Authors:
Background:
An alternative investment fund (AIF) is a privately pooled investment fund which collects funds from investors and invests in products (such as listed stocks, derivatives, debt and unlisted companies) depending on the investment strategy of the fund. The characterisation of the AIF as a category I, II or III is dependent on SEBI regulations and on the class of investments made by the AIF. An AIF is typically set up as a trust, company, or limited liability partnership (LLP).
Under the Income-tax Act, 1961 (Act), a pass-through status has been accorded to Category I and II AIFs. In other words, income earned by the AIF (other than business income, which is taxable at the maximum marginal rate (MMR1)) is exempt at the fund level, but taxable in the hands of the investors in the same manner as if the income accrued or arose to them directly.
Category III AIFs have not been accorded such pass-through status and are taxable depending upon the legal structure of the fund (i.e. trust, LLP or company). Frequently, category III AIFs are set up as trusts. Such trusts can be determinate or indeterminate. Determinate trust is a trust where the beneficiaries and their respective shares are known, hence, the income is taxable in the hands of the trustee in the like manner and to the same extent as it would be leviable upon the beneficiaries. However, an indeterminate trust (where beneficiaries are not identified) is taxed at MMR.
In this context, there has been a long-standing dispute on whether a Category III AIF trust would qualify as a determinate or indeterminate, if the beneficiaries and their share are not known upfront, i.e., at the time of setting up the Trust, but are otherwise ascertainable (say at the time of distribution) and not at the discretion of the trustee.
The Karnataka High Court in the case of India Advantage Fund2 and the Madras High Court in the case of TVS Shriram Growth Fund3 had previously held that not naming the beneficiaries/investors in the trust deed did not render its classification as indeterminate. Circular No. 13 of 2014, issued by the Central Board of Direct Taxes (CBDT), mandates upfront mentioning of the names of investors in the original trust deed to qualify as a determinate trust. Interestingly, this Circular also exempted its applicability in states where the Jurisdictional High Court had taken a contrarian view.
Facts of the case:
Equity Intelligence India AIF Trust (Taxpayer), a single open-ended scheme, is registered with SEBI as a Category III AIF to invest in listed equity shares. The Taxpayer was established as a trust, but the trust deed did not explicitly name the beneficiaries or the identities of the investors. Still, their respective income entitlements were ascertainable through the Contribution Agreements, as envisaged explicitly in the trust deed.
In 2018, the Taxpayer was before the Authority for Advance Rulings (AAR) under section 245R of the Act to seek clarification on multiple legal issues. While the application was still pending before the AAR, the Tax Officer completed the tax audit and accepted the return of income as filed by the Taxpayer.
Following the statutory dissolution of the AAR and the subsequent establishment of the Board for Advance Rulings (BAR), the matter was transferred to the BAR. In light of prolonged institutional delays in the functioning of the BAR, the Taxpayer sought to withdraw its pending application.
However, the BAR declined the withdrawal request and proceeded to adjudicate the matter. Relying on the aforementioned CBDT Circular, the BAR concluded that the trust was “indeterminate” due to the absence of any beneficiaries expressly named in the trust deed, thereby attracting taxation at the MMR. Aggrieved, the Taxpayer filed a writ petition before the Hon’ble Delhi High Court challenging both the validity of the Circular and the order passed by the BAR.
Key Findings of the High Court:
Not Naming Beneficiaries Does Not Render a Trust “Indeterminate”
- The mandate of Circular No. 13/2014 for upfront mentioning of the names of investors in the original trust deed to qualify as a determinate trust is in contradiction to the SEBI (Alternative Investment Funds) Regulations, 2012. The Regulations, inter alia, state that unless a trust registers the original trust deed under the provisions of the Registration Act, 1908, and obtains SEBI registration, it cannot accept any investment from a beneficiary. Accordingly, it is practically impossible for an AIF upfront to name the investors in the Original Trust Deed. Relying on the doctrine of impossibility, it was observed that no entity can be expected to commit an act which is impossible in law.
- Further, the Court clarified that the determinability of a trust does not hinge on whether beneficiary details are identified in the original trust deed, but rather on whether such information can be reliably ascertained at a later stage.
Enforcement of the Impugned CBDT Circular No. 13/2014
- Circular no. 13/2014 clearly states that it will not apply to AIF/Trust situated in all those states where the High Court has taken a contrary view. The Court held that an issue of law, settled by a Constitutional Court, neither challenged nor set aside by a higher Constitutional Court, will be binding on the Revenue Authorities all over the country and cannot be implemented State-specific or area-specific. Therefore, decisions of Karnataka and Madras High Court (supra), even though non-jurisdictional, were binding on the Revenue and applicable to the Taxpayer’s case.
BMR Legal’s View:
The decision by the Delhi High Court reaffirms the established principle that tax authorities cannot enforce obligations that conflict with other regulatory compliances. This ruling has reinforced the position of investors in Category III AIFs and will significantly benefit the AIF industry, where investor churn is high. One will need to wait and watch whether the impugned Circular will be repealed or whether the Revenue will appeal against this High Court ruling.
Interestingly, the Private Placement Memorandum issued by the Taxpayer cautioned the investors about potential taxation at MMR. This fact pattern was considered by the Tax authorities, which also coloured their mind. Careful documentation has become more crucial than ever.
While the Delhi High Court ruling is welcome, the taxation of private trusts is still plagued with contentious issues. Notably, the debate on questions like whether MMR will apply to capital gains income, which are otherwise taxable at reduced rates4, or the application of surcharge would be vis-à-vis the highest slab of income, or actual income is open to interpretation and litigation5.
A copy of the ruling can be found here
1 Maximum marginal rate has been defined in section 2(29C) of the Act to mean the rate of income-tax (including surcharge, if any) applicable in relation to the highest slab of income in the case of an individual, association of persons or, as the case may be, body of individuals as specified in the Finance Act of the relevant year
2 CIT vs. M/s India Advantage Fund VII (2017) SCC OnLine Kar 6857
3 CIT vs. TVS Shriram Growth Fund (2020) SCC OnLine Mad 28112; Special Leave Petition against High Court decision dismissed on grounds of low tax effect
4 12.5%/20% plus applicable surcharge and cess
5 Recently, the Mumbai Tribunal in the case of Aradhya Jain Trust v. ITO – [2025] 173 taxmann.com 343 (Mum. – Trib.) (SB) held that while determining MMR applicable to indeterminate trusts, the highest income tax slab rate as applicable to individuals is to be adopted, whereas surcharge is to be considered in a graded manner depending upon the level of total income
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