MANU/SC/0716/1994

Equivalent Citation: AIR1994SC 2759, (1994)119C TR(SC )169, [1994]209ITR101(SC ), JT1994(4)SC 16, 1994(2)SC ALE976, (1994)4SC C 308,
[1994]3SC R942, [1994]74TAXMAN392(SC )

IN THE SUPREME COURT OF INDIA

Civil Appeal Nos. 2145, 2147-48, 2151-53 and 2155-56 of 1978 , 2099, 2147-48 of
1979, 63 of 1980, 2074 of 1981, 733 and 734 of 1982, 905 of 1989 and 3313 of
1990
Assessment Year: 1969-1970
Decided On: 09.05.1994
Appellants: Commissioner of Income Tax, Gujarat, Ahmedabad
Vs.
Respondent: Kamalini Khatau
Hon'ble Judges/Coram:
M.N. Venkatachaliah, C.J., S.C. Agrawal and S.P. Bharucha, JJ.
Counsels:
For Appellant/Petitioner/Plaintiff: N. Subhashini and JBD and Co
Case Note:
Direct Taxation - assessment - Sections 4, 5, 160 and 161 to 166 of Income
Tax Act, 1961, Section 4 of Income Tax Act, 1922 and Section 21 of Wealth
Tax Act, 1957 - whether Revenue has option to assess and to recover tax
from either trustees or beneficiaries of discretionary trust when income
thereof is distributed and received by beneficiaries in accounting year -
Sections 160 to 165 do not bar direct assessment or recovery of tax of
person on whose behalf or for whose benefit income is receivable provided
that is permissible under any other provisions of Act - beneficiary in
question though not falling under Section 166 but could be assessed and
taxed if permissible under any other provisions of Act - Section 5 defining
total income of any person to include income received by him or received on
his behalf or which accrues or arises to him - a person may be directly
assessed in respect of such income - beneficiary falling within clean swap
of Section 5 can be direly assessed and taxed.

Head Note:
INCOME TAX
Liability in special cases--DISCRETIONARY TRUST--Assessment.Held :
The income of a discretionary trust which is within the accounting year distributed to
and received by the beneficiary would, therefore, be subject to assessment in his
hands and tax thereon would be recoverable from him. Such income would squarely
fall within the broad sweep of total income under s. 5 and the beneficiary would be
liable to assessment and recovery of tax thereon under s. 4. It is implicit in the terms
of s. 161(1) that the ITO could assess a representative assessee as regards the
income in respect of which he was a representative assessee, but he was not bound

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to do so. He could assess the representative assessee or the person represented by
him. When a trustee is assessed to tax upon the income of the trust it is "really the
beneficiaries who are sought to be assessed in respect of their interest in the trust
properties through the trustee". In the absence of an express provision it is difficult
to hold that the beneficiaries of a discretionary trust are not liable to be assessed in
respect of their interest in the trust properties even when such interest is identified in
the accounting year and that the trustees who represent them alone are so liable so
that tax can be recovered only from them. Accordingly, the revenue has the option to
assess and recover tax from either the trustees or the beneficiaries of a discretionary
trust in respect of such income thereof as has been distributed and received by the
beneficiaries in the course of the accounting year.-- C. R. Nagappa v. CIT 73 ITR 626
(SC), CWT v. Trustee of H.E.H. Nazam's family (Remainder Wealth Trust) 108 ITR 555
(SC) followed. Conclusion :
Revenue has option to assess either the trustee or the beneficiary in respect of
income received by the beneficiary in case of a discretionary trust. Citation :
Income Tax Act 1961 s.164
JUDGMENT
S.P. Bharucha, J.
1 . An interesting question arises in these appeals. It is this: has the Revenue an
option to assess and recover tax from either the trustees or the beneficiaries of a
discretionary trust when the income thereof is distributed and received by the
beneficiaries in the accounting year? The appeals have been heard together and may
be disposed of by a common judgment, taking as illustrative, the facts of the lead
appeal (Civil Appeal No. 2145 of 1978, CIT Gujarat, Ahmedabad v. Mrs. Kamalini
Khatau)
2 . The relevant Assessment Year is 1969-70, the previous year being the calender
year 1968. The assessee was the beneficiary of 9 trusts. In respect of three of these
she was the sole beneficiary, and there is no dispute about their income. In regard to
the other six trusts, the assessee was one of the beneficiaries thereunder. In each of
these six trust . deeds the clause relevant for our purpose read thus:
From and after the date hereof (i.e., the date of the Trust Deed) and during
the periods mentioned in this clause, the Trustees may either accumulate the
net income of the Trust or at their discretion pay the same to the persons as
mentioned therein or to any one or more of them to the exclusion of others
or other of them for the or, his or her absolute use or benefit in such
proportion and in such manner as the Trustees may in their absolute
discretion think fit...
During the accounting year relevant to the Assessment Year 1969-70 the assessee
received the amounts set out hereafter. The amounts were received pursuant to the
resolutions of the trustees to distribute the same from out of the income of the six
trusts for the accounting year.

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3. The assessee contended before the Income-tax Officer that the said amount of Rs.
18,000/- was not liable to be taxed in her hands. The payment of income under the
said six trusts to any one or more of the beneficiaries thereof depended upon the
discretion o f the trustees; accordingly, the shares of the beneficiaries thereof were
indeterminate and unknown. The income of the trusts was, therefore, taxable only in
the hands of the trustees thereof, having regard to the provisions of Section 164 of
the Income-tax Act, 1961 (hereinafter referred to as "the Act"). The ITO rejected the
assessee's contention and assessed the said amount of Rs. 18,000/- in her hands. In
doing so he relied upon the provisions of Section 166 of the Act. The assessee
preferred an appeal. The Appellate Assistant commissioner affirmed the view taken by
the ITO. The assessee preferred a second appeal before the Income Tax Appellate
Tribunal. The Tribunal held that no part of the income of the said six trusts was
receivable on behalf of or for the benefit of any of the beneficiaries thereof. The
provisions of Section 164 were, therefore, attracted. The Tribunal rejected the 4
Revenue's contention that Section 166 was applicable. Accordingly, the Tribunal
allowed the assessee's appeal. At the behest of the Revenue, the Tribunal referred to
the High Court of Gujarat for its opinion the following question:
Whether, on the facts and in the circumstances of the case, various amounts
totalling to Rs. 18,000/- received by the assessee out of the income of the
six discretionary trusts are liable to be taxed in the hands of the assessee?
4 . A Division Bench of the High Court referred the matter to a larger Bench, and it
was heard by a Bench of three learned Judges. The order of the Tribunal was upheld
by the majority judgment, the third learned Judge dissented. We shall have occasion
to refer to the majority and dissenting judgments.
5. It is convenient now to set out those provisions of the Act which have a bearing
on the issue that we are called upon to decide. Section 4 imposes the charge: it says
that where any Central Act enacts that income-tax shall be charged for any
assessment year at any rate, income-tax at that rate shall be charged for that year, in
accordance with and subject to the provisions of the Act, in respect of the total
income of the previous year of every person. Section 5 defines the total income of a
person resident in India to include "all income from whatever source derived which-

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 (a) is received or is deemed to be received in India in such year by or on
behalf of such person; or
(b) accrues or arises or is deemed to accrue or arise to him in India during
such year; or
(c) accrues or arises to him outside India during such year.
Chapter XV of the Act is entitled "Liability in Special Cases". Part B thereof sets out
the general provisions applicable to representative assessees. Section 160 defines a
representative assessee for the purposes of the Act to mean:
(i) in respect of the income of a non-resident specified in Sub-section (i) of
Section 9, the agent of the non-resident, including a person who is treated as
an agent' under Section 163;
(ii) in respect of the income of a minor lunatic or idiot, the guardian or
manager who is entitled to receive or is in receipt of such income on behalf
of such minor, lunatic or idiot:
(iii) in respect of income which the Court or Wards, the Administrator-
General, the Official Trustee or any receiver or manager (including any
person, whatever his designation, who in fact manages properly on behalf of
another) appointed by or under any order of a court, receives or is entitled to
receive, on behalf or for the benefit of any person, .such Court of Wards,
Administrator-General, Official Trustee, receiver or manager;
(iv) in respect of income which a trustee appointed under a trust declared by
a duly executed instrument in writing whether testamentary or otherwise
(including any wakf deed which is valid under the Mussalman Wakf
Validating Act, 1913 (VI of 1913) receives or is entitled to receive on behalf
or for the benefit of any person, such trustee or trustees;
(v) in respect of income which a trustee appointed under an oral trust
receives or is entitled to receive on behalf or for the benefit of any person,
such trustee or trustees.
At the relevant time Section 161 read thus:
Liability or representative assessee - (1) Every representative assessee, as
regards the income in respect of which he is a representative assessee, shall
be subject to the same duties, responsibilities and liabilities as if the income
were income received by or accruing to or in favour of him beneficially, and
shall be liable to assessment in his own name in respect of that income; but
any such assessment shall be deemed to be made upon him in his
representative capacity only, and the tax shall, subject to the other
provisions contained in this Chapter, be levied upon and recovered from him
in like manner and to the same extent as it would be leviable upon and
recoverable from the person represented by him. (2) Where any person is, in
respect of any income, assessable under this Chapter in the capacity of a
representative assessee, he shall not, in respect of that income, be assessed
under any other provision of this Act.
Section 162 entitles every representative assessee who, as such, pays any sum under

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the Act to recover it from the person on whose behalf it is paid or to retain an
amount equal to the sum so paid out of moneys that are or may come to him in his
representative capacity. As it stood at the relevant time, Section 164 read thus:
Charge of tax where share of beneficiaries unknown - Where any income in
respect of which the persons mentioned in Clauses (iii) and (iv) of Sub-
section (i) of Section 160 are liable as representative assessees or any part
thereof, is not specifically receivable on behalf or for the benefit of any one
person, or where the individual shares of the persons on whose behalf or for
whose benefit such income or such part thereof is receivable (which persons
are hereinafter in this section referred to as the beneficiaries) are
indeterminate or unknown, tax shall be charged as if such income or such
part thereof were the total income of an association of persons, or where
such income or such part thereof is actually received by a beneficiary, then at
the rate or rates applicable to the total income or total world income of the
beneficiary if such course would result in a benefit to the revenue.
Section 166 read thus:
Direct assessment or recovery not barred Nothing in the foregoing
sections in this Chapter shall prevent either the direct assessment of
the person on whose behalf or for whose benefit income therein
referred to is receivable or the recovery from such person of the tax
payable in respect of such income.
6 . We may now paraphrase, and thus emphasise, the provisions of Chapter XV that
are most material to our discussion. By reason of Section 160 trustees appointed
under a trust deed or will who receive or are entitled to receive on behalf or for the
benefit of any person any income are representative assessees in respect of such
income. Under Section 161 every representative assessee is, as regards the income in
respect of which he is a representative assessee, subject to the same duties,
responsibilities and liabilities as if the income were income received by or accruing to
or in favour of him beneficially . and he is liable to assessment in his own name in
respect thereof. Such assessment, however, is deemed to be made upon him only in
his representative capacity and tax can be levied upon and recovered from him in like
manner and to the same extent as it would be leviable upon and recoverable from the
person represented by him. A representative assessee may not, in such capacity and
in respect of income received by him as a representative assessee, be assessed under
any provision of the Act other than Chapter XV. Section 164 sets out how tax is to be
charged where the share of the beneficiaries is unknown. It applies when the persons
mentioned in Clauses (iii) and (iv) of Sub-section (1) of Section 160 are liable as
representative assessees. It, therefore, applies in the case of trustees who receive or
are entitled to receive income on behalf or for the benefit of any person. Where
income in respect of which the trustees are liable as representative assessees "is not
specifically receivable on behalf or for the benefit of any one person, or where the
individual shares of the persons on whose behalf or for whose benefit such income or
such part thereof is receivable .... are indeterminate or unknown" tax shall be
charged as if that income were the total income of an association of persons. Section
164 itself, therefore, sets out what a discretionary trust for the purposes of the Act is.
A discretionary trust is a trust whose income is not specifically receivable on behalf
or for the benefit of any one person or wherein the individual shares of the
beneficiaries are indeterminate or unknown. The rate of tax payable by trustees upon
the income of a discretionary trust is that which would be paid upon such income by

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an association of persons. Where, however, such income or a part thereof is actually
received by a beneficiary, tax shall be charged thereon at the rate applicable to the
total income of the beneficiary if this benefits the Revenue. Section 166 states that
nothing in Sections 160 to 166 shall prevent the direct assessment of the person on
whose behalf or for whose benefit income therein referred to is receivable or the
recovery from such, person of the tax payable in respect thereof.
7 . Some analogous provisions of the Indian Income Tax Act, 1922, may also be
noted. Section 40 stated that where the guardian or trustee of any person being a
minor, lunatic or idiot was entitled to receive on behalf of such beneficiary or was in
receipt on behalf of such beneficiary of any income, profits or gains chargeable under
that Act, tax would be levied upon and recoverable from such guardian or trustee in
like manner and to the same amount as it would be leviable upon and recoverable
from any such beneficiary if of full age or sound mind and in direct receipt of such
income, profits or gains. More relevant are the provisions of Section 41, which read
thus:
Courts of Wards, etc. - (1) In the case of income, profits or gains chargeable
under this Act which the Courts of Wards, the Administrators-General, the
Official Trustees or any receiver or manager (including any person whatever
his designation who in fact manages property on behalf of another)
appointed by or under any order of a Court, [or any trustee or trustees
[appointed under a trust declared by a duly executed instrument in writing
whether testamentary or otherwise] (including the trustee or trustees under
any Wakf deed which is valid under the Mussalman Wakf Validating Act,
1913), are entitled to receive on behalf of any person] the tax shall be levied
upon and recoverable from such Court of Wards, Administrator-General,
Official Trustee, receiver or manager [or trustee or trustees], in the like
manner and to the same amount as it would be leviable upon and
recoverable from [the person on whose behalf such income, profits or gains
are receivable], and all the provisions of this Act shall apply accordingly:
Provided that where any such income, profits and gains or any part
thereof are not specifically receivable on behalf of any one person,
or where the individual shares of the persons on whose behalf they
are receivable are indeterminate or unknown, the tax shall be levied
and recoverable at the maximum rate, but, where such persons have
no other personal income chargeable under this Act and none of
them is an artificial juridical person, as if such income, profits or
gains or such part thereof where the total income of an association
of persons: Provided further that when part only of the income,
profits and gains of a trust is chargeable under this Act, that
proportion only of the income, profits and gains receivable by a
beneficiary from the trust which the part so chargeable bears to the
whole income, profits and gains of the trust shall be deemed to have
been derived from that part.
(2) Nothing contained in Sub-section (1) shall prevent either the direct
assessment of the person on whose behalf income, profits or gains therein
referred to are receivable, or the recovery from such person of the tax
payable in respect of such income, profits or gains.
8 . We may now revert to the High Court's judgments. The majority judgment laid

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emphasis upon the word "charge" in the marginal note to Section 164 and upon the
word "charged" in the body thereof. The charge created by Section 4 was in
accordance with an subject to the provisions of the Act and it was held that,
therefore; the charge in the case of the special class of representative assesses
created by Section 164 prevailed over the charge created by Section 4. In cases
falling under Section 164 one had to look only to its provisions rather than to the
provisions of Section 161. The word "receivable" in the context in which it occurred
in Section 164 indicated that it was the trust deed that one had to look at and not the
actual exercise of discretion by the trustees in the course of the year. Section 166
permitted the direct assessment of the beneficiary when it could possibly be done
under the provisions of Sections 160 to 169 in Chapter XV. What was crucial was not
Section 166 but Section 164; because if, under Section 164, it was not open to the
Revenue to proceed against the beneficiary, it was not open to the Revenue to treat
the income of the trust except as the income of a fictional association of persons. The
last portion of Section 164 only gave an option as to rates at which the tax was to be
levied. The interest of a beneficiary under a discretionary trust was merely his right
to be considered by the trustees. Because of the impossibility to deal with income in
such cases the legislature had made the special provision of Section 164. The
question was, accordingly, answered by the majority judgment in the negative, that
is, in favour of the assessee and against the Revenue.
9 . The dissenting judgment noted that tax liability arose on the last date of an
accounting year. It was, therefore, permissible to tax a beneficiary under a
discretionary trust provided that, upon exercise of the discretion conferred upon the
trustees under the trust deed before the last date of the accounting year in which the
income was received, they had indicated that a part or the whole thereof was of the
beneficial ownership of one or more of the beneficiaries. The money in question, so
soon as the direction was exercised in favour of one or more beneficiaries, was
receivable by them in fulfillment of the disposition made by the trust deed and what
was merely a right to be considered as a potential recipient of a benefit became a
vested right to receive the income or part of it according to the exercise of the
discretion by the trustees. The money in question, as soon as the discretion was
exercised, was held in trust for the respective beneficiaries and they became entitled
to receive the same. In other words, before the accounting year ended and the tax
liability arose the beneficiaries were the persons in whom a vested right to receive
and control the income arose. There was, therefore, no reason why, on principle, the
resulting payment upon the exercise or discretion could not be taxed optionally in the
hands of the beneficiaries for they were the persons in actual receipt and control of
the income. Section 164 was no more than an enabling section similar to Section
161(1) and nothing more or less could be read therein. In cases covered by Section
161(1) the option could be exercised on the strength of the trust deed itself since the
income in such cases was specifically receivable by the trustees on behalf of or for
the benefit of a single beneficiary or, where there were more beneficiaries than one,
the individual shares of the beneficiaries were determinate and known. So far as
cases covered by Section 164 were concerned, the exercise of the option became
possible only upon the discretionary trustees allocating amongst the beneficiaries the
whole or part of the income in the exercise of their discretion during the accounting
year for, upon the happening of such event, the income was received by the
beneficiaries in fulfillment of the disposition made by the trust deed and such income
became chargeable to tax in the hands of the beneficiaries in view of the provisions
of Sections 4 and 5 of the Act. As regards the use of the word 'charge' in the
marginal note and the body of Section 164 in contradistinction to the use of the
expression "levied upon and recovered from" in Section 161, the difference in the

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choice of language was of no significance. The word 'charged' in Section 164 could
only be construed as conveying the meaning levied and recovered'. Section 166 was
attracted in cases covered by Section 164 where the beneficiaries had received the
income or part thereof pursuant to the exercise of discretion by the trustees of a
discretionary trust in the course of the same accounting year. Even assuming that the
word 'receivable' in Section 164 had to be interpreted to mean receivable under the
trust deed and that it was the trust deed that one had to look at, this interpretation
did not come in the way of holding that even a discretionary beneficiary, pursuant to
the exercise of discretion in his favour and upon his receiving his share of the income
in the course of the accounting year in which it was received by the trustees, was
liable to be assessed and taxed in respect thereof. The dissenting judgment,
therefore, answered the question that was posed in the affirmative, that is to say, in
favour of the Revenue and against the assessee.
10. The learned Solicitor General appearing for the Revenue submitted that when
income was received on behalf of a beneficiary of a trust, the beneficiary could be
directly assessed wider Section 5. The Act did not intend to levy tax except in relation
to the person who received income beneficially. Sections 160 to 166 were enacted to
take care of a situation where the recipient of the income was not the person entitled
to the beneficial enjoyment thereof and they created the concept of a "representative
assessee" as also the fiction that he received the income beneficially. At the same
time, it was made clear that the representative assessee's liability did not extend
beyond the limit of the direct assessee, implicitly recognising the liability of the
direct assessee to be assessed. When the beneficiaries of a trust or their shares
therein were indeterminate or unknown, the first part of Section 161 applied for the
liability of the trustee of a discretionary trust flowed from Section 161. The second
part of Section 161, namely, levy and recovery in like manner and to the same
extent, was inherently inapplicable to the situation and it was here that Section 164
made special provision as to the status in which and the rate at which the tax was to
be levied and recovered from the trustee. No judgment stated that the income of a
trust must only be assessed in the hands of the trustee. What was stated was that
where the assessment was made in the hands of the trustee, it could only be made in
terms of the provisions of Sections 160 to 166, or the equivalent provisions of
Sections 40 and 41 of the 1922 Act. Even where the trustee was taxed it was the
beneficial interest which was taxed. There was and could be no dispute that in the
case of a specific trust the Revenue could assess and recover the tax from the
beneficiary even though the trustee was the first recipient of the income and had
legal title thereto. On a parity of reasoning, there was no impediment to taxing the
beneficiary of a discretionary trust when he had received the income in the
accounting year. Section 161 made the representative assessee subject to the same
duties, responsibilities and liabilities as if the income was received by him
beneficially. It was necessary to create this fiction because it was never the object or
intention of the Act to charge tax upon anybody other than the beneficial owner of
the income. Having created the fiction of beneficial receipt, protection was given to
the representative assessee by providing by the tax in his hands would be levied
upon and recovered from him in the like manner and to the same extent as it would
be leviable upon and recoverable from the person represented by him. It was implicit
in this that the tax could be leviable upon and recoverable from the person
represented by the representative assessee.
11. In the submission of Mr. Salve, learned counsel for the assessee, Section 161
dealt generally with the taxation of all representative assessees, including trustees,
whereas Section 164 was the special provision applicable to discretionary trusts and

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was a complete code which laid down not only the mode and manner of taxation but
also prescribed the basis and extent of the charge of tax. Section 164, therefore,
excluded the application of Section 161 wherever it became applicable on account of
the existence of the circumstances therein mentioned. The assessment of
beneficiaries even where their shares were unknown was unworkable because there
could not be a fragmented assessment, partly on the trustees and partly on the
beneficiaries. The tax was on the accrual of income upon the person who was in
direct control thereof. The point at which the income was levied was when the
income accrued to the trustees. The distribution of income did not clothe the sum
received by the beneficiary with the character of income which could be taxed once
again on its receipt, the argument that there were two limbs to Section 161 was
misconceived because the trustees were liable to tax as owners and a beneficial
interest in the income was not a condition essential to make the income taxable. Any
person in effectual control of income could be taxed thereon, the subsequent
deployment being irrelevant It was conceivable that in certain circumstances, e.g., in
the case of a specific trust in which a specific beneficiary was in direct receipt or
control of specified income, the beneficiary could be directly assessed on general
principles. Section 166 only clarified that if, generally, in law a beneficiary could be
assessed to tax then the provisions of Sections 160 to 165 would not by implication
bar direct assessment.
12. There are three judgments of this court which have a bearing on these appeals.
In C.R. Nagappa v. Commissioner of Income Tax MANU/SC/0100/1968 : [1969] 73
ITR 626 (SC) ,the assessee had executed several trust deeds settling specific
properties for the benefit of his minor children. . Under each deed he had settled
certain properties for the benefit of a named minor child and had vested the
properties in four trustees, namely, himself, his two wives and a married daughter.
Under each of the trust deeds a portion of the income was to be utilised immediately
for the benefit of the beneficiary and the balance was to be accumulated and handed
over to the beneficiary upon a stated date. It was contended on behalf of the
appellant that the Income-tax Officer was bound to assess the income under each
trust deed separately in the hands of the trustees as representative assessees and, by
reason of Section 161(2) was incompetent to assess the income in the hands of
either the appellant or the beneficiaries. This court held that it was implicit in the
terms of Section 161(1) that the Income-tax Officer could assess a representative
assessee as regards the income in respect of which he was a representative assessee,
out he was not bound to do so. He could assess either the representative assessee or
the person represented by him, and this was expressly so enacted in Section 166.
The Income-tax Officer could assess the person represented in respect of the income
of the trust property and the appropriate provisions of the Act relating to the
computation of his total income and the manner in which the income was to be
computed would apply to such assessment. The Income-tax Officer could also assess
the representative assessee in respect of that income and limited to that extent and
tax could be levied and . recovered from the representative assessee to the same
extent as it was leviable upon and recoverable from the person represented by him.
The contention raised by the appellant's counsel that since the trustees were
assessable in respect of the income of the beneficiaries under Section 161(1) that
income could not by virtue of Section 161(2) be assessed in the hands of the
beneficiaries was contrary to the plain terms of Section 166. Section 161(2) did not
purport to deny the Income-tax Officer the option of assessing the income in the
hands of the person represented by the representative assessee. It merely enacted
that when a representative assessee was assessed to tax in the exercise of the option
of the Revenue, he could be assessed only under the provisions of Chapter XV and

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under no other provisions of the Act. It was pointed out that Section 161(2) had been
enacted to remove the conflict of judicial opinion which had arisen in regard to the
interpretation of the analogous provisions of Sections 40 and 41 of the 1922 Act. The
observations of Chagla, C.J. of the Bombay High Court in the case of CIT v.
Balwantrai Jethalal Vaidya MANU/MH/0094/1959 : 34, ITR 784, which dealt with the
scheme of Section 41 of the 1922 Act, were approved. They read:
... it is clear that every case of an assessment against a trustee must fall
under Section 41, and it is equally clear that, even though a trustee is being
assessed, the assessment must proceed in the manner laid down in Chapter
III
... Section 41 only comes into play after the income has been computed in
accordance with Chapter III. Then the question of payment of tax arises and it is at
that stage that Section 41 issues a mandate to the taxing department that, when they
are dealing with the income of a trustee, they must levy the tax and recover it in the
manner laid down in Section 41. The same considerations applied to the
interpretation of Section 161(2). It merely enacted that when income was assessed in
the hands of a representative assessee in his own name the assessment would be
deemed to be made upon him in the representative capacity only and tax could be
levied and recovered in the manner provided in Section 161(1).
13. In Jyotendrasiriji v. S.I. Tripathi and Ors. MANU/SC/0313/1993 : [1993] 201 ITR
611 (SC) , a bench of two learned Judges of this court founded their judgment
principally upon Nagappa's case -and concluded that by virtue of Section 166 the
Revenue had an option in the case of the income of a discretionary trust either to
make an assessment upon the trustees or to make an assessment upon the
beneficiaries.
1 4 . In Commissioner of Wealth-Tax, A.P. v. Trustees of H.E.H. Nizam's Family
(Remainder Wealth) Trust MANU/SC/0203/1977 : [1977] 108 ITR 555 (SC) , this
court was dealing with provisions of the Wealth-tax Act, 1957, analogous to Sections
160 to 166 of the Act and Sections 40 and 41 of the 1922 Act. Section 21(1) of the
Wealth-Tax Act stated that in the case of assets chargeable to tax thereunder which
were held, inter alia, by a trustee appointed under a trust deed, wealth-tax "shall be
leviable upon and recoverable from the ... trustee .... in the like manner and to the
same extent as it would be leviable upon and recoverable from the person on whose
behalf the assets are held ..." Sub-section (2) stated that nothing contained in Sub-
section (1) would prevent either the direct assessment of the person on whose behalf
the assets were held or recovery form him of the tax payable in respect thereof. This
was a case in which the late Nizam of Hyderabad had created several trusts. For the
purposes of the judgment it was sufficient that the provisions of what was called "the
family trust" were referred to. By the trust deed the Nizam had transferred a corpus
of rupees nine crores to the trustees to be nationally divided into 175 equal units, of
which 166-1/2 units were allotted to the relations mentioned in the second schedule
to the trust deed in the manner specified therein, the number of units allocated to
each relation being mentioned there. The Wealth-tax Officer assessed only the value
of 13 units in the hands of the trustees and the value of the other units in the hands
of the representative beneficiaries. The matter reached the High court upon a
reference by the Income Tax Appellate Tribunal and thereafter this Court. The
question that was considered was whether assessment could be made on the trustees
under Section 3 apart from and without reference to Section 21. The answer was
seen to depend upon the true meaning and effect of Sections 3 and 21 and the inter-

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relation between them. Section 3 was the charging section and it levied the charge of
wealth tax on the net wealth of the assessee on the relevant valuation date. Net
wealth was defined in Section 2(m) to mean "the amount by which the aggregate
value computed in accordance with the provisions of this Act of all the assets,
wherever located, belonging to the assessee on the valuation date is in excess of the
aggregate value of all the debts owed by the assessee on the valuation date". It was
clear from this definition that any property, wherever located, "belonging to" the
assessee on the relevant valuation date would be includible in the net wealth of the
assessee assessable to wealth tax. An argument was advanced on behalf of the
trustees that assets held by a trustee in the trust for others could be said to be assets
"belonging to" the trustee so as to be included in his net wealth. The assets so held
were not the trustee's property in any real sense. They were the property of the
beneficiaries and the beneficiaries were the true owners. The trustee could not,
therefore, be assessed to wealth tax in respect of the trust properties under Section
3. It was for this reason, went the argument, that special provision had to be made in
Section 21 for assessing the trustee and hence assessment on the trustee could only
be made in accordance with such special provision, Prima facie, this court observed,
there seemed to be force in the argument but it was not thought necessary to express
any final opinion since there was an alternative argument advanced on behalf of the
assessee which left no room for doubt. For this purpose it was assumed that the
trustee of a trust could be assessable in respect of the trust properties under Section
3 even in the absence of Section 21. But Section 3 imposed the charge of wealth tax
subject to the other provisions of the Act and these other provisions included Section
21. Section 3 was, therefore, made expressly subject to Section 21 and had to yield
to that section in so far as the latter made special provision for the assessment of
trustee of a trust. Section 21 was mandatory in its terms. It was clear on a combined
reading of Sections 3 and 21 that whenever assessment was . made on a trustee, it
had to be made in accordance with the provisions of Section 21. Every case of
assessment on a trustee would necessarily fall under Section 21 and he could not be
assessed apart from and without reference to that section. To take a contrary view,
giving option to the Revenue to assess the trustee under Section 3 without following
the provisions of Section 21, would be to refuse to give effect to the words "subject
to the other provisions of this Act in Section 3", to ignore the maxim "generally
specialibus non derogant" and to deny mandatory force and effect to the provisions
of Section 21. The court noted that in Nagappa's case the observations of Chaola,
C.J. quoted above had been approved and the court went on to state that the same
consideration must apply in the interpretation of Section 161(2). It had, therefore, to
be held incontrovertible that whenever a trustee was sought to be assessed that
assessment had to be made in accordance with Section 21. It had also to be noted
that the assessment which was to be made on a trustee under Section 21 was an
assessment in a representative capacity. It was really the beneficiaries who were
sought to be assessed in respect of their interest in the trust properties through the
trustees. Section 21 provided that in respect of the trust properties held by a trustee
wealth-tax could be levied upon him in the like manner and to the same extent as it.
would be leviable on the beneficiary for whose benefit the trust properties were held.
This provision could apply only where the trust properties were held by the trustee
for the benefit of a single beneficiary or, where there were more beneficiaries than
one, the individual shares of the beneficiaries in the trust properties were
determinate and known. Where such was the case wealth-tax could be levied on the
trustee in respect of the interest of any particular benefit under the trust properties in
the same manner and to the same extent as it would be leviable upon the beneficiary
and to respect of such interest in the trust properties the trustee would be assessed

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in a representative capacity as representing the beneficiary. This did not mean that
the Revenue could not make a direct assessment on the beneficiary in respect of the
interest in the trust property which belonged to him. The beneficiary would always be
assessable in respect of his interest in the trust properties since such interest
belonged to him and the right of the Revenue to make direct assessment on him in
respect of such interest stood unimpaired by the provisions enabling assessment to
be made on the trustee in a representative capacity. Sub-section (2) made this clear.
What has important to note was that in either case what was taxed was the interest of
the beneficiary in the trust properties. Where the beneficiaries were more than one
and their shares were indeterminate or unknown the trustee would be assessable in
respect of their total interest in the trust properties. Obviously in such a case it was
not possible to make direct assessment on the beneficiaries in respect of their
interest in the trust properties because their shares were indeterminate or unknown
and that is why it was provided that the assessment could be made on the trustee as
if the beneficiaries for whose benefit the trust properties were held were an
individual. The beneficial interest was treated as if it belonged to one individual
beneficiary and assessment was made on the trustee in the same manner and to the
same extent as it would be made on such fictional beneficiary. In this case too it was
the beneficial interest which was assessed to wealth tax in the hands of the trustee.
15. It may be added that this court in the case of Commissioner of Wealth-tax v.
Kirpashankar Dayashanker Worah MANU/SC/0334/1971 : [1971] 81 ITR 763 (SC) ,
has held that Section 21(1) of the Wealth-tax Act, 1957, was analogous to Section
41(1) of the 1922 Act, the only difference being that whereas the former dealt with
assets the latter dealt with income and, subject to this difference, the two provisions
were identically worded. Hence, the decisions rendered under Section 41(1) of the
1922 Act had a bearing upon the interpretation of Section 21(1) of the Wealth-tax
Act.
16. Mr. Salve drew our attention to the judgment of this court in Commissioner of
Wealth-tax, Gujarat II, Ahmedabad, v. Arvind Narottam MANU/SC/0109/1988, where
the trust deed provided for payment to the beneficiary of a minimum sum and left it
to the discretion of the trustees whether or not any further distribution of income
should be made. There were similar provisions in relation to the corpus of the trust.
The court held that only the minimum guaranteed income could be said to be the
property of the beneficiary. On the distribution of the accumulated balance at the end
of the stipulated period, there was no right in the beneficiary to receive any part
thereof: it was open to the trustees to ignore him altogether and they could pay it to
such other members of the family as they chose. It was, therefore, held that it was
only the capitalized value of the interest of the assessee that had to be included in
his net wealth.
17. Both sides cited some English decisions but we do not think it profitable to refer
to them for what we are really concerned with is the interpretation of the language
employed in the relevant provisions of the Act.
1 8 . As the judgments of this Court referred to above lay down, a representative
assessee may be assessed in respect of income received by him as such and tax
recovered from him thereon only under and in the manner provided by the provisions
in the statute dealing with representative assessees. A trustee may, therefore, be
assessed in respect of the income of the trust and tax recovered from him thereon
only under and in the manner provided by Sections 160 to 166 of the Act. The
question then is: is the trustee of a discretionary trust liable to be taxed in respect of

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the income of the trust and tax recovered from him thereon by reason of the
provisions of Section 164 alone or has Section 164 to be read with the other
provisions dealing with representative assessees, viz., Sections 160 to 163 and 165
and 166? In other words, is, as Mr. Salve contended, Section 164 is code in itself
dealing with all matters relating to a discretionary trust?
19. To begin with, the trustee even of a discretionary trust is, by reason of the terms
of Section 160, a representative assessee. Section 161(1) sets out the liability of a
representative assessee. Its first part makes him subject, as regards the income in
respect of which he is a representative assessee, to the same duties, responsibilities
and liabilities as if the income were income received by or accruing to or in favour of
him beneficially, and he is made liable to assessment in his own name in respect
thereof. The second part affords protection to the representative assessee; it states
that such assessment shall be deemed to be made upon him only in his
representative capacity and also that tax may be levied upon and recovered from him
only in like manner and to the same extent as it would be leviable upon and
recoverable from the person represented by him. Section 161(2) gives the
representative assessee a further measure of protection by making it explicit that "he
shall not in respect of that income be assessed under any other provision of this Act".
This is of significance for "any other provisions of this Act" must plainly mean any
provision of the Act other than Section 161.
20. Section 164 states that where any income in respect of which a trustee is liable
as representative assessee is not specifically receivable on behalf or for the benefit of
any one person or where the individual shares of the persons on whose behalf or for
whose benefit such income or part thereof is receivable are indeterminate or
unknown, tax shall be charged as if such income were the total income of an
association of persons or where such income or part thereof is actually received by a
beneficiary, then at the rate applicable to the total income of the beneficiary if such
course benefits to Revenue. But differently, Section 164 states that tax shall be levied
upon the income of a discretionary trust as if it were the total income of an
association of persons, except that if it or part of it is actually received by a
beneficiary it or that part of it becomes chargeable to tax at the rate applicable to the
total income of the beneficiary if that course is beneficial to the Revenue. Section 164
does not create a charge on the income of a discretionary trust. The word "charged"
in the context in which it is used in Section 164 means only "levied". Section 164
does not make the trustee of a discretionary trust liable to assessment or the
recovery of tax on the income of the trust. Section 164 harks back to Section 161
when it refers to "persons... liable as representative assessee". It is Section 161,
therefore, which has to be read to make the trustee even of a discretionary trust
liable to assessment and recovery of tax on income received by him as a trustee.
Further, Section 161 as pointed out above, protects the representative assessee by
stating that assessment upon him shall be deemed to be only in his representative
capacity, by mandating that tax can be levied upon and recovered form him only in
like manner and to the same extent as it would be leviable upon and recoverable
from the person represented by him and by stating that he may not be assessed
under any other provision of the Act. Section 164 does not give any of these
protections, as, clearly, they must be given to all representative assessees.
21. The liability of a trustee of a discretionary trust to be assessed to tax in respect
of its income and to recovery thereof is created by Section 161 and it also states that
he is not liable to such assessment under any other provisions of the Act. Section
164 set out only how such tax shall be charged when the income is not distributed

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and when the income is distributed.
22. It does appear, therefore, that Section 164 cannot be read as being a code in
itself applicable to the taxation of the income of a discretionary trust. Consequently,
it cannot be held that the beneficiary of a discretionary trust, even he has received its
income in the accounting year, cannot be taxed thereon because Section 164 does
not provide for such contingency. The principle contention raised by Mr. Salve on
behalf of the assessee must, accordingly, be rejected.
2 3 . Why, then, should the beneficiary of a discretionary trust stand on a footing
different from that of the beneficiary of a specific trust? It is true that the language of
Section 166 does not avail the Revenue because it states that Sections 160 to 165 do
not prevent "either the direct assessment of the person on whose behalf or for whose
benefit income therein referred to is receivable or the recovery from such person of
the tax payable in respect of such income." The section is clearly clarificatory. It does
not empower any assessment or recovery by itself. It only makes it clear that
Sections 160 to 165 do not bar the direct assessment of the person on whose behalf
or for whose benefit the income is receivable or the recovery from such person of the
tax payable thereon, provided that is permissible under any other provisions of the
Act. Even so, since the word used in Section 166 is "receivable" it cannot apply to a
discretionary trust for it cannot be said that the income thereon is "receivable" for
one or more beneficiaries, it being left to the discretion of the trustees whether or not
the income should be distributed to one or more of the beneficiaries or not at all. But
that is not to say that the beneficiary of a discretionary trust, because he does not fall
within the ambit of Section 166, may not be assessed upon income received by him
and tax recovered from him thereon if that is permissible under any other provisions
of the Act for, as afforestated, Section 166 is merely clarificatory. Section 5 of the Act
defines the total income of any person to include income received by him or received
on s his behalf or which accrues or arises to him. A person may be directly assessed
in respect of such income. The income of a discretionary trust which is within the
accounting year distributed to and received by the beneficiary would, therefore, be
subject to assessment in his hands and tax thereon would be recoverable form him.
Such income would squarely fall within the broad sweep of total income under
Section 5 and the beneficiary would be liable to assessment and recovery of tax
thereon under Section 4.
24. In Nagappa's case this was clearly stated. It was said that it was implicit in the
terms of Section 161(1) that the Income Tax Officer could assess a representative
assessee as regard the income in respect of which he was a representative assessee,
but he was not bound to do so. He could assess the representative assessee or the
person represented is by him. It must also be remembered, as was said in the case of
the Nizam's Family Trust, that when a trustee is assessed to tax upon the income of
the trust it is "really the beneficiaries who are sought to be assessed in respect of
their interest in the trust properties through the trustee". In the absence of an
express provision it is difficult to hold that the beneficiaries of a discretionary trust
are not liable to be assessed in respect of their interest in the trust properties even
when such interest is identified in the accounting year and that the trustees who
represent them alone are so liable so that tax can be recovered only from them.
25. We hold, accordingly, that the Revenue has the option to assess and recover tax
from either the trustees or the beneficiaries of a discretionary trust in respect of such
income thereof as has been distributed and received by the beneficiaries in the
course of the accounting year.

