AIFs Seek Tax Parity with Foreign Portfolio Investors (FPIs) in Budget 2024

During a recent pre-budget consultation meeting with the government, the Indian Private Equity and Venture Capital Association (IVCA) proposed that Alternative Investment Funds (AIFs) be granted tax parity with Foreign Portfolio Investors (FPIs).

Legal experts argue that this tax parity is necessary because FPIs benefit from lower tax rates under the Double Tax Avoidance Agreement (DTAA). They add that foreign investors looking to invest in Indian AIFs should also enjoy similarly reduced tax rates to make these investments more attractive. 

FPIs generally have lower tax liabilities in India due to the benefits of the DTAA. However, experts point out that when a foreign investor invests in an Indian AIF, the tax could be higher because the AIF is considered a taxable entity and does not have access to DTAA benefits. This results in higher effective tax rates for foreign investors investing in AIFs. 

"This arbitrage should be plugged and all AIFs should be brought at par with FPI so as to make AIFs equally attractive for foreign investors" said Dipesh Jain, partner at Economic Laws Practice. Experts indicate that another clarification is necessary to determine whether profits made by AIFs are considered capital gains or business income.

“Currently securities held by FPIs are considered as capital assets thereby plugging the controversy of business income versus capital gains and the litigation around that. Similar clarity could be brought out for AIFs as well; this would immensely help category III AIFs in particular,” said Jain.

There is ongoing debate about whether gains from investments should be taxed as capital gains or business income. For FPIs, the Income Tax Act classifies investments as capital assets, so gains are treated as capital gains. However, for AIFs, gains from investments are currently considered business income.

The IVCA also suggested that exemptions from the angel tax in genuine situations should be extended. Section 56(2)(viib) of the Income Tax Act, 1961 applies to start-up companies when they issue shares to investors. On May 23, 2023, the Central Board of Direct Taxes issued notifications 29 and 30, which provide exemptions to start-up companies from this tax rule.

Rubal Bansal Maini, Direct Tax Partner at Luthra and Luthra, stated that currently, foreign investments from 21 countries to Indian startups are exempted under the provisions of Section 56(2)(viib) of the Income Tax Act, 1961. These countries include the United States, United Kingdom, Sweden, New Zealand, Denmark, Finland, France, and others.

However, she added, “If there are genuine investments in Indian startups made from other countries, apart from the 21 countries investments from which are already exempted, like Singapore or Mauritius, then, the income tax on these investments should also be exempted in the hands of the start-ups.” 

Suggestions also included incentivizing global fund managers to establish their operations in India rather than in overseas jurisdictions.