPV paid dividends to them.
Both these problems were addressed in the subsequent Budgets with the Union
Budget 2015-16 providing tax pass-through to REITs and InvITs for income from
directly held assets and the recently announced Budget proposing to exempt these
funds from DDT. The previous Budget had gone further by also announcing tax pass

3. through for certain categories of AIFs. IDFs structured as mutual funds already had a
taxpass-through since their launch in 2011.
With these changes, we are at a point today where the different fund structures
broadly adhere to the principle that investors in a fund should be taxed and not the
fund itself. However, the similarity in their taxation ends there. Each fund structure
has its own set of rules on how different income heads are to be taxed at the time of
receipt and at the time of distribution (see table).

4. While some of the differences in taxation can be justified based on factors specific to
each fund structure, most differences are not defensible. For instance, withholding
tax applicable on a fund at the time of distributing surplus to investors varies from the
maximum of 30% to nil depending on the type of income and the fund structure. In
the case of IDFs and AIFs, the withholding is 30% and 10%, respectively, regardless
of the type of income, while in the case of REITs and InvITs, withholding is 10% for
certain types of incomes and zero for others.
These differences in withholding seem to lack coherence. Even if an AIF earns
dividend income on which it has suffered DDT, it still needs to withhold 10% on such
income at the time of distribution, leaving the investors to either claim a refund
(which has its own set of challenges) or set off this tax against other incomes
(problematic for investors with carried forward losses).
Also, the higher withholding on IDFs structured as mutual funds is disadvantageous
as compared to InvITs.
IDFs are mandated to invest 90% of their corpus in debt securities or securitised
debt instruments, and therefore, primarily earn interest income. The distribution of
this income attracts 30% withholding as compared to 10% withholding in the case of
interest income earned by InvITs.
Another area where taxation differs widely is secondary market trading of fund units.
The listed units of REITs and InvITs attract similar taxation as for listed equity shares
with short-term capital gain tax of 15% and no long-term capital gain tax. Holding the
units for more than one year is classified as long term in the case of REITs and
InvITs. This is in contrast to taxation of capital gains on units of IDFs, which are
treated on par with non-equity oriented mutual funds. In this case, minimum holding
period for classification as long term is three years and long term capital gains are
taxed at 20% after indexation.
Though we have made substantial headway in harmonizing tax rules across different
fund structures, the above differences suggest that west ill have some distance to
cover.
Unless warranted by considerations specific to each fund structure, investors and
fund managers should not face disparate taxation for the same income heads under
different fund vehicles.