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26. The appeals are allowed. The judgment (of that majority) under appeal is set
aside. The references are answered in the manner aforestated.
27. There shall be no order as to costs.

© Manupatra Information Solutions Pvt. Ltd.

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1/30/2019 EY A setback for alternative investment funds - EY - India

Published Editorial
A setback for alternative investment funds
Financial Express
Subramaniam Krishnan

Tax Partner, EY

Contributed by:

Jaiman Patel

Senior Tax Professional, EY

The Securities and Exchange Board of India (Sebi)—recognising the need for long-term, cost-effective funding
source from the private sector, capital markets or private pool of capital for start-ups, small & medium
businesses and infrastructure—notified the alternative investment fund (AIF) regulations in May 2012 after
extensive stakeholder consultation. As of May 2014, Sebi had granted registrations to over 100 AIFs and, until
March 2014, AIFs had raised net commitments totalling R13,465 crore.

Currently, there is a provision in the tax law that provides a pass-through tax status on specified income to AIFs
that are registered under the venture capital fund (VCF) sub-category of category 1 AIFs. The same status is
also available to VCFs registered under the erstwhile Sebi (VCF) Regulations, 1996. However, funds registered
as category 1 (other than VCF), category 2 and category 3 AIFs—which include small & medium enterprises,
social ventures, private equity, debt and hedge funds, majority of which have been formed as a trust—have to
deal with ambiguities and uncertainties of the trust taxation provisions in the Indian tax laws.

The Central Board of Direct Taxes (CBDT) may have compounded the uncertainty by issuing a circular on July
28, 2014, to clarify certain tax aspects for AIFs (other than VCFs). The circular addresses that if a trust deed
does not either name the investors or their beneficial interest, the provisions dealing with taxation of trust whose
beneficiaries’ share is unknown would come into play and the entire income of the fund shall be taxable at the
maximum marginal rate (MMR, 30% plus applicable surcharges) in the hands of the AIF’s trustee. In such
cases, the income tax authorities should not seek to directly assess the AIF’s investors. Further, where the trust
deed contains the names of the investors and their beneficial interest, the tax on whole of the income of the AIF,
consisting of or including business profits, shall be taxable at MMR in the hands of the AIF’s trustee.

Conceptually and by regulation, AIFs raise funds from investors by issuing units which represent the investors’
beneficial interest in the AIF. The manner and timing of distribution of invested capital and returns thereon by
the AIF to its investors is discernible from the AIF’s trust deed and associated documentation, which are legally
binding. Typically, there is no discretion on this matter granted to the AIF’s trustee. However, due to the manner
in which AIFs raise funds, it is not always possible to ensure that the names of the investors and their beneficial
interest are identifiable on the date of the trust deed.

Courts have examined this matter, albeit not specifically in the context of AIFs, and have held that the names of
the beneficiaries need not be mentioned in the trust deed so long as the trust deed gives details of the
beneficiaries and the description of the person who is to be benefited. It has also been held that the requirement
of specifying individual shares of beneficiaries would stand fulfilled where the basis and mechanics of sharing is
specified in the trust deed, although some computation may be needed to find out the individual shares.

https://www.ey.com/in/en/newsroom/news-releases/pe-ey-a-setback-for-alternative-investment-funds 1/2
1/30/2019 EY A setback for alternative investment funds - EY - India

Clarifications issued by the CBDT in the past indicate that the intention of imposing a requirement that the name
and share of the individual beneficiaries should be stated in the trust deed on its execution date was to prevent
misuse of the trust tax provisions. On this issue, it would have really benefited the sector if, in addition to the
clarification provided, the CBDT had stipulated that so long as the AIF’s constitution documents clearly provide
a mechanism for the trustee to identify beneficiaries and their respective share, the AIF should be regarded as a
specific trust (i.e. trust taxed on pass-through basis). Without this clarity, there is a clear risk that, armed with the
circular, the tax authorities regard AIFs as not being specific trusts and tax their income at MMR, leading to
avoidable litigation.

The second issue dealt with by the circular relates to the characterisation of income earned by the AIF and the
resultant tax consequences. In essence, the circular states that if an AIF earns profits and gains of business,
the whole of the AIF’s income shall be taxable at MMR. The predominant source of income for AIFs, depending
upon the strategy adopted by the AIF, could be gains from sale of investments in shares and other securities.
Characterisation of income as capital gains or business income has always been a vexed issue for financial
investors. The recent Budget, in order to impart certainty to the foreign portfolio investors, has provided a
deeming provision that income from securities transactions will be characterised as capital gains. It would have
been useful if the circular provided guidance on this aspect. In its absence, on this issue as well, the circular can
be used by the tax authorities to characterise the AIF’s income as business income and thereby tax the same at
MMR.

AIFs are a vital source of risk capital and significantly contribute to nurturing investment activity across many
sectors which, in turn, promotes employment and growth. The tax law provides a specific tax code for mutual
funds, securitisation trusts and the recent Budget has also introduced a tax code for real estate investment
trusts and infrastructure investment trusts. The AIF sector has been operative for more than a decade and has
faced tax uncertainties with flip-flops in tax approaches. The sector has sufficient scale and potential to warrant
a specific tax code consistent with the recommendations of various committees and global practices, i.e. AIFs
should be granted an automatic tax pass-through at the fund level on registration with Sebi, while maintaining
taxation at the investor level without any other requirements under tax laws. To restore investor confidence in
this asset class, the CBDT should relook at the circular and engage in a constructive dialogue with all the
stakeholders.

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 30 July 2014

EY Tax Alert
CBDT clarifies taxability of Alternative Investment Funds having
status of non-charitable trusts

Executive summary
This Tax Alert summarizes a circular [1] issued by the Central Board of Direct
Tax Alerts cover Taxes (CBDT) clarifying taxability of the Alternative Investment Funds (AIFs)
significant tax news, having status of non-charitable trusts.
developments and
changes in legislation
that affect Indian
businesses. They act
as technical summaries
to keep you on top of
the latest tax issues.
For more information,
please contact your EY
advisor.

[1]
Circular no. 13 of 2014 dated 28 July 2014.
Background beneficiaries or their beneficial interest
in the trust is unknown.
► The Securities and Exchange Board of
► In a landmark ruling rendered in the
India (SEBI) on 21 May 2012 notified the
context of contributory trusts, the
SEBI (AIF) Regulations, 2012
Authority for Advance Rulings4 held that
(AIF Regulations)2 for regulating private
even if the name of the investors and
pooling vehicles.
their beneficial interest in a trust is not
specified in the trust deed, the trust
► Depending on their operation strategies,
should qualify to be a determinate trust
objectives and fund structure, AIFs
provided the trust deed specifies the
(which can be set-up in the form of a
manner of computing the beneficial
trust, company or a limited liability
interest of the investors.
partnership) are classified either as a
Category I AIF, Category II AIF or
► Income earned by a determinate trust is
Category III AIF.
taxable in the hands of the trustee as a
representative assessee in the like
► The Finance Act 2013, accorded a 'tax
manner and to the same extent as that of
pass through status3 [similar to the
the beneficiaries/investors. However,
status available to Venture Capital Funds
where the total income of a determinate
(VCFs) registered under the SEBI
trust includes profits and gains of
(Venture Capital Funds) Regulations,
business or profession, the entire income
1996] to the VCFs that are registered
will be taxable in the hands of the trustee
with SEBI as a Category I AIF by
as a representative assessee at the
amending section 10(23FB) of the
Maximum Marginal Rate i.e. 30% (MMR).
Income-tax Act, 1961 (Act) read with
section 115U of the Act.
► Further, in the case of an indeterminate
trust, the entire income of the trust will
► However, the above tax pass through
be taxable in the hands of the trustee as
status has not been granted to other
a representative assessee at the MMR.
Category I AIFs (i.e. Small and Medium
Enterprises, Social Venture Funds and
► The CBDT, has issued Circular no. 13
Infrastructure Funds), Category II AIFs
dated 28 July 2014 to provide
and Category III AIFs. Accordingly, the
clarifications with respect to taxability of
tax treatment of the income earned by
AIFs having status of non-charitable
these AIFs is governed by the general
trusts.
provisions of the Act dealing with the
taxation of trusts.
CBDT Circular
Taxation of Trusts ► The CBDT has clarified that, where the
name of the investors or their beneficial
► The taxability of a trust as per the interest is not specified in the trust deed,
provisions of the Act, would depend on, the income earned by the AIFs would be
inter alia, whether the trust is taxable in the hands of the trustees as a
determinate or indeterminate. representative assessee at the MMR. The
Circular further clarifies that in such
► A trust will be regarded as a determinate situations, income distributed after
trust, if the name of investors are stated payment of taxes will not be taxable in
in the trust deed and their beneficial the hands of investors since the trustees
interest is known on the date of the trust would have already paid tax on it.
deed. As a corollary, an indeterminate
trust is a trust where the names of the

2
Please refer our alert dated 23 May 2012 summarizing
the AIF Regulations.
3
A pass through status means the income generated
4
would be taxed in the hands of the investor and the Trust Advance Ruling P No. 10 of 1996 (AIG Ruling) (224 ITR
will not be liable to pay tax on the income earned by it. 473).
► Where the name of the beneficiaries and
their interest in the AIFs is stated in the
trust deed and the entire/ part of the Comments
income of the AIF consist/ includes
profits and gains of business or The CBDT has clarified its position in
profession, the income of the trust would relation to the taxability of the
be taxable in the hands of the trustee as
a representative assessee at the MMR.
income earned by AIFs (other than
VCFs) having status of a
► Further, the clarification provided by the non-charitable trust.
Circular shall not apply where the
jurisdictional high court has in the past Where the tax treatment set out in
taken or in future takes a contrary view
on the aforesaid issue.
the Circular is adopted, most of the
AIFs (not entitled to tax pass
through status) set up as trusts
would be characterized as
indeterminate trusts. Consequently,
the above would result in an
effective denial of concessional tax
rate/ tax exemptions to the investor
(where available) had they made the
investments directly.
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 20 November 2015

EY Regulatory Alert
Reserve Bank of India issues notification permitting foreign
investments in Indian investment vehicles

Executive summary
Regulatory Alerts cover The Finance Minister in his Budget speech delivered on 28 February 2015 had
significant regulatory news, indicated allowing foreign investments in Alternative Investment Funds (AIFs)
developments and changes in given the need to increase investments from all sources. Further, in May 2015,
legislation that affect Indian the Union Cabinet, via a press release, had announced its approval to Real Estate
businesses. They act as Investment Trusts (REITs) being considered as an eligible financial instrument/
technical summaries to keep structure under the exchange control regulations.
you on top of the latest
regulatory issues. For more
In furtherance of the Government’s intent to attract foreign investments, the
information, please contact
your Ernst & Young advisor Reserve Bank of India (RBI) has issued a notification1 dated 16 November 2015
allowing foreign investments in investment vehicles regulated, inter alia, by the
Securities and Exchange Board of India (SEBI) including REITs, Infrastructure
Investment Trusts (InvITs) and AIFs [Investment Vehicles].

The notification paves the way for foreign investors to invest in the Investment
Vehicles under the automatic route and be treated as domestic investments
subject to meeting stipulated conditions.

This alert summarizes the key features of the notification issued by the RBI.

1.
No. FEMA. 355/2015-RB
Background ► Downstream investment by an
Investment Vehicle shall be regarded
► Foreign investments in AIFs constituted as foreign investment if neither the
as trusts were permitted subject to Sponsor nor the Manager nor the
obtaining an approval from the Foreign Investment Manager is Indian ‘owned
Investment Promotion Board. The and controlled’2.
Finance Minister in his Budget speech
delivered on 28 February 2015 ► Control of the AIF should be in the
indicated allowing foreign investments hands of Sponsors and Managers/
in AIFs given the need to increase the Investment Managers;
investments from all sources. Further, ► Where individuals are the
in May 2015, the Union Cabinet, via a Sponsors and Managers/
press release, had announced its Investment Managers of the AIF,
approval to Real Estate Investment the Sponsors and Managers/
Trusts (REITs) being considered as an Investment Managers should be
eligible financial instrument/ structure resident Indian citizens for the
under the exchange control regulations. downstream investments to be
treated as domestic investments;
► In furtherance of the Government’s ► Limited Liability Partnerships
intent to attract foreign investments, (LLPs) are restricted to act as
RBI has issued a notification dated Sponsor or Manager/ Investment
16 November 2015 (Notification) Manager of the AIF given that the
allowing foreign investments in ownership and control cannot be
investment vehicles regulated, inter determined under the extant
alia, by SEBI including REITs, InvITs and Foreign Direct Investment policy.
Alternative Investment Funds AIFs.
► The extent of foreign investment in the
This alert summarizes the key features of corpus of the Investment Vehicle will
the Notification issued by the RBI. not be a factor to determine the nature
of the downstream investment by the
Investment Vehicle (i.e. whether
Key announcements in the foreign or domestic).
Notification
► Downstream investments by an
► Foreign investments (including Investment vehicle which is reckoned
investments by Registered Foreign as foreign investment will need to be in
Portfolio Investors (FPIs) and Non- compliance with the extant Foreign
resident Indians) in REITs, InvITs and Direct Investment Policy.
AIFs are permitted under the automatic
route. An individual who is a citizen of ► Category III AIF with foreign
or any entity which is registered/ investments are permitted to make
incorporated in Pakistan or Bangladesh portfolio investment in only those
are not permitted to make investments. securities or instruments in which a
registered FPI is allowed to invest.
► A person who has acquired or
purchased the units in accordance with
the Notification can sell or transfer in
any manner or redeem the units as per
regulations framed by SEBI or
directions issued by RBI.

2 While the manner in which the Notification is worded, and controlled’, the intent appears to be to apply the
the condition could be read as either the sponsor or the condition cumulatively to the sponsor, manager/
manager/ investment manager being an Indian ‘owned investment manager.
► Foreign investors are permitted to
pledge the units to secure credit Comments
facilities.
The Notification issued by the RBI
► Foreign investments in the Investment was much awaited by the industry
Vehicle are subject to the reporting
requirements as may be prescribed by
and would provide impetus to
RBI/ SEBI from time to time. foreign investments in AIFs, REITs
and InvITs.

While the condition of the quantum

of foreign investments in the
Investment Vehicle not being a
factor in characterising downstream
investments is welcome, the
determination solely based on the
ownership and control of the
sponsor/ manager throws up
several challenges.

The limitation on sponsors/

managers being LLPs perhaps may
need a reconsideration in
circumstances where all the
partners in the LLP are Indian
resident citizens or entities
controlled by such persons.
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 M U M B AI SILICON VALLEY BANGA LORE SINGA P ORE MUMBA I BK C NE W DE L HI MUNICH

Fund Governance
Aspects and Fiduciaries to be
Considered by Fund Directors

July 2015

© Copyright 2015 Nishith Desai Associates www.nishithdesai.com

 Fund Governance
Aspects and Fiduciaries to be Considered by Fund Directors

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 Fund Governance
Aspects and Fiduciaries to be Considered by Fund Directors

Contents
1.
INTRODUCTION 01

2. GENERAL FIDUCIARIES EXPECTED FROM FUND DIRECTORS 02

3. DUTIES OF DIRECTORS AT DIFFERENT STAGES DURING LIFE-CYCLE

OF A FUND 04

4. ASPECTS CONCERNING GOVERNANCE OF HEDGE FUNDS 06

5. EMERGING JURISPRUDENCE ON DUTIES OF FUND DIRECTORS 08

6. REGULATORY FRAMEWORKS ON FUND GOVERNANCE 10

7. INVESTOR ACTIVISM: ROLE OF INVESTORS IN GOOD GOVERNANCE 13

8.
CONCLUSION 14

ANNEXURE-I
Institutional Limited Partners Association Private Equity Principles 15

© Nishith Desai Associates 2015

 Fund Governance
Aspects and Fiduciaries to be Considered by Fund Directors

1. Introduction
The crucial decision-makers of a fund1 are generally This paper summarizes the emerging jurisprudence
the investment manager, investment committee, which suggests that the threshold of fiduciaries to
advisory board and directors. While these decision- be met by directors is shifting from “sustained or
makers may play intrinsically different roles in systematic failure to exercise oversight” to “making
the governance of a fund, they all have a common reasonable and proportionate efforts commensurate
fiduciary duty towards the investors. with the situations”.

The objective of this paper is to highlight the roles A failure to perform their supervisory role could
and responsibilities of fund directors and managers raise issues as to the liabilities on independent
generally. The objective parameters may very well directors for resultant business losses as would be
also be considered by members of the investment seen in the recent Cayman Islands Court of Appeals’
committee in the context of the India based funds judgment in the case of Weavering Macro Fixed
that are primarily set up in the form of a trust. Income Fund (summarized later in this paper). The
paper also discusses duties of directors at different
Good governance of funds is important not only for stages during the cycle of a fund, concepts such as
investor protection but also for better investment investor activism and ‘managerialism of hedge funds’
returns and preventing early or untimely investor and the regulation of fund governance in different
exits. jurisdictions.

1. The usage of the term ‘fund’ throughout this paper, unless specified otherwise, refers to several forms of pooling vehicles under discretionary manage-
ment. The pooling or raising of private capital could be from institutional or High Net Worth Investors (HNIs) with a view to investing it in accord-
ance with a defined investment policy for benefit of those investors.

© Nishith Desai Associates 2015 1

Provided upon request only

2. General Fiduciaries Expected from Fund

Directors
The fund directors are often described as being II. The Duty to Act in Good Faith
subject to certain ‘fiduciary’ duties which refer to
the general guiding principles under which they and in a Bona Fide Manner in
are required to act. These duties and guidance the Best Interests of the Fund
thereon are derived from the various statutes, fund
organizational documents and case laws.
Directors are not liable for the decisions of the Board
that cause harm to the fund or its shareholders if
such decisions are made in good faith, in the best
I. The Duty to Act with interests of the fund and have been carried out in a
Reasonable Care, Skill and well-informed manner. Often termed as the ‘Business
Judgment Rule’, which was first used the case of
Diligence Charitable Corp v. Sutton5 directors are presumed
to have met the standards of care as long as no fraud,
Generally the directors of a fund are required to illegality, or conflict of interests is established,
perform their duties with that diligence, care and thereby protecting them from the constant fear of
skill which would be exercised by ordinarily prudent prosecution if a business decision goes awry.
persons in similar circumstances. The dereliction
However, this standard of protection offered by the
of such duty so as to give rise to the liability of
rule does not provide unlimited scope to the directors
directors involves a ‘gross’ or sustained abdication of
for instance if it is discovered that the decision-
responsibility on the part of the directors, or a serious
making process was ‘grossly negligent’, the director
deficiency in the board’s decision-making process
would be liable for breach of fiduciary duty.
when a particularly important decision is involved.2
A sound ‘business judgment’ by a director should be
In Frances vs. United Jersey Bank,3 the court observed
taken in good faith in the best interests of the fund
that “a director is not an ornament, but an essential
by participating in an informed decision-making
component of corporate governance.” Further the
process bearing in mind reports and opinions of
court also laid down that directors as a basic rule
committees, employees and experts on a rational
should acquire a rudimentary understanding of the
basis in compliance with applicable laws.6
business; engage in general monitoring of corporate
affairs and activities; regularly attend board meetings;
regularly review financial statements; and make
inquiries into doubtful matters, raise objections on III. The Duty to Act Loyally in the
what appear to be illegal, and consult counsel and/or
resign if corrections are not made.4 Interest of the Fund
In a recent case, the US Securities and Exchange Fund directors owe to the fund a duty of loyalty that
Commission (the “SEC”) charged an investment requires them to put the best interests of the fund
firm with misallocating diligence expenses up to and its shareholders before their personal interests.7
$17.4 million related to unconsummated deals to The conflict of interest of the ‘interested’ directors
its private equity funds, resulting in a breach of with that of the fund does away with the business
its fiduciary duty as an investment adviser. It was judgment rule in making an informed decision.
alleged that the firm failed to provide justifiable The interested director has the burden of proving
grounds for the misallocation. that in the process of taking the decision, he has not

2. Fund Governance: Legal duties of Investment Company Directors, Part I, 2-25.

3. 432 A.2d 814 (N.J. 1981)
4. Ibid.
5. 2 Atk. 400, 26 Eng. Rep. 642 (Ch. 1742).
6. Fund Governance: Legal duties of Investment Company Directors, Part I, 2-38.
7. Ibid. at 2-45.

2 © Nishith Desai Associates 2015

 Fund Governance
Aspects and Fiduciaries to be Considered by Fund Directors

breached the duty of loyalty when such conflict of ￭￭ To prevent irreparable damage to the interests
interest is involved. of the LPs, conditions precedent and other such
removal mechanisms should be included in the
A director may be considered an ‘interested’ party partnership agreement.
when the transactions relate to the purchase or sale
The Principles also suggest on-boarding independent
of property, loans and other financial arrangements
auditors and other such third party mechanisms for
between the fund and the director. The involvement
monitoring the performance of fiduciary and other
of family members in such transactions may also give
such duties by the GPs. The independent auditors
rise to concerns
are tasked with informing the LPAC of the conflict
The Institutional Limited Partner’s Association of interests the GPs might have in relation to the
(“ILPA”) released the Private Equity Principles performance of their duties.
(“Principles”) to encourage discussions between the
Among other things the auditors are expected to
fund managers (general partners or “GPs”), directors
review the capital accounts with specific attention
and the investors to the fund (limited partners or
to management fee, partnership expenses, and
“LPs”) or the shareholders regarding key issues
carried interest calculations to provide independent
including governance.8
verification of distributions to the GP and LP.
The Limited Partner Advisory Committees (“LPACs”)
As regard other third parties, a reasonable minority
play a crucial role in the governance of a fund. LPAC’s
of the LPAC may engage independent counsel at the
are of various types and not constant through all
fund’s expense when considering matters where the
funds, they could be in the form advisory boards,
GPs interests may not be entirely aligned with those
investment committees, valuation committees,
of the LPs.
etc. The primary functions performed by an LPAC
generally include resolving conflicts of interests
However, recently the expenses of third party
of the GPs, waivers of partnership restrictions and
services going up, is not just to do with supply and
general oversight of the governance of the fund.
demand. The securities’ regulators now require that
LPACs are comprised of the LP representatives who
service providers who don’t do enough to catch
often are the significant LPs appointed by the GPs.9
clients’ bad behavior can be held liable, which has
led to these specialist service providers taking a more
Operation of the fund involves a high level of
compliance-minded approach themselves.
discretion assigned to the GPs. This often results
in provisions being included in the partnership
Apart from independent auditors and third parties,
agreement which reduce the GPs fiduciary duties or
the Principles outline the functions of LPACs which
in some cases, the GPs even avoid certain duties. The
are generally limited to reviewing and resolving
Principles provide for mechanisms via which such
conflict of interest transactions such as cross-
provisions could be avoided:
fund investments and related party transactions,
methodology used for valuations of portfolio
￭￭ The GPs should present all conflicts of interest
companies, etc. The formal responsibilities of LPACs
to the LPAC for review and seek prior approval
are provided in the private placement memorandum,
for such conflicts and/or non-arm’s length
the LP agreements and fund’s constitutional
interactions or transactions. The GPs should not
documents (depending on the format in which the
clear their own conflicts.
fund has been set up).
￭￭ The GPs should preclude provisions that allow
them to be exonerated or indemnified for acts
constituting a material breach of the partnership
agreement, the fiduciary duties or other “for
cause” events.
￭￭ Majority of the LPs should be given the authority
to remove a GP or terminate the fund for cause.

8. See Annexure-1: ILPA Private Equity Principles, Version 2.0, January, 2011.
9. ILPA PE Principles version 1.0

© Nishith Desai Associates 2015 3

Provided upon request only

3. Duties of Directors at Different Stages

During Life-Cycle of a Fund
The Directors perform wide-ranging duties during The AIF Regulations were notified on May 21, 2012.
different stages of the fund. These duties should guide Subject to certain exceptions, the ambit of the AIF
everything that a director does during the following Regulations is to regulate all forms of vehicles set up
phases in the life of a fund. in India for pooling of funds on a private placement
basis. To that extent, the AIF Regulations provide
the bulwark within which the privately pooled
discretionary fund management industry operates in
I. At the Fund Formation Stage India.

The Directors must satisfy themselves that the The Circular inter alia requires detailed tabular
offering documents comply with applicable laws, example of how fee and other charges are calculated
that the terms of the service providers’ contracts are and how the distribution waterfall is structured.
reasonable and consistent with industry standards,
and that the overall structure of the fund will ensure
a proper division of responsibility among service
providers. Directors must act in the best interests
II. During the Fund’s Tenure
of the fund which, in this context, means its future
investors.
A. Appointment of Service Providers
In this respect, we believe ‘verification notes’ can be
generated. The notes would record the steps which The Directors should consider carefully which
have been taken to verify the facts, the statements service providers are selected for appointment. They
of opinion and expectation, contained in the fund’s should understand the nature of the services to be
offering document(s). The notes also serve the provided by the service providers to the fund.
further purpose of protecting the directors who
may incur civil and criminal liability for any untrue
and misleading statements therein or material or
B. Agenda
misleading omissions therefrom. Alternatively, a
The formalities of conducting proper board meetings
‘closing opinion’ may also be relied upon.
should be observed. An agenda for such meetings
should list the matters up for discussion, materials
Following closely on the footsteps of the SEC’s recent
to be inspected, and inputs from the manager, the
observations10 by U.S. Securities and Exchange
service providers and directors themselves. It should
Commission (SEC) that there are several disconnects
be circulated in advance.
between “what [general partners] think their [limited
partners] know and what LPs actually know”, the
Indian Securities Exchange Board of India (“SEBI”) C. Actions Outside Board Meetings
has issued a circular11 (“Circular”) that consolidates
guidelines on disclosures and reporting that The Directors should review reports and information
alternative investment funds (“AIFs”) have to make. that they receive from the administrator and auditors
The Circular also provides certain clarifications from time to time to independently assess the
on the interpretation of the provisions of the SEBI functioning of the fund and whether it is adhering to
(Alternative Investment Funds) Regulations, 2012 with the fund’s investment strategy.
(“AIF Regulations”).

10. On May 6, 2014, Andrew Bowden, Director of the U.S. Securities and Exchange Commission’s Office of Compliance Inspections and Examinations
(OCIE), stated that the OCIE has found widespread instances of insufficiently disclosed fees in the private equity industry. Also see http://blogs.wsj.
com/privateequity/2014/06/10/sec-official-points-to-disclosure-shortcomings-by-private-equity-firms/11. July 08, 2014 – Reuters, http://www.reuters.
com/article/2014/07/08/financial-regulations-sec-alternatives-idUSL2N0PJ0XB20140708
11. CIR/IMD/DF/14/2014

4 © Nishith Desai Associates 2015

 Fund Governance
Aspects and Fiduciaries to be Considered by Fund Directors

D. Decision Making Process F. Remuneration

The remuneration for independent directors should
The Directors should exhibit that there was an
be commensurate to the role and functions expected
application of mind when considering different
to be discharged by them. While a more-than-
proposals before it. For example, in case of investor
adequate remuneration does not establish anything,
‘side letters’ that may restrict the fund’s investments
an inadequate recompense can be taken as a ground
into a restricted asset class, etc., it could raise
to question whether the concerned director intends
management issues.
to perform his/her duties to the fund.
While execution of such ‘side letters’ may not be
harmful to the fund, but an approval at ‘short notice’ G. Conflict of interest
may be taken up to reflect on the manner in which
the directors perform their duties. The director of the If related party transactions or transactions that may
SEC’s Division of Investment Management recently raise conflict of interest cannot be avoided, a policy
stated that the SEC will launch examinations of fund should be outlined where events and mechanisms
companies targeting, among other issues, quality to identify and resolve events which could lead to
of fund governance. For example, a fund’s board of potential conflicts, should be recorded. Suitable
directors is expected to review and approve the fund’s measures that demonstrate governance and that
compliance program, ensure that the fund does not the interest of the investors would not be impaired,
have misleading names which suggest protection should be adopted.
from losses and other such promises.12
The rulings discussed above and the responsibilities
enlisted thereafter confirm that a fund’s board has
E. Minutes duties cast on it and the ‘business judgment rule’
may not shield them from liability in all cases.
Board meetings should be followed by accurately
There are certain non-delegable functions for the
recorded minutes. They should be able to
directors to discharge on an on-going basis and
demonstrate to a reader that how the decision
none more paramount than reviewing of the fund’s
was arrived at and resolution thereon passed. The
performance, portfolio composition and ensuring
minutes should reflect that the directors were alive
that an effective compliance program is in place.
to the issues that were being discussed. Clearly, a
These functions require action ‘between’ board
‘boilerplate’ approach would not work.
meetings and not ‘during’ board meetings only.

12. July 08, 2014 – Reuters, http://www.reuters.com/article/2014/07/08/financial-regulations-sec-alternatives-idUSL2N0PJ0XB20140708.

© Nishith Desai Associates 2015 5

Provided upon request only

4. Aspects Concerning Governance of Hedge

Funds
The governance dynamics of different types of funds investors more information about the fund and the
differ due to their structures. For example, it has been manger’s activity. However, complete transparency
argued (as explained later) that the governance of may not necessarily be the way forward. Complete
hedge funds varies greatly from other types of funds transparency into a fund’s specific investments may
because of the exit options available to its investors. be overwhelming for an investor. This can be true
even in the case of sophisticated investors. This
Governance in the hedge fund context is would also probably not provide a sufficient basis
conceptually different from other forms of corporate for the investor to make meaningful comparisons
governance.13 Investors generally have a right to between managers. Additionally, in the case of
short term redemption, managers have high pay hedge funds that hold illiquid securities or complex
performance sensitivity and there is presence of instruments, disclosure would provide significant
sophisticated investors who are expected to have insight into the fund’s investment strategy, which
taken into account the risk-return profile of the asset might erode the manager’s competitive advantage
class. and thereby reduce returns. Therefore, the best form
of transparency is not greater disclosure but rather
In most public corporations, ultimate control disclosure focused on providing right level and
(or management) rests with directors who have frequency of meaningful information about strategy
authority over managers and other constituencies. and risks.
In the hedge fund context however, managers have
complete discretion and authority over the structure From an onshore (India based) funds perspective,
and operation of the funds they manage. This is so under the AIF Regulations introduced different
because, hedge funds are organized as functional categories of AIFs to cater to different investment
equivalents of privately held limited partnerships, strategies. Category III AIF is a fund which employs
which restrict the otherwise typical rights held by diverse or complex trading strategies and may
‘equity’ holders. Equity investors are issued shares involve leverage including through investments in
that neither have voting rights nor any forthwith listed or unlisted derivatives.
mechanism to replace manager or directors leaving
the hedge fund manager with more control and The AIF Regulations provide that Category III
authority.14 AIFs may engage in leverage or borrow subject to
consent from the investors in the fund and subject
Hedge fund governance also has to be uniquely to a maximum limit specified by SEBI. On July 29,
responsive i.e. even though investors have limited 2013, SEBI issued a circular which laid down certain
role on management, responsiveness to their important rules relating to redemption restrictions
preferences is essential to retain and to obtain capital. and leverage.
The failure to be responsive can lead the investors
to seek redemption and cash out of the fund thereby
disrupting its operations.
II. Redemption Restrictions
A Category – III AIF cannot impose redemption
I. Transparency restrictions unless the possibility of suspension of
redemptions has been disclosed in the placement
Transparency continues to remain the number memorandum and such suspension can be justified
one concern regarding the working of hedge funds. as being under exceptional circumstances and in the
Greater disclosures will also likely lower a hedge best interest of investors. This could mean that the
fund’s cost of capital and increase the liquidity practice of using ‘gates’ to limit the frequency and
of the shares in the secondary markets by giving quantum of redemption may be impacted. Further,

13. Houman B. Shadab, Associate Professor of Law, New York Law School. B.A. 1998, University of California Berkley J.D. 2002, University of Southern
California.
14. Shabad at page 147

6 © Nishith Desai Associates 2015

 Fund Governance
Aspects and Fiduciaries to be Considered by Fund Directors

in the event of a suspension of redemption, a fund IV. Requirement of Maintaining

manager cannot accept new subscription and will
have to meet the following additional obligations: Minimum Corpus
i. Document reasons for suspension of redemption Regulation 10(b) of the AIF Regulations provides
and communicate the same to SEBI; that each scheme of an AIF should have a corpus
ii. Build operational capability to suspend of at least INR 20 crores (approx. USD 3.3 million)
redemptions in an orderly and efficient manner; (“Minimum Corpus”). Further, Regulation 2(1)(h)
of the AIF Regulations defines “corpus” as the total
iii. Keep investors informed about actions taken amount of funds committed by investors to the AIF
throughout the period of suspension; by way of a written contract or any such document
iv. Regularly review the suspension and take as on a particular date. An AIF cannot commence
necessary steps to resume normal operations; operations until it has secured the Minimum Corpus.
and communicate the decision to resume normal SEBI now proposes to extend regulatory oversight
operations to SEBI. to a post-commencement scenario where an open-
ended scheme (post redemption(s) by investors or
exits) is not able to sustain the Minimum Corpus.
III. Reporting Leverage The Circular provides that where the corpus of
an open-ended scheme falls below the Minimum
Corpus, the AIF shall intimate SEBI within 2 days
On July 29, 2013, SEBI issued a circular specifying
of receiving request of redemption from the client.
the extent to which leverage can be employed by
Further, the fund manager is given a period of 3
Category III AIFs and also prescribing a formula for
months to restore the Minimum Corpus, failing
computing leverage. SEBI had also indicated that
which, all the interests of the investors will need to
those Category III AIFs which employ leverage are
be mandatorily redeemed. The Circular also provides
required to report the amount of leverage to the
that SEBI may take appropriate action where the
custodian on a daily basis. SEBI has now formally
Minimum Corpus is breached repeatedly.
taken cognizance of the fact that the calculation of
leverage by a Category III AIF requires information
from various parties who provide such information
at varied time periods which has consequently made
it difficult for Category III AIFs to report the amount
of end-of-day leverage to the custodian on the same
day. The Circular provides that Category III AIFs
shall report the amount of end-of-day leverage to the
custodian by the end of the next working day.

© Nishith Desai Associates 2015 7

Provided upon request only

5. Emerging Jurisprudence on Duties of Fund

Directors
In the context of emerging jurisprudence, we to restrict a withdrawal of capital if it results in
examine some of the recent cases and events that more than a defined threshold of the total assets
directors would do well to take note of. of the fund being withdrawn in a period. It so also
happened that the fund manager could not secure
any other outside investor in the fund, and the fund’s
contributed capital significantly comprised of the
I. Puda Coal, Inc. Stockholders seed investment.
Litigation
Controversy arose when the ‘gates’ were raised after
15 the 3rd year (under the LP Agreement) to prevent the
In Puda Coal, Inc. Stockholders Litigation,
exit of the investor (as was understood under the
Chancellor Strine of the Delaware Chancery
Seeder Agreement) for preserving the management
Court issued a bench ruling addressing the duty
fee for the manager.
of independent directors. The court reasoned that
outside directors are selected, not “for their industry
If wide powers are granted to a person pursuant to
experience,” but “because of their independence and
the terms of their appointment, the same may make
their ability to monitor the people who are managing
such party a fiduciary. In the concerned matter,
the company.”
the court observed that acting in self-interest does
not absolve a governing fiduciary. Accordingly,
As a matter of brief background, Puda was a publicly-
preventing the exit of an investor for preserving
held Delaware corporation with its operations in
its management fee is in violation of fiduciary
China. The audit committee determined that the
obligation of the investment manager. The case also
company’s chairman had inappropriately transferred
provides the limits of discretion that fund managers
the company’s primary operating subsidiary to
can validly exercise.
himself.

