Despite the recent tax clarity on income generated by Category I and II Alternative Investment Funds (AIFs), the taxation of “carried” interest still remains unclear, creating uncertainty for fund managers. Carried interest (or carry) is the percentage of a fund’s investment profits that is paid to the fund managers as performance-based compensation, if the fund’s returns exceed a certain threshold.
While most AIFs structure ‘carry’ as capital gains, benefiting from lower tax rates, Indian tax laws do not explicitly specify how carried interest should be treated. Authorities could challenge it as a service fee, which attracts indirect taxes like GST of upto 20%. This increases the overall expense ratio of the fund and lowers net returns.
The alternative investment industry has been urging the government to explicitly classify carried interest as capital gains, aligning with global standards. In many countries with established fund management industries, the tax treatment of carried interest is clearly defined, typically classifying it as investment income or capital gains under local tax laws.
“The clarification on the characterisation of income as capital gains for Category 1 and 2 AIFs is a welcome move, particularly for funds making investments beyond pure equity. However, clarity on the taxation of carried interest remains an open question, which the industry was hoping would be addressed.” said Keyur Shah, Partner and Tax leader – Financial Services, EY India.
The Union Budget on Saturday clarified that income generated by Category I and II alternative investment funds will be treated as capital gains and taxed at 12.5%, and not as “business income” that could be taxted at 30%. This cleared the ambiguity around taxation of AIF income and put it on par with foreign portfolio investors (FPIs).
“If you invest in the private equity space and it gets taxed at a higher rate, then the whole risk that you took, the reward for it goes away,” said Abhishek Prasad, Managing Partner at Cornerstone Ventures. “This clarity makes it much easier for us to onboard limited partners (LPs), especially first-time investors,” he added.
However, it is still unclear if the tax clarity applies to prior ligigations. “This amendment is unfortunately made effective from FY 2025-2026 ; it should expressly have been a “clarificatory” amendment applicable to past years. Amending it from FY 2025-26 may still cause some confusion for the past,” noted Ketan Dalal, Managing Director at Katalyst Advisors.