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The Taxation of AIF Units Has a Ripple Effect

The inclusion of AIF units in the definition of securities has a knock-on impact on the taxation of Category I and II AIF units in the hands of unitholders when they are issued and inter se transferred at a valuation below the FMV under ITA section 56(2)(x)(c). Under the heading of "revenue from other sources," the clause provides for taxation on any property, excluding immovable property, including securities obtained for less than the FMV. This interpretation also results in rigidity in the process used to calculate the AIF's valuation.

The taxation of AIF units is governed by Section 115UB of the Internal Revenue Code, which is a "non obstante" rule. Nonetheless, because AIF units are securities, the law can be interpreted in favor of imposing a tax on the consideration paid for them if they are transacted or issued for less than the FMV of the AIF units by an amount exceeding fifty thousand rupees, as provided in section 56(2)(x)(c) of the ITA.

When the legislation permits the taxation of such transactions, it obstructs the industry's ordinary practice and introduces legitimate transactions into the mix. Section 56(2)(x)(c) is an anti-abuse clause that levies a tax on fraudulent, fictitious capital-building operations in exchange for nonsensical compensation. If private company securities are issued to the AIF for less than FMV, the unitholder is taxed on the difference. Previously, there was no tax on the issuing or transfer of AIF units. When AIF units are issued or transferred for less than their aggregate FMV, the transaction is currently taxable in the hands of the unitholder under section 56(2)(x) of the Internal Revenue Code (c). If the consideration is less than the FMV for such investments, the unitholder will be taxed again, despite the AIF's status as a pass-through corporation under section 115UB. Furthermore, an AIF unit's value is not determined by the unitholder. This results in double taxation in the hands of investors, impeding efficiency and the growth of the AIF business.


Assessment of the AIF

Because AIF units are securities, they must follow the standards for valuing securities. The adjusted book value technique is used to value stocks under rule 11UA of the Income Tax Rules of 1962. This application adds rigidity to the valuation of an AIF with numerous investments in several portfolio companies that hold various securities classes. Because the FMV is evaluated on a case-by-case basis, there is no uniform methodology accessible in good faith for a fair assessment. AIF can decide the methodology of valuation at its leisure and only once, according to regulation 23 of the AIF Regulations. The geopolitical and economic environment of the country also influences investment valuation. The regulation has been flexible because it recognizes the difficulty of estimating the AIF's valuation. The law currently promotes a one-size-fits-all approach as a straight-jacket formula, which is a significant setback for the AIF industry's development.

Furthermore, under regulation 23(2) of the AIF Regulations, the valuation of Categories I and II AIFs must be done at least once every six months or once a year with the permission of at least 75% of the investors. Typically, there is a time gap between the unitholder's commitment to invest and the investment's withdrawal, which could result in a change in the portfolio firms' valuations, hence changing the AIF's valuation. The AIF units are distributed to the investors during drawdowns. Following the amendment, there is an indirect obligation to conduct a valuation prior to the completion of each investment round for the issuance of AIF units at the FMV, consistent with the portfolio company's worth. Furthermore, if the AIF units are moved inter se, they must be sold at the FMV, necessitating a new valuation. This raises the frequency of AIF valuations and is in violation of the AIF requirements. Due to the high threshold for the frequency of AIF valuation, there may be delays in closing as well as increased investment costs, preventing legitimate firms from raising financing. Implementation

After April 1, 2017, section 56(2)(x)(c) applies. The change does not apply to AIF investments made prior to the amendment's implementation. The ambiguity in its application generates confusion while also bringing earlier AIF investments into its scope ex post facto. When a transaction is made for issue or transfers below the FMV, it can be taxed, resulting in litigation. Unitholders and fund managers are more fearful and insecure because of the ambiguity surrounding retrospectivity.

For AIFs, the modification has created ambiguity in terms of valuation, taxation, and implementation. Previously, AIF laws gave fund managers the necessary leeway and a clear line of demarcation when it came to taxation under section 115UB of the Internal Revenue Code. However, the amendment is currently causing more harm than good. It failed to anticipate the rippling impact on the taxation of AIF units when it set out to standardise stamp duty.

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