The Court held that the complaint sufficiently

alleged that the former outside directors breached III. Weavering Macro Fixed
their fiduciary duty of loyalty by failing to discharge
their oversight function. Interestingly, the court Income Fund Limited v. Stefan
observed that independent directors have a duty not Peterson and Hans Ekstrom
to be dummy directors.

It is also interesting to note the learnings from a

ruling by the Cayman Islands Court of Appeals
II. Paige Capital Management, (“CICA”), in the case of Weavering Macro Fixed
Income Fund Limited (In Liquidation) v. Stefan
LLC v. Lerner Master Fund, LLC Peterson and Hans Ekstrom 17 (“Judgment”) dated
February 12, 2015, which set-aside the Cayman
In Paige Capital Management, LLC v. Lerner Master Islands’ Grand Court’s ruling in the case dated August
Fund, LLC.,16 the Delaware Chancery Court inter 26, 2011. The objective is to lay down the ‘standard’
alia investigated who owes ‘fiduciary’ obligations for directors’ role in a funds context.
to the fund and its investors. The seed investor had
a specifically negotiated ‘Seeder Agreement’ which As a matter of brief background, Weavering Macro
allowed withdrawal from the fund within 3 years Fixed Income Fund (“Fund”) was a Cayman Islands
only upon a liquidated penalty being levied. The based hedge fund. The Fund appointed an investment
investor also had a typical fund limited partnership manager to ‘manage the affairs of the Fund subject
agreement (“LP Agreement”) that had a usual ‘gates’ to the overall supervision of the Directors’. The Fund
clause. Such clause enabled the hedge fund manager went into liquidation when it was discovered that

15. C.A. No. 6476-CS (Del. Ch. Feb. 6, 2013)

16. 5502-CS, Delaware Chancery Court
17. CICA 10 of 2011, delivered on 12th February 2015.

8 © Nishith Desai Associates 2015

 Fund Governance
Aspects and Fiduciaries to be Considered by Fund Directors

certain assets shown on the Fund’s balance sheet However, the CICA, while affirming the original
were fictitious, at which point in time, action for findings of breach of duty by the directors held that
damages was initiated by the official liquidators there was no element of ‘wilful’ negligence or default
against the former “independent” directors. on their part; therefore, the indemnity provisions
in the Fund documents relieved the directors from
In the instant case, the Grand Court found evidence liability arising out of breach of their duties.
that while board meetings were held timely, the
meetings largely recorded information that was also The CICA held that the evidence available to the
present in the communication to fund investors and Grand Court was insufficient to support the finding
that the directors were performing ‘administrative that the directors’ conduct amounted to “wilful
functions’ in so far as that they merely signed the neglect or default”.
documents that were placed before them.
The Court of Appeal accordingly set aside the earlier
Based on such factual matrix, the Grand Court held judgments against each of the directors for $111
against the directors for wilful neglect in carrying million.
out their duties. It was also observed that based on
their inactions, the defendant directors “did nothing
and carried on doing nothing”. The measure of
loss was determined on the difference between the
IV. In Re Bear Stearns High Grade
Fund’s actual financial position with that of the Structured Credit Strategies
hypothetical financial position had the relevant
duties been performed by the directors. (Overseas) Ltd. (In Voluntary
Liquidation)
The Grand Court had ruled against each of the
directors in the amount of $111 million. It was also
observed, that the comfort from indemnity clauses In this case, director misconduct was alleged but not
are for reasonably diligent independent directors established in the court proceedings. The allegation
to protect those who make an attempt to perform was that the directors and trustees put up the fund
their duties but fail, not those who made no serious for liquidation voluntarily because they were
attempt to perform their duties at all. apprehending their removal through shareholders’
votes. Even though the court could not reach a
The Grand Court observed that the directors are conclusion that directors were acting ultra vires their
bound by a number of common law and fiduciary fiduciary duties, it denied the directors and trustees
duties including those to (1) act in good faith in of the convenience of getting the liquidation done by
the best interests of the fund and (2) to exercise liquidators appointed by them. The court appointed
independent judgment, reasonable care, skill and liquidators as per the shareholders’ preferences.
diligence when acting in the fund’s interests.

© Nishith Desai Associates 2015 9

Provided upon request only

6. Regulatory Frameworks on Fund

Governance
I. Mauritius A. Resident Director Qualifications
Before the amendment, a company holding GBL-1
The Financial Services Commission , Mauritius was required to have at least two resident directors of
(“FSC”) recently revised the Guide to Global Business sufficient caliber to exercise independence of mind
(“Guide”)18 to enhance the level of substance required and judgment. While these requirements have been
to be demonstrated by Mauritius based entities for retained, there is now an additional requirement for
holding a Category 1 Global Business Licence (“GBL- the Mauritius resident directors to be “appropriately
1”).19 qualified”.
This development is important since it is necessary
for a company to obtain a GBL-1 to be eligible to B. Administration of Closed-end Funds
apply for a Tax Residence Certificate (“TRC”) which
and Collective Investment Schemes
itself is a necessary pre-condition for a company to
qualify for treaty benefits under the India-Mauritius The FSC has introduced a fresh requirement that
Double Taxation Avoidance Agreement (“Treaty”). a company seeking GBL-1 which is a collective
investment scheme or a closed-end fund or an
The revised rules of substance as introduced also
external pension scheme must be administered from
require the resident directors to meet certain
Mauritius.
standards of governance including committing
required levels of time, attention and independent
exercise of mind. This seems to be in line with the C. Mandatory Parameters
emerging jurisprudence which suggests that the
threshold of fiduciaries to be met by the directors In addition to these, a GBL-1 will have to continue
is shifting from “sustained or systematic failure to fulfill the other criteria, being: (i) maintaining
to exercise oversight” to “making reasonable and its principal bank account in Mauritius at all times;
proportionate efforts commensurate with the (ii) keeping and maintaining its accounting records
situations”. at its registered office in Mauritius at all times; (iii)
preparing its statutory financial statements having
FSC’s approach seems to be in line with other them audited in Mauritius; and (iv) providing
jurisdictions like Singapore and Luxembourg for meetings’ of directors to include at least two
that expect a level of substance from a resident Mauritius resident directors.
company beyond being just the jurisdiction of its
incorporation.
D. Mauritius Resident Director
Requirements
II. What has the FSC Prescribed?
The amended Guide also mentions that the Mauritius
resident directors will have to comply with the
The FSC has revised the list of guidelines that it requirements of Circular Letter (CL280313) issued
considers relevant while determining whether a by the FSC (“Circular”).20 The Circular summarizes
company is being managed and controlled from duties and obligations of directors of Mauritius
Mauritius for the purpose of issuing / renewing a companies. In this regard, the FSC will consider
GBL-1 through amendments to Section 3 of Chapter 4 ‘Qualification and experience’21, ‘Independence of
of the Guide. These revisions are:

18. The Guide to Global Business has been issued by the Board of the FSC under section 7(1)(a) of the Financial Services Act, 2007.
19. Section 71(4) of the Financial Services Act, 2007 provides that the FSC may consider any such matters when determining whether a company holding
GBL-1 is managed and controlled in Mauritius.
20. Circular Letter dated March 28, 2013 issued by the FSC.
21. The Mauritius resident director must have relevant qualification and experience to exercise sufficient care, diligence and skills for good conduct of
the business.

10 © Nishith Desai Associates 2015

 Fund Governance
Aspects and Fiduciaries to be Considered by Fund Directors

mind’22, ‘Judgment’23 and ‘Time Commitment’24 mind” of the fund with ‘ultimate responsibility’
of the Mauritius resident directors of a company for directing and supervising the fund’s activities.
holding GBL-1. How easily this can be extended to the fund’s
investment activities will depend on the
complexity of the manager’s investment strategy,
the extent of the manager’s responsibilities
III. European Economic Area as defined in the investment management
agreement and the sophistication of the investors
In the European Economic Area (“EEA”), the in the fund.
undertakings for collective investment in
ii. Expertise: The board collectively must have
transferable securities directive (“UCITS Directive”)
sufficient knowledge and expertise, not just to
makes it important for each fund to have a depositary
understand the manager’s investment strategy
independent from the fund and its manager to
and the risk profile it creates for the fund, but
monitor cash flows, custody and safekeeping of
also to monitor compliance with investment
assets. It also oversees whether the fund is in due
strategy and evaluate performance. Having a
compliance with legal and regulatory requirements
person affiliated to the manager on the board is a
as well as its own policies. The UCITS Directive
necessary component of maintaining sufficient
mandates that the directors of the depositary have to
oversight of the fund, i.e. directors being able to
be sufficiently experienced and of good repute.25
monitor and supervise the manager’s strategy and
It is important to note that alternative investment performance.
funds in the EEA are not regulated by the UCITS iii. Independece: All corporate governance codes
Directive but by the Alternative Investment Fund insist that directors, as a minimum, exercise
Managers Directive (“AIFMD”) which also requires independent judgement, and most corporate
AIFs to have an independent depositary with similar governance codes recommend that boards have at
responsibilities and duties as under the UCITS least one independent director. These essentially
Directive. restate existing legal principles that are found in
most major financial jurisdictions.
iv. Directors: The SoG-MF, mindful that the number
IV. Cayman Islands of directorships an individual can competently
discharge is contingent on a number of factors,
In the Cayman Islands, the Cayman Islands Monetary states that the board should “consider carefully”
Authority (“CIMA”) has recently adopted CIMA the number of directorships a potential director
Guidance, registration and licensing requirements holds. In its Corporate Governance Survey, CIMA
for directors. In pursuance of this step, a Statement found that respondents were more or less split
of Guidance (“SoG-MF”) was issued to be effective evenly over the issue of limiting the number of
from January, 2014. It basically covers all regulated directorships that can be held by an individual.
mutual funds that are defined by Mutual Funds Law Additionally, CIMA prepared a bill which was made
and details corporate governance principles applying public on March 21, 2014. The bill mainly establishes
to operators as well as governing body. Rules cover the registration and licensing requirements for
oversight function, conflicts of interest, meetings and fund directors (for all funds regulated or licensed
documentation, operator’s duty of skill and care, risk in the Cayman Islands). There are three types of
management, and disclosures to the CIMA. directors mentioned in the bill, i.e. , registered
directors, professional directors and corporate
The key areas which the new abovementioned code directors whereby the latter category is subject to
covers are as follows :26 a compulsory licensing regime. The license will be
granted based upon capacity in terms of qualification,
i. Degree Of Delegation: SoG-MF describes the “fit and proper” test (including the honesty, integrity
fund’s governing body as “the directing will and and reputation confirmation, competence and

22. The Mauritius resident director must act with integrity, freedom of mind, without any influence, interest or relationship that might impair his
professional judgment or objectivity.
23. The Mauritius resident director must provide impartial and good judgment.
24. A Mauritius resident director serving on multiple boards must ensure that sufficient time is given to the affairs of each company in which he/she is a
director.
25. ILPA
26. http://www.aima.org/en/education/aimajournal/past-articles/index.cfm/jid/4898EC23-66AA-4065-8EAD6137DEBC8126

© Nishith Desai Associates 2015 11

Regulatory Frameworks on Fund Governance
Provided upon request only

capability and financial soundness).

Corporate directors, on the other hand, have to

make certain filings to CIMA on a specified form but
they also have to satisfy the fit and proper persons’
requirement. There is a compulsory requirement for
keeping minimum insurance coverage. Violations of
these regulations may lead to criminal penalties.

12 © Nishith Desai Associates 2015

 Fund Governance
Aspects and Fiduciaries to be Considered by Fund Directors

7. Investor Activism: Role of Investors in Good

Governance
Investor activism is the practice of active supervisory I. No-fault Clauses
participation of investors in the management affairs
of the fund by way of exercising their voting rights The inclusion of a ‘no-fault divorce’ clause gives the
effectively, scrutinizing the decisions taken by the ability to the LPs to end the acquisition of new assets
managers or directors and generally exhibiting by the fund and enforcing the liquidation of existing
keen interest in the way affairs of the fund are being assets. Similarly, a related provision may prescribe
handled. the removal of an existing GP and installing a new GP
in his/her stead
The trend is for investors to assume that managers
and directors know the best about management
of the fund and their job is not to interfere.
However, as we observed earlier, there are cases of
II. Key Person Provisions
mismanagement and unethical conduct due to which
investors have to question the trust they placed A key person provision (also referred to as a key-man
on the managers and directors. Research and data provision) casts a duty on the GPs to inform the LPs
suggest that investor activism in hedge funds has of the departure of a key person involved with the
resulted in abnormally high returns for investors.27 fund’s operations such as the portfolio manager.
In certain cases the departure may also trigger the
It is understood that the directors of a hedge fund will provision of offering a redemption window to the
automatically increase standards of good governance LPs with no penalty fees being charged. In other cases
if the investors emphasize on the importance of these the GPs ability to acquire new assets may be frozen
standards as being factored into their investment for a specified period of time, subject to the consent
decisions.28 In the latter quarter of 2013 to early 2014, of a majority of investors. In case of private equity
activist hedge funds were the best-performing hedge funds, the commitment period (i.e. the period during
fund strategy.29 which capital is drawn down) may be suspended as a
consequence of a key person event.
At the time of formation of a fund, a feature that
is quasi-set in stone is the establishment of the
advisory board which performs a crucial role in fund
governance. The advisory board comprises of several
representative investors tasked with providing advice
to the GP regarding management of the fund. The
monitoring of the adherence of GPs to the provisions
of the partnership agreement usually with regard
to basic fees and other terms which are activated
or triggered on the occurrence of certain events or
upon the decision of the LPs is a paramount function
that the advisory board performs. Some of the
aforementioned provisions may include:

27. http://www.hbs.edu/faculty/Publication%20Files/08-004.pdf.
28. www.treas.gov/press/releases/reports investors committeereportapril152008.pdf.
29. http://americasmarkets.usatoday.com/2014/07/09/activist-hedge-funds-agitate-their-way-to-gains.

© Nishith Desai Associates 2015 13

Provided upon request only

8. Conclusion
The quality of governance of a fund highly depends Also, in some cases, where the administrators fill in
on observance of the basic fiduciary duties by its for the post of directors in a fund, such administrators
directors and managers. However, as additional will have to be mindful of their fiduciaries and be
measures, the structure or form of a fund can be vigilant and supervise the actions of the outsourced
such that maximum governance standards are met entities such as accountants, etc. more diligently.
at the formation stage itself. These measures may
include appointment of independent directors, better The fund documents generally provide for indemnity
incentives for directors such as encouraging the of its directors with a carve-out for directors acting in
directors to invest in the funds they are overseeing ‘willful negligence or default’. Since the element of
as directors, giving retirement benefits to the ‘willfulness’ is the determining factor, the directors
directors, provisions for frequent evaluation of their should be extremely cautious about their acts and
performance and increase general awareness and omissions with respect to the fund.
circulate important industry related advancements
to the directors.30

30. http://www.ici.org/pdf/rpt_best_practices.pdf.

14 © Nishith Desai Associates 2015

 ANNEXURE-I

Institutional Limited Partners Association

Private Equity Principles

VERSION 2.0  JANUARY 2011
Contents

ILPA Private Equity Principles 2

Alignment of Interest 4
Carry/Waterfall
Management Fee and Expenses
Term of Fund
General Partner Fee Income Offsets
General Partner Commitment
Standard for Multiple Product Firms

Governance 7
Team
Investment Strategy
Fiduciary Duty
Changes to the Fund
Responsibilities of the LPAC

Transparency 11
Management and Other Fees
Capital Calls and Distribution Notices
Disclosure Related to the General Partner
Risk Management
Financial Information
LP Information

Appendix A 13
Limited Partner Advisory Committee

Appendix B 16
Carry Clawback Best Practice Considerations

Appendix C 18
Financial Reporting

About the ILPA 20

ILPA Private Equity Principles

T he Institutional Limited Partners Association

(“ILPA”) released the Private Equity Principles

We continue to believe three guiding principles form
the essence of an effective private equity partnership:
(the “Principles”) in September 2009 to encourage
discussion between Limited Partners (“LPs”) and 1. Alignment of Interest
General Partners (“GPs”) regarding fund partnerships.
These Principles were developed with the goal of 2. Governance
improving the private equity industry for the long-term
benefit of all its participants by outlining a number of 3. Transparency
key principles to further partnership between LPs and
GPs. Over the past year, ILPA has heard numerous The three guiding principles are elaborated upon further
success stories regarding improved communication in the following sections to introduce the revised
between LPs and GPs. To that end, the Principles preferred private equity terms and best practices for
are off to a great start in achieving the goals Limited Partner Advisory Committees (“LPAC”).
that were originally envisioned.
These preferred private equity terms and best practices may
In order to make ongoing improvements to the Principles, inform discussions between each GP and its respective LPs
ILPA committed to solicit additional feedback from both in the development of partnership agreements and in the
the LP and GP communities throughout 2010. After management of funds. ILPA does not seek the commitment
reflecting on the extensive input from these discussions, of any LP or GP to any specific terms. They should not be
the ILPA Best Practices Committee drafted a new applied as a checklist, as each partnership should be
version of the Principles. This release retains the key considered separately
tenets of the first Principles release while increasing their and holistically. We recognize that a single set of terms
focus, clarity and practicality. cannot provide for the broad flexibility of market

2
ILPA Private Equity Principles
circumstance and therefore we emphasize the Each section starts with a general discussion of the
importance of LPs and GPs working in concert to application of the three guiding principles and
develop the same set of expectations when entering continues with detail on specific aspects or points of
into any particular partnership. We believe that careful emphasis. The detail should always be seen as
consideration to each of these preferred private equity subordinate to the more general principles. The
terms and best practices will result in better investment appendices are offered as “deeper dives” into specific
returns and a more sustainable private equity industry. topics of broad relevance or great complexity. The
appendix on LPAC Best Practices is a completely
In line with the spirit of the Principles, we encourage all redrafted version of the original Appendix A,
LPs to be transparent in their consideration and reflecting considerable input from GPs. The appendix
application of these Principles. A list of organizations on Carry Clawback is new, and given the complexity
that endorse the ILPA Private Equity Principles is of this subject, it was deemed worthy of outlining
posted on the ILPA website (ilpa.org). suggestions for what we all hope will be a rare
contingency. Appendix C covers GP reporting
The remainder of the document comprises three sections best practices. “Standardized Reporting Templates”
on Alignment of Interest, Governance, and Transparency are being developed concurrently. Going forward,
and three appendices on LPAC Best Practices (Appendix ILPA will consider issuing further appendices to
A), Carry Clawback Best Practice Considerations address similar topics as industry best practices
(Appendix B) and Financial Reporting (Appendix C). continue to evolve. Suggestions for such
consideration should be submitted to the ILPA.

3
ILPA Private Equity Principles
Alignment of Interest

A lignment of interest between LPs and GPs is CARRY/WATERFALL

best achieved when GPs’ wealth creation is
Waterfall Structure
primarily derived from carried interest and returns
generated from a substantial equity commitment to  A standard all-contributions-plus-
the fund, and when GPs receive a percentage of preferred-return-back-first model must be
profits after LP return requirements are met. recognized as a best practice 

GP wealth creation from excessive management,  Enhance the deal-by-deal model: 
transaction or other fees and income sources, reduces 
alignment of interest. We continue to believe that a GP’s Return of all realized cost for given
own capital at risk serves as the greatest incentive for investment with continuous makeup of
alignment of interests. GP equity interests in funds partial impairments and write-offs, and
primarily made through cash contributions result in return of all fees and expenses to date 
higher alignment of interest with LPs compared to those (as opposed to pro rata for the exited deal) 
made through the waiver of management fees.
For purposes of waterfall, all unrealized
We continue to believe that an all-contributions-plus- investments must be valued at lower of cost
preferred-return-back-first waterfall is best practice. or fair market value
In situations where a deal-by-deal waterfall is used,
the accompanying use of significant carry escrow Require carry escrow accounts with significant
accounts and/or effective clawback mechanisms will reserves (30% of carry distributions or more) and
help ensure LPs are fully repaid in a timely manner require additional reserves to cover potential
when the GP has received carry it has not earned. clawback liabilities

We recognize alignment of interests can be achieved  The preferred return should be

through many different combinations of the elements calculated from the day capital is
stated above or indeed, through new approaches. contributed to the point of distribution 
Alignment of interest must be evaluated in giving
consideration to each of these elements in totality.

4
ILPA Private Equity Principles
 ALIGNMENT OF INTEREST

Calculation of Carried Interest  Management fees should take into account the
lower levels of expenses generally incident to the
 Alignment is improved when carried interest 
 formation of a follow-on fund, at the end of the
is calculated on the basis of net profits (not gross
investment period, or if a fund’s term is extended 
profits) and on an after-tax basis (i.e. foreign or
other taxes imposed on the fund are not treated as
Expenses
distributions to the partners) 
  The management fee should encompass all
 No carry should be taken on current income or normal operations of a GP to include, at a
recapitalizations until the full amount of minimum, overhead, staff compensation, travel,
invested capital is realized on the investment  deal sourcing and other general administrative
items as well as interactions with LPs 
Clawback 
 The economic arrangement of the GP and its
 Clawbacks should be created so that when they
placement agents should be fully disclosed as
are required they are fully and timely repaid  part of the due diligence materials provided to

prospective limited partners. Placement agent
 The clawback period must extend beyond the
fees are often required by law to be an expense
term of the fund, including liquidation and any
borne entirely by the GP 
provision for LP giveback of distributions 

TERM OF FUND
 Appendix B serves as a model given this is
an area of considerable complexity   Fund extensions should be permitted in 1
year increments only and be approved by a
MANAGEMENT FEE AND EXPENSES majority of the LPAC or LPs 

Management Fee Structure  Absent LP consent, the GP must fully
 Management fees should be based on reasonable liquidate the fund within a one year period
operating expenses and reasonable salaries, as following expiration of the fund term 
excessive fees create misalignment of interests 

GENERAL PARTNER FEE INCOME OFFSETS
 During the formation of a new fund, the
 Transaction, monitoring, directory, advisory,
GP should provide prospective LPs with a
exit fees, and other consideration charged by
fee model to be used as a guide to analyze
the GP should accrue to the benefit of the fund 
and set management fees 

5
ILPA Private Equity Principles
 ALIGNMENT OF INTEREST

GENERAL PARTNER COMMITMENT  The GP should not invest in opportunities

that are appropriate for the fund through
 The GP should have a substantial equity interest
other investment vehicles unless such
in the fund, and it should be contributed in cash
investment is made on a pro-rata basis under
as opposed to being contributed through the
pre-disclosed co-investment agreements
waiver of management fees 
established prior to the close of the fund 


 GPs should be restricted from transferring their
 Fees and carried interest generated by the 
real or economic interest in the GP in order to 
GP of a fund should be directed predominantly to
ensure continuing alignment with the LPs 
the professional staff responsible for the success

of that fund 
 The GP should not be allowed to co-invest in

select underlying deals but rather its whole equity
 Any fees generated by an affiliate of the GP,
interest shall be via a pooled fund vehicle 
such as an advisory or in-house consultancy,
whether charged to the Fund or an underlying
STANDARD FOR MULTIPLE PRODUCT FIRMS
portfolio company, should be reviewed and
 Key-persons should devote substantially all approved by a majority of the LPAC 
their business time to the fund, its predecessors
and successors within a defined strategy, and its
parallel vehicles. The GPs must not close or act
as a general partner for a fund with substantially
equivalent investment objectives and policies 

until after the investment period ends, or the fund
is invested, expended, committed, or reserved for
investments and expenses 

6
ILPA Private Equity Principles
Governance

T he vast majority of private equity funds are based

on long-term, illiquid structures where the GP
 LPs should be notified of any changes
to personnel and immediately notified
when key-man provisions are tripped 
maintains sole investment discretion. LPs agree to such
structures based on their confidence in a defined set of 
investment professionals and an understanding of the  Changes to key-man provisions should be
strategy and parameters for the investments. approved by a majority of the LPAC or LPs 

Given that a Limited Partnership Agreement (“LPA”) INVESTMENT STRATEGY

cannot make advance provision for all circumstances
The stated investment strategy is an important
and outcomes, LPs need to ensure that the appropriate
dimension that LPs rely on when making a decision
mechanisms are in place to work through unforeseen
to commit to a fund. Most LPs commit to PE funds
conflicts as well as changes to the investment team or
within the context of a broad portfolio of investments
other fund parameters. An effective LPAC enables
– alternative and otherwise – and select each fund for
LPs to fulfill their duties defined in the partnership
the specific strategy and value proposition it presents.
agreement and to provide advice to the GP as
The fund’s strategy must therefore be well defined
appropriate during the life of the partnership. The role
and consistent:
of the LPAC is discussed further in Appendix A.
 The investment purpose clause should clearly
TEAM
and narrowly outline the investment strategy 
The investment team is a critical consideration in making 
a commitment to a fund. Accordingly, any significant  Any authority to invest in debt instruments,
change in that team should allow LPs to reconsider and publicly traded securities, and pooled
reaffirm positively their decision to commit, through the investment vehicles should be explicitly
operation of the key-man provisions: included in the agreed strategy for the fund 

 Automatic suspension of investment period,  Funds should have appropriate limitations on
which will become permanent unless a defined investment and industry concentration and
super-majority of LPs in interest vote to re- may consider investment pace limitations, 
instate within 180 days, when a key-man event if appropriate 
is triggered or for cause (e.g. fraud, material 

breach of fiduciary duties, material breach of  The GP should accommodate a LP’s exclusions policy,
agreement, bad faith, gross negligence, etc.)  which may proscribe the use of its capital in certain
 sectors and/or jurisdictions. However, consideration of
 Situations impacting a principal’s ability to increased concentration effects on remaining 
meet the specified “time and attention” standard LPs and transparency of process and policies must be
should be disclosed to all LPs and discussed requisite in the event of a non-ratable allocation 
with, at a minimum, the LPAC 
7
ILPA Private Equity Principles
 GOVERNANCE

FIDUCIARY DUTY case more than 25% and limited to a reasonable

period, such as two years following the date of
Given the GP’s high level of discretion regarding
operation of the partnership, any provisions that allow distribution
the GP to reduce or escape its fiduciary duties in any
To assist in monitoring the GP in the performance of its
way must be avoided:
fiduciary and other duties to the fund, LPs rely upon
independent auditors and may need, in certain instances,
 GPs should present all conflicts to the LPAC for
other support from third parties. Independent auditors are
review and seek prior approval for any conflicts
engaged on behalf of the fund and should alert the LPAC
and/or non arm’s length interactions or
to any known conflicts of interest in relation to
transactions. As materiality is a subjective
performing such duties.
criterion, it is best to consult the LPAC in all
instances. No GP should clear its own conflicts 
 The auditor should present their view on valuations

and other relevant matters annually to the LPAC
 The high standard of fiduciary duty applicable
and be available to answer questions at the annual
to the GP should preclude provisions that allow
meeting of the fund. A list of the members of the
for them to be exculpated in advance or
LPAC should be provided to the auditors 
indemnified for conduct constituting a material
breach of the partnership agreement, breach of 
 LPs should be notified of any change in the
fiduciary duties, or other “for cause” events 
independent external auditor of the fund 

 A majority of LPs must be able to remove 
 The auditors should review the capital accounts
the GP or terminate the fund for cause 
with specific attention to management fee,

other partnership expenses, and carried interest 
 Conditions precedent and other removal
calculations to provide independent verification of
mechanisms should be constructed so that LPs
can act before there is irreparable damage to their
distributions to the GP and LP 
interests. To the extent that there are mitigating 
 When considering important matters of fund
factors, LPs will take these into consideration in
governance or other matters where the GP’s
evaluating their response to the “for cause” event 
interests may not be entirely aligned with the

LPs’, a reasonable minority of the LPAC may
 To the extent that an all-partner clawback is
engage independent counsel at the fund’s expense 
appropriate in order for the fund to indemnify
the GP, this should be limited to a reasonable
proportion of the committed capital but in no 

8
ILPA Private Equity Principles
 GOVERNANCE

CHANGES TO THE FUND (ii) the increasing complexity brought by multi-

product firms; and (iii) most recently, the strains of the
Given the long-term nature of the PE partnership, the
financial crisis. The LPAC has no broad governance
fund’s terms and governance must be well defined
role in a PE limited partnership. Its formal
upfront but also be flexible enough to adapt to
responsibilities are defined by the LPA and are
changing circumstances. With appropriate protections
generally limited to reviewing and approving:
for the interests of the GP, LPs should have the option
to suspend or terminate the fund.
 Transactions that pose conflicts of
interest, such as cross-fund investments
 Any amendment to the LPA should require the
and related party transactions 
approval of a majority in interest of the LPs, and

certain amendments should require a super-
 The methodology used for portfolio
majority approval. Amendments that negatively
company valuations (and in some cases,
affect the economics of a particular LP should
approving the valuations themselves) 
require that LP’s consent 


 Certain other consents or approvals pre-
 No fault rights upon two-thirds in interest vote
defined in the LPA 
of LPs for the following: 

The LPAC should engage with the GP on discussions of
Suspension of commitment period 
partnership operations, including but not limited to:

Termination of commitment period 
 Auditors 


 No fault rights upon three-quarters in interest 
 Compliance (including CSR/ESG/PRI) 
vote of LPs for the following:

 Allocation of partnership expenses 
Removal of the GP

 Conflicts 
Dissolution of the Fund

 Team developments 
RESPONSIBILITIES OF THE LPAC

The role of the LPAC has been evolving in recent  New business initiatives of the firm 
years in response to (i) the requirement for increased
transparency into the operations of the GP and the fund
(driven by increasing emphasis on LPs’ fiduciary duties);

9
ILPA Private Equity Principles
 GOVERNANCE

However, as indicated, the LPAC is not intended to properly prepared, and responsibly fulfill the duties
serve as a representative or proxy for the broader base of their role. LPAC members should be able to take
of LPs and should not replace frequent, open into account their own interest in voting on the
communications between the GP and all LPs. LPAC and should be appropriately indemnified.

Additionally, an effective LPAC depends on a high Additionally, GPs should disclose the identity of
degree of trust and commitment among the various certain LPs which they believe may have conflicts of
parties. LPs serving on the LPAC and receiving interest with other LPs in a fund. The GP is in a
sensitive information must keep such information position to determine if LP-LP conflicts may arise in
confidential. LPAC members should support the GP selected situations, including but not limited to, (i) LPs
in taking appropriate sanctions against any LP that participating in an investment “related” to the fund, such
breaches this confidentiality. as a separate managed account which invests alongside
the fund or a co-investment in one of the fund’s portfolio
LPs that accept a seat on the LPAC should commit companies, (ii) if an LP has an ownership
the necessary time and attention to the fund. LPAC in the GP or one of its affiliates, or vice-versa or
members should participate in all LPAC meetings, be (iii) if a LP has received preferential economic terms.

10
ILPA Private Equity Principles
Transparency

G Ps should provide detailed financial, risk

management, operational, portfolio, and
DISCLOSURE RELATED TO
THE GENERAL PARTNER
transactional information regarding fund
The following should be immediately disclosed to
investments. This enables LPs to effectively fulfill
LPs upon occurrence:
their fiduciary duties as well as to act on proposed
amendments or consents. LPs acknowledge the  Any inquiries by legal or regulatory
important responsibility they bear with higher
bodies in any jurisdiction 
transparency in the form of confidentiality.

 Any material contingency or liability
MANAGEMENT AND OTHER FEES
arising during the fund’s life 
 All fees (i.e., transaction, financing, 
monitoring, management, redemption, etc.)  Any breach of a provision of the LPA or
generated by the GP should be periodically other fund documents 
and individually disclosed and classified in
each audited financial report and with each Other activities related to changes in the actual or
capital call and distribution notice  beneficial economic ownership, voting control of

the GP, or changes or transfers to legal entities who
 All fees charged to the fund or any are a party to any related document of the fund
portfolio company by an affiliate of the GP should be disclosed in writing to LPs. Such
should also be disclosed and classified in activities include but are not limited to:
each audited financial report 
 Formation of public listed vehicles 
CAPITAL CALLS AND 

DISTRIBUTION NOTICES  Sale of ownership in the management

company to other parties 
 Capital calls and distributions should provide

information consistent with the ILPA  Public offering of shares in the management 
Standardized Reporting Format  
  Formation of other investment vehicles 
 The GP should also provide estimates of quarterly
projections on capital calls and distributions 

11
ILPA Private Equity Principles
 TRANSPARENCY

RISK MANAGEMENT FINANCIAL INFORMATION

GP annual reports should include portfolio 


Annual Reports - Funds should provide 
company and fund information on material risks information consistent with the ILPA Standardized
and how they are managed. These should include: 1
Reporting for Portfolio Companies and Fund
information at the end of each year (within 90 days
 Concentration risk at fund level  of year-end) to investors 
 
 Foreign exchange risk at fund level   Quarterly Reports - Funds should provide
 information consistent with the ILPA
 Leverage risk at fund and portfolio company levels  Standardized Reporting for portfolio companies
 and fund information at the end of each 
 Realization risk (i.e. change in exit environment) quarter (within 45 days of the end of the quarter)
at fund and portfolio company levels  to investors 

 Strategy risk (i.e. change in, or divergence from, LP INFORMATION
investment strategy) at portfolio company level 
  A list of LPs, including contact information,
 Reputation risk at portfolio company level  excluding those LPs that specifically request to
 be excluded from the list 
 Extra-financial risks, including environmental, 
social and corporate governance risks, at fund  Closing documents for the fund, including
and portfolio company level  the final version of the partnership
 agreement and side letters 
 More immediate reporting may be 
required for material events   LPs receiving sensitive information as described
above must keep such information confidential.
Agreements should clearly state that LPs 
may discuss the fund and its activities amongst
themselves. LPs should support the general
partner in taking appropriate sanctions against
any LP that breaches this confidentiality 

1
Appendix C outlines current reporting best practices, however, as standardized reporting templates
(available on ilpa.org) continue to evolve, they are intended to encompass all reporting best practices

12
ILPA Private Equity Principles
Appendix A: Limited Partner Advisory Committee

These best practices are offered to provide a model for  The LPAC should operate as a committee, 

LPAC duties, its role in the partnership, and meeting not as a collection of individual members; to this
protocol. We recognize the differing constituencies of end, GPs should seek to centralize important
individual partnerships and acknowledge that one discussions within the advisory board context,
standard may not fit every situation. We believe that and not on a bilateral basis 
LPs and GPs should explicitly establish the duties of the 
LPAC through the LPA and mutually adopt preferred  Regular provisions for an in camera session
meeting protocol upon establishment of the LPAC. The should be made so that LPs can speak, when
role of the LPAC is not to directly govern, nor to audit, appropriate, with a unified voice 
but to provide a sounding board for guidance to the GP
and a voice for LPs when appropriate. LPAC Formation
During the formation of the LPAC, the GP should
Common objectives in relation to every board
generally adhere to the following protocol:
should include:
 The GP should issue a formal invitation to
 Facilitating the performance of the
those LPs it has agreed to invite to serve on
responsibilities of the advisory board (as
the LPAC. Such invitations should provide: 
defined in the LPA or by mutual agreement),

without undue burden to the general partner  Information about the meeting schedule 


 Creating an open forum for discussion of matters
Expense reimbursement procedures 
of interest and concern to the partnership while
preserving confidentiality and trust  An outline of the LPAC’s responsibilities

under the partnership agreement
 Providing sufficient information to LPs so
that they can fulfill these responsibilities  A statement of indemnification

We note that the role of the advisory board may

 Simultaneously with each closing, the GP
evolve during the term of the fund, depending on
should compile a list of LPAC members and
the environment, the specific situation of the fund,
their contact information and circulate this list
and other considerations. The focus should clearly
to all LPs, providing an updated list if and
be on substance over form and efficiency over
when any information is changed 
formalistic mechanisms. To this end, there are two
points of emphasis in this revised protocol:

13
ILPA Private Equity Principles
 APPENDIX A

 The LPAC should be made up of a small number LPAC Meeting Suggested Best Practices
of voting representatives of LPs, with larger
The GP and LPAC members in each fund will
funds having as many as a dozen members,
determine the best way to conduct the operations of
representing a diversified group of investors 
the LPAC. The following best practices are suggested

 Upon initial constitution of the LPAC, any to aid in developing a joint approach in line with the
replacements of LPAC members should be objectives outlined above:
determined by the GP with any additional or
Convening a Meeting:
eliminated seats to be approved by mutual consent
of a majority of the LPAC and general partner 
 LPAC meetings should be held in person 


 A standing LPAC meeting agenda should be
at least twice a year with an option to dial-in
developed and a calendar established as far telephonically 

in advance as possible. The meeting agenda
 The GP is encouraged to convene the LPAC more
and calendar should be available to all LPs 
frequently to discuss time-sensitive matters of

 Clear voting thresholds and protocols should be importance (e.g. conflicts); in these cases, LPAC
members should be flexible and responsive. With
established, including requiring a quorum of
the consent of the LPAC, certain matters may be
50% of LPAC members when votes are taken 
handled by written consent 

 LPAC members should receive no remuneration, 
 After initially consulting the GP, a minority of
but the partnership should reimburse their
three or more members using reasonable
reasonable expenses in serving on the LPAC 
judgment and discretion should have the right to
call for a LPAC meeting 

14
ILPA Private Equity Principles
 APPENDIX A

Agenda: For convenience, LPAC meetings and/or members

of other related funds may be pooled when general
 Any member of the LPAC may add an topics are discussed
agenda item to the LPAC meeting
agenda subject to a reasonable notice  The partnership should indemnify members
requirement to the GP  of the LPAC 
 
 With any request for consent or approval by a  Each LPAC member should consider whether
fund’s LPAC, the GP will use best efforts to  they have any potential conflicts of interest prior
send each LPAC member background information to voting in all circumstances. LPAC members
on the matter at least 10 days in advance of  should disclose actual conflicts to other LPAC
the meeting  members during discussions at LPAC meetings 

 A portion of each LPAC meeting will be set a Records:
side for an in camera session with only the
LPs present. LPs may elect one or more  The GP should take minutes at all LPAC
members of the LPAC to lead the discussion meetings. LPAC meeting minutes should be
and report back to the GP  circulated to LPAC members within 30 days
 and submitted for approval at the next LPAC
 The LPAC should have in camera access meeting. Once approved, LPAC minutes should
to partnership auditors to discuss be available upon request to all LPs within a
valuations. A representative from the reasonable time period 
audit firm should attend each year-end 
LPAC meeting or annual meeting   The GP should record all votes taken during
conference calls or at meetings and maintain a
Voting: copy of consents obtained in writing, by
facsimile, or by email. Detailed voting records
 Any meeting requiring a vote of the LPAC should promptly be made available by the GP to
should be held with only the members of any LPAC member upon request 
that specific fund’s LPAC in attendance. 

15
ILPA Private Equity Principles
Appendix B: Carry Clawback Best Practice
Considerations

While fortunately rare, carry clawback situations Ensure GPs Backstop Themselves
represent one of the greatest challenges to the GP/LP
ILPA strongly recommends joint and several liability of
relationship. Appropriate processes and remedies should
individual GP members as a best practice as LPs contract
therefore be defined at the start of the fund, as alignment
with the GP as a whole rather than individual members.
between GP and LP will usually be at a low point when
In cases where joint and several liability is not provided,
they occur. The following “building blocks” should be
a potential substitution would be a creditworthy
considered with regard to clawbacks:
guarantee of the entire clawback repayment by any of:
Seek to Avoid Clawback Situations
 a substantial parent company; OR 
 Best approach is all capital back waterfalls 
(“European style”) as this will minimize  an individual GP member; OR 
excess carry distributions  

  a subset of GP members 
 If deal-by-deal carry, then 
However, in general, repayment obligations should
NAV coverage test (generally at least 125%) to directly track the carry distributions. An escrow
ensure sufficient “margin of error” on valuations account (generally of at least 30%) may also provide
an effective mechanism for clawback guarantee.
Interim clawbacks should apply, triggered
both at defined intervals and upon specific LPs should have robust enforcement powers,
events (e.g., key-man, insufficient NAV including direct ability to enforce the clawback
coverage) against individual GPs. Actual and potential GP
clawback liabilities should be disclosed to all LPs
annually along with a plan to address as additional
disclosure in the audited financial statements.

16
ILPA Private Equity Principles
 APPENDIX B

Ensure Fair Treatment of Tax Burden  Loss carryforwards and carrybacks 


GPs receive tax distributions from the fund in order to
 The character of the fund income and
pay their tax liabilities on carry (capital gains tax
deductions attributable to state tax payments 
treatment). To the extent that the GP either does not

receive (or must return) carry, there is a loss of the tax
 Any ordinary deduction or loss as a result 
paid since there are limitations on the GP’s ability to 
of any clawback contribution or related capital
carry back losses to offset the gains on which tax was
account shift 
previously paid. Historically, LPs have absorbed this

loss on behalf of GPs. The initial release of Principles
 Any change in taxation between the date of
stated that all carry clawbacks should be gross of tax,
the LPA and the clawback 
but after extensive discussions with GPs, we believe
that it would be impractical to ask them to bear the cost. Any tax advances made to the GP should be returned
immediately if in excess of the actual tax liability.
However, current practice in some cases does not take
into account the GP’s ability to reduce the tax burden
Fix the Clawback Formula
through carrying losses forward, offsetting a gain against
a loss, or living in a favorable tax jurisdiction. GPs clearly In essence, the clawback amount should be the lesser of
should not make a profit from the LPs’ willingness to bear excess carry or total carry paid, net of actually paid taxes.
their tax payments in clawback situations. Accordingly, However, there are often errors in the stipulated formulas
instead of assuming the highest hypothetical marginal tax which have a material impact on fund cash flows:
rate in a designated location,
the rate should be based on the actual tax situation of the  The tax amount should not simply be subtracted
individual GP member and should take into account: from the amount owed under the clawback 

 The clawback formula should take the
preferred return into account 

17
ILPA Private Equity Principles
Appendix C: Financial Reporting

 Annual Reports - Funds should provide the Management letter describing the activities of
following information at the end of each year the fund directed to the LPAC but distributed to
(within 90 days of year-end) to investors:  all investors;

Audited financial statements (including a clean Political contributions made by placement agents,
opinion letter from auditors and a statement from the manager or any associated individuals to trustees
the auditor detailing other work performed for the or elected officials on investor boards.
fund);
 Quarterly Reports - Funds should provide
Internal Rate of Return (“IRR”) calculations the following information at the end of each
prepared by the fund manager (that clearly set quarter (within 45 days of the end of the
forth the methodology for determining the quarter) to investors: 
IRR);
Unaudited quarterly profit and loss statements
Schedule of aggregate carried interest received; also showing year-to-date results;

Breakdown of fees received by the manager Schedule showing changes from the prior quarter;
as management fees, from portfolio companies
or otherwise; Schedule of fund-level leverage, including
commitments and outstanding balances on
Breakdown of partnership expenses; subscription financing lines or any other credit
facilities of the fund;
Certification by an auditor that allocations,
distributions and fees were effected consistent with Information on material changes in investments
the governing documentation of the fund; and expenses;

Summary of all capital calls and distribution notices; Management comments about changes during
the quarter;
Schedule of fund-level leverage, including
commitments and outstanding balances on If valuations have changed quarter-to-quarter,
subscription financing lines or any other an explanation of such changes;
credit facilities of the fund;
A schedule of expenses of the general partner

18
ILPA Private Equity Principles
 APPENDIX C

 Portfolio Company Reports - A fund should • Revenue (Debt terms and maturity);
provide quarterly a report on each portfolio
company with the following information:  • EBITDA;

Amount initially invested in the portfolio company • Profit and loss;

(including loans and guarantees);
• Cash position;
Any amounts invested in the portfolio company
in follow-on transactions; • Cash burn rate

A discussion by the fund manager of recent key Capital Call and Distribution Notices –
events in respect of the portfolio company; A standardized reporting template has been developed
by ILPA and is available at ilpa.org
Selected financial information (quarterly and
annually) regarding the portfolio company Under development – standardized reporting
including: templates to cover annual and quarterly reporting as
well as supporting financial schedules
• Valuation (along with a discussion of
the methodology of valuation;

19
ILPA Private Equity Principles
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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

Authority Tribunal
In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996
Equivalent citations: 1997 224 ITR 473 AAR
Bench: S Ranganathan, R Meena
RULINGS Application P. No. 10 of 1996 Decided On: 14.08.1996 Appellants: In Re: Advance Ruling
P. No. 10 of 1996 Vs.

Respondent:

Hon'ble Judges:

S. Ranganathan, J. (Chairman) and R.L. Meena, Member Subject: Direct Taxation

Acts/Rules/Orders:

Income Tax Act, 1961 - Sections 161, 161(1), 161(1A), 164, 164(4), 166 and 245Q; Finance Act, 1970;
Double Taxation Avoidance Agreement - Articles 5, 10(2) and 13 Cases Referred:

CIT (Addl.) v. Surat Art Silk Cloth Manufacturers Association, [1980] 121 ITR 1; K.P. Varghese v.
ITO, [1981] 131 ITR 597 (SC); CIT v. Gotla, [1985] 156 ITR 323; CWT v. Trustees of H.E.H. Nizam's
Family (Remainder Wealth) Trust, [1977] 108 ITR 555; CIT v. P. Krishna Warrier's case, [1970] 75
ITR 154; CIT v. Balwantrai Jethalal Vaidya, [1958] 34 ITR 187; CIT v. Trustees, T. Stanes and Co.,
[1995] 200 ITR 396; Trustees of Gordhandas Govindram Family Charity Trust's case, [1973] 88 ITR
47; Mohsinally Alimohammed Rafik's case, [1995] 213 ITR 317 (AAR); In Re: Advance Ruling No. P.
9 of 1995, [1996] 220 ITR 377 (AAR); CIT v. H. E. H. Mir Osman Ali Bahadur [1966] 59 ITR 666
(SC) RULING

1. Very interesting and far-reaching questions arise for consideration in these applications under
Section 245Q(1) of the Income-tax Act, 1961 ("the Act"). The two applicants are companies
incorporated in Mauritius. They are, for convenience, referred to hereafter as "the investor
company" (IC) and "the investment manager" (IM), respectively. The facts relating to transactions
in relation to which the applications have been filed by the two applicants overlap to a considerable
extent and it will, therefore, be desirable and convenient to dispose of both the applications by a
common order.

2. The number of entities that have a part to play in these transactions are many and it will,
therefore, be useful to present at the outset the dramatis personae involved, The principal motivator
of the transactions is an American company having an active participation in economic activities in
Asian countries. With its considerable operational and investment experience, it has made a strong
commitment to develop third party investment of funds in Asian countries. Towards this end, it
constituted an infrastructure fund focussing on infrastructure and infrastructure-related
investments to which one of its subsidiaries agreed to contribute up to $100 million. Two other
subsidiaries were made advisers. It believes that it is "well-positioned to establish emerging market
direct investments bringing together the complex organisational elements, attracting experienced
individuals and institutions as partners and fully utilising its own substantial resources and

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

understanding of the region".

3. The transactions now proposed (which give rise to the present applications) are restricted in its
operations to the "Indian sector". The American company in collaboration with an Indian financial
service company now proposes to set up another fund. This fund will consist of two tranches
(sections or branches), one a rupee tranche called a "contributory trust" holding funds in Indian
currency and a Mauritian company (referred to as "the foreign tranche") holding funds in dollars.
The rupee tranche is to be set up as a contributory trust (hereinafter referred to briefly as "the CT")
constituted under an indenture of trust drawn up between the Indian financial service company and
another Indian trust company. The trust company will be trustees of the CT and the trust funds will
vest in it under the Indian law. The expression "CT" and "trustees" are, therefore, interchangeably
used in the ensuing discussions.

4. Parallel to the CT, the foreign tranche plans to hold funds to the tune of $100 million. The
American company has committed to itself to contribute $15 million to this company for
investment. Other contributors from several countries are expected to make up the balance of $85
million. As of now, the activities of the CT and of the fund company are intended to be kept separate
though perhaps, at a later point of time, they may be combined together. The two tranches are to be
managed from abroad by a common manager and propose to enter into a co-investment agreement
for providing for investment by the two tranches in approximate proportion to their respective asset
sizes. It is agreed that it is not necessary now to consider that eventuality and it may be left out of
consideration for the present.

5. The funds of the CT are to be invested in Indian companies and projects in India. In order to
decide on the nature, area and investments to be made, a subsidiary of the American company
incorporated in Mauritius (IM) has been set up. Its actual functioning, though under the direction
and control of its board of directors ("the Board"), will be guided and monitored in three different
ways :

(i) The IM will constitute an investment committee with four representatives nominated by the
American company and three including the chairman nominated by the Indian financial service
company which will recommend (acting by majority vote) portfolio investments for approval by the
board but with a right of veto to the American company.

(ii) The Indian financial service company which has rich experience in this line of business will act
as the principal investment adviser in India to the trust under an advisory agreement. A similar
agreement appointing another foreign company also as an investment adviser to the IM in relation
to the operations of the offshore tranche will also be entered into.

(iii) Under the advisory agreement, the Indian financial service company and the American
company can also constitute "service units" from their respective staff to assist them.

(iv) The management agreement also envisages an advisory board consisting of representatives of
industries, institutions, investors and the Asian Development Bank (ADB) which, as its name

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

indicates, will be purely advisory in character.

6. But though the investment committee, the investment advisers, service units and the advisory
board may offer their suggestions and recommendations, the final word and responsibility will rest
with the board of the IM which can be convened anywhere in the world except in India and the U. S.
A.

7. Necessary documents to give effect to the above arrangements have been drawn up and placed
before the Authority. These are :

(i) Draft indenture of trust (T. D.) between the Indian financial service company and the trust
company constituting the CT of which the said company is appointed trustees. [A draft trust deed
originally filed with the application was allowed to be replaced by a revised draft trust deed at the
time of arguments and it is this revised T. D. that is referred to below].

(ii) Draft contribution agreement (C. A.) between the contributors on the one hand and the trustees
and the IM on the other.

(iii) Draft investment management agreement between the trustees and the IM.

(iv) Draft advisory agreement between the Indian financial service company and the management
company.

8. Arguments before the Authority were addressed on the basis of these draft agreements. However,
since the transactions are still in the stage of proposed ones, counsel for the applicant was willing to
consider suitable modifications in the agreement in respect of clauses which, as they stand, may
create some difficulties for the applicants from the tax angle. These aspects are touched upon in due
course while dealing with the arguments put forward by counsel. The modifications agreed to by
counsel are indicated in the discussions that follow in bold type. The attention of the Authority has
also been drawn to a "private placement memorandum" drawn up for "the fund" which is in the
nature of a prospectus inviting contributions and this will be touched upon when necessary.

1. Indenture of trust (T. D.) ;

By this deed, the Indian financial service company makes an initial settlement of Rs. 1 lakh on the
trustees on trust. This along with contributions that may be made to the trust fund by others is
compendiously referred to in Clause 1(h) of the deed as the "contribution fund". The contributions
by various persons is considered in terms of a unit of one million rupees, fractional units also being
permissible [Clause 1(y)]. Thus, with its contribution of Rs. 1,00,000, the Indian financial service
company is having 1/10th of a unit in the fund. The contributors are also the only beneficiaries
under the trust deed [Clause 1(c)]. The beneficiaries mentioned in the Third Schedule to the deed at
present are the IC and the Indian financial service company. To this will be added the names of
others who may be making contributions to the fund till the trust deed is signed along with the
amounts of their contribution and the number of units held by them. Persons coming forward to

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

contribute to the fund till the execution of the trust deed also enter into a "contribution agreement"
(C. A.) with the trustees and the IM [Clause 1(g)]. An agreement on the same lines is to be signed by
all the contributors who join up later and such persons will also be included as beneficiaries of the
trust. The trustees are to stand possessed of the trust fund, invest the same, hold the income for the
benefit of the beneficiaries and distribute the income among the beneficiaries in terms of the C. A.
The trust is expected to operate for a period defined as "the trust period" [Clause 1(x)]. This is the
period up to the first of the following dates :

(i) the day on which shall expire 14 and half years from the date of the settlement ;

(ii) such dates as the trustee may appoint by deed at their discretion ;

(iii) such dates as shall be agreed upon by all the contributors ;

(iv) such dates as shall be determined by the I. M. after six months' prior notice to the contributors ;
and

(v) the date of winding up of the I. M.

9. Clause 3(a) of the T. D. obliges the trustees to appoint the I. M. to carry out its investment
policies.

10. The mode of distribution of the trust fund and income is set out in clause 5 of the trust deed
which reads thus :

"Distribution of trust fund and income :

5. The trustee shall stand possessed of the trust fund and the income thereof shall accrue upon the
trust for the benefit of the beneficiaries and the trustee shall make distributions to the
beneficiaries/contributors as follows :--

(a) as regards the initial settlement as specified in the second schedule to distribute the same and
any income accumulated thereon in equal proportions on termination of the trust amongst the
beneficiaries as listed in the third schedule,

(b) as regards all additional amounts to be distributed to the beneficiaries in proportion to the
contributions made by them and in accordance with the fourth schedule--the contribution
agreement."

11. Clause 7 of the trust deed contains a provision to the following effect:

"Power of addition :

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

7. (a) The trustee shall have the power at any time or times during the trust period to add as
beneficiaries such one or more persons or class of persons as the trustee shall in their absolute
discretion determine.

(b) Any such addition shall be made by a deed signed by the trustee and :--

(i) naming or describing the person or persons or class of persons to be added as beneficiaries ;

(ii) specifying the date (not being earlier than the date of the deed but during the trust period) from
which such person or persons to be thereby added as beneficiaries ; and

(c) It is hereby clarified that such beneficiaries will be entitled to only such share that is in
proportion to the contribution made by them and in accordance with the contribution agreement."

12. At the time of hearing, a doubt was expressed by the Authority as to how far a provision
conferring an absolute discretion on the trustees to add names of beneficiaries to the trust would be
justified in law. Though the authorised representative of the applicant (A. R.) contended that this
clause was perfectly in order (citing O.P. Agarwalla on Trust, pages 220-222), he also expressed his
willingness to modify clause 7(a) as follows in order to obviate any kind of objection :

" 7. (a) The trustee shall, during the trust period, have the power at their discretion to admit as
beneficiary any institutional investor which agrees to enter into a contribution agreement."

and, consequent on the above, to insert a definition of the expression "institutional investor" in
Clause 1 to the following effect :

"(1) 'institutional investor' means any entity other than an individual, being a natural person
including but not limited to financial institution, company or corporation, Government, State or
political subdivision or local authority, that trustees may consider a reputable investor."

13. After a little discussion he was willing also to drop the last seven words which were considered to
be somewhat vague.

14. One may pause here to consider whether there could be any valid objections to the constitution
of a trust in this manner. The authors of the trust are the IC, the Indian financial service company
and others contributing to the trust by the date of the trust deed. Indeed even institutional investors
contributing to the trust, in helping the CT achieve its target of 50 million dollars can be considered
as supplemental authors of the trust, the C. A. constituting read with the trust deed, the instruments
constituting the trust in their cases. The purposes of the trust are, as stated in the TD, to invest the
trust funds and distributing the proceeds to the beneficiaries. This is, in a sense, nothing more than
an arrangement by which certain parties agreed to contribute funds for a common purpose and
divide the profits amongst themselves. No doubt, the same objective could be achieved by the
constitution of a firm or a company but, equally, there seems to be no valid objection if the parties
wish to do it in the form of a trust which, under the trust act, merely represents certain obligations

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

annexed to the ownership of property in the form of the contributed funds. The purposes of the trust
cannot be said to be forbidden by law or likely to defeat the provisions of any law or fraudulent or
involving injury to any person or property or opposed to public policy : vide Section 4 of the India
Trusts Act (2 of 1882). It will appear later that, in entering into the present transactions, the parties
took into account certain difficulties if the same transactions had been put through the format of a
company and also took into account certain financial and tax implications. But these cannot render
the purposes of the trust unlawful within the meaning of the Indian statute. The clause which
enabled the trustees to admit any one as a beneficiary, the Authority felt, might introduce a degree
of uncertainty regarding the element of beneficiaries under the trust. The parties have agreed to
modify the clause as indicated above. The result is that now the trustee's choice of beneficiaries is
restricted (a) by the overall limit of the fund ; (b) only to institutional investors ; and (c) to persons
who agree to subscribe to the C. A. The criteria for persons to become beneficiaries and the shares of
income they are entitled to are clearly defined in the deed. The Authority is of opinion, that with the
introduction of the modifications referred to above and in the light of the statement of law contained
in the passages from Agarwalla's Trust Act cited by learned counsel, there can be no objection to the
validity of the modified trust deed. [Parenthetically, however, it may be observed that, in the
definition in Clause (1) proposed to be inserted, the words "being a natural person" appears to be a
surplusage and may be omitted without detracting from the meaning of the clause. But this has no
impact on the validity of the trust deed].

15. Clause 9 specifies the extent of the beneficiaries' interest. It reads :

" 9. Provision relating to beneficiaries.-

Extent of beneficiaries interest.--The beneficial interest of each beneficiary in the trust fund shall
extend to and be limited to the aggregate value of the units subscribed to and held by that
beneficiary in the trust fund."

16. It is necessary to mention Clause 14 and paragraph (d) of Clause 17 to which the Departmental
Representative raised some objection to which reference will be made later. The provisions read as
under :

" 14. Power to apportion between income and capital.-

The trustee shall have power to make such reserves out of the income or capital as the trustee deem
proper for expenses, taxes and other liabilities of this settlement to pay from income or from capital
or to apportion between income and capital any expenses of making or changing investment or
selling, exchanging or leasing including broker's commissions and charges and generally to
determine what part of the expenses of this settlement can be charged to capital and what part to
income and to determine as between separate funds and separate parts or shares the allocation of
income, gains, profits, losses and distributions and so that any decisions of the trustee under this
regulation whether made in writing or implied from their acts shall so far as the law may permit be
conclusive and binding on the beneficiaries and all persons actually or prospectively interested
under this settlement.

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

17. Decisions, etc., of the trustee.--....

(d) The following powers of the trustee shall only be exercised by a majority of the directors of the
trustee present and voting at a meeting of its board of directors :

(i) application of the net profit of the trust otherwise than by way of distribution to the beneficiaries
; and

(ii) delegation of any powers and authorities of the trustee. "

17. The First Schedule to the T. D. sets out the Regulations that govern the trustee. Attention has
been drawn to paragraph 2 and paragraph 8 which read thus :

" 2. The trust fund shall be managed by the investment manager in accordance with the investment
objectives, policies and restrictions set forth in the private placement memorandum dated
November, 1995, which is hereby incorporated by reference herein.

8. Trustee shall not engage in any business or trade :

Provided however, they may make investment in shares or projects and may appoint representatives
on the management or board of the portfolio investments or projects for the surveillance or
protection of such investments."

18. Paragraph 3 provides that the trustee will not be bound to interfere in the business of any
company in which the trust is interested. Paragraph 4 gives the trustee power to employ agents,
paragraph 5 a power to employ an investment adviser or manager and paragraph 6 a power to
employ nominees and custodians to hold the property or investment of the fund in their names.

19. The Second Schedule sets out Rs. 1,00,000 as the initial settlement, the third is to contain the
names of the applicant company, the Indian financial service company and others who have agreed
to join in the execution of the trust deed and the Fourth Schedule embodies the contribution
agreement to which each one of the investors will have to subscribe. This has to be dealt with in
greater detail.

2. Contribution agreement (C. A.) :

The contribution agreement will be between the initial investors set out in the Third Schedule to the
trust deed [presumably the same as Schedule A here] the trustee and the investment manager. By a
letter dated June 27, 1996, the applicants have indicated an insertion in the preamble of the C. A. of
a paragraph (c) as follows :

" (c) Indian trust company is a subsidiary of the Indian financial service company and is in an
independent business of acting as trustee of trusts. "

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

20. Every additional investor will have to execute in favour of the trust company and the
management company an agreement on the same lines [paragraphs 2.01 and 2.02]. Every
contributor, by these agreements, agrees to contribute a stated amount (called his "commitment"
amount) to the fund in exchange for a corresponding number of units [paragraphs 1.01(5), (7) and
(16)]. Such commitment is valid for five years [paragraph 7.01].

21. Paragraphs 2.04 to 2.06 of the agreement are important and have to be extracted here in full :

" 2.04 Contribution procedure :

(a) Capital contributions shall be made by the contributor to the trust for all or a portion of a
contributor's unpaid capital commitment on an as needed basis as specified by the investment
manager. Each contributor's capital contribution shall be in an amount pro rata to the contributor's
capital commitments to the trust. The investment manager shall give the contributor a takedown
notice (draw down) in accordance with this agreement (notice clause) within 21 calendar days in
advance of the date on which the capital contribution shall be required to be made.

(b) On the draw down date, for any draw down of the contribution amount, if all conditions
specified in Article IV (conditions of contributions) are met, each of the contributors will pay their
draw down in rupees, payable at par, to the trust's bank account as specified in the investment
manager's notice of contribution.

(c) Notwithstanding the above, the investment manager may choose to establish the contribution
fund with minimum commitments of Rs. 750 million for the initial closing (the closing) with staged
closings for subsequent commitments. Such staged closings will occur not later than 12 months after
the closing.

2.05 Upon receipt of draw down amount from any of the contributors, the trustee, shall : -

(a) issue, to the respective contributor, units with a total nominal value equal to the instalment
amount, credited as fully paid on the date of actual payment ;

(b) enter the respective contributor's name in a register of unitholders as the holder of those units ;
and

(c) deliver to the respective contributor a unit certificate or certificates evidencing valid title to the
units, 2.06 Default in payment: In the event that any contributor fails to contribute any portion of
its capital commitments within five business days of the date such contribution is due under a
takedown notice, the investment manager shall mail (by registered mail) a notice of default to such
contributor. If such contributor fails or refuses to pay in full the unpaid capital commitments, or any
portion thereof, within five business days after the mailing of such notice, then the investment
manager may declare such contributor to be a defaulting contributor and the following provisions
shall apply :-

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

(a) such defaulting contributor shall not be entitled to make any further capital contributions to the
trust, provided however, that such defaulting contributor shall remain fully liable to the creditors of
the trust, to the extent permitted by law, and to the trust, as if such default had not occurred.

(b) such defaulting contributor will not be entitled to participate in any subsequent contributor's
vote, consent or any decision to be made by the trust or the investment committee and such
defaulting contributor's contributed capital percentage shall be disregarded for purposes of any
super majority vote or consent requirement ;

(c) such defaulting contributor's capital account shall be reduced to the lesser of (i) the defaulting
contributor's unreturned capital contributions determined as on the date of the default and (ii) the
defaulting contributor's contributed capital percentage multiplied by the excess of the fair market
value of the trust's investments over the liabilities of the trust determined as on the date of the
takedown notice with respect to which the defaulting contributor defaulted ;

(d) following the date of default, no items of income or loss shall be allocated to such contributor ;

(e) notwithstanding any provisions to the contrary in this agreement, following the date of default,
such defaulting contributor shall be entitled to distributions from the trust in liquidation or
otherwise, amounting in the aggregate to no more than its capital account adjusted under paragraph
2.06(c) and payable only out of, and to the extent of, that portion of the proceeds of investments
made prior to the date of the takedown notice, with respect to which such defaulting contributor
defaulted, which corresponds to such defaulting contributor's contributed capital percentage as of
such date ; and

(f) appropriate adjustments shall be made to the contributed capital percentages of the
non-defaulting contributors.

Each of the contributors hereby consents to the application to it of the remedies provided in this
paragraph 2.06 in recognition of the risk and speculative damages its default would cause to the
other contributors, and further agrees that the available such remedies shall not preclude any other
remedies which may be available in law, in equity, by statute or otherwise. "

22. The "initial closing" is to be on the date of the trust deed [Clause 1(k) of the deed] and will be
followed by subsequent closings within 12 months from this date [paragraph 4.04]. Investments
made subsequent to this date but before any subsequent closing are governed by paragraph 2.09
which reads :

" 2.09 Investments prior to second dosing : In the event a portfolio investment by the trust is
completed subsequent to the closing but prior to the subsequent closing, there will be a draw down
from the commitments of investors participating in such subsequent closing in an amount equal to
the pro rata original cost of the equity investment plus interest from the date of the investments
completion. Indian investors will be required to pay interest at the Indian prime rate as set by the
State Bank of India plus 3 per cent. Such amount will simultaneously be refunded pro rata to the

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existing contributor and amounts other than interest will be immediately restored to the unfunded
commitments and will thereafter be subject to recall and reinvestment by the fund in other portfolio
investments. In addition for investors participating in a subsequent closing interest on the fee paid
to the investment and any amounts drawn down by the investment manager will be assessed to
interest at the prime rate as set by the State Bank of India plus 2 per cent. "

23. Under paragraph 4.04, the I. M. may choose to close the contribution fund with minimum
commitments aggregating to Rs. 750 millions for the initial closing and paragraph 4.05 disables any
contributor from withdrawing from the fund or transferring its interest therein.

24. Article VI deals with the distribution of profits, allocation of income, etc. It may be sufficient to
set out here paragraphs 6.01, 6.02, 6.04 and 6.06 :

"ARTICLE VI Distribution of profits, allocation of income and loss, cancellation of units and
investors rights and obligations :

6.01 Distribution : Income received by the trust in respect of the contribution fund will be a charge
on the income of the contribution fund, and will be distributed annually or at such direct intervals as
the trustees may in their absolute discretion think fit. The contribution fund may also declare special
distributions. The method by which the distribution will be made and the allocation of income
between the contributor and the investment manager are as set out in paragraphs 6.02 to 6.07 and
will depend upon the source of the income.

6.02 Income from portfolio investments : Contribution proceeds attributable to the fund's portfolio
investments (which shall include all proceeds attributable to the disposition of such investments,
together with interest, dividends and distributions from such investments, net of operating expenses
including distribution of fees and share of profit to the investment manager and capital
expenditures as the investment manager shall reasonably determine will be distributed as follows :

(a) First, to the contributor until 100 per cent. of capital contribution has been deemed to have been
returned plus a 9 per cent. annual rate of return compounded semi-annually on all such capital
contributions from the time of draw down ('the priority return').

(b) Thereafter, 80 per cent. to the contributor and 20 per cent. to the investment manager, provided
that distributions will be made in accordance with sub-paragraphs (a) above until the earlier of :

(i) the first anniversary of the first closing,

(ii) the date on which the fund is deemed to be fully invested by the investment manager, or

(iii) the date on which the investment manager gives written notice of the dissolution of the
contribution fund to the contributor. . . .

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6.04 Income and expenses from other sources : All items of income gain, loss or expenses not
directly attributable to a particular portfolio investment (e.g., interest or temporary investments,
and the contribution fund's share of any advisory fees net of general operating expenses) shall be
allocated among the investors in proportion to their capital contributions. . . .

6.06 Special allocation among late entering contributors of organisation and operating expenses :
All operating expenses allocated for any period to the capital accounts of the contributors as a group
shall be specifically allocated among the capital accounts of the contributors so that such operating
expenses are allocated among the capital accounts of the contributors in proportion to their
respective contributed capital percentages as at the end of such period :

Provided, however, that if the additional contributors are admitted to the trust such operating
expenses shall be allocated among the capital accounts of the contributor so that to the extent
possible the cumulative operating expenses allocated with respect to such contributor at any time
are proportionate to their respective contributed capital percentages."

25. Article VIII, providing for winding-up and dissolution of the trust, reads :

"ARTICLE VIII Dissolution and winding-up :

8.01 The trust is expected to wind up and liquidate its assets on the period from the date hereof until
whichever of the following dates shall first occur, namely :--

(i) the day on which shall expire 10 years and an additional three year period from the date of this
settlement ; and

(ii) upon the winding-up of management company, this agreement shall terminate immediately ;

(iii) such day as determined by the board of directors of the investment manager upon at least six
months prior written notice to the investors. "

26. Article X deals with miscellaneous matters of which it is necessary to refer to paragraph 10.02 :

"ARTICLE Miscellaneous :

10.2 Liability of contributor : Except as specifically set forth herein, no contributor shall have any
personal liability whatever in its capacity as a contributor whether to the trust, to any other
contributor or to the creditors of the trust for the debts, liabilities, contracts or any other obligations
of the trust or for any losses of the trust. A contributor shall only be liable to pay its capital
commitments to the trust. After its capital commitment shall have been paid in full, a contributor
shall not be obligated to make any further capital contribution to the trust or to repay to the trust,
any contributor or any creditor of the trust all or any fraction of any negative amount of such
contributor's capital account."

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3. Investment management agreement (I. M. A.) :

The management of the trust funds is to be entrusted by the CT to the IM under an agreement
entered into with it. The IM is a limited life company incorporated in Mauritius. It is a 100 per cent.
subsidiary of an American asset management company but it is proposed to restrict its shareholding
to 73 per cent. by transferring 22 per cent. to the Indian financial service company and five per cent.
to the Asian Development Bank Ltd. (ADB). Its board of directors will also have representatives of
the two companies and ADB. The IM is to be responsible for the day-today management of the trust
fund "in accordance with the provisions of this Agreement and any directions and instructions of the
trustees" [2.01]. Paragraph 3.03 states that "the investment manager shall be responsible for the
day-to-day management of the trust fund, which shall be subject to any directions, instructions and
guidelines provided by the trustees". Paragraphs 5.01, 6,04 and 7.01 refer to the areas in which the
trust funds should be invested and their respective priorities. Paragraph 5.01 provides : "In addition,
trust fund investments may include holdings of listed companies that could be of particular benefit
of the fund". Under paragraph 6.02, the IM should make best endeavours to maximise capital gains
income of the contribution funds. Paragraph 6.05 permits the investment of contributions received
"but not yet invested in portfolio investments.... in high quality short-term debt instruments in
accordance with quality guidelines set forth in the private placement memorandum". The
memorandum has this to say on the strategic objectives of the trust :

"Strategic objective :

The fund's investment objective will be to seek to achieve long-term capital appreciation by
primarily making direct investments in a portfolio of Indian companies and infrastructure projects
in India. The fund's direct investment participations will generally take the form of equity,
quasi-equity, equity-related, preferred stock, and convertible debt instruments. The fund will focus
on opportunities that will seek to take advantage of India's expanding infrastructure requirements,
increasingly active consumer product appetites and growing new technology base as well as
opportunities arising from corporate turn around strategies, privatisation opportunities, business
restructuring and reorganisation strategies, among other areas. Investments may be spread across
the focus sectors in new projects, expansions and diversifications, opportunities arising from
restructurings and reorganisations, product development efforts, privatisations and the like.

The fund will only invest in projects that at the time of the investment comply with all relevant
Indian State and Central Government legislation regarding environmental protection, and such
guidelines on environmental protection and social and rehabilitation issues which may be adopted
by the Asian Development Bank, a core investor (as defined below).

In addition, fund investments may include holdings of listed companies that could be of particular
benefit to the fund."

27. Clause (iii) of paragraph 10.01(a) also needs to be referred to. It says that the functions of the
investment manager shall include, inter alia :

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"To engage professionally skilled and/or experienced personnel to provide the necessary advisory
and investment managerial support and/ or guidance to the portfolio investment and the
entrepreneurs and if necessary to assist in the administration of the trust fund."

28. Article XIII dealing with delegation of duties envisages an investment committee (paragraph
13.01), an advisory board (paragraph 13.02) and advisory contracts with the Indian financial service
company and the American company (paragraph 13,03) but makes it clear (paragraph 13.04) that,
regardless of all delegation, the manager shall remain responsible for all decisions and be liable for
any delegate's act or omission that it would otherwise have been liable for. Paragraph 14.01
stipulates for the payment to the IM of a fee of 2.5 per cent. of the aggregate capital commitments of
the contributors reduced by returns of capital directly attributable to specific investments upon
which distributed gains (or losses) of the trust have been realised. At the end of the commitment
period, the investment management fee shall be based on the aggregate unreturned capital. To the
extent that the balance of capital commitments or unre-turned capital of the trust fund plus the
capital commitment or unreturned capital of the "the fund" in the aggregate exceeds US $
150,000,000 or the equivalent in rupees, the investment management fee with respect to such
balance shall be reduced to two per cent. Paragraph 14.04 on distribution reproduces paragraph
6.02 of the C.A. entitling the IM, after a particular stage, to a part of the proceeds attributable to
portfolio investments.

4. Investment advisory agreement (I.A.A.)

29. The I.A.A. is entered into between the Indian financial service company and the IM (there being
a similar agreement between the American company and the IM), pertaining to the off-shore
tranche. Paragraphs 2(a) and (b) of this agreement provide for the appointment of "service units". It
is sufficient to extract paragraph 2(e) :

"Paragraph 2(e).--Notwithstanding the services provided by the advisor, the advisor shall not be
authorised to manage the affairs of, act in the name of or on behalf of, or bind the fund or the
investment manager. The management, policies and operations of the fund shall be the exclusive
responsibility of the investment manager acting pursuant to and in accordance with the investment
management agreement(s), (hereinafter referred to as 'agreements') and all decisions relating to the
fund, including, without limitation, the acquisition, management and disposition of portfolio
investments, shall be made solely by the board of directors of the manager acting pursuant to and in
accordance with the agreements."

30. The Authority has been informed that the "initial closing" of the offshore tranche held by "fund"
has already been completed with commitments of 70 million US dollars (66 per cent. of which is
from international investors) and that a second closing had been targeted for the month of April for
an additional corpus of 80 million US dollars.

31. In the background of this configuration, two applications have been filed before the Authority.

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(a) The application filed by the IC raised as many as seven questions set out in annexure "I" to the
application. After some discussions in the course of the hearing this has been revised in the form of
eleven questions (to which one more was orally added). The revised questions are :

"1. Based on the facts and circumstances of the case, whether the applicant would be assessed in
respect of its proportionate share of income earned by the contributory trust as per the provision of
Section 161 of the Income-tax Act, 1961 (the Act) ?

2. Based on the facts and circumstances of the case, whether the contributory trust would be
regarded as a 'see through' or 'transparent entity' vis-a-vis the applicant ; i.e., to say the applicant
will be taxed in respect of its proportionate share of income under Section 161 of the Act ?

3. Based on the facts and circumstances of the case, if it is held that the provisions of Section 161 do
not apply to the income of the applicant from the contributory trust because of the power vested in
the trustees to add to the list of the beneficiaries on the terms laid down in the indenture of trust and
the contribution agreement, then if such power is deleted, would the assessment of the applicant in
respect of its proportionate share of income of the trust be made in accordance with Section 161 ?

4. Based on the facts and circumstances of the case, even if it is held that the shares of the additional
beneficiaries are indeterminate whether the capital gains arising to the applicant will be charged to
tax at the rate of 20 per cent. as prescribed in Section 112 of the Act ?

5. Based on the facts and circumstances of the case, will there be any tax withholding by the investee
companies at the time of distribution of income to the CT ?

6. Whether, on the facts and circumstances of the case, the character of the applicant's
proportionate share in the income of the contributory trust will be the same as in the hands of the
contributory trust ?

7. Based on the facts and circumstances of the case, whether the applicant's share in the dividend
earned by the contributory trust will be chargeable to tax and if so at what rate ?

8. Based on the facts and circumstances of the case, will the applicant's share in the interest earned
by the contributory trust be chargeable to tax at the rate of 20 per cent. ?

9. Whether, on the facts and in the circumstances of the case, will the applicant's share in the capital
gains earned by the contributory trust be chargeable to tax ?

10. Based on the facts and circumstances of the case, whether there would be any withholding tax
liability on the CT in respect of the distributions made to the applicant ?

11. Whether, on the facts and in the circumstances of the case, the applicant's proportionate share in
the surplus arising on the realisation of the investments made by the contributory trust would
constitute capital gains ?

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12. Whether, in case the answer to question No. 11 is in the negative, the proportionate share of the
applicant in such surplus will be chargeable to income-tax in India in the applicant's hands ?"

(b) The application filed by the investment manager raises the four questions set out below ;

"1. Based on the facts and circumstances of the case, and in view of the provisions of the
India-Mauritius double tax avoidance agreement, can it be construed that the applicant does not
have a permanent establishment ('PE') in India ?

2. Based on the facts and circumstances of the case, will the applicant be liable to tax in respect of
the management fees received from the CT ?

3. Based on the facts and circumstances of the case, will the applicant be liable to tax in respect of
the carried interest received from the CT ?

4. Based on the facts and circumstances of the case, if the answer to the above question is yes, will
there be a withholding tax liability on the CT, in respect of the payment of management fees and
carried interest to the applicant ?"

32. The AR submitted that the phrasing of the first question above in the negative is not correct and
that this question may be reframed thus:

" 1. Based on the facts and circumstances of the case, and in view of the provisions of the
India-Mauritius double tax avoidance agreement, can it be construed that the applicant has a
permanent establishment (P.E.) in India ?"

33. There can be no objection to this and it is the question, as thus modified, along with the other
three questions that will be considered by the Authority.

34. Though numerous and seemingly involved in their language, the points raised by the applicants
lie within a narrow compass. In the case of the IC, the basic question to be decided is whether the
assessments of the CT and the IC will be governed by Section 161 or Section 164 of the Act and what
rates of tax would be applicable to the IC's receipts from the CT. In the case of the IM, the very short
question that has to be answered is whether it can be said to have a permanent establishment in
India within the meaning of the Agreement for the Avoidance of Double Taxation between India and
Mauritius (DTAA) and, if not, whether any part of its income can be assessed in India.

35. To understand the points raised by the applicant company, it is necessary to consider the
provisions of sections 160, 161, 164 and 166 of the Act. The relevant portions of these sections are
extracted below :

" 160.--Representative assesses.--(1) For the purposes of this Act, 'representative assessee' means--. .
.

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(iv) in respect of income which a trustee appointed under a trust declared by a duly executed
instrument in writing whether testamentary or otherwise (including any wakf deed which is valid
under the Mussalman Wakf Validating Act, 1913 (6 of 1913)), receives or is entitled to receive on
behalf, or for the benefit, of any person, such trustee or trustees ;

161. Liability of representative assessee.--(1) Every representative assessee, as regards the income in
respect of which he is a representative assessee, shall be subject to the same duties, responsibilities
and liabilities as if the income were income received by or accruing to or in favour of him
beneficially, and shall be liable to assessment in his own name in respect of that income ; but any
such assessment shall be deemed to be made upon him in his representative capacity only, and the
tax shall, subject to the other provisions contained in this Chapter, be levied upon and recovered
from him in like manner and to the same extent as it would be leviable upon and recoverable from
the person represented by him.

(1A) Notwithstanding anything contained in Sub-section (1), where any income in respect of which
the person mentioned in Clause (iv) of Sub-section (1) of Section 160 is liable as representative
assessee consists of, or includes, profits and gains of business, tax shall be charged on the whole of
the income in respect of which such person is so liable at the maximum marginal rate :

Provided that the provisions of this sub-section shall not apply where such profits and gains are
receivable under a trust declared by any person by will exclusively for the benefit of any relative
dependent on him for support and maintenance and such trust is the only trust so declared by him.

(2) Where any person is, in respect of any income, assessable under this Chapter in the capacity of a
representative assessee, he shall not, in respect of that income, be assessed under any other
provision of this Act,

164. Charge of tax where share of beneficiaries unknown.--(1) Subject to the provisions of
Sub-sections (2) and (3), where any income in respect of which the persons mentioned in clauses
(iii) and (iv) of subsection (1) of Section 160 are liable as representative assessees or any part thereof
is not specifically receivable on behalf or for the benefit of any one person or where the individual
shares of the persons on whose behalf or for whose benefit such income or such part thereof is
receivable are indeterminate or unknown (such income, such part of the income and such persons
being hereafter in this section referred to as "relevant income", 'part of relevant income' and
'beneficiaries', respectively), tax shall be charged on the relevant income or part of relevant income
at the maximum marginal rate :

Provided that in a case where-

(i) none of the beneficiaries has any other income chargeable under this Act exceeding the
maximum amount not chargeable to tax in the case of an association of persons or is a beneficiary
under any other trust ; or

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(ii) the relevant income or part of relevant income is receivable under a trust declared by any person
by will and such trust is the only trust so declared by him ; or

(iii) the relevant income or part of relevant income is receivable under a trust created before the 1st
day of March, 1970, by a non-testamentary instrument and the Assessing Officer is satisfied, having
regard to all the circumstances existing at the relevant time, that the trust was created bona fide
exclusively for the benefit of the relatives of the settlor, or where the settlor is a Hindu undivided
family, exclusively for the benefit of the members of such family, in circumstances where such
relatives or members were mainly dependent on the settlor for their support and maintenance ; or

(iv) the relevant income is receivable by the trustees on behalf of a provident fund, superannuation
fund, gratuity fund, pension fund or any other fund created bona fide by a person carrying on a
business or profession exclusively for the benefit of persons employed in such business or
profession, tax shall be charged on the relevant income or part of relevant income as if it were the
total income of an association of persons :

Provided further that where any income in respect of which the person mentioned in Clause (iv) of
Sub-section (1) of Section 160 is liable as representative assessee consists of, or includes, profits and
gains of business, the preceding proviso shall apply only if such profits and gains are receivable
under a trust declared by any person by will exclusively for the benefit of any relative dependent on
him for support and maintenance and such trust is the only trust so declared by him.

(2) In the case of relevant income which is derived from property held under trust wholly for
charitable or religious purposes, or which is of the nature referred to in Sub-clause (iia) of Clause
(24) of Section 2 or which is of the nature referred to in Sub-section (4A) of Section 11, tax shall be
charged on so much of the relevant income as is not exempt under Section 11 or Section 12, as if the
relevant income not so exempt were the income of an association of persons :. . .

Explanation 1.--For the purposes of this section,--

(i) any income in respect of which the persons mentioned in Clause (iii) and Clause (iv) of
Sub-section (1) of Section 160 are liable as representative assessee or any part thereof shall be
deemed as being not specifically receivable on behalf or for the benefit of any one person unless the
person on whose behalf or for whose benefit such income or such part thereof is receivable during
the previous year is expressly stated in the order of the court or the instrument of trust or wakf deed,
as the case may be, and is identifiable as such on the date of such order, instrument or deed ;

(ii) the individual shares of the persons on whose behalf or for whose benefit such income or such
part thereof is received shall be deemed to be indeterminate or unknown unless the individual
shares of the persons on whose behalf or for whose benefit such income or such part thereof is
receivable, are expressly stated in the order of the court or the instrument of trust or wakf deed, as
the case may be, and are ascertainable as such on the date of such order, instrument or deed.

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166. Direct assessment or recovery not barred.--Nothing in the foregoing sections in this Chapter
shall prevent either the direct assessment of the person on whose behalf or for whose benefit income
therein referred to is receivable, or the recovery from such person of the tax payable in respect of
such income."

36. Before proceeding to discuss these provisions, it is necessary to deal with two preliminary
objections to the maintainability of the application by the IC. It is contended for the Department
that what the application seeks virtually is a ruling on the mode of assessment of the CT (i.e., the
trustee company) which is an Indian domestic company-whether it should be assessed on its total
income at the maximum rate under Section 164 or whether it should be assessed separately in
respect of the portions of income earned by it on behalf of the various beneficiaries under Section
161. The effect of sections 161 and 164, which is sought to be got clarified by the IC, may be explained
by a simple example. If a trustee earns an income, say, of Rs. 10,00,000 holding it on behalf of
certain beneficiaries, Section 161 calls for an examination whether the beneficiaries and their shares
are indeterminate or unknown. Suppose it is clear that the beneficiaries would be A, B, C and D
entitled to shares in the ratio 2:2:3:3, then, four assessments would be made on the trustee, one on
behalf of each of the beneficiaries, bringing to tax the respective share incomes of Rs. 2 lakhs, Rs. 2
lakhs, Rs. 3 lakhs and Rs. 3 lakhs at the tax rates appropriate thereto. Alternatively, but not
additionally, A, B, C and D could also be assessed on such income. On the other hand, if the shares
of the beneficiaries should be unknown or indeterminate, the officer would assess the trustee on the
entire income of Rs. 10,00,000 at the maximum rate as defined in Section 2(29C) of the Act as the
Department would not be able to make assessments on the individual beneficiaries whose identity
or shares are not known. Here, the IC wants to know which of these methods of assessing the trust
should be adopted by the Assessing Officer and such a question cannot be entertained from it under
Chapter XIX-B.

37. The Department's objection is that this is a question which really affects the CT--a resident
Indian company--and that the IC, though a nonresident, cannot avail of the benefits of Chapter
XIX-B for getting clarifications about a resident assessee's liability to income-tax merely because
they have some mutual connections. Reliance is placed, in support of this contention, on the ruling
given by this Authority in A.A.R. 207 of 1994. In that case, a non-resident applicant sought a ruling
on whether, in the assessment of its wholly-owned resident subsidiary running slot machines in
India, cash disbursements to the winners in excess of Rs. 10,000 could be disallowed under Section
40A(3) of the Act. The Authority rejected the application "for the simple reason that the question
sought to be raised relates not to the applicant but to a resident Indian subsidiary". This objection is
not maintainable here in the view of the Authority. The IC, as a non-resident, is entitled to file an
application under Chapter XIX-B and, though the definition of "advance ruling" in Section 245N(a)
places no specific restrictions regarding the nature of the questions to be asked, the Authority is of
opinion that the question raised should be one which directly involves or affects the income-tax
liability of the non-resident. That requirement is fulfilled in the present case. In the case cited, the
question pertained to the assessment of an Indian company. The applicant, a totally different entity,
was affected only in a remote and indirect manner in that any disallowances of expenses in the
hands of the subsidiary might result in larger profit distributions to it. But here the applicant
company and the CT are connected as beneficiary and trustee and the provisions of Chapter XV

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containing sections 161, 164 and 166 really incorporate a method of assessing the beneficiary
through the trustee. In other words, they are conferred a common identity for the purposes of the
Act. Any assessment on the trustee is only in a representative character and will directly and vitally
affect the beneficiary. Further, if the CT is assessed to income-tax at the maximum marginal rate
under Section 164, there will be no assessment at all on the IC. Moreover, not only will the income of
the trust distributable to the beneficiaries, including the IC, be correspondingly reduced but if the
income-tax is, for some reason, not paid by, or recoverable from, the trust, the Department can take
recourse against the beneficiaries (including the IC) in respect of the higher tax charged on the
trustee from the distributions received by them. On the other hand, if the assessment is made on the
trust under Section 161, the tax leviable in respect of the IC's share thereof will be a much smaller
amount. Thus, the investor company is directly and immediately affected by the nature and mode of
assessment of the trust. The right of the applicant, therefore, to seek a ruling on the questions raised
cannot be denied. The ruling in A.A.R. 207 of 1994 will not be applicable on the facts and
circumstances of the present case.

38. It is argued for the Department that a ruling given by the Authority on its application can bind
only the IC and the Department in relation to the IC and that the trustee or the Department, in
relation to an assessment on the trustee, will not be bound. They will be at liberty to proceed
independently and take, if so advised, a different stand. It is, therefore, suggested that any ruling by
the Authority in the matter would be infructuous or ineffective. It can be by-passed by the trust or
the Department whichever was aggrieved by it. Such a ruling, it is said, should be avoided. This
contention is also without force. If the view of the Authority on this application and the view of the
officer assessing the trust coincide--and it may be reasonably presumed, that though the ruling of
the authority in the present application may not be binding as a precedent, the concerned
authorities would defer to the view taken by the Authority on a pure question of law--there will be
no difficulty. If, on the other hand, the Authority should hold that Section 164 is applicable and the
officer assessing the trust should hold--though it is perhaps unlikely--that Section 161 would apply,
neither the CT nor the IC would have any grievance. On the other hand, if the Authority should hold
Section 161 to be applicable and the officer assessing the trust should take a contrary view and the IC
should be affected, it will have to raise a contest but, whether this is done in another application
under Section 245Q, or raised before the authorities in some other proceedings, the ruling of the
Authority will have to be given effect to. However, what steps should be taken in the matter in that
eventuality, is a matter for the IC to decide at the appropriate time, and, if the IC is prepared to "risk
a ruling" even now, it is not for the Authority to say "nay" to it. It is difficult to see how any ruling
given by the Authority could be infructuous. The objection is overruled.

39. The second objection raised to the maintainability of the application is on the basis of Clause (c)
of the proviso to Section 245R(2). It is pointed out that the scheme for making investments in India
in infrastructural and other core sectors has been initiated by the American company and the Indian
financial service company. The American company could have, therefore, directly contributed to the
CT and secured other investors also to participate directly. But, since the interest and dividend
income realised, in that event, from India by the American company would not be entitled, under
the DTAA between India and USA, to any tax concession, this arrangement has been devised to
secure the concessional tax advantages that are available under the DTAA between India and

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Mauritius by putting up, as a front, a Mauritian subsidiary (the IC) for making the investment. It is
contended that the transaction in question is thus a transaction by the American company designed,
prima facie, for the avoidance of Indian income-tax and that the application should be dismissed on
this ground. Strong reliance is placed, in support of this argument, on the ruling given by this
Authority in another case.

40. In reply to this objection, learned counsel for the applicants contended that there was no
substance in this contention and that the location of the IC and the IM in Mauritius was decided
upon after taking into account several circumstances. This is not the first experiment of the kind
made by the American company and reference has been made to the constitution of other
companies by it earlier to focus on infrastructure and infrastructure-related investments in China
and Asia. This trust has been patterned on like basis. The present set-up is not confined to India in
that, though investments are proposed to be made in India, at some stage a co-investment by both
tranches is envisaged and contributions may be invited eventually from international investors
belonging to several countries. A central location for the foreign tranche was, therefore, desirable.
The shareholders of the IC are three subsidiaries of the American company located in Bermuda,
Hongkong and the U. S. and Mauritius was considered centrally located for all of them. Hence, the
IC was located at the same place. An additional reason for this, it was said, was that, due to foreign
exchange restrictions in India, it will be difficult to secure direct contributions to the CT from a large
number of companies and the IC was, therefore, chosen as a single channel of such foreign
investment in India to the CT. This difficulty has been explained, as follows, in a note filed by the
applicant :

" India does not as yet welcome foreign investment in the financial services sector. If the
management company were to be set up in India, the foreign investors would need the approval of
the Foreign Investment Promotion Board (FIPB). As per the internal guidelines of Ministry of
Finance, in case the foreign management company wishes to hold a controlling interest, in the
Indian asset management company, it is required to invest a higher amount of capital, e.g., for a 51
per cent.--75 per cent. stake, such companies are generally required to invest US $ 5 million whereas
for holding more than 75 per cent. stake, they may be required to invest up to US $ 50 million,
although the management company as such, does not require much capital. In one of the cases, we
have received a letter from Ministry of Finance stating that the application has been rejected on the
ground that the applicant does not satisfy the capitalisation norms for non-banking finance
companies (attachment).

Generally, FIPB takes approximately 90 days to approve a proposal. In the case of offshore funds,
many a time, core investors insist to hold a stake in the management company. It would be a very
cumbersome process for making application and obtaining FIPB approval separately for each
investor who may be investing at different points in time.

In view of the high capitalisation requirement and hardship involved, it is much convenient for the
management company also to be located in the same jurisdiction where the fund is situated, i.e.,
Mauritius."

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41. It was found convenient for this purpose also to locate the IC in Mauritius. The IM was located at
Mauritius as it functions as the manager of both the trusts. Mauritius was chosen for locating many
of these companies because it has emerged recently as a low cost off-shore financial centre and is
preferred by off-shore investors in view of its well-developed low cost financial services sector. It
was explained :

" Since investors come from a wide range of countries, it is absolutely essential to domicile the fund
in a tax neutral jurisdiction. Also, costs for legal, accounting and other professional services are
comparatively lower there. "

42. The applicant's counsel also furnished comparative figures of the financial cost incurred in
operating from various centres, as follows :

Country Cost in INR United States of America (USA) 8,840,000

17,680,000 United Kingdom (UK) 1,558,170 Hong Kong 1,768,000

2,121,600 Guernsey 537,300

805,950 Mauritius 702,200

1,060,800

43. Counsel has pointed out that it was not essential to the scheme of the American company to
incorporate the IC at Mauritius to gain a tax advantage. The scheme of the American company could
have operated in an equally effective manner by investing funds of the off-shore tranche in the CT
and secured the same advantages that are now sought. But due to the difficulty pointed out and with
a view to keep the contributions of the American company to the CT distinct from its contributions
to the off-shore tranche it became necessary to establish the IC and, for the locational advantages
already referred to, it was got incorporated at Mauritius. The IC was set up only to demonstrate a
commitment of the American company group to contribute to it and give other Indian investors a
feeling of confidence inspired by the commitment of a member of the American company family to
involve itself therein. It is also pointed out that there is no reason to doubt the bona fides of the
American company's desire to help development of infrastructural sector in India with international
help. It should not be overlooked that several benefits flow to India and the Indian financial service
company from the arrangements made under this dispensation.

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44. The Authority has carefully considered these contentions. The setting up of a large number of
subsidiaries of the American company group with their headquarters at Mauritius no doubt
generates a first impression that there may be some deeper purpose underlying such creations. In
the first place, the share capital of the IC is a nominal amount. Mention has earlier been made that
the IC has been incorporated with a share capital of only $4. This might seem to indicate that the
company was a mere front, an insignificant entity incapable of substantial investment handling.
Such an inference, however, would not be correct, for it is seen that the company advanced a loan of
more than 1 million US dollars to a Canadian group through shareholders' capital contributions.
Much importance need not, therefore, be attached to this circumstance. Secondly, one would
certainly be too naive if one were to believe that self interest and tax considerations did not enter the
picture. No doubt the American company and several subsidiaries thereof hope to make substantial
profits. No doubt also, tax considerations did enter largely into their calculations. It indeed finds
place in the private placement memorandum. At page 40, reference is made to the advantages of the
DTAA :

" Limited life company interests = Indian tax considerations :

In order to benefit from favourable treatment under the India-Mauritius Double Taxation Treaty
(the 'treaty'), the company will file with the investee companies in which it owns stock, a no
objection certificate from the Indian Tax Department granting benefits under the treaty for the
company. Thereafter, dividends received from any Indian company in which the company owns
stock will be subject to a withholding tax of (i) 5 per cent. for companies in which the company has a
percentage ownership of 10 per cent or more and (ii) 15 per cent. for companies in which the
company's percentage ownership is less than 10 per cent. Interest income generated from or
received in India will be subject to a withholding tax of 20 per cent. Capital gains of the company
generated from or received in India will be exempt from otherwise applicable Indian withholding
taxes, including all Indian capital gains taxes. Under current law, such tax treatment will be
available so long as the company does not maintain a permanent establishment in India. The
manager intends to operate the fund to ensure to the extent possible that neither the fund nor the
company in Mauritius will be treated as having a permanent establishment in India. However, there
is no guarantee that absence of a permanent establishment will be maintained."

45. It then proceeds to refer to Section 161 of the Income-tax Act and says :

" The Indian trust will be regarded as a transparent entity and the character of income in the hands
of the beneficiaries but each of the beneficiaries will be taxed in respect of their income from the
trust. The Indian revenue authorities may choose to assess the trustee company acting in the
fiduciary capacity on behalf of the beneficiaries as 'representative assessee'. However, in accordance
with the provisions of Section 161 of the Income-tax Act, 1961, even if the trustee company is
assessed to tax in respect of income of the beneficiaries, tax shall be levied upon and recovered from
the trustee company in like manner and to the same extent as it would be leviable upon and
recoverable from the beneficiaries. An advance ruling is being sought from the Indian revenue
authorities on this matter. In view of the particularized nature of tax consequences, each investor is
advised to consult its own tax adviser with respect to the specific tax consequences of being an

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investor of the fund."

46. Mauritius tax considerations :

" The company in Mauritius has been established as an 'offshore company' for the purpose of the
Mauritian Offshore Business Activities Act, 1992, with the result that its income will not be subject
to income-tax in Mauritius unless it elects to pay tax at specified rates not exceeding 35 per cent. It
is the intention of the company in Mauritius that it may elect to pay tax on income distributions
received from its investments in India at a rate, which, when offset by the credits available in respect
of tax withheld in India on payments of income to the company in Mauritius, will result in a net
payment in Mauritius in respect of such distributions at a maximum rate of one per cent.

No tax on capital gains will be payable in Mauritius on disposals by the company of its investments
in India."

and U.S. tax considerations are then dealt with. But it cannot be said that the disabling requirement
of Section 245R(2) is attracted here. On behalf of the applicant several circumstances have been
indicated which induced the setting up of the IC and the IM in Mauritius and these are certainly
relevant considerations. When there are several relevant considerations which have weighed with
the parties to evolve a particular arrangement, it cannot be described as one "designed, prima facie",
for the avoidance of Indian Income-tax. The existence of tax concessions under the DTAA was one of
the factors taken into account but was not the only, or dominant, object of the transaction. There is,
in particular, one important circumstance to show that the transaction was not designed for the
avoidance of Indian income-tax. The applicants have pointed out that, on account of restrictions
under Indian law, it was found more expedient to channelise all foreign investments into India
through one entity rather than to attempt persuading such investors to come to India individually.
That being so, the applicant, it may be said, could have channelised its funds through the offshore
trust company instead of setting up the IC. It has been explained that the setting up of the IC was
intended as an indication of the bona fides of the IC which would encourage other entrants. If the
offshore tranche alone had been launched and it had made direct contributions to the CT it would
have been beyond the pale of criticism and been welcome in India. Unlike the other ruling of the
Authority to which reference has been made, the foreign tranche could not be treated as just a
benami or dummy for the American company for the funds invested through it will be flowing from
several international sources. The tax advantages suggested now could have been obtained then
also. It is, therefore, difficult to characterise the setting up of the IC and the provision of a
contribution by it as designed for the avoidance of income-tax. In the light of these considerations,
the Authority has come to the conclusion that, certain suspicious features notwithstanding, a ruling
cannot be declined on the ground that the transaction was designed for the avoidance of Indian
income-tax.

47. With the preliminary objections disposed of, one may turn now to the basic issue raised in one of
the applications, viz., whether the CT is assessable to tax under Section 161 or Section 164 of the Act.
That the trustee is a representative assessee within the meaning of Section 160(1)(iv) of the Act and
that it can be assessed in its name in a representative capacity on the income that it receives or is

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entitled to receive on behalf of the beneficiaries is beyond doubt. Section 161(1), however, declares
that such assessment shall be made and the tax thereon shall be levied upon and be recovered from
it "in like manner and to the same extent as it would be leviable upon and recoverable from the
person represented by him". In other words, in a case to which Section 161(1) applies, the trustee
cannot be assessed on the aggregate income received by it. The assessment in the name of the
trustee in terms of the sub-section can be made in two ways. The Assessing Officer may make as
many assessments, in the name of the trustee, as there are beneficiaries and levy the tax appropriate
to such income at the rate of tax applicable to the total income of each beneficiary. Or, he may make
a single assessment on the trustee but indicate therein the share income of each beneficiary and the
tax attributable to it. In other words, in the present case, if Section 161 were to apply, the CT cannot
be assessed on the total income derived by it from its investments and the assessment qua the IC,
should indicate, inter alia, the income distribution made to it and levy the tax appropriate thereto
after taking into account such reliefs and concessions as may be available to it. To the above rule,
however, three exceptions have been incorporated in the Act :

(a) Under Section 161(1A), this rule of apportionment and determination of proportionate tax
attributable to the beneficiary will not apply to any income earned by the trustee as profits and gains
of a business. The whole of such income shall be taxed at the "maximum marginal rate". A similar
proviso occurs also in Section 164(1) restricting benefits where business income is involved.

(b) Under Section 164(1), if the individual shares of the persons on whose behalf and for whose
benefit the income is receivable are indeterminate or unknown, such income, again, will be taxed at
the "maximum marginal rate".

(c) In certain other circumstances, set out in the proviso to Section 164(1), the relevant income will
be assessable not at the maximum rate but at the rate applicable to it as if it were the total income of
an association of persons.

48. The Department's case is that the circumstances of the present case attract both (a) and (b)
above and this has to be examined.

49. The representative of the Income-tax Department (DR) urged that the income derived by the CT
will be in the nature of "profits and gains of a business". He points out that the CT does not just
invest in portfolio investments and equity shares of companies (including listed companies). Its
activities are much wider and far-reaching. He draws attention to paragraph 5.01 of the C.A., the
relevant part of which may be extracted here :

"5.01.--The trust fund's investment objective will be to seek to achieve long-term capital
appreciation by primarily making direct investments in a portfolio of Indian companies and
infrastructure projects in India. The trust fund's direct investment participations will generally take
the form of equity, quasi-equity, equity-related, preferred stock and convertible debt instruments.
The trust fund will focus on opportunities that will seek to take advantage of India's expanding
infrastructure requirements, increasingly active consumer product appetites and growing new
technology base as well as opportunities arising from restructuring and reorganisation strategies,

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among other areas. Investment may be spread across the focus sectors in new projects, expansions
and diversifications, opportunities arising from restructuring and reorganisation, product
development efforts, privatisations and the like.

The trust fund will only invest in projects that at the time of investment comply with all relevant
Indian State and Central Government legislation regarding environmental protection and such
guidelines on environmental protection and social and rehabilitation issues which may be adopted
by the Asian Development Bank, a core investor.

In addition, trust fund investments may include holdings of listed companies that could be of
particular benefit to the fund."

50. Under this paragraph, the IC can also invest directly in projects in the infrastructure sectors and
this can be on terms and conditions which may amount to the carrying on of a business. Under
paragraph 6.05 of the I.M.A., it can, though temporarily, invest in "high quality short term debt
instruments in accordance with the quality guidelines set forth in the private placement
memorandum", a relevant extract from which has been set out earlier. The DR would describe, at
least a part of the income of the CT, as profits and gains from a business of "providing financial
assistance and money market operations". He says that its activities are analogous to those of
organisations like the Industrial Credit and Investment Corporation of India (ICICI) or the
Industrial Development Bank of India (IDBI) which return, and are assessed on, income from
business and of the Unit Trust of India (UTI) which is deemed to be a company and whose income
would be assessable as business income but for the exemption it enjoys under Section 52 of the UTI
Act, 1963. He also points out that organisations which are entirely engaged in investment can seek
approval and claim exemption under Section 10(25F) of the Act. The CT has not chosen to do so, he
says, as its income is not restricted to long-term capital gains as envisaged in that clause.

51. On the other hand, the AR draws attention to paragraph 8 of the Regulations contained in the
First Schedule to the trust deed barring the trustees from carrying on business. Both paragraphs
5.01 and 6.02 of the I.M.A. outline the trust's objective to seek to achieve long-term capital
appreciation. He draws attention to paragraphs 18 and 19 of a letter to the Indian Foreign
Investment Promotion Board pointing out how the objectives of the CT could be achieved only by
investing in unlisted securities and the clarification given in a subsequent letter of February 23,
1996, that the fund would not invest in any listed security in the primary or secondary market. By
their letter dated June 27, 1996, counsel for the applicant have informed the Authority that the last
sub-paragraph of paragraph 5.01 of the draft I.M.A. (italicised in the extract in paragraph 34 above)
have been deleted. Paragraph 8 of the Regulation only provides for temporary investment in other
debt instruments and not to make quick profits. He says that Section 10(23F) does not include the
infrastructure sector and that is why the investor company could not seek for any approval
thereunder.

52. The Authority is of opinion that this is not a question on which a ruling can be given at this stage.
It does appear that the Regulations contemplate only investments and not business operations. But
the sense in which this expression is used by parties will not be conclusive. Whether the activities

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that may be carried on by the CT will only be in the nature of investment or whether the income
resulting from any activities embarked upon by it could or would amount to profits and gains of a
business will depend on the facts and circumstances of the activities actually put through. It may be
that the primary objective of the CT is only to invest capital and derive income therefrom but it has a
very wide range of operations. Even temporary investments in debt instruments, if indulged in
frequently, might give rise to business profits. Even changes in shares and investments carried out
systematically at periodic intervals could amount to a business. It cannot be postulated in the
abstract that none of the surpluses of the activities carried on by the CT could amount to profits and
gains of business at all. All that the Authority can say now is that if any income of the CT is found to
be assessable as profits and gains of business, the Assessing Officer will be entitled to assess such
income under the provisions of Section 161(1A) or the proviso to Section 164(1), as the case may be,
at the maximum marginal rate.

53. Turning then to objection (b) referred to in paragraph 33 (at page 503) above, is the income of
the CT liable to assessment under Section 161(1) or are the provisions of Section 164(i) attracted ?
Section 164(1) will not be attracted unless it can be postulated that the shares of the beneficiaries of
the income are indeterminate or unknown, having regard to the terms of the Explanation. For this
purpose, one has to examine the provisions of the T.D. Paragraph 5 says that the income accruing
under the trust shall be distributed among the beneficiaries in equal proportions so far as the initial
settlement to be returned on the termination of the trust is concerned and, as regards other
distributions, in proportion to their respective contributions and in accordance with the CA.
Paragraph 7(c) of the TD is also to like effect. One has, therefore, to turn to the CA. The principal
clause in the CA that deals with this topic is paragraph 6.01 which has already been set out. The
representative of the Income-tax Department (DR) says that this paragraph is defective in two
respects rendering the shares of the contributors vague and indeterminate :

(a) It does not set out in definite terms that the allocation of income among the contributors will be
in the respective proportions of their contributions to the trust. On the contrary, paragraph 6.04,
which says so, concerns income other than that earned on portfolio investments.

(b) It says that the trustees will be at liberty to make special distributions and there is nothing to
limit the manner or extent of such distributions.

(c) The words "income ... will be distributed annually or at such direct intervals as the trustees may
in their absolute discretion think fit" confer an absolute power on them to distribute dividends in
their absolute discretion.

54. The result, the DR says, is that the distributions can be made by the trustees in their absolute
discretion. In other words, it is a purely discretionary trust under which the trustees have complete
liberty to distribute any part of the income to any beneficiary at any time at their absolute discretion.

55. The AR replied to this saying that these criticisms are not justified as clauses 5 and 7 of the TD
are clear on this and the provisions of paragraph 6.01 have to be read along with those of the TD
which place the matter beyond all doubt. The Authority is of opinion that the provisions of the TD in

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

this behalf are clear but the provisions of the CA are ambiguous. Paragraph 6.01 no doubt states that
the distribution will be made as set out in the succeeding paragraphs but paragraph 6.04, which
talks of proportionate distribution, only refers to income other than portfolio investments. Also,
special distributions are not even made subject to paragraphs 6.02 to 6.07. But the second criticism
of the DR does not appear to be correct : the discretion vested in the trustees pertains to the
periodicity of the distributions rather than their mode of distribution. When all this was brought to
the notice of counsel for the applicant, he agreed that the parties would be willing to recast the
wording of paragraph 6.01 placing this beyond all doubt. The proposed modification was as follows :

" 6.01. Distributions.--Income received by the trust in respect of the contribution fund will be a
charge on the income of the contribution fund, and will be distributed annually or at such direct
intervals as the trustees may in their absolute discretion think fit, in proportion to the contributions
made by the contributors. The contribution fund may also declare special distributions. The method
by which the distribution will be made and the allocation of income between the contributor and the
investment manager are as set out in sections 6.02 to 6.07 and will depend upon the source of the
income."

56. However, this alternation also did not answer the second criticism of the DR and the AR agreed
that this will also be set right by inserting, after the words "special distributions" in the proposed
paragraph, the words "Such special distributions shall also be made to the contributors in
proportion to the respective contributions made by them". This has been reiterated by counsel in a
letter dated June 27, 1996, addressed to the Authority but the revised paragraph has been couched
in the following words :

" 6.01. Distributions.--Income received by the trust in respect of the contribution fund will be a
charge on the income of the contribution fund, and will be distributed annually or at such direct
(sic) intervals as the trustees in their absolute discretion think fit. The contribution fund may also
declare special distributions. Both the distributions shall be in proportion to contributions made by
the contributors. The method by which the distribution will be made and the allocation of income
between the contributor and the investment manager are as set out in sections 6.02 to 6.07 and will
depend on the source of the income."

57. These modifications, it is clear, overcome the objections based on the CA and establish beyond
doubt that the distribution of income will be proportionate to the contributions.

58. The DR next objected that the determination of the shares of the contributors becomes
indeterminate because the trustees have been empowered to add further contributors (clause 7 of
TD) and because of the formula set out in paragraph 6.02 of the contribution agreement. The first of
these causes no difficulty as, after the modification of clause 7 made at the hearing and agreed to by
counsel (see paragraph 8 (at page 487) above), the trustees can admit as
contributors-cum-beneficiaries only institutional investors who agree to sign an agreement on the
lines of the CA. Paragraphs 2.02 and 2.03 of the first CA also permit such a course. In other words,
after the modification, the trustees will have no discretion to admit any person as a beneficiary ; the
beneficiaries to the trust at any point of time will be an ascertainable and definite body, defined in

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the TD to be those institutions who have committed themselves to defined contributions and
executed the initial CA or entered into a CA on same lines with the trust and the IM later. The
Authority would also like to point out that, question No. 3, in the revised list of questions (see
paragraph 24 (at page 498) above), indicated that the parties may be willing to delete altogether the
trustees' power of addition under Clause 7 of the TD. To do so would alter the scope of the CT and
restrict it to the parties to the TD. If, however, the parties are willing for this and modify the T.D.
accordingly, the beneficiaries will only be those stated in the TD and their shares will be
proportionate to their contribution and the DR's objection would no more be valid.

59. The second objection based on paragraph 6.02 is this. Paragraph 6.02 provides that the
distributable income will be determined after adding back the "fees and share of profit to the
investment manager" which the DR says, is absurd as it will not be possible to distribute the income
without making payment of the fee and share of profit to the IM, He also submitted that the
provision in this paragraph enabling the trustees to deduct, in computing the net profits, "capital
expenditures as the investment manager shall reasonably determine" also renders the share income
indeterminate. The AR contended that this clause does not place any obstacle in the way of
determination of the share income of the contributors but would only involve the use of a simple
algebraic formula for making the computation. He, however, agreed that, with a view to avoiding
any unnecessary controversy in the matter, the parties are willing to delete the words "including
distribution of fees and share of profit to the investment manager" occurring in this clause. He
contended that the second criticism of this paragraph by the DR is unwarranted as the discretion to
the trustees in this regard also may affect the distributable income but not its mode of distribution.

60. The Authority is of the view, as mentioned earlier, that this modification removes the first
ambiguity pointed out by the DR. It also agrees with the AR that the second criticism is unjustified.
It is for the trust deed (and the CA is part of it) to decide how distributable income should be
determined for distribution among the beneficiaries and also indicate, if it results in the retention of
any part of the income in the hands of trustees, in what way the trustees should hold such
undistributed part of the income remaining in their hands. Under the present clause, the capital
expenditure referred to goes out of the coffers of the trust and does not remain in the trustees' hands
for distribution at all. The direction of the trustees that such expenses should be met out of the
income of the trust to the extent the trustees consider necessary is one they are empowered to make
under Clause 14 of the trust deed. It may result in the diminution of the distributable income
available to the beneficiaries but does not render the shares of the beneficiaries in any way uncertain
or unknown.

61. The DR also next raised three points based on paragraph 6.04 which provides for an allocation
among the investors of all income, loss or expenses attributable to a particular portfolio investment
in proportion to their capital contribution. His first point was that a similar rule has not been
explicitly stated in paragraph 6.02. This contention has been dealt with earlier and it has been
pointed out that the trust deed and paragraph 6.01 (as agreed to be modified) make it clear that even
income from portfolio investments is distributable only in proportion to the contributions made.
There is, in other words, no difference between the mode of allocation of income arising out of
portfolio investments and other investments. His second objection was that it would be difficult for

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the CT to apportion the income earned from portfolio investment and others, to attribute the
income earned to a particular contribution or to allocate expenses as between income arising out of
portfolio investment and others. It is no doubt true that these are difficult exercises to carry through
but they have to be done in any business and usually achieved by applying a rule of three. Moreover,
these factors may have some impact on the determination or computation of the distributable
income but have no impact on the identity of the beneficiaries or in the share of income that is to be
distributed to them. His third point was that while under paragraph 2.06, a defaulting contributor
will not be entitled to any distribution after the date of his default, this clause provides for a
distribution even to such contributors. This, he says, will disturb the inter se proportion vis-a-vis
contributions that is sought to be maintained otherwise. The AR stated that as a point of possible
conflict has been raised, the parties are prepared to amend paragraph 6.04 to read thus :

" 6.04. Income and expenses from other sources.--Subject to paragraph 2.06(3), all distributions of
income, gain, loss or expenses not directly attributable to a particular portfolio investment (e.g.,
interest on temporary investments and the contribution fund's share of any advisory fees net of
general operating expenses) shall be distributed to the contributor in proportion to their capital
contributions."

62. There is a slight mistake here as the reference in this amendment should really be to both
paragraphs 2.06(d) and (e) and the opening words of the revised paragraph 6.04 should read
Subject to paragraph 2.06". paragraph 6.04 is, therefore, read with the correction. In fact, by their
letter dated April 27, 1996, the applicant's counsel have modified the CA by substituting the words;
"Subject to paragraph 2" in the opening words of paragraph 6.04. It is clear that, with this
amendment, the DR's objection is overcome.

63. The DR also drew attention to Clause 17(d)(i) of the trust deed and submitted that the shares of
the beneficiaries in the net profits would become indeterminate if such portion of it, as the trustees
may determine, could be applied "otherwise than by way of distribution to the beneficiaries". The
answer to this criticism is also the same as discussed above. Any amount applied by the trustees for
other purposes would just cease to be part of the distributable income like the capital expenses on
repairs and would affect the quantum of income available for distribution but not the mode of its
distribution. It will also be seen that Clause 17(d) is not a clause conferring any special power on the
trustees in this behalf : it only provides that the decision regarding such application, even if arrived
at in conformity with the other provisions of the trust deed, shall not be effective unless voted for by
a majority of the directors of the trustee company present and voting at a meeting. However, counsel
by their letter dated June 27, 1996, have intimated that they have since amended the draft deed by
substituting the following Sub-clause (d) in place of the earlier one :

" 17. (d) The trustee shall only delegate its powers by a majority vote of its directors voting at a
meeting of the board of directors of the trustee."

64. This amendment deletes the clause objected to by the DR and nothing more needs to be said
about it.

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65. An important point made by the DR, however, deserves serious notice. He said that a good deal
of uncertainty is cast regarding the shares of the members by the provisions in the trust deed
(Clause 7) authorising the addition of further contributors to the trust at different points of time (in
addition to the initial contributors who are parties to the trust deed and whose names find a place in
the Third Schedule to it and the provision enabling contributions to be called up from time to time
(paragraph 2.04 of the CA) as well as by the provision in the CA regarding the rights of members
who default in payment of the contributions demanded from them in compliance with their
commitment (paragraph 2.06). This objection calls for detailed consideration.

66. The scheme under which the income distributions are to take place under the TD is somewhat
complicated but the basic principle is quite clear. The fund is initially set up with minimum
commitment of Rs. 750 million as on the date of the trust deed but the IM can stage closings for
subsequent commitments up to a period of 12 months thereafter (paragraphs 2.04 and 4.04 of CA).
Naturally later commitments will be received only after the date of the trust deed. The trust deed
will contain only the names of those who have agreed to contribute up to the date of the TD,
However, on the terms of the trust deed, income distributions will have to be made to the persons
who have agreed to contribute to the trust much later. But this creates no difficulty as the
contributors are known, A difficulty may arise here since a contributor will not be called upon to pay
up the entire amount of his commitment at one time. It is left to the IM to call for such amounts
from the contributors as may be necessary to meet the amounts needed for the investments
necessary at any particular point of time. There could be difficulty if different contributors are asked
to contribute different amounts but this is obviated by making clear that the contributions called up
from the contributors cannot be haphazard but should be in proportion to the amount of
commitment undertaken by him so that the inter se proportions are maintained. Two further
difficulties that can arise would be by reason of the facts ; (a) that the contributors come in at
different points of time, and (b) that some of the contributors may default in the payments they are
called upon to make. These situations are covered by paragraphs 2.01 and 2.06 of the CA. These
clauses have been set out earlier and need not be discussed in detail except to say that these
difficulties are overcome by procedures respectively calling for interest and the writing down of their
capital contributions. In essence, the distribution rule is that distribution should be in the
proportion of the capital contributions of the respective members. We may add that, in view of the
criticism made by the DR on these aspects, we called upon learned counsel for the applicant to
explain by means of clear illustrations how the income distributions will take place in cases where
default occurs. In compliance with the instructions of the Authority, the applicant has filed detailed
workings of the mode of distribution in such cases. It is not necessary to go into these meticulously ;
it is sufficient just to say that, complicated as the scheme is, it is not possible to say that the share
income of the beneficiaries cannot be determined or known from the TD.

67. The next argument of the DR is that Section 164 will be applicable unless the individual shares of
the persons who are the beneficiaries are determinate and known and that these two expressions
have to be understood in the light of the Explanation. It can hardly be said that the shares of the
beneficiaries here are expressly stated in the trust deed or are ascer-tainable as such on the date of
the TD. He points out that the Explanation lays down two conditions and that they should be both
fulfilled.

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

68. The construction of the section and its Explanation is indeed a matter of some difficulty. It may
appear also that there is a slight redundancy in the language of the Explanation which, having
required that the shares should be expressly stated in the TD, proceeds to say that they should also
be ascertainable from it. It may, therefore, be useful to study the history of this provision and
examine the object of the introduction of the Explanation. Section 164(1) was in the Act when it was
enacted in 1961 but its wording underwent a change, introducing a concept of taxation at marginal
rate in 1970 by the Finance Act of 1970 with effect from 1st April, 1971. The object and scope of this
amendment were elaborated in a circular of the Central Board of Direct Taxes (CBDT) (Circular No.
45 dated 2nd September, 1970 (see [1971] 79 ITR (St.) 33)) as under (at page 46) :

" Private discretionary trusts.--Under the provisions of Section 164 of the Income-tax Act before the
amendment made by the Finance Act, 1970, income of a trust in which the shares of the
beneficiaries are indeterminate or unknown, is chargeable to tax as a single unit treating it as the
total income of an association of persons. This provision affords scope for reduction of tax liability
by transferring property to trustees and vesting discretion in them to accumulate the income or
apply it for the benefit of any one or more of the beneficiaries, at their choice. By creating a
multiplicity of such trusts, each one of which derives a comparatively low income, the incidence of
tax on the income from property transferred to the several trusts is maintained at a low level. In
such arrangements, it is often found that one or more of the beneficiaries of the trust are persons
having high personal incomes, but no part of the trust income being specifically allocable to such
beneficiaries under the terms of the trust, such income cannot be subjected to tax at the high
personal rate which would have been applicable if their shares had been determinate.

In order to put an effective curb on the proliferation of such trusts, and to reduce the scope for tax
avoidance through such means, the Finance Act, 1970, has replaced Section 164 of the Income-tax
Act by a new section. Under Section 164 as so replaced, a 'representative assessee', who receives
income for the benefit of more than one person whose shares in such income are indeterminate or
unknown, will be chargeable to income-tax on such income at the flat rate of 65 per cent. or the rate
which would be applicable if such income were the total income of an association of persons,
whichever course would be more beneficial to the Revenue."

69. When the Explanation was added in 1980, the Central Board of Revenue issued the following
circular (see [1980] 123 ITR (St.) 159) :

" 49. (iv) Under the existing provisions, the flat rate of 65 per cent. is not applicable where the
beneficiaries and their shares are known in the previous year, although such beneficiaries or their
shares have not been specified in the relevant instrument of trust, order of the court or wakf deed.
This provision has been misused in some cases by giving discretion to the trustees to decide the
allocation of the income every year and in other ways. In such a situation, the trustees and
beneficiaries are able to manipulate the arrangements in such a manner that a discretionary trust is
converted into a specific trust whenever it suits them tax-wise. In order to prevent such
manipulation, it is proposed to provide that unless the beneficiaries and their shares are expressly
stated in the order of the court or the instrument of trust or wakf deed, as the case may be, and are
ascertainable as such on the date of such order, instrument or deed, the trust will be regarded as a

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discretionary trust and assessed accordingly."

70. From these extracts it would seem that the object of the amendments to the provision was only
that the distribution of the income should not be entirely at the discretion of the trustees and that
the trust deed should regulate the shares.

71. The DR contends that the beneficiaries under the TD here are neither known nor are their shares
determinable as on the date of the trust deed. The AR, on the other hand, contends that the section
does not require the names of the beneficiaries or the extent of their shares to be mentioned in the
TD. It is sufficient if it provides a formula for their ascertainment. To construe the section as
requiring more would defeat the object of the provision and render it impracticable and unworkable.
Such an interpretation, he urges, should be avoided. In support of this contention, he relied on
certain decisions of the Supreme Court. Interpreting the scope of Section 2(15) of the Act, the
Supreme Court in CIT (Addl.) v. Surat Art Silk Cloth Manufacturers Association [1980] 121 ITR 1,
observed that "if the language of a statutory provision is ambiguous and capable of two
constructions, that construction must be adopted which will give meaning and effect to the other
provisions of the enactment rather than that which will give none". This principle has been further
extended in later cases. In K.P. Varghese v. ITO [1981] 131 ITR 597 (SC), the court was concerned
with the interpretation of Section 52(2) of the Income-tax Act, 1961. This sub-section provided that
where the consideration for a transfer of property stated in the instrument of transfer falls short of
its market value by more than a particular percentage, the property should be deemed to have been
transferred at the market value (and not the stated consideration) and the capital gains computed
accordingly. Literally, this provision would apply even to cases where the transferor received no
more than the actually stated consideration although the market value was higher. But the court
construed the provision in a restricted manner and held that it could be invoked only in cases where
the consideration has been understated by the assessee ; or, in other words, the full value of the
consideration in respect of the transfer is shown at a lesser figure than that actually received by the
assessee and has no application where the consideration received by the assessee has been correctly
declared or disclosed by him. The court observed (headnote) :

" A statutory provision must be so construed, if possible, that absurdity and mischief may be
avoided. Where the plain literal interpretation of a statutory provision produces a manifestly absurd
and unjust result which could never have been intended by the Legislature, the court may modify
the language used by the Legislature or even do some violence to it, so as to achieve the obvious
intention of the Legislature and produce a rational construction."

72. In CIT v. Gotla [1985] 156 ITR 323, the Supreme Court was concerned with the question whether
the assessee was entitled to set off the losses incurred by him in his individual business in earlier
years and carried forward by him against the share income of his wife and minor children in a firm
of which he was not a partner but which was included in his total income for the year under
consideration by applying the provisions of Section 16(3) of the Indian Income-tax Act, 1922.
Section 24 of the said Act permitted a set off only against the profits and gains of any business
carried on by the assessee in the subsequent year. The literal meaning of the section was extended
by the court which observed (headnote) :

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" If a strict and literal construction of the statute leads to an absurd result, i.e., a result not intended
to be subserved by the object of the legislation ascertained from the scheme of the legislation, then,
if another construction is possible apart from the strict literal construction, then, that construction
should be preferred to the strict literal construction and, again, where the plain literal interpretation
of a statutory provision produces a manifestly unjust result which could never have been intended
by the Legislature, the court might modify the language used by the Legislature so as to achieve the
intention of the Legislature and produce a rational result."

73. The AR contends that a similar situation prevails here and should be dealt with in like manner.

74. There is force in his contention. The whole object and intent of the section, as amended, is to
prevent the shares of beneficiaries being manipulated at the discretion of the trustees. If it is read as
requiring the specification of the beneficiaries and their shares in the deed itself, it may lead to
absurdities. A trust is very often created to benefit a class of beneficiaries who may exist on the date
of the trust or who may come into being later and the shares of the individual beneficiaries may also
vary depending upon the numerical strength of the class to which they belong or the conditions
attached to the receipt of the benefit. Several instances of trusts, particularly family trusts, can be
thought of in which reversionary interests in favour of the author's descendants are created. They
would all be caught by the mischief of Section 164 if this interpretation were adopted even though
the class of beneficiaries is clearly ascertainable from the deed as also the share which every
beneficiary is entitled to receive. It could hardly have been the intention of the Legislature to bring
the income of such trusts to charge at the maximum marginal rate though it is very clear that the
income of a particular previous year is held by the trustees specifically in defined shares on behalf of
known beneficiaries and they have absolutely no discretion to distribute the income otherwise than
to such persons or in accordance with such shares. As explained by the Supreme Court in the cases
cited, the proper way in which to understand a section is to avoid absurd and inequitable and
unintended results even if it means some strain on the language.

75. In the opinion of the Authority, however, it is not even necessary to invoke these principles of
extended construction in the present case. Literally also, what the section requires is that the shares
of the several beneficiaries should be stated and be ascertainable, not from an extraneous source at a
later point of time but from the trust deed on the date on which it is executed. There is no
redundancy in the language of the Explanation either. If the shares are expressly stated in the deed
they must necessarily be ascertainable from it; what the second phrase means is that they should be
so ascertainable on the date of the trust deed. It should be noticed that the section does not require
that the names of the beneficiaries should be mentioned in the trust deed. Indeed, it would be
impossible to do this where future settlements are involved. It no doubt requires that the individual
shares of the beneficiaries should be expressly stated in the trust deed. But this requirement can also
be said to be satisfied where the proportion of sharing is clearly specified in the instrument although
some computation may be needed to find out the individual shares. For e.g., if a deed were to say
that four beneficiaries should share the income equally or in the ratio of 1 : 2 : 3 : 4, it must be
considered to have expressly stated the individual shares though a process of arithmetical
computation is necessary to arrive at the individual shares. This rule can be said to be satisfied even
in a more complicated example. For instance, if the deed were to say that the settlor's five

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grandchildren will get the income each male adult being entitled to four times the share of a minor
and twice the share of a female included in the class, there is no difficulty in saying even in such a
case that the individual shares are expressly stated in the trust deed. The words "and are
ascertainable at the date of the instrument" will in any event apply in such cases, though they are
actually intended to cover a slightly different type of case where the number of beneficiaries are not
known at the date of the deed but the shares are ascertainable by reference to the specifications and
directions given in the deed itself. Thus, to take the examples given above, a trust deed providing
that the sons of the settlor should receive the income would fulfil the requirements of the
Explanation as, on the date of the deed, it is possible to say who will share the income and in what
proportion although the number of shares may not be known on such date. So also, in the second
example, if the deed were to say that all descendants of the author will get the income in the
proportion 1:2:3:4 calculated as stated earlier, the specification would be sufficient to satisfy the
terms of the Explanation. This would be so even where the ascertainment of the class and the actual
share may depend on certain conditions precedent or subsequent which may or may not be fulfilled
in the previous year the distributable income of which is under consideration at any point of time. It
would be a fair construction of the provision to say that Section 164(4) will not come into operation
if the trust deed sets out expressly the manner in which the beneficiaries are to be ascertained and
also the share to which each of them would be entitled without ambiguity. The persons as well as the
shares must be capable of being definitely pin-pointed and ascertained on the date of the trust deed
itself without leaving these to be decided upon at a future date by a person other than the author
either at his discretion or in a manner not envisaged in the trust deed. In any event, such a practical
interpretation, in the light of the objects of the amendment Acts, would clearly be warranted and
justified by the Supreme Court decisions cited by the AR. The Supreme Court, in CWT v. Trustees of
H. E. H. Nizam's Family (Remainder Wealth) Trust [1977] 108 ITR 555, was concerned with the
interpretation of the words, "when the shares of the persons on whose behalf or whose benefit any
such assets are held are indeterminate or unknown" employed in Section 21(4) of the Wealth-tax
Act, 1957. The court observed (headnote) :

" The question in regard to the applicability of Sub-section (1) or (4) of Section 21 has to be
determined with reference to the relevant valuation date. The Wealth-tax Officer has to determine
who are the beneficiaries in respect of the remainder on the relevant valuation date and whether
their shares are indeterminate or unknown. It is not at all relevant whether the beneficiaries may
change in subsequent years before the date of distribution, depending upon contingencies which
may come to pass in future. So long as it is possible to say on the relevant valuation date that the
beneficiaries are known and their shares are determinate, the possibility that the beneficiaries may
change by reason of subsequent events such as birth or death would not take the case out of the
ambit of Sub-section (1) of Section 21. The position has to be seen on the relevant valuation date as if
the preceding life interest had come to an end on that date and if, on that hypothesis, it is possible to
determine who precisely would be the beneficiaries and on what determinate shares, Sub-section (1)
of Section 21 must apply and it would be a matter of no consequence that the number of
beneficiaries may vary in the future either by reason of some beneficiaries ceasing to exist or some
new beneficiaries coming into being.

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If, on the relevant valuation date, it is not possible to say with certainty and definiteness as to who
would be the beneficiaries and whether their shares would be determinate and specific, if the event
on the happening of which the distribution is to take place occurred on that date, the case will be
governed by Sub-section (4) of Section 21."

76. The Authority is of opinion that the question : "Has the Explanation superseded this
interpretation ?" has to be answered in the affirmative only in respect of cases where the instrument
of trust leaves the determination of the shares of the beneficiaries in a particular previous year
dependent on a person other than the author of the trust or events and conditions not specified in
the instrument of trust. If there be any ambiguity in the matter it should be resolved by resort to the
principles stated by the Supreme Court in the cases referred to earlier.

77. Judged by these considerations, the TD and the CA (which is a part thereof) in the present case
leave no doubt as to who would be the beneficiaries and what their individual shares would be. The
beneficiaries are the persons whose names are set out in the Third Schedule to the trust deed as well
as other persons who are permitted to make, contributions to the trust fund according to the terms
and conditions set out in the CA. The share of the beneficiaries in the distributable fund will inter se
be in the same proportion as the amounts actually contributed by them to the fund as on the date of
the distribution, irrespective of the date on which the contribution was actually made by them.
There is no uncertainty regarding the beneficiaries and there is no uncertainty regarding the share
of income to which he is entitled. The class of persons who become contributories subsequent to the
date of the trust deed are also expressly defined in the instrument and the manner in which the
share of each of them should be ascertained is also mentioned in the instrument. Ultimately despite
the very complicated structure the position is very simple. All persons who contribute to the trust
are entitled to receive the benefits of income distribution. The total distributable income is
distributed among these beneficiaries in proportion to the respective contribution made by each of
them to the fund. There is no discretion left in anybody to manipulate the beneficiaries or their
shares. The Authority is, therefore, of the opinion that the present case does not fall within the vice
of Section 164 and that the provisions of Section 161(1) will be applicable to the income of the trust,
otherwise than from business.

78. The next point for discussion relates to the nature of the income received from the CT by the IC,
in the latter's hands. As will be presently seen, this question assumes great importance in the light of
the provisions contained in the Agreement for Avoidance of Double Taxation between India and
Mauritius (DTAA). The point arises this way. The income earned by the CT from the investments
made in India may be in the nature of dividends, interest, capital gains, and perhaps also, business
income. Will the aliquot part of this income, when distributed to the IC partake of the same
character ? The answer prima facie may appear to be that it cannot. For example, the CT may receive
dividends in respect of the investments made by it in various companies. But so far the IC is
concerned they cannot be dividends since this company has made no investments in shares of
companies but is just receiving a share of the income of the trust in which receipts of various kinds
are mingled. This answer, however, does not take into account the effect of the application of
Section 161. This section treats the trustee as having a representative character. The assessment on
the trustee is to be in like manner and to the same extent as if it were made on the beneficiary

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

himself directly. The practical effect of this provision is to render the assessment of the trustee and
beneficiary identical in every respect. Thus if the trustee receives income by way of dividend or
interest or capital gains it cannot but be treated as dividend, interest or capital gains respectively in
the representative assessment which is to be made on the trustee. Any plausibility of an argument to
the contrary is ruled out by the decisions of the Supreme Court in the cases of CIT v. H. E. H. Mir
Osman Ali Bahadur [1966] 59 ITR 666 (SC) and in CIT v. P. Krishna Warrier's case [1970] 75 ITR
154. In CIT v. H. E. H. Mir Osman Ali Bahadur [1966] 59 ITR 666 (SC),the Nizam had delivered
certain tax-free State securities on trust with directions that the interest income therefrom be paid
to certain beneficiaries, including himself, for life. As such a beneficiary, the Nizam claimed that he
was exempt from tax on the distribution made to him. The Revenue took the view (which the High
Court approved) that (at page 681) :

"... after the execution of the trust deed, the assessee was divested of his ownership of the securities
and the trustees became their owners. On that basis . . . though the income was interest on securities
in the hands of the trustees, it was in the hands of the assessee only the income which he got from
the trustees . . . the character of the income, namely, interest on securities, had changed when it
reached the hands of the assessee."

79. The Supreme Court did not agree. It explained the scope of Section 41 of the Indian Income-tax
Act, 1922 (to which Section 161 of the Act corresponds) thus (at page 682) :

" Under this section the Revenue has the option to levy or collect tax from the trustee or the
beneficiary ; the tax can be levied upon and recoverable from the trustee in the like manner and to
the same amount as it would be leviable upon and recoverable from the person, on whose behalf
such income, profits or gains are receivable. In short, it imposes a vicarious liability on the trustee.
The expression 'all the provisions of this Act shall apply accordingly' indicates that there is no
distinction in the matter of assessability of the income in the hands of a trustee or the beneficiary, as
the case may be. Indeed, Section 41 of the Act comes into play only after the income is computed in
accordance with Chapter III of the Act. In the case of income from securities Section 8 applies and
under the second proviso thereto, the income-tax payable on the interest receivable on any security
of the State Government issued income-tax free shall be payable by the State Government. No tax on
interest on such securities is payable by the assessee. After ascertaining the income and after giving
the exemptions, the income-tax authority has the option to assess the beneficiary directly or, in
respect of the same income, the trustee on behalf of the beneficiary. This construction finds support
in the decision of the Bombay High Court in CIT v. Balwantrai Jethalal Vaidya [1958] 34 ITR 187. If
that be the scope of the assessment under Section 41 of the Act, we find it difficult to appreciate the
contention that the interest on securities in the hands of the trustee becomes an income other than
such interest in the hands of the beneficiary. The interest retains its character whether the
assessment is made on the trustee or the beneficiary. We cannot, therefore, accept the construction
put upon Section 41 of the Act by the High Court. "

80. In P. Krishna Warrier's case [1970] 75 ITR 154 (SC), the assessee had settled his business in
Ayurvedic drugs on trust. He directed the trustees to maintain a school and hospital that had been
set up by him out of 60 per cent. of the income from the business and apply the balance of 40 per

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cent. on two tavazhies. The Income-tax Officer sought to levy a special surcharge on the latter
treating it as "unearned" income under the Finance Act (No. 2) of 1957 and the Finance Acts of 1958
to 1961. "Earned income" was defined in the Finance Acts as meaning, "in the case of income
chargeable under the head 'Profits and gains of business', 'profession or vocation', where the
business, etc., is carried on by the assessee". The Income-tax Officer held that since the business was
carried on by the trustees and not the tavazhies it could not be treated as earned income. By a short
order, the Supreme Court upset that conclusion. It observed (at page 157) :

" Under the will of P. S. Warrier the trustees were directed to carry on the business of 'Arya Vaidya
Shala'. In the income of the business the trustees had no beneficial interest, but it was still income
chargeable under the head 'profits and gains of business, profession or vocation' carried on by the
trustees. Being income chargeable under the head 'Profits and gains of business, profession or
vocation' carried on by the trustees, it was earned income in their hands, and to the earned income
the special surcharge under the Finance Acts of 1957, 1958, 1959, 1960 and 1961 had no application.
The High Court was right in answering the third question referred by the Tribunal in favour of the
trustees."

81. The AR also referred to the decision of the Madras High Court in CIT v. Trustees, T. Stanes and
Co. [1995] 200 ITR 396. In this case the assessees were the trustees of the company's staff pension
fund. Under the terms of a trust, the balance of income remaining after payment of pension to the
four beneficiaries was to be paid to the company. The beneficiaries having died, the entire income
became payable to the company itself. The income of the assessee was from dividends and the
Income-tax Officer was of opinion that since the recipients of the dividends were the trustees (an
association of persons) no relief could be given under Section 80M relating to inter-corporate
dividends. The High Court held, applying the ratio of the Nizam's case that the assessment of the
trustee would have to be made in the same status as the beneficiary, i.e., as a company, and hence
relief under Section 80M would be available. This decision also illustrates the same principle, viz.,
that, in making an assessment on an assessee in respect of a beneficiary, the assessment should be
made as if the income in question had been directly earned by the beneficiary and not the trustee.
The Supreme Court has thus read the effect of Section 41 of the 1922 Act (section 161 here) as
obliterating, except for the facility of making an assessment on it, the personality of the trust and of
assessing the trust (for the beneficiary) as he would have been assessed had he been earning the
income himself directly, instead of through the trust. The argument of learned counsel for the
applicants that the character of the income for purposes of the assessments in so far as they relate to
the investor company cannot be different from its character in the hands of the trust has, therefore,
to be accepted. Dividends, interest and capital gains included in the distributable income would be
dividends, interest and capital gains in the hands of the investor company to an aliquot extent.

82. The consequence of the above conclusion results in benefits to the IC under the DTAA. This
agreement confers certain benefits on a resident in Mauritius within the meaning of the DTAA in
respect of various categories of income earned by him in India. Relevant portions of articles 10, 11,
13 and 22 of the DTAA which deal with the benefits relevant for the purposes of the case need to be
set out (see [1984] 146 ITR (St.) 214, 221) :

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

"Article 10-DIVIDENDS (1) Dividends paid by a company which is a resident of a Contracting State
to a resident of the other Contracting State may be taxed in that other State.

(2) However, such dividends may also be taxed in the Contracting State of which the company
paying the dividends is a resident and according to the laws of that State, but if the recipient is the
beneficial owner of the dividends the tax so charged shall not exceed :

(a) 5 per cent. of the gross amount of the dividends if the beneficial owner is a company which holds
directly at least 10 per cent. of the capital of the company paying the dividends ;

(b) 15 per cent. of the gross amount of the dividends in all other cases.

This paragraph shall not affect the taxation of the company in respect of the profits out of which the
dividends are paid . . .

(4) The term 'dividends' as used in this Article means income from shares or other rights, not being
debt-claims participating in profits, as well as income from other corporate rights which is subjected
to the same taxation treatment as income from shares by the laws of the Contracting State of which
the company making the distribution is a resident . . .

Article 11-INTEREST (1) Interest arising in a Contracting State and paid to a resident of the other
Contracting State may be taxed in that other State.

(2) However, subject to the provisions of paragraphs 3 and 4 of this article, such interest may also be
taxed in the Contracting State in which it arises and according to the laws of that State.

(3) Interest arising in a Contracting State shall be exempt from tax in that State provided it is
derived and beneficially owned by :

(a) the Government or a local authority of the other Contracting State ;

(b) any agency or entity created or organised by the Government of the other Contracting State ; or

(c) any bank carrying on a bona fide banking business which is a resident of the other Contracting
State . . .

(5) The term 'interest' as used in this Article means income from debt-claims of every kind whether
or not secured by mortgage and whether or not carrying a right to participate in the debtor's profits,
and, in particular, income from Government securities and income from bonds or debentures,
including premiums and prizes attaching to such securities, bonds or debentures. Penalty charges
for late payment shall not be regarded as interest for the purpose of this Article ...

Article 13--CAPITAL GAINS (1) Gains from the alienation of immovable property, as defined in
paragraph 2 of Article 6, may be taxed in the Contracting State in which such property is situated.

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(2) Gains from the alienation of movable property forming part of the business property of a
permanent establishment which an enterprise of a Contracting State has in the other Contracting
State or of movable property pertaining to a fixed base available to a resident of a Contracting State
in the other Contracting State for the purpose of performing independent personal services,
including such gains from the alienation of such a permanent establishment (alone or together with
the whole enterprise) or of such a fixed base may be taxed in that other State.

(3) Notwithstanding the provisions of paragraph 2 of this article, gains from the alienation of ships
and aircraft operated in international traffic and movable property pertaining to the operation of
such ships and aircraft, shall be taxable only in the Contracting State in which the place of effective
management of the enterprise is situated.

(4) Gains derived by a resident of a Contracting State from the alienation of any property other than
those mentioned in paragraphs 1, 2 and 3 of this Article shall be taxable only in that State . . .

Article 22--OTHER INCOME (1) Subject to the provisions of paragraph 2 of this article, items of
income of a resident of a Contracting State, wherever arising, which are not expressly dealt with in
the foregoing articles of this Convention, shall be taxable only in that Contracting State.

(2) The provisions of paragraph 1 shall not apply to income, other than income from immovable
property as defined in paragraph 2 of Article 6, if the recipient of such income being a resident of a
Contracting State, carries on business in the other Contracting State through a permanent
establishment situated therein, or performs in that other State independent personal services from a
fixed base situated therein, and the right or property in respect of which the income is paid is
effectively connected with such permanent establishment or fixed base. In such case, the provisions
of Article 7 or Article 14, as the case may be, shall apply."

83. Starting from the position earlier explained that the dividends, interest and capital gains earned
by the CT and distributed to the investor company should be treated as dividend, interest and
capital gains in the hands of the latter as well, the distributed income would be liable to tax in India
at five per cent. or 15 per cent. (in the case of dividend income) and at the normal rates of tax in
India (in the case of interest) and to no tax in the case of capital gains. Learned counsel for the IC
sought to wriggle out even from this liability on dividends and interest by taking advantage of the
language of articles 10 and 11. The point made by him was that Article 10 would be attracted only
where an Indian company pays a dividend to a resident of Mauritius ; likewise, Article 11 would be
applicable only where interest is paid by a person in a Contracting State to a resident of Mauritius.
Here, however, the AR argues, the dividends and interest are paid by the companies and other
investees to the CT and not to the IC. Hence, he argues, these receipts will not attract articles 10 and
11 and would fall within the purview of Article 22 with the consequence that they can be charged to
tax only in Mauritius and not in India. The advantage to the IC is that at Mauritius it is not liable to
tax unless it elects to pay tax at specified rates not less than 15 per cent. and not exceeding 35 per
cent. (vide page 41 of the placement memorandum). (In paranthesis, it may be observed that when it
was pointed out at the hearing that this seemed to be a rather unusual type of provision that gives
the assessee an option of choosing his tax rate, it was stated by counsel that a provision of such

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nature can be found even under the Indian law : for, e.g., see Section 44AD of the Act. But that is
really a different kind of provision giving an option to the Revenue to estimate the income at a
prescribed rate or a higher income declared by the assessee). Ingenious as this argument is, the
Authority is of the view that it cannot be accepted as it cuts across the principle behind Section 161
on which he has built up his argument, relying on the Supreme Court decisions, that the assessment
on the IC should be made as if it were in direct receipt of the income and not through the CT.
Though it is the CT that receives the dividend and interest and makes the capital gains, it is the hand
of the IC that is deemed to have received the income directly. It is true that the fiction is one created
by Section 161 of the Act but the fiction of Section 161 should be extended to its legitimate
consequences: in the present context, even to the interpretation of the DTAA. If the IC wishes to
seek the benefit of the provision for the purpose of an assessment on it, it cannot turn around and
deny the logical follow up of the fiction for purposes of the DTAA. The Authority is, therefore, of
opinion that interest will be assessable to income-tax in India, that dividends will be liable to be
charged to tax at five per cent. or 15 per cent. (as the case may be) and that capital gains will not be
chargeable to tax.

84. The AR next contends that, if dividends and capital gains must be taxed in the hands of the
investor company, they should be taxed at five per cent. in the case of dividends and at 20 per cent.
in the case of capital gains. He further says that even if an assessment is to be made on the CT under
Section 164, the amount of CG included in its income can only be taxed at 20 per cent. and not at the
maximum marginal rate. To take up the first contention, the rate of five per cent. will be available
only where the recipient of the dividends is the beneficial owner of the dividends and that, too, when
it holds directly at least 10 per cent. of the capital of the company paying the dividend. In the
present case, the Indian companies pay dividends to the CT as trustee and not as beneficial owner. It
may seem that the logic of treating the investor company as the direct recipient of the dividends by
reason of the application of Section 161 should be extended here also but such a view would run
counter to the explicit language used in Article 10(2)(a) of the treaty (see words in italics) and also to
its manifest intent that no concessional tax treatment will be available if the person holding the
shares in the company is not its beneficial owner. In any event, even if such interpretation be
acceptable, the relief asked for can be available only if the holding of the Mauritian company
(through the CT) exceeds 10 per cent. of the share capital of the company paying the dividend. The
dividends, therefore, will be taxable at the rate of 15 per cent.

85. The other point raised by the AR also raises certain difficulties. He bases his claim for having the
CG assessed at 20 per cent. on the language of Section 112 of the Act. This provision may now be
extracted, to the extent relevant, for facility of easy reference :

" 112. Tax on long-term capital gains.--(1) Where the total income of an assessee includes any
income, arising from the transfer of a long-term capital asset, which is chargeable under the head
'Capital gains' the tax payable by the assessee on the total income shall be the aggregate of,--

(a) in the case of an individual or a Hindu undivided family, being a resident,--

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(i) the amount of income-tax payable on the total income as reduced by the amount of such
long-term capital gains, had the total income as so reduced been his total income ; and

(ii) the amount of income-tax calculated on such long-term capital gains at the rate of twenty per
cent. :

Provided that where the total income as reduced by such long-term capital gains is below the
maximum amount which is not chargeable to income-tax, then, such long-term capital gains shall be
reduced by the amount by which the total income as so reduced falls short of the maximum amount
which is not chargeable to income-tax and the tax on the balance of such long-term capital gains
shall be computed at the rate of twenty per cent. ;

(b) in the case of a domestic company,--

(i) the amount of income-tax payable on the total income as reduced by the amount of such
long-term capital gains, had the total income as so reduced been its total income ; and

(ii) the amount of income-tax calculated on such long-term capital gains at the rate of thirty per
cent. :

Provided that in relation to long-term capital gains arising to a venture capital company from the
transfer of equity shares of venture capital undertakings, the provisions of Sub-clause (ii) shall have
effect as if for the words 'thirty per cent.', the words 'twenty per cent' had been substituted ;

(c) in the case of a non-resident (not being a company) or a foreign company,--

(i) the amount of income-tax payable on the total income as reduced by the amount of such
long-term capital gains, had the total income as so reduced been its total income ; and

(ii) the amount of income-tax calculated on such long-term capital gains at the rate of twenty per
cent. ;

(d) in any other case of a resident,--

(i) the amount of income-tax payable on the total income as reduced by the amount of long-term
capital gains, had the total income as so reduced been its total income ; and

(ii) the amount of income-tax calculated on such long-term capital gains at the rate of thirty per
cent."

86. He says, therefore, that a tax rate of only 20 per cent. can be applied to the CG whether an
assessment is made on the trustee under Section 164 directly or under Section 161 as representative
of the individual beneficiaries qua their shares. There is no difficulty in accepting the argument if
the assessment is made under Section 161. In that case, the trustee, being assessable in the same

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status as the beneficiary, will be assessable as a "foreign company" attracting the provisions of
Section 112(c) or Section 115A read with Section 2(3) of the relevant Finance Act (set out later).
Section 112 and Section 115A will then apply as if the investor company were the direct recipient of
the CG from the investee and the tax will be chargeable at 20 per cent.

87. The legal position where the assessment is made under Section 164, however, bristles with
difficulties. The first question is regarding the status in which the CT should be assessed to tax.
Should it be treated as an "individual", "domestic company" or "association of persons" ? The
second is : what are the rates at which the CG part of its total income should be assessed ; at the
maximum rates as directed by Section 164 or at the appropriate rate applicable under Section
112(1)(a), (b) or (d), as the case may be ? The AR contends that the assessment should be made in
the status of "individual" and that the rate of 20 per cent. prescribed by Section 112(1)(a) will apply.

88. The first question thus is whether the AR is right in claiming that whereas, if an assessment is
made on the CT as trustee qua investor company, the status should be taken as that of the
beneficiary, viz., as a "company", assessment under Section 164 on it will have to be in the status of
an "individual". He prefers this status because of the rate of 20 per cent. prescribed under Section
112(1)(a), in contradistinction to the rate of 30 per cent. under Section 112(1)(b) or (d). In support of
his contention, Sri Dastur relies on the decisions of the Supreme Court in Trustees of Gordhandas
Govindram Family Charity Trust's case [1973] 88 ITR 47 and in Nizam's case [1977] 108 ITR 555.
The decisions referred to by him were rendered under the Wealth-tax Act, 1957, on the question as
to whether, where there is more than one trustee, the body of trustees could be treated as an
"individual" and brought to tax even though "association of persons" was not a category of assessee
under that Act as under the Income-tax Act. They are not helpful to decide that even where there is a
sole trustee and it is a company and the assessment is made on it under Section 164, the assessment
should be made on it in the status of an "individual". Having considered the pros and cons carefully,
the Authority is of the view that the assessment on the CT will have to be made in its status as a
company. The Authority cannot see how a direct assessment on the CT, without recourse to Section
161, can be made in a status different from what the assessee in fact possesses. Once Section 161 is
out of the way and the assessment on the trustee is a direct one under Section 164, the idea that it is
a representative assessment of the income of the beneficiary should be eschewed, except possibly for
the fact that tax levied on the trustee may eventually be recoverable from the beneficiary as well.
(But there will be difficulties in this course as well as no one beneficiary can be made liable for the
tax liability of another beneficiary and the postulate of Section 164 is that the extent of share income
of the beneficiary or beneficiaries in question is indeterminate or unknown). The assessee is a
company and an assessment on it must be made in that status.

89. Turning now to the second question, should the CT be taxed at the maximum rate (40 per cent.)
as stipulated in Section 164 or at the rates of 20 per cent. or 30 per cent. mentioned in Section 112 ?
In the case of any assessee who is directly assessed under Section 4 of the Act read with the
provisions of the relevant Finance Act, the rates mentioned in Section 112 in respect of capital gains
will prevail over the rates prescribed under the Finance Act. This is so because Chapter XII contains
provisions for certain special cases and will prevail over the general rates. This is also made clear by
Section 2(3) of the relevant Finance Act (the Act of 1995 is considered here but there is a similar

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provision in other Finance Acts as well) :

" Section 2(3). In cases to which the provisions of Chapter XII or Chapter XIIA or Sub-section (1A)
of Section 161 or Section 164 or Section 164A or Section 167B of the Income-tax Act, 1961 (43 of
1961) (hereinafter referred to as Income-tax Act), apply, the tax chargeable shall be determined as
provided in that Chapter or that section, and with reference to the rates imposed by Sub-section (1)
or the rates as specified in that Chapter or section, as the case may be :

Provided that the amount of income-tax computed in accordance with the provisions of Section 112
shall be increased in the case of a domestic company by a surcharge as provided in Paragraph E of
Part I of the First Schedule :

Provided further that in respect of any income chargeable to tax under Section 115B, or in the case of
a domestic company having a total income exceeding seventy-five thousand rupees, under Section
115BB of the Income-tax Act, the income-tax computed shall be increased by a surcharge calculated
at the rate of fifteen per cent. of such income-tax."

90. This not only makes Section 112 applicable in such a case and provides for a surcharge in
addition, where the assessee is a domestic company, to the rate of 30 per cent. Where, however, the
assessment is one made under Section 164, the choice has to be between the maximum rate
prescribed under that section and the lower rates specified in Section 112. Section 2(3) of the
Finance Act does not meet this situation. It does not solve the issue of priority as between a
provision contained in Chapter XII (section 112) and Section 164 both of which are specifically
mentioned in it. Perhaps the correct solution would be to give weightage to Section 164 which is
designed to meet the issue of liability in special cases and to counter a strategy of tax avoidance as
mentioned earlier.

91. Fortunately, the Authority is not constrained to express a concluded opinion on the two
questions discussed above in paragraphs 59 to 61 in view of its conclusion that Section 161 applies to
the present case and that the capital gains received by the investor company will not be chargeable
to tax in India by reason of Article 13 of the DTAA.

92. The DR, however, raised the contention that neither the investment company nor the
investment manager is entitled to avail of the benefits of the DTAA. It is common ground that these
companies cannot claim relief under the DTAA unless they can be said to be resident in Mauritius
within the meaning of the DTAA. That definition is contained in Article 4 of the DTAA which reads
as follows (see [1984] 146 ITR (St) 214, 216) :

"Article 4 ~ RESIDENTS (1) For the purposes of this Convention, the term "resident of a Contracting
State" means any person who under the laws of that State, is liable to taxation therein by reason of
his domicile, residence, place of management or any other criterion of similar nature. The terms
"resident of India" and "resident of Mauritius' shall be construed accordingly.

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(2) Where by reason of the provisions of paragraph 1, an individual is a resident of both Contracting
States, then his residential status for the purposes of this Convention shall be determined in
accordance with the following rules :

(a) he shall be deemed to be a resident of the Contracting State in which he has a permanent home
available to him ; if he has a permanent home available to him in both Contracting States, he shall
be deemed to be a resident of the Contracting State with which his personal and economic relations
are closer (hereinafter referred to as his 'centre of vital interests') ;

(b) if the Contracting State in which he has his centre of vital interest cannot be determined, or if he
does not have a permanent home available to him in either Contracting State, he shall be deemed to
be a resident of the Contracting State in which he has an habitual abode ;

(c) if he has an habitual abode in both Contracting States or in neither of them, he shall be deemed
to be a resident of the Contracting State of which he is a national ;

(d) if he is a national of both Contracting States or of neither of them, the competent authorities of
the Contracting States shall settle the question by mutual agreement.

(3) Where by reason of the provisions of paragraph 1, a person other than an individual is a resident
of both the Contracting States, then it shall be deemed to be a resident of the Contracting State in
which its place of effective management is situated."

93. Clause (2) of this definition is not relevant for the present purposes. The residential criterion has
to be decided only with reference to clauses (1) and (3). Taking up Clause (1), it is argued by the AR
that the companies are liable to tax in Mauritius. They are incorporated there--the certificates of
incorporation as well as tax residency certificates to the effect that the companies are resident in
Mauritius under the Income-tax Act, 1995, of that country have been filed and they are, therefore,
resident in Mauritius. They are not liable to tax in India. The mere fact that they are liable, even as
non-residents, on the income accruing or arising or deemed to accrue or arise in India is not
sufficient, according to counsel, to make them residents in India under Clause (1). Hence, they are
entitled to claim benefits under the DTAA.

94. On the other hand, the DR urges that the companies cannot be said to be residents of Mauritius
as they are not liable to income-tax in Mauritius unless they choose to submit themselves to
assessment and pay tax there. On the other hand, they are certainly liable to tax on their Indian
income. Even if'they can be said to be resident in Mauritius, they are also resident in India and so
the tie-breaker provision in Clause (3) has to be invoked. But this clause refers not to the place of
incorporation but to the place of effective management and the DR says that there is nothing to
show that the effective management of the companies is exercised from Mauritius. The companies
are subsidiaries of the American company and their shareholders are other companies (also the
subsidiaries of the same company) with registered offices in different countries (except to the extent
of 27 per cent. in the case of the investment manager which is with the Indian financial service
company and an Asian Bank). They have no doubt some Mauritians as directors but the real and

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effective management may well come from the location of the American company or the other
shareholding companies : say USA or Hongkong or the like.

95. Interesting as these contentions are, they are concluded, so far as this authority is concerned, by
its own earlier decisions. In Mohsinally Alimohammed Rafik's case [1995] 213 ITR 317 (AAR) this
Authority has held that an individual living in Dubai would be a 'resident' of Dubai within the
meaning of Article 4(1) of the DTAA between India and the United Arab Emirates though actually no
tax is collected from individuals there. The applicants in the present case are in a better position.
There is an Income-tax Act in Mauritius and it is said that a minimum tax at 15 per cent. is payable
by them, though earlier they had an option to pay tax or not. Hence, the IC and the IM should both
be treated as resident in Mauritius. It was also held by the Authority in Mohsinally Alimohammed
Rafik's case [19951 213 ITR 317 (AAR) that the individual in that case was a 'resident' of India within
the meaning of Article 4(1) (in that case, identified with the one here) as he was liable to tax on his
Indian income. There was a liability on him to Indian income-tax based on the criterion of
residence, etc., and this was sufficient for purposes of the article. The AR contests the correctness of
this part of that ruling as, according to him, if that principle is applied, all persons (individuals,
companies or other associations, wherever living) would be resident of India for purposes of the
DTAA. This authority has pointed out in Mohsinally Alimohammed Rafik's case [1995] 213 ITR 317
(AAR), that there is no substance in this objection because : (i) a person seeks relief under the DTAA
in India only when he is subjected to tax here and so there would be no error in saying that he is
liable to tax in India within the meaning of Article 4(1) ; and (ii) the Article itself provides for the
eventuality of a person being resident in both countries and prescribes tie-breaker tests to meet the
situation. Hence, his contention that the IC and the IM are not resident in India cannot be accepted.
Nor can the interpretation by the DR of Article 4(3) be accepted. In the case of the investor
company, its registered office is in Mauritius and its only transaction is the investment in India. In
an application made in January, 1996, to the Mauritius Offshore Business Activities Authority
(MOBAA) for a residency certificate--there is also a like letter on behalf of the investment
manager--certain features of the investor company which show that its place of management will be
in Mauritius have been set out. This letter can be usefully quoted here ;

" The following steps are to be taken to ensure Mauritian place of management, in particular :

1. The company has two resident directors of appropriate calibre to exercise independence of mind
and judgment.

2. The company's secretary is resident in Mauritius ;

3. The registered office is Mauritius ;

4. Banking transactions will be channelled through the Hongkong and Shanghai Banking
Corporations ;

5. Accounting records will be maintained in Mauritius in accordance with the Companies Act, 1984 ;

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6. Board meetings will be held in or chaired from Mauritius ;

7. All statutory records, such as minutes and members' register, will be kept at the registered office ;

8. The company has an ordinary status."

96. Firstly, it is difficult to say that the effective management of the affairs of the company is not in
Mauritius in the above situation unless there are facts to at least prima facie indicate that such
control emanates elsewhere than from Mauritius. (The factual position in the case of IM is
separately dealt with in its application). Secondly, in its ruling reported as Advance Ruling No. P. 9
of 1995, In re, [1996] 220 ITR 377 (AAR) the Authority has pointed out that Article 4(3) is intended
to break the tie on the issue of residence as between the two Contracting States. The companies are,
on Article 4(1), resident both in India and Mauritius and under Article 4(3), the seat of effective
management as between these two Contracting States, should be taken to be in Mauritius. Article
4(3) does not authorise the exploration of a possibility that the effective management, despite the
company's location and residence in Mauritius, could lie elsewhere, in a third country. The
Authority would, therefore, hold that the investor company is a resident of Mauritius entitled to
claim the benefit of the DTAA.

97. The next point for discussion before the Authority is the mode of treatment of the income, if any,
of the CT assessable under the head "Profit and gains of business, profession and vocation" in the
hands of the investor company when an assessment is made on the CT under Section 161. This
situation is dealt with in Article 7 of the DTAA which makes such income taxable only if the investor
company has a permanent establishment in India and the income is attributable to such permanent
establishment (PE). There are no facts to suggest that, apart from barely investing the funds, the
investor company has any office, place of business or other apparatus that would come within the
definition of permanent establishment in Article 5 of the DTAA. It is true that Section 161(1A)
provides for a tax at the maximum rate on the income from business in the hands of a trust but the
beneficiary here being eligible for the benefit of the DTAA, that benefit can be availed of under
Section 90(2) of the Act. The Authority, therefore, accepts the plea of counsel for the investor
company that in case there are any business profits earned by the CT and an aliquot share thereof is
distributed to the investor company, such distribution will not be liable to income-tax in India.

98. The discussion thus far disposes of the issues raised by the IC in its application.

99. To turn to the application filed by the investment manager, the four questions raised by the
applicant have already been set out and as mentioned earlier, the principal question sought to be
raised is whether that company can be said to have a permanent establishment in India within the
meaning of the DTAA. Reference has earlier been made to the argument of the DR that the
investment manager cannot seek to avail of the provisions of the DTAA since that company cannot
be said to be a resident of Mauritius within the meaning of the DTAA. This argument has already
been dealt with in so far as IC is concerned. In the case of the IM, however, there are certain
additional facts which need consideration on this issue. These will be dealt with now.

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100. The investment manager is a company incorporated in Mauritius. It is proposed that 73 per
cent. of the shareholding of this company will be with the American company while Indian financial
service company and an Asian Bank will have shareholdings of 22 per cent. and five per cent.,
respectively. It is the responsibility of this company to manage the affairs of the CT. The investment
proposals are to be finally approved and decided upon by the board of directors of the company
which paragraph 13.01 of the IMA specifically says will be done at its meetings outside of United
States and India. But in carrying out its duties, the investment manager will be helped by various
other bodies. Firstly, there is the investment committee which will consist of seven members with
the chairman appointed by the Indian financial service co. Four members of the committee will be
from the AIG and the ILFS will nominate three members of the committee. The investment
committee will act by majority vote but the American company retains a veto right on any
recommendation of the investment committee. It will be seen that though the nominee of the Indian
financial service co. will be the chairman of the investment committee, the decisions of the
committee will always be dominated by the American company and that organisation has also a
right of veto. It is not quite clear from where the investment committee is to function. The second
body to assist the investment manager is the advisory board. This is a body comprised of
professional business and financial executives. But the recommendations of the advisory board will
not be binding on the investment manager unless otherwise agreed to by the trustee. Thirdly, the
investment manager also enters into separate contracts with the Indian financial services company
and the American company as investment advisors. The terms and conditions of the draft
investment advisory agreement with the Indian financial service company have already been set out.
The Indian financial service company and the American company team of advisors provide the
investment manager with the advisory services, consulting services and assistance in the
identification, analysis and review of the investments of the CT. From the terms of the advisory
agreement, it is also seen that the investment advisors may function with the help of service units.
But these only appear to be advisory bodies in no way controlling the decision of the board.

101. The provisions of the investment management agreement, however, contain certain provisions
which require consideration. Reference may be first made to paragraph 2.01 under which the
investment manager agrees to provide and be responsible for day to day management and
administrative services to the trust fund in accordance with the provisions of the agreement and any
directions and instructions of the trustees. Likewise, paragraph 3.03 makes the responsibility of the
IM subject to any directions, instructions and guideliness provided by the trustees. It was pointed
out to learned counsel for the applicants that the words in italics might lead to the conclusion that
the control and management of the affairs of the management company would rest ultimately in
India where the trustee company is located. Shri Dastur thereupon agreed that the applicants would
be willing to drop the offending words from paragraph 2.04 and to delete paragraph 3.03 altogether.
The position is, therefore, considered on the footing that that these provisions are no longer in the
IMA. Apart from these provisions, there is nothing in the IMA which would indicate that the
functions of the IM are not completely independent or that its business is subject to any control
from India. Reference has already been made to paragraphs 3.04 and 13.01 under which the
decisions of the board of directors will be taken at locations outside the United States and India.
Though the IM has certain restrictions placed on its functioning by the introduction of other bodies
such as the investment committee, the investment advisor, the advisory board, and the service units,

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it appears clear that the last word and decision on any of the functions of the investment manager
rests with its own board of directors. From paragraph 13.04, it is clear that, regardless of any
delegation, the investment manager shall remain responsible for all decisions and acts of any
delegate if it would have been liable under the Act for such act or omission if it had been done by
itself. It is no doubt true that, in carrying out its functions, the investment manager will rely to a
considerable extent on the investment advisors such as the Indian financial service co. But as
pointed out, these bodies are not decision-making bodies but are just advisors whose expertise is
taken advantage of by the investment manager. The Indian financial service has a great experience
in advising on such matters and its credentials in this regard have been set out at page 37 in the
placement memorandum. It would, therefore, appear that the effective management of the IM is in
Mauritius. This company has, therefore, also to be treated as a resident of Mauritius for the
purposes of the DTAA.

102. On the question of permanent establishment, the DR referred to a sentence occurring at page
40 of the placement memorandum which has been extracted earlier. Attention was also drawn to
paragraph 10.01 of the IMA under which the functions of the investment manager will include the
engagement of "professionally skilled and/or experienced personnel to provide the necessary
advisory and investment managerial support and/ or guidance to the portfolio and investment and
the entrepreneurs and if necessary to assist in the administration of the trust fund". It was
contended that the amplitude of this clause was so wide as to enable the investment manager to
carry on its work and functions with the aid of its own personnel rendering services in India. The AR
replied to this objection by saying that this clause should be read with paragraph 13.04 and that it
only envisages the appointment of professionally skilled persons to assist the IM in the discharge of
its functions. He also explained that the passage at page 40 of the placement memorandum pertains
to the investor company and not the investment manager.

103. He, however, saw the force of the arguments of the DR. Counsel, by their letter dated June 27,
1996, have proceeded to give the following undertaking :

"During the hearing of the captioned company (hereinafter referred to as 'the company') certain
concerns were raised as to whether the company would undertake activities that would result in its
being construed to have a permanent establishment in India. It is, therefore, submitted that the
company does not intend to undertake the following activities :

1. Open a fixed place of business in India as contemplated under Article 5(1) of the India Mauritius
Double Taxation Avoidance Agreement (DTAA).

2. Undertake any activity or open any place of business as contemplated under Article 5(2) of the
India Mauritius DTAA.

3. Appoint any agent or broker in India who has the authority to conclude contracts in the name of
the company and who is not of an independent nature."

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104. They have also intimated the change effected in paragraph 10.01(a)(iii) of the IMA by
rewording it thus :

" 10.01(a)(iii) to engage professionally skilled and/or experienced personnel to provide the
necessary advisory support and investment managerial entrepreneurs and if necessary to assist in
the administration of the trust fund."

105. Having considered the pros and cons of these arguments, the Authority is of the view that it is
not possible to give any ruling on the question whether the investment manager has a permanent
establishment in India or not, unless more details are available regarding the actual functioning and
the activities performed by or on behalf of the company in India. In the first place, the passage at
page 40 of the placement memorandum clearly shows that the memorandum does not exclude the
possibility, at least in future, of the IM having to have a permanent establishment in India. It is no
doubt true that the word "company" referred to in the said paragraph refers to the IC and its tax
advantages. But the reference to "permanent establishment" is clearly related to the investment
manager. This is also quite understandable because the investor company has nothing to do in India
except to invest funds under the contribution agreement. It is really the investment manager that
has to take all action in regard to the selection of investments, the placing of investments, the
management of investments and the collection of the proceeds of the investments on behalf of the
CT. Secondly, the facts before us do not indicate at all the manner in which the investment manager
proposes to set about its business. It could, for example, establish an office in India to facilitate its
functions. It could have agents and other persons of that type to help it in discharging its functions.
Or again if the activities became too numerous it can also make use of paragraph 10.01 to appoint its
own employees or personnel to carry on its activities in India. The AR placed considerable reliance
on clause 5 of Article 5 of the DTAA. He pointed out that the mere presence of professional agents or
independent parties dealt with at arm's length for carrying out its activities in India would not
amount to the setting up of a permanent establishment in India. That is no doubt true. But one
cannot anticipate in what manner the investment manager will organise its activities. The language
of paragraph 10.01 is sufficiently wide to enable it to carry on its activities, if not through an office in
India, at least through its own employees and other personnel functioning in India and looking after
some or all of its operations. It is true that some changes in paragraph 10.01 have been made and
counsel have given certain assurances in their letter of 27th June, 1996. These are no doubt of some
help but the absence of a clause such as paragraph 10.01 is not sufficient to prohibit the IM from
carrying on the business to best advantage in such manner as it considers fit and proper. The
undertakings are also not wholly satisfactory as they repeat the clauses of the DTAA and it may have
to be decided on actual facts whether a fixed place of business exists for the IM in India and whether
persons employed to carry out its activities are independent within the meaning of the DTAA. The
Authority cannot be expected to envisage all possible methods or channels through which the
investment manager can function and to give an advance ruling as to which of them will amount to a
permanent establishment and which not. All that can be stated now is that if the investment
manager functions purely outside in India and does not get any assistance from India, except by way
of advice from the various bodies envisaged under the agreement, it cannot be said to have a
permanent establishment in India. However, if the business of the investment manager is so carried
out that it necessitates an office in India or the employment of personnel in India or the carrying out

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

of systematic operations in India in some manner or the other, then it may be necessary to consider,
on the facts as they emerge, whether a permanent establishment has been created in India or not.

106. The other three questions raised by the applicant depend for their answer on the first. The
Authority has already concluded that, on the facts so far disclosed and on the provisions of the
various agreements that have been placed before it, it can be said that the applicant does not have a
permanent establishment in India at present. This being so, the applicant will not be liable to tax in
respect of the management fees or carried interest received from the CT. Consequently, the CT will
not be under an obligation to withhold tax in respect of the payment of the management fees and
carried interest to the investment manager. However, as has already been made clear more than
once, it will be open to the assessing authorities, should necessity arise, to examine the modus
operandi of the investment manager in carrying on its business under the agreement and, if at any
time, a conclusion is reached that a permanent establishment has been set up in India, the fees and
interest paid to the investment manager by the CT will become liable to tax and the CT will be
obliged to deduct tax at source from such payments.

107. Before parting with the case, reference must be made to two matters. The first is this. Reference
has been made in the course of the discussions to the consent of counsel to make certain changes in
the draft instruments to meet the criticisms raised by the other side. This may seem to be a
somewhat unusual procedure but there is nothing wrong in it. The applicants are seeking a ruling on
certain proposed transactions which have not yet materialised. There could be no objection to their
revising the proposed drafts so as to be beyond the pale of criticism. The Authority has, however,
ensured that there is no ambiguity about the changes made by indicating both the changes and the
reasons for them in bold letters in this order. That apart, the changes in the draft have to be made by
the Indian financial service company, the IC, the IM and the trust company, as the case may be. The
Authority has been informed by counsel's letter dated June 27, 1996 (in each of the cases), of the
precise terms of the changes effected in the various documents and presumes that these
modifications have been by the persons respectively competent to effect these changes. The ruling
given by this order is based on these changes being validly carried out in the various documents.

108. The second matter to which the Authority would like to refer is this. Before the case was heard,
the applicants were asked whether they would have any objection to the publication of the rulings
given by the authority on these two applications; The answer was in the negative initially but later it
was said that there would be no objection if the answers are in favour of the applicants but that, if
the rulings are adverse, they would have every objection to such publication. The Authority has
considered this objection and is of opinion that the objection has to be overruled. The confidentiality
that once attached to proceedings under the Income-tax Act, 1961, has since been abolished. Section
138 no doubt refers to some situations in which details of assessment records could be given to
outsiders at their request. But the proceedings of this Authority are not assessment proceedings and
there is no statutory rule of confidentiality that prevents publication of the rulings given by it. It is
true that, under the statute, the rulings of the Authority are binding only in respect of the
transactions on the basis of which the questions have been raised by both the applicants and the
income-tax authorities. But this will not be decisive of the present issue. The scheme of advance
rulings has been introduced for the benefit of non-residents and to enable them to have an advance

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

ruling on matters of doubt and ambiguity arising under the Act. Though the rulings of the Authority
are generally given on the basis of stated facts and background, they also have a general value as
guides to the interpretation of the various provisions of the Act, the rules, the Double Tax Avoidance
Agreements and so on. Many of these rulings deal with questions of law also. Hence, irrespective of
the binding nature of the ruling given in a particular case vis-a-vis other cases, the Authority is of
the opinion that it is in public interest that the rulings be published particularly where they deal
with general questions of far-reaching importance. The Authority is aware that, when parties are
proposing to enter into transactions in India, the applications may sometimes contain confidential
particulars, the disclosure of which they may not desire and may even be harmful to them. In the
present case, the applicants are setting out on a course of open business operations to benefit India
and its placement memorandum has been circulated to prospective investors. The Indian financial
service company is actively interested in securing participation from Indian investors. It would,
therefore, seem that publicity of the setup proposed is actually being solicited by the applicants. The
Authority, therefore, does not consider that there is any element of confidentiality involved. The
Authority is, therefore, of the opinion, having regard to the importance of the various questions
raised by the applicants in the present cases, both on the interpretation of sections 112, 161 and 164
of the Act as also of several important treaty provisions of the DTAA with Mauritius, that it is
desirable to publish the rulings. The Commissioner of Income-tax on the Authority is, therefore,
directed to have the rulings on these applications also published in due course. However, in doing
so, he may carefully examine the contents of the rulings and consider the possibility of expunc-tion
therefrom of references to persons, figures and other like details of a personal nature to the extent it
can be done without detracting from a proper comprehension of the principles and reasonings
contained in the Ruling.

109. In the light of the foregoing discussions, the Authority hereby makes the following rulings on
the two applications before it :

RULING

(i) Application of IC :

Question No. 1 : Based on the facts and circumstances of the case, and in view of the provisions of
India-Mauritius double tax avoidance agreement, can it be construed that the applicant does not
have a permanent establishment (PE) in India ?

Answer No. 1 : On the basis of the documents placed and undertakings given by the parties, it can be
said that no permanent establishment for the applicant is envisaged at present. However, this
answer to the question will be subject to the manner in which the applicant company's activities are
actually carried on.

Question No. 2 : Based on the facts and circumstances of the case, will the applicant be liable to tax
in respect of the management fees received from the CT ?

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

Question No. 3 : Based on the facts and circumstances of the case, will the applicant be liable to tax
in respect of the carried interest received from the CT ?

Question No. 4 : Based on the facts and circumstances of the case, if the answer to above question is
yes, will there be a withholding tax liability on the CT, in respect of the payment of management fees
and carried interest to the applicant ?

Answer Nos. 2, 3, 4 : The answer to these questions will depend upon the answer to question No. 1
as it will emerge on a full examination of the facts and circumstances of the carrying on of the
business by the applicant. It may, however, be stated that, if on the facts, the conclusion is reached
that there is no permanent establishment in India for the applicant, questions Nos. 2, 3 and 4 have
to be answered in the negative. In that event, the applicant will not be liable to Indian Income-tax on
the management fees and 'carried interest' received from the CT and consequently the CT will not be
liable to withhold tax from such payments made to the company. If, however, it is held that there is
a permanent establishment of the applicant in India, the profits attributable to the permanent
establishment will be taxable in India and questions Nos. 2, 3 and 4 will have to be answered in the
affirmative.

(ii) Application of IM :

Question No. 1 : Based on the facts and circumstances of the case, whether the applicant would be
assessed in respect of its proportionate share of income earned by the contributory trust as per the
provision of Section 161 of the Income-tax Act, 1961 (the Act) ?

Question No. 2 : Based on the facts and circumstances of the case, whether the contributory trust
would be regarded as a 'see through' or 'transparent entity' vis-a-vis the applicant ; i.e., to say, the
applicant will be taxed in respect of its proportionate share of income under Section 161 of the Act ?

Answer Nos. 1 and 2 : The applicant company can be assessed and made liable either directly or
through the CT only in respect of its proportionate share of income derived from the CT.

Question No. 3 : Based on the facts and circumstances of the case, if it is held that the provisions of
Section 161 do not apply to the income of the applicant from the contributory trust because of the
power vested in the trustees to add to the list of the beneficiaries on the terms laid down in the
indenture of trust and the contribution agreement, then if such power is deleted, would the
assessment of the applicant in respect of its proportionate share of income of the trust be made in
accordance with Section 161 ?

Answer No. 3 : Yes. As the trustees' power to add to the list of beneficiaries has been held not
detrimental to the application of Section 161, the question is hypothetical. But, if this power is
altogether deleted, the case for an assessment on the CT under Section 161 will become stronger.

Question No. 4 : Based on the facts and circumstances of the case, even if it is held that the shares of
the additional beneficiaries are indeterminate whether the capital gains arising to the applicant will

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

be charged to tax at the rate of 20 per cent. as prescribed in Section 112 of the Act ?

Answer No. 4 : The word "additional" appears to be superfluous. The question does not arise in view
of the finding that the beneficiaries are not indeterminate and the Authority wishes to express no
ruling on the issue.

Question No. 5 : Based on the facts and circumstances of the case, will there be any tax withholding
by the investee companies at the time of distribution of income to the CT ?

Answer No. 5 : At the end of the question, the words "and if so to what extent" were requested to be
added. So far as the investee companies are concerned, they will be required to withhold tax from
the amounts paid to the CT at the rates appropriate in the case of an Indian company on all
payments made by them in accordance with the provisions of the relevant Finance Act. It may,
however, be open to the CT or to the applicant to apply to the Assessing Officer praying that tax may
not be deducted, or should be deducted at a smaller rate on the whole or part of such income held on
behalf of the IC in view of Section 161 and the DTAA.

Question No. 6 : Whether, on the facts and circumstances of the case, the character of the
applicant's proportionate share in the income of the contributory trust will be same as in the hands
of the contributory trust ?

Answer No. 6 : The answer to this question is in the affirmative.

Question No. 7 : Based on the facts and circumstances of the case, whether the applicant's share in
the dividend earned by the contributory trust will be chargeable to tax and if so at what rate ?

Answer No. 7 : The answer to this question is in the affirmative. The rate of tax payable under Article
10 of the DTAA will be 15 per cent.

Question No. 8 : Based on the facts and circumstances of the case, will the applicant's share in the
interest earned by the contributory trust be chargeable to tax at the rate of 20 per cent. ?

Answer No. 8 : The applicant's share of the interest earned by the contributory trust will be
chargeable to tax at normal rates.

Question No. 9 : Whether, on the facts and in the circumstances of the case, the applicant's share in
the capital gains earned by the contributory trust will be chargeable to tax ?

Answer No, 9 : The capital gains embedded in the applicant's share of distributions made by the CT
will be exempt from tax under Article 13.

Question No. 10 : Based on the facts and circumstances of the case, whether there would be any
withholding tax liability on the CT in respect of the distributions made to the applicant ?

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 In Re: Advance Ruling P. No. 10 Of ... vs Unknown on 14 August, 1996

Answer No. 10 : The CT would be liable to withhold tax from the distributions made to the applicant
in so far as such distributions are attributable to dividend and interest income earned by the trust.

Question No. 11 : Whether, on the facts and in the circumstances of the case, the applicant's
proportionate share in the surplus arising on the realisation of the investments made by the
contributory trust would constitute capital gains ?

Answer No. 11 : It is difficult to give a ruling on this question at this stage, The surplus arising on
investments pure and simple will be capital gains in the hands of the CT. But circumstances could
arise, or the manner of the carrying on of the activities of the CT may be such, as to render such
surplus or part of its income, profits and gains from a business. That determination has necessarily
to be made by the officer assessing the trust based upon the facts and circumstances placed before
him.

Question No. 12 : Whether, in case the answer to question No. 11 is in the negative, the
proportionate share of the applicant in such surplus will be chargeable to income-tax in India in the
applicant's hands ?

Answer No. 12 : This question, which was added at the time of oral hearing, will arise only if the
whole or any part of the income of the trust is held to be the profits and gains of a business. In that
eventuality Article 7 of the DTAA would come into operation and, since the applicant has no
permanent establishment in India, the distributable income attributable to such profits will be
exempt in its hands,

110. The two applications are disposed of accordingly.

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 NEWSFLASH

KEY CHANGES IN THE ALTERNATIVE INVESTMENT FUNDS

(AIFS) SPACE

1 August 2017 The past few months have been a period of significant change for Alternative Investment
Funds (AIFs). Amongst others, the regulatory landscape governing funds has been
greatly reformed by the introduction of four major reforms, which have been introduced
by the Securities and Exchange Board of India (SEBI), the Bombay Stock Exchange and
the National Stock Exchange (collectively, Stock Exchanges) and the Central Board of
Direct Taxes, Government of India (CBDT). The rapid pace of reformation in the field has
been largely brought out by the release of recommendations suggested by the
Alternative Investment Policy Advisory Committee (AIPAC), which was constituted by
SEBI for this very purpose. After its first report led to an overhaul of the angel funds
regime, amongst others, the second report, released in December 2016, has culminated
in a wider set of reforms in 2017, which have been implemented not only by SEBI, but by
other regulatory bodies as well.

Accordingly, we have summarised the key regulatory and tax updates relevant to the
AIF regime, along with our analysis, in the following four sections:

Category III AIFs and Commodity Derivatives

SEBI Circular

On 21 June 2017, SEBI vide its circular on ‘Participation of Category III Alternative
Investment Funds (AIFs) in the Commodity Derivatives Market’ permitted Category III
AIFs to participate in all commodity derivatives products that are traded on commodity
derivatives exchanges in India, thus opening up the market to institutional investors.
Category III AIFs will be treated as ‘clients’ and hence, will be subject to all regulations
applicable to clients on commodity derivative exchanges.

The SEBI circular reiterates certain conditions that are already applicable to Category III
AIFs under the SEBI (AIF) Regulations, 2012 (AIF Regulations). Thus, when participating
in commodity derivative products that are traded on commodity derivatives exchanges
in India, Category III AIFs may engage in leverage or borrow, subject to consent from the
investors in the fund and subject to a maximum limit specified by SEBI. Further, no more
than 10% of the investable funds of such Category III AIFs can be invested in 1 (one)
underlying commodity.

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ERGO KEY CHANGES IN THE ALTERNATIVE INVESTMENT FUNDS (AIFS) SPACE

Requirement to Give Exit Opportunity to Dissenting Investor

Category III AIFs will also be required to make disclosure(s) in the private placement
memorandum (PPM) issued to investors about investment in commodity derivatives. If
the existing Category III AIFs intend to invest in commodity derivatives, they shall seek
consent of existing investor(s) and they are mandated to provide exit opportunity to
dissenting investor(s).

In the past also, SEBI had notified (vide Circular dated 19 June 2014) the requirement to
provide exit opportunity to dissenting investors in case of material changes to PPM.
However, based on market inputs, SEBI had subsequently (vide Circular dated
18 July 2014) provided an exemption from offering exit to dissenting investor in certain
cases, i.e. if the change is approved by 75% of unit holders by value of their investment
in AIF. However, this exemption does not appear to have been extended to investment
in commodity derivatives by existing Category III AIFs, even though past experience
shows that the market prefers such an exit option to be available to it.

Comment

SEBI had cited reasons of lack of desired liquidity and depth for efficient price discovery
and price risk management for this regulatory change. It also hopes that deepening the
market for hedgers will help reduce the risks of defaults and volatility. This is a welcome
move for market participants as it can be expected that institutional participation will
make the markets more reliable and in line with the goals of SEBI, the commodity
derivatives market may be opened further for other institutional investors such as mutual
funds and Foreign Portfolio Investors (FPIs).

This step taken to permit Category III AIFs to invest in the commodity derivatives market
is also one of the crucial steps towards further integration of the commodities market
with the securities market from the financial investor perspective, ever since SEBI
subsumed the role of the Forward Markets Commission in India. This change will surely
usher into the commodities market an institutional platform which it had lacked for all
these years. This move will also help expand the bouquet of products offered by
managers to investors.

As of date, almost all Category III AIFs have foreign investment in them, including
investment by Non-Resident Indians (NRIs). Given that as per Schedule 11 of the Foreign
Exchange Management (Transfer or Issue of Security by a Person Resident outside India)
Regulations, 2000 (TISPRO Regulations), a Category III AIF with foreign investment is
permitted to make portfolio investment in only those securities or instruments in which
a Registered FPI is allowed to invest under the TISPRO Regulations, the SEBI Circular
permitting Category III AIFs to invest in commodity derivatives is a non-starter, as
currently, FPIs are not permitted to invest in commodity derivatives.

In addition to the above, a number of other reforms are required to ease the norms
governing Category III AIFs. For instance, while ‘Fund of Funds’ (FoF) structure is
available to Category III AIFs, such FoF structures may invest only in units of Category I
and Category II AIFs. This limits the scope of a FoF registered as a Category III AIF by a
huge margin. Accordingly, this restriction ought to be done away with, as it will help such
FoF structures invest in Category III AIFs and diversify risk.

Moreover, unlike Category I and Category II AIFs, Category III AIFs have not been given
a tax pass-through status, thus making it less attractive to fund managers and investors
as opposed to the other two categories. We hope that in line with the increasing
liberalisation of the AIF regime this year, measures to implement these much-needed
reforms will also be undertaken in the coming months of 2017.

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ERGO KEY CHANGES IN THE ALTERNATIVE INVESTMENT FUNDS (AIFS) SPACE

Category II AIFs and one-year lock-in on Share Capital post-IPOs

Background

Currently, Regulation 37 of the SEBI (Issue of Capital and Disclosure Requirements)

Regulations 2009 (ICDR Regulations) mandates a one-year lock-in period for the entire
pre-issue capital held by non-promoters in case of initial public offers (IPOs). Employee
stock option/purchase schemes and venture capital funds were exempted from the
one-year lock-in period of equity shares in case of initial public offerings. With the AIF
Regulations replacing the erstwhile SEBI (Venture Capital Funds) Regulations 1996
in 2012, SEBI also included Category I AIFs in this exemption. Therefore, in cases of IPOs,
the entire pre-issue capital held by Category I AIFs, venture capital funds and foreign
venture capital investors is not subject to the lock-in period of 1 (one) year, provided
that such equity shares are held for a period of at least 12 (twelve) months from the date
of purchase by the Category I AIF, venture capital fund or foreign venture capital
investor.

Approved Change

In a Board Meeting held on 21 June 2017 (Board Meeting), SEBI approved a proposal to
extend this exemption to Category II AIFs, citing reasons of uniformity, ease of business
and expanding the investor base available for raising capital. Once this amendment to
the ICDR Regulations is notified, Category II AIFs will also be able to freely trade equity
shares within the one-year period right after the IPO.

Comment

The proposed change, while not implemented yet, has brought a lot of cheer to Category
II AIFs. A majority of companies at the pre-IPO stage across the world are backed by
private equity (i.e. Category II AIFs). Thus, the relaxation of the lock-in period will
facilitate time-bound exits and allow more flexibility, raising greater capital for pre-IPO
stage stocks. These attractive terms of investment will help incentivise private equity
investors to go through the funds route for investing in IPOs, as opposed to direct
investment. This may result in more investment into private equity funds, and also
increase returns for the funds from their investments in pre-IPO stage stocks.

Listing Guidelines for AIFs

Background

The AIF Regulations provide flexibility for a close-ended AIF to list its units after the final
close of the fund or scheme, subject to a minimum tradeable lot of INR 1,00,00,000
(Rupees One crore). In consideration of the aforementioned flexibility of close-ended
AIFs to list, the Stock Exchanges, on their websites, recently set out the process and
procedures to be followed for listing of units of a close-ended AIF.

Regulatory change, Process and Documentation

Recently, the Stock Exchanges, in pursuance of the permission provided under the AIF
Regulations to list their units, released a set of listing guidelines for such AIF units. The
process set out by the Stock Exchanges involves 2 (two) steps:

(a) Obtaining in-principle approval of Stock Exchanges for listing of units by an AIF;
and

(b) Listing and trading of units.

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ERGO KEY CHANGES IN THE ALTERNATIVE INVESTMENT FUNDS (AIFS) SPACE

The Stock Exchanges require AIFs to submit a certified true copy of certain set of
documentation during the in-principle approval process and during the listing of units
which are, inter alia, set out below.

LISTING AND TRADING

FOR IN-PRINCIPLE APPROVAL
(POST ALLOTMENT)

Draft copy of information / private Letter of Application for listing of units

placement memorandum (PPM)
Details of the applicant, copy of
Investment Management Agreement observations received from SEBI on the
placement memorandum
Registration details of AIF
Final PPM
Trust Deed/MoA & AOA
Unitholding pattern of Unitholders of the
Resolution passed by trustee / Board of Scheme
directors / partners (as the case may be)
approving listing of units of AIF. Confirmation from the CEO / compliance
officer regarding allotment of units and
An undertaking from the CEO/ the actual no. of units allotted
compliance officer that AIF is in
compliance with AIF Regulations. Statement of collection details

Any other document as requested by the Confirmation from CEO / compliance

exchange officer regarding compliance with the
provisions of AIF Regulations.
Custodian Agreement / Registrar &
Transfer Agent (RTA) Agreement Confirmation from NSDL and CDSL (ISIN
activation)

Confirmation from RTA on the final

number of units to be allotted with NSDL,
CDSL and under physical form

Comment

It remains to be seen if the AIF listing guidelines will be adopted by AIFs with much
gusto, going by the experience of venture capital funds under the erstwhile SEBI
(Venture Capital Funds) Regulations, 1996 (VCF Regulations). Under the VCF
Regulations, the listing guidelines provided received a lukewarm response from the funds
industry, such that till date, there is not even one venture capital fund which is listed on
a stock exchange in India. This was primarily due to the fact that investors were unsure
of the creation of liquidity through the listing of their units, and absence of any definitive
guidelines for listing. However, given the large number of AIFs that have been set up
since the notification of the AIF Regulations in 2012, alongside the number and variety
of products that are being offered by them, the AIF listing guidelines is a great move
towards developing a secondary market for such products, and hence, will per se support
and strengthen the evolution of the AIF regime in India.

Amendment to Section 10(38) of the Income Tax Act, 1961

Background

Until 31 March 2017, long-term capital gains arising on the transfer of listed equity shares
were exempt from tax in India under section 10(38) of the Income Tax Act, 1961 (ITA) if

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ERGO KEY CHANGES IN THE ALTERNATIVE INVESTMENT FUNDS (AIFS) SPACE

such transfer was undertaken on a recognized stock exchange and Securities Transaction
Tax (STT) was paid on the same.

However, this exemption was being abused by many, such that unaccounted income was
declared as exempt long-term capital gains by entering into sham transactions.
Accordingly, in order to prevent such misuse, the Finance Act, 2017 amended Section
10(38) with effect from 1 April 2017, to limit the benefit of this provision to transactions
where STT was also paid at the time of acquisition of the shares sought to be transferred,
provided such shares were acquired on or after 1 October 2004, subject to certain
exemptions as may be prescribed (Amendment).

To protect genuine cases, it was clarified that the Indian Government would notify those
acquisitions to which the Amendment shall not apply.

The CBDT Notification

The CBDT notification dated 5 June 2017 (Notification) sets out a negative list and
provides that except for certain transactions of acquisition of equity shares (entered on
or after 1 October 2004) which are covered in that list, the acquisition of shares under
all other transactions which did not result in payment of STT at the time of acquisition,
would be eligible for the long-term capital gains tax exemption, provided STT was paid
at the time of transfer of such shares. The Notification provides, inter alia, that acquisition
of listed equity shares by a Category I AIF, Category II AIF or venture capital fund (as
defined under the ITA) will be exempt from the requirement of having paid the STT at
the time of acquisition of listed shares of a company, to be able to avail the long-term
capital gains tax exemption under Section 10(38). The Notification has come into force
with effect from 1 April 2017.

Comment

The Notification has brought much needed cheer to Category I and Category II AIFs, as
it ensures that they can avail the capital gains tax exemption under Section 10(38) and
are not subject to tax on long-term capital gains due to non-payment of STT at the time
of acquisition of such listed shares. It was realised by the Government, upon urging by
stakeholders, that given the nature of Category I and Category II AIFs, wherein they
invest primarily in unlisted securities (i.e. at least 51%) as per the AIF Regulations, STT
would not have been paid when shares held by such Category I and Category II AIFs are
sold/transferred on the Stock Exchanges. Such a case, wherein STT has not been paid,
was due to circumstances arising from the nature of the AIF Regulations and hence,
should not come under the ambit of transactions where Section 10(38) was abused.

While it has been a favourable Amendment for Category I and Category II AIFs, Category
III AIFs have been given the step-motherly treatment by not being included in the
Notification alongside Category I AIFs and Category II AIFs. This is a huge disincentive
for fund managers hoping to set up a Category III AIF in India, as it disentitles Category
III AIFs from claiming long term capital gains tax exemption under Section 10(38) unless
such Category III AIF has paid STT at the time of acquisition of shares, as opposed to
Category I and Category II AIFs.

Amendment in rules for valuation of unquoted equity shares

Background

Section 56(2) of the ITA provides that the difference between the Fair Market Value
(FMV) and the consideration paid/payable, would be regarded as income from other
sources in the hands of the recipient. Such income is taxed at the tax rate applicable to
the recipient on its ordinary income. The Finance Act 2017, had introduced section 50CA

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ERGO KEY CHANGES IN THE ALTERNATIVE INVESTMENT FUNDS (AIFS) SPACE

of the ITA, to tax the seller of an unquoted equity share on the fair market value on a
deemed basis, where the sale consideration was less than the FMV.

In this regard, Rule 11UA of the Income-tax Rules, 1962 (IT Rules) provided the mechanism
to arrive at the FMV for unquoted equity shares, which was based on the book value of
net assets of the company, the shares of which were transferred. The CBDT has recently
amended the rules for valuation of unquoted equity shares with effect from 1 April 2017
(Amended Valuation Rules). The Amended Valuation Rules apply to valuation under both
section 56 and section 50CA of the ITA.

As per the Amended Valuation Rules, the value of an equity share shall depend on the
asset composition of the target company and is to be computed basis, inter alia: (a)
stamp duty value of immovable property; (b) fair value of shares and securities, artwork,
paintings, jewellery; and (c) book value of other assets (subject to prescribed
adjustments), owned by the target. Further, such valuation is required to be carried out
on the basis of audited financial statements of the target company, as on the date of
transfer of the shares.

Comment

It needs to be seen whether the sale consideration agreed between by the PE investor
for unquoted equity shares met the FMV test under the Amended Valuation Rules for
unquoted shares transferred between 1 April 2017 and 13 July 2017 (the date on which
the Amended Valuation Rules were notified) and transfer of unquoted shares going
forward. It is vital that the sale consideration meets the FMV as per the Amended
Valuation Rules since the difference between the FMV (determined in accordance with
the Amended Valuation Rules) and the sale consideration would be taxable in the hands
of the purchaser at the applicable slab rate, which would be 40% (plus applicable
surcharge and cess) if the purchaser is a foreign company. Also, the seller would be
taxable on the FMV of such shares on deemed basis under Section 50CA of the ITA,
where the sale consideration is less than the FMV.

Though the rules require the valuation to be as on the date of transfer, however, if this
is not practically feasible, the valuation may be carried out based on the latest available
financial statements with factual confirmations from management that no significant
changes have taken place in such values.

- Siddharth Shah (Partner), Vivek Mimani (Associate Partner), Ritu Shaktawat

(Associate Partner), Alvin Selvam (Senior Associate), Ankit Namdeo (Associate) and
Saiya Savooji (Associate)

For any queries please contact: editors@khaitanco.com

6
Tax Insights

from India Tax & Regulatory Services

Distribution of income by trust to

beneficiaries not chargeable to tax
under section 56(2)(vi)

June 2, 2016

In brief
In a recent decision, the Bangalore Bench of the Income-tax Appellate Tribunal (the Tribunal) held
that distribution of income by a trust to its beneficiaries would not be construed as amounts received
without consideration by the beneficiaries, and hence, section 56(2)(vi) of the Income-tax Act, 1961
(the Act) would not apply to such receipts. It also held that the Tax Officer (TO) had an option to
assess the amount received by the taxpayer from various trusts as a beneficiary of such income, either
in the hands of the trust or in the hands of the beneficiary. The Tribunal further held that if such
option was exercised by the TO and income was taxed in the beneficiary’s hands, income would be
classified in the hands of the beneficiary in the same manner as it was classified in the hands of the
trust.

In detail to the trust after Income-tax (Appeals) [CIT

commencing proceedings (A)] upheld the TO’s order.
Facts under section 143(2) of the He also stated that if this
 The taxpayer1, a beneficiary Act on the taxpayer - thus amount was not taxed
of an employer trust (the the TO exercised the option under section 17(3) of the
trust), earning salary and to assess the trust’s income Act, then it would have
professional income had in the taxpayer’s hands. been definitely taxable
filed her return of income under section 56(2)(vi) as it
 The taxpayer claimed that was a receipt without
for the assessment year
since the trust had paid consideration.
(AY) disclosing a certain
income tax on the amounts
income received from
distributed, it should not be Issues before the Tribunal
twelve trusts floated by the
taxable in its hands.
taxpayers’ employer.  Would the distribution of
 The TO contended that the income by the trust floated
 In the AY in question, the by the employer be taxed in
amount received by the
trust had earned capital the beneficiary’s hands as
taxpayer from the trust
gains income and income profits in lieu of salary
should have been
chargeable under section under section 17(3) of the
considered as emanating
56(2)(i) of the Act, on which Act?
from her employer-
taxes were paid by the
employee relationship, and
trusts. Thereafter, the trust  Could any income of the
should have been
distributed a part of the trust be taxed in the hands
chargeable under section
same income to the of the trust or the
17(3) of the Act as profit in
taxpayer. beneficiary at the TO’s
lieu of salary.
discretion by invoking
 An intimation under section section 166?
 The Commissioner of
143(1) of the Act was issued
1
I.T.A No.1594/Bang/2014
(Assessment Year : 2008-09)

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Tax Insights

 Would the distribution of the trustee, and therefore the and received by the
income by the trust to its beneficiaries could not be assessed beneficiaries in the course of
beneficiary be taxed as income thereafter on the same income. an accounting year. This
received without any principle had also been laid
consideration under section Key contentions of the down by the Apex Court in the
Revenue
56(2)(vi)? case of Smt. Kamalini Khatau3.
The CIT (A) opined that income
 If the TO invoked section 166, received by the trustees of various  The Tribunal further held that
whereby income of the trust trusts fell within section 164(1)(iv) for bringing a sum of money to
was taxed in the hands of the of the Act. He contended that a tax under section 56(2)(vi) of
beneficiaries, would the discretionary trust should have the Act, it was necessary that
taxpayer be allowed credit for been considered as an Association the money should have been
the taxes paid by the trust? of Persons for the purpose of received by the taxpayer
charging tax. without consideration. In a
Key contentions of the trust, whether discretionary or
taxpayer
The CIT (A) also opined that the otherwise, the trustees held
 The taxpayer contended that trust’s income had passed on to the the property and income for
the amounts received from the taxpayer, and just the fact that the the benefit of the beneficiaries.
trust was encashment of pre- trust had paid tax would not mean The trust as such did not have
existing rights as a beneficiary that such income was exempt in a separate legal existence, but
of the trust, and hence, it could the beneficiary taxpayer’s hands. only represented its
not be considered as having beneficiaries. Income of the
been received without any The CIT (Appeals) further trust was the income of the
consideration. The trustees concluded that the trust and beneficiary. The trustees in a
were holding the property and beneficiaries were two separate discretionary trust only had
funds only in a fiduciary legal entities, and hence, could be the power to decide when and
capacity, and the trust property taxed separately. Further, the how much money to distribute
and income always belonged to credit of taxes paid by the trust was among the beneficiaries.
the beneficiaries. Receipt of also denied to the beneficiary since
something belonging to a tax due from the taxpayer was in  Thus, what was received by the
person could not be considered her individual capacity as a taxpayer as a beneficiary was
as a gift or a receipt without separate taxable entity. nothing but his own income in
consideration. his status as a beneficiary in
The Revenue contended that in the the trust. What had flown from
 The taxpayer also contended case of Smt. Indramma2, the trust the trustee to the beneficiary
that by virtue of section 161 of had already been assessed and was only the income collected
the Act, the character of therefore the beneficiaries would by the trustee on behalf of the
income in the hands of trusts not be assessable. beneficiary.
as well as the beneficiaries Tribunal’s Ruling
would always remain the  Once the character of income
same. Hence, if the trust  The Tribunal observed that in the hands of the beneficiary
earned income which was though there was a connection took the same colour as that of
taxable under section 56(2)(i), of employment between the the trust, and once it had been
then the distribution of the settlor and the taxpayer, there accepted that the trust as such
same income could not be was no direct nexus between did not have a persona distinct
taxed in the hands of the the payments affected by the from its beneficiaries, it could
beneficiary under section trusts to the taxpayer. not be said that the income
56(2)(vi) of the Act. Therefore, the amount was received without any
received by the taxpayer would consideration. Hence, the
While relying on the Karnataka not fall within the meaning of money received by the
High Court decision in the case of profit in lieu of salary. taxpayer from various trusts
Smt. Indramma2, the taxpayer could not have been taxed
contended that assessment in case  The Revenue had an option to under section 56(2)(vi) of the
of discretionary trusts could be assess and recover the tax Act.
made either on the trustee or on from either the trustees or the
the beneficiary. The taxpayer beneficiaries of a discretionary  Accordingly, the case was
contended that the TO had trust in respect of the income referred back to the CIT (A)
exercised his option to assess the which had been distributed for appropriate classification

2 3
CIT v. Smt Indramma [ITA No. CIT v Smt. Kamalini Khatau [209 ITR
2785/2005]- Karnataka H.C 0101]

PwC Page 2
Tax Insights

of income in the taxpayer’s give credit of the taxes paid that the amount received by a
hands and for apportioning it by the trust. beneficiary from a trust (on
in the same ratio as such its dissolution) could not be
income bore to the income of The takeaways termed to be without
the various trusts under  This decision reaffirms the consideration.
different heads. position that distribution of
Let’s talk
 As a corollary to the above income from a trust to its
decision, the Tribunal also beneficiary, could not be said For a deeper discussion of how
to be without consideration. this issue might affect your
held that if the taxpayer felt
Though this decision dealt business, please contact:
that the taxes paid by the
trust were refundable since with section 56(2)(vi), the
Tax & Regulatory Services –
the taxes were assessable in ratio laid down in this case
Mergers and Acquisitions
the beneficiary’s hands, it would squarely apply to
section 56(2)(vii) of the Act as Gautam Mehra, Mumbai
could move the appropriate
well. +91-22 6689 1154
authority for getting the
gautam.mehra@in.pwc.com
relief. However, there was no  This decision is in line with
enabling provision in the law the view taken by Mumbai Hiten Kotak, Mumbai
which would empower the Tribunal in the case of Ashok +91-22 6689 1288
Tribunal to direct the TO to hiten.kotak@in.pwc.com
C Pratap4, wherein it was held

4
Ashok C. Pratap v. Additional
Commissioner of Income-tax [4615 (Mum)
of 2011]

PwC Page 3
Tax Insights

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At PwC, our purpose is to build trust in society and solve important problems. We’re a network of firms in 157
countries with more than 208,000 people who are committed to delivering quality in assurance, advisory and tax
services. Find out more and tell us what matters to you by visiting us at www.pwc.com.

In India, PwC has offices in these cities: Ahmedabad, Bangalore, Chennai, Delhi NCR, Hyderabad, Kolkata, Mumbai
and Pune. For more information about PwC India's service offerings, visit www.pwc.com/in

PwC refers to the PwC International network and/or one or more of its member firms, each of which is a separate,
independent and distinct legal entity in separate lines of service. Please see www.pwc.com/structure for further
details.

©2016 PwC. All rights reserved

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This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information
contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness
of the information contained in this publication, and, to the extent permitted by law, PwCPL, its members, employees and agents accept no liability, and disclaim all
responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based
on it. Without prior permission of PwCPL, this publication may not be quoted in whole or in part or otherwise referred to in any documents.

© 2016 PricewaterhouseCoopers Private Limited. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers Private Limited (a limited liability company
in India having Corporate Identity Number or CIN : U74140WB1983PTC036093), which is a member firm of PricewaterhouseCoopers International Limited (PwCIL), each
member firm of which is a separate legal entity.
 February 2017

Determinate status of the trust not to be affected if trust deed is capable of identifying the
beneficiaries and determining their respective shares

Background
The taxation of domestic Venture Capital Funds (VCFs) and Alternative Investment Funds (AIFs) has
undergone various changes over the years. Currently, VCFs1 and Category I/ II AIFs2 have been granted tax pass
through status under the Income-tax Act, 1961 (the Act) in relation to specified income. Such income is directly
chargeable to tax in the hands of the beneficiaries/ investors3.
In certain cases, the tax pass through status is not available to such Funds (generally set-up as contributory
trusts), in which case they are governed by normal trust taxation principles set out under the Act, whereby the
trustee of the Funds (set-up as a trust) are assessable in the capacity of a representative assessee. Some of the
cases are provided as under:
 Category III AIFs
 Category I/ II AIFs (in past years when tax pass through status was not available)
 VCFs (for non-specified income)
 VCFs (in past years when the tax pass through status was limited to investment income from investments in
specified sectors)
In the above cases, it is critical that the Fund (set-up as a trust) qualifies as a determinate trust, so that tax levied
in the hands of the trustee is in the like manner and to the same extent as it would be leviable upon the
beneficiaries.
In case where the Fund is treated as ‘indeterminate trust’, it could get taxed under section 164(1) of the Act,
which provides for taxation at maximum marginal rate under certain circumstances.
Explanation 1 to section 164 of the Act provides that for a trust to be determinate, (i) the beneficiaries should be
expressly stated and identifiable as on the date of the trust deed; and (ii) their individual shares should be
expressly stated and ascertainable as on the date of the trust deed.
In this connection, it may be noted that the Authority for Advance Ruling4 held that if the trust deed sets out
expressly the manner in which the beneficiaries are to be ascertained and also the share to which each of them
would be entitled without ambiguity, then it cannot be said that the trust is indeterminate.
However, the Central Board of Direct Taxes issued Circular No. 13/2014, dated 28 July, 2014, wherein it had
stated that in a situation where the trust deed either does not name the investors or does not specify their
beneficial interest, the provisions of section 164(1) of the Act would apply and the entire income should be
chargeable to tax at maximum marginal rate in the hands of the trustee in their representative capacity.
In brief
In a recent decision, the Karnataka High Court in the case of the Trust5, upheld the decision of the Bangalore
Income-tax Appellate Tribunal and held that for a trust to be a determinate trust, it would be sufficient if the
trust deed laid down that the beneficiaries would be the persons who had made, or had agreed to make,
contributions to the trust in accordance with the contribution agreement, and their shares were capable of being
determined based on the provisions of the trust deed.
In detail
Issue before the Karnataka High Court
Whether the Tribunal was right in holding the Trust as a determinate trust and not assessing the Trust at the
maximum marginal rate as per section 164(1) of the Act?
High Court's ruling
The High Court upheld the decision of the Tribunal on the following principles:
 All that is necessary is that the beneficiaries should be identifiable based on the provisions of the trust deed,
and it was not necessary that the beneficiaries should be specifically named in the trust deed. In the present
case, the trust deed clearly laid down that beneficiaries meant the persons, each of whom had made or
agreed to make, contributions to the trust in accordance with the contribution agreement.
 It is not necessary that the trust deed should actually prescribe the percentage share of the beneficiaries in
order for the trust to be determinate. It is enough that the share of the beneficiaries is capable of being
determined based on the provision/ formula as on the date of the trust deed and not at the discretion of the
trustee. In the present case, the trust deed clearly specified the manner in which the income had to be
distributed.
 If the trust deed authorises addition of further contributors to the trust at different points in time in addition
to the initial contributors, the same would not make the beneficiaries unknown or their shares
indeterminate.
The Revenue had also raised other questions before the High Court, but since the above question of law was held
in favour of the assessee, other questions did not arise.
Key takeaways
This is a welcome decision in the area of taxation of contributory trusts, and should provide relief to the
domestic fund industry.
While Circular No. 13/2014 mentioned above in the context of taxation of the trusts has not been discussed in
the present case, this High Court decision would have a binding effect on all tax Tribunals until any other High
Court or Supreme Court takes a different view on this matter.

1
Section 10(23FB) of the Act
2
Section 10(23FBA) of the Act
3
Section 115U and Section 115UB of the Act
4
224 ITR 473 (AAR)
5
India Advantage Fund-VII ITA No. 191/2015

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additional information, please reach out to your PwC relationship manager or write in to
pwctrs.knowledgemanagement@in.pwc.com

With Best Regards

PwC TRS Team

About PwC

At PwC, our purpose is to build trust in society and solve important problems. We’re a network of firms in 157 countries
with more than 223,000 people who are committed to delivering quality in assurance, advisory and tax services. Find out
more and tell us what matters to you by visiting us at www.pwc.com.

In India, PwC has offices in these cities: Ahmedabad, Bengaluru, Chennai, Delhi NCR, Hyderabad, Kolkata, Mumbai and
Pune. For more information about PwC India's service offerings, visit www.pwc.com/in

PwC refers to the PwC International network and/or one or more of its member firms, each of which is a separate,
independent and distinct legal entity. Please see www.pwc.com/structure for further details.

©2017 PwC. All rights reserved

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© 2017 PricewaterhouseCoopers Private Limited. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers Private Limited (a limited
liability company in India having Corporate Identity Number or CIN : U74140WB1983PTC036093), which is a member firm of PricewaterhouseCoopers
International Limited (PwCIL), each member firm of which is a separate legal entity

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 November 2018
SEBI issues operating guidelines for AIFs in IFSC

Background
In 2015, the Securities and Exchange Board of India (SEBI) had issued detailed guidelines to facilitate and
regulate the securities market in India’s first International Financial Services Centre (IFSC) set up under section
18(1) of the Special Economic Zones Act, 2005 at Gujarat International Finance Tec-City, Gujarat (GIFT City).

The above guidelines contained enabling provisions for various capital market players including Alternative
Investment Funds (AIFs) in the IFSC. These guidelines provided the basic framework for AIFs, such as
permissible investors, permissible investments, etc. However, the operating guidelines were yet to be specified
by SEBI.

Operating guidelines for AIFs in IFSC

On 26 November 2018, the SEBI issued Circular No. SEBI/HO/IMD/DF1/CIR/P/143/2018 specifying the
‘Operating guidelines for AIFs in IFSC’ (operating guidelines).

The key highlights of the operating guidelines are as follows:

1. Registration process:
An AIF established or incorporated in IFSC in the form of a trust, or a company, or a limited liability
partnership (LLP), or a body corporate can seek registration with SEBI.

2. Investment conditions:
 AIFs in IFSC can now invest in India under the foreign portfolio investment (FPI) or foreign venture
capital investment or foreign direct investment route (earlier, only the FPI route was permitted).
 AIFs in IFSC can invest in units of other AIFs in IFSC in India.

3. Minimum requirements:

Particulars Amount (in USD)

Minimum corpus requirement for each scheme of the AIF 3,000,000
Minimum investment by an investor in AIF:
o For employees or directors of the AIF or its manager 40,000
o For other investors 150,000
Minimum continuing interest requirement for manager or sponsor of Lower of the following:
the AIF (not through waiver of fees)
o For Category I and Category II AIF 2.5% of corpus or 750,000
o For Category III AIF 5% of corpus or 1,500,000

4. Set up requirements for manager/ sponsor of AIFs in IFSC:

 Existing sponsor/ manager of an AIF in India can set up a branch or company or LLP in IFSC.
 New sponsors/ managers will have to set up a company or LLP in IFSC.

5. Requirement to appoint custodian:

 For Category I and Category II AIFs - Only if corpus > USD 70 million.
 For Category III AIF, mandatory requirement.

6. Requirements for Angel funds:

 Minimum corpus should be at least USD 750,000.
 Criteria specified for angel investor investing into Angel fund in IFSC as follows:
 - individual investor with net tangible assets of at least USD 300,000 (excluding value of his
principal residence).
- body corporate with net worth of at least USD 1.50 million.
 Angel funds in IFSC can invest in Venture Capital Undertakings (VCUs) in India, as per Department
of Industrial Policy and Promotion guidelines, which -
- have turnover less than USD 3.75 million.
- are not promoted or sponsored or related to an industrial group whose group turnover exceeds
USD 45 million.
 Minimum investment by Angel funds in VCUs shall be USD 40,000 subject to an upper cap of USD
1.50 million.

7. Overseas investments:
The SEBI vide para 2.B. of the Circular No. CIR/IMD/DF/7/2015 dated 1 October 2015, had laid down
conditions for AIFs to comply with before investing outside India. Such conditions included obtaining
prior approval from SEBI, capping investments to a limit of USD 500 million (now USD 750 million) and
25% of investible funds, etc. As per the operating guidelines issued by the SEBI, these conditions should
not apply to an AIF set up in the IFSC.

Key takeaways
This Circular is a welcome move, which will act as a catalyst to the growth of the fund regime in the IFSC and
will provide global investors with a new option to set up global funds from the IFSC in the form of an AIF. These
guidelines provide the much needed clarity on key regulatory issues like applicability of existing regulations,
conditions for overseas investment, form of set up for existing manager/ sponsor and flexibility to invest in
India through all routes. As a next step, while SEBI has issued the much awaited operating guidelines, the
Government should also bring out the changes in the tax laws to encourage the global investors to participate in
the fund regime in India's first IFSC at the GIFT City.

If your interest lies in a specific area or subject, do advise us so we can send you only the relevant alerts. For any
additional information, please reach out to your PwC relationship manager or write in to
pwctrs.knowledgemanagement@in.pwc.com

With Best Regards

PwC TRS Team

About PwC

At PwC, our purpose is to build trust in society and solve important problems. We’re a network of firms in 158 countries
with more than 236,000 people who are committed to delivering quality in assurance, advisory and tax services. Find out
more and tell us what matters to you by visiting us at www.pwc.com.

In India, PwC has offices in these cities: Ahmedabad, Bengaluru, Chennai, Delhi NCR, Hyderabad, Jamshedpur, Kolkata,
Mumbai and Pune. For more information about PwC India's service offerings, visit www.pwc.com/in

PwC refers to the PwC International network and/or one or more of its member firms, each of which is a separate,
independent and distinct legal entity. Please see www.pwc.com/structure for further details.

©2018 PwC. All rights reserved

Follow us on Facebook, Linkedin, Twitter and YouTube.

© 2018 PricewaterhouseCoopers Private Limited. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers Private Limited (a limited
liability company in India having Corporate Identity Number or CIN : U74140WB1983PTC036093), which is a member firm of PricewaterhouseCoopers
International Limited (PwCIL), each member firm of which is a separate legal entity

Our Tax & Regulatory Services Direct Tax Indirect Tax Transfer Pricing Regulatory M&A
Tax Controversy and Dispute Resolution Financial Services
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Tax Insights

from India Tax & Regulatory Services

Income earned by a fund set up as a

revocable trust to be taxed only in
the hands of the beneficiaries as per
the provisions of sections 61 to 63

November 5, 2014

In brief
In a recent decision, the Bangalore Bench of the Income-tax Appellate Tribunal (the Tribunal) in the
case of India Advantage Fund-VII [ITA No. 178/Bang/2012] (the fund or the trust) held that in the
case of a revocable trust, income had to be taxed in the hands of the beneficiaries of the trust and not
in the hands of the trustee in the capacity of a representative taxpayer.
It also held that for a trust to be a determinate trust, it would be sufficient if the trust deed laid down
that the beneficiaries would be the persons who had made, or had agreed to make, contributions to
the trust in accordance with the contribution agreement, and their shares were capable of being
determined based on the provisions of the trust deed.
Lastly, it held that the fund could not be regarded as an Association of Persons (AoP) as the
beneficiaries had not set up the trust; they had not come together with the object of carrying on
investment in a mezzanine fund, which was the object of the trust; and there was no inter se
agreement between the beneficiaries of the fund.

In detail as well as the investment investment manager was

management agreement appointed by the trust by
Issues before the Tribunal and the offer document. virtue of powers conferred
 Whether the trust was a under the trust deed,
revocable trust?  the prospectus inviting would be sufficient to
contributions from the conclude that the
 Whether the trust was a contributors clearly laid transferor/ beneficiary had
determinate trust? down that in certain deemed power of
circumstances, 75 per cent revocation.
 Whether the trust could be of the contributors could
regarded as an AoP? revoke their contributions The Tribunal also held that:
to the fund at any point in
Tribunal’s ruling time, and the trustees  As per section 61 of the
should then terminate the Act, it was not necessary
Revocability of the Trust fund. that the power of
revocation should be at the
The Tribunal held that sections instance of the transferor/
 though the power of the
61 to 63 of the Income-tax Act beneficiary, but could be at
transferor/ beneficiary to
1961 (the Act), would apply, on the instance of any person
revoke the transfer was not
the following reasoning: either settlor, trustee,
in the instrument of
transfer, but by virtue of transferee or the
 the contribution
power conferred in the beneficiaries. The power of
agreement had to be read
document by which the revocation under the trust
along with the trust deed

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Tax Insights

deed was a general power of  The beneficiaries as well as The takeaway

revocation, and the same their shares must be capable
would be sufficient for of being definitely pin pointed This is a welcome decision in the
construing the transfer in the and ascertained on the date of area of taxation of trusts, and
present case as a revocable the trust deed itself, without should be very relevant and useful
transfer. leaving these to be decided to the domestic alternative asset
upon at a future date by a management industry. While the
 Section 61 read with section person other than the author. Tribunal has not dealt with
63 of the Act, which Circular No. 13/2014, dated July
mandated that income arising  Even if the trust deed 28, 2014, issued by Central Board
to a person by virtue of a authorised addition of further of Direct Taxes, in the context of
revocable transfer of assets contributors to the trust at taxation of the trusts (other than
should be chargeable to different points in time in holding that the circular was not
income-tax as the income of addition to the initial applicable to the facts of the
the transferor, would apply in contributors, the same would present case), the position laid
the present case. not make the beneficiaries down in the decision should have
unknown or their shares a persuasive value even while
 Even if a settlement on the indeterminate. interpreting the Circular.
face of it was stated to be
irrevocable, if the same Trust being regarded as an AoP Having said this, the decision has
provided for the direct or not explicitly dealt with the
indirect re-transfer of income The Tribunal held that the trust conflict between section 61 and
or assets of the settlement to was not an AoP, on the following section 161 of the Act, and their
the settlor or gave the settlor reasoning: overriding effect.
a right to resume power  the beneficiaries had not set
directly/ indirectly over such In any case, we think that the
up the trust;
income or assets, the Government should extend the
settlement would be deemed benefit of the provisions of
 the beneficiaries contributed
to be revocable. section 10(23FB) of the Act, to all
money to the trust under
forms of alternative funds. This
separate agreements, and
Determinate status of the trust could be a step in reducing
there was no inter se
litigation.
The Tribunal held that it was a arrangement between either
determinate trust, and that the of the beneficiaries;
Let’s talk
provisions of section 164(1) of the
Act did not apply, on the  it could not be said that two For a deeper discussion of how
following facts: or more beneficiaries joined this issue might affect your
in for a common purpose or business, please contact:
 The trust deed clearly laid common action;
down that beneficiaries Tax & Regulatory Services –
meant the persons, each of  therefore, they could not be Financial Services
whom had made or agreed to regarded as an AoP.
make, contributions to the Shyamal Mukherjee, Gurgaon
trust in accordance with the The fact that the trust had its PAN +91-124 330 6536
contribution agreement. under the status of an AoP was shyamal.mukherjee@in.pwc.com
irrelevant.
 The trust deed clearly Ketan Dalal, Mumbai
specified the manner in which The fact that the trust filed the +91-22 6689 1422
the income had to be return of income as an AoP/ BoI ketan.dalal@in.pwc.com
distributed. was irrelevant.
Gautam Mehra, Mumbai
The Tribunal also held that: Other points discussed by the +91-22 6689 1154
Tribunal gautam.mehra@in.pwc.com
 It was enough if the shares
were capable of being The Tribunal also held that once
determined based on the the choice was made by the
provisions of the trust deed, department to tax either the trust
and it was not necessary that or the beneficiaries, it was no
the beneficiaries should be more open to the department to
specifically named in the trust go behind and assess the other at
deed. the same time.

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1/10/2019 www.taxmann.com

Section - 164, Income-tax Act, 1961 - FA, 2018

30[Charge 31 of tax where share of beneficiaries unknown.

32 164. (1) 33[Subject to the provisions of sub-sections (2) and (3), where] any income in respect of which the
persons mentioned in clauses (iii) and (iv) of sub-section (1) of section 160 are liable as representative
assessees or any part thereof is not specifically receivable on behalf or for the benefit of31any one person31 or
where the individual shares of the persons on whose behalf or for whose benefit such income or such part
thereof is receivable are indeterminate or unknown (such income, such part of the income and such persons
being hereafter in this section referred to as "relevant income", "part of relevant income" and
31"beneficiaries", respectively), 34[tax shall be charged on the relevant income or part of relevant income at

the maximum marginal rate35 :]

Provided that in a case where—
36[(i) none of the beneficiaries has any other income chargeable under this Act exceeding the maximum
amount not chargeable to tax in the case of an 37[association of persons] or is a beneficiary under any
other trust; or]
(ii) the relevant income or part of relevant income is receivable under 38[a trust declared by any person
by will and such trust is the only trust so declared39 by him]; or
(iii) the relevant income or part of relevant income is receivable under a trust created before the 1st day of
March, 1970, by a non-testamentary instrument and the 40[Assessing] Officer is satisfied, having
regard to all the circumstances existing at the relevant time, that the trust was created bona fide
exclusively for the benefit of the relatives of the settlor, or where the settlor is a Hindu undivided
family, exclusively for the benefit of the members of such family, in circumstances where such
relatives or members were mainly dependent on the settlor for their support and maintenance; or
(iv) the relevant income is receivable by the trustees on behalf of a provident fund, superannuation fund,
gratuity fund, pension fund or any other fund created bona fide by a person carrying on a business or
profession exclusively for the benefit of persons employed in such business or profession,
tax shall be charged 41[on the relevant income or part of relevant income as if it] were the total income of an
42[association of persons] :

43[Provided further that where any income in respect of which the person mentioned in clause (iv) of sub-
section (1) of section 160 is liable as representative assessee consists of, or includes, profits and gains of
business, the preceding proviso shall apply only if such profits and gains are receivable under a trust declared
by any person by will exclusively for the benefit of any relative dependent on him for support and
maintenance, and such trust is the only trust so declared by him.]
44[(2) In the case of relevant income which is derived from property held under trust wholly for charitable or
religious purposes, 45[or which is of the nature referred to in sub-clause (iia) of clause (24) of section 2,] 46[or
which is of the nature referred to in sub-section (4A) of section 11,] tax shall be charged on so much of the
relevant income as is not exempt under section 1145[or section 12], as if the relevant income not so exempt
were the income of an association of persons :
47[Provided that in a case where the whole or any part of the relevant income is not exempt under section 11
or section 12 by virtue of the provisions contained in clause (c) or clause (d) of sub-section (1) of section 13,
tax shall be charged on the relevant income or part of relevant income at the maximum marginal rate.]]
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44[(3) In a case where the relevant income is derived from property held under trust in part only for charitable
or religious purposes 45[or is of the nature referred to in sub-clause (iia) of clause (24) of section 2] 48[or is of
the nature referred to in sub-section (4A) of section 11,] and either the relevant income applicable to purposes
other than charitable or religious purposes (or any part thereof) 49[is not specifically receivable on behalf or
for the benefit of any one person or the individual shares of the beneficiaries in the income so applicable are
indeterminate or unknown, the tax chargeable on the relevant income shall be the aggregate of—
(a) the tax which would be chargeable on that part of the relevant income which is applicable to
charitable or religious purposes (as reduced by the income, if any, which is exempt under section 11)
as if such part (or such part as so reduced) were the total income of an association of persons; and
(b) the tax on that part of the relevant income which is applicable to purposes other than charitable or
religious purposes, and which is either not specifically receivable on behalf or for the benefit of any
one person or in respect of which the shares of the beneficiaries are indeterminate or unknown, at the
maximum marginal rate :]
Provided that in a case where—
50[(i) none of the beneficiaries in respect of the part of the relevant income which is not applicable to
charitable or religious purposes has any other income chargeable under this Act exceeding the
maximum amount not chargeable to tax in the case of an association of persons or is a beneficiary
under any other trust; or]
(ii) the relevant income is receivable under 51[a trust declared by any person by will and such trust is the
only trust so declared by him]; or
(iii) the relevant income is receivable under a trust created before the 1st day of March, 1970, by a non-
testamentary instrument and the 52[Assessing] Officer is satisfied, having regard to all the
circumstances existing at the relevant time, that the trust, to the extent it is not for charitable or
religious purposes, was created bona fide exclusively for the benefit of the relatives of the settlor, or
where the settlor is a Hindu undivided family, exclusively for the benefit of the members of such
family, in circumstances where such relatives or members were mainly dependent on the settlor for
their support and maintenance,
tax shall be charged 53[on the relevant income] as if the relevant income (as reduced by the income, if any,
which is exempt under section 11) were the total income of an association of persons :]
54[Provided further that where the relevant income consists of, or includes, profits and gains of business, the
preceding proviso shall apply only if the income is receivable under a trust declared by any person by will
exclusively for the benefit of any relative dependent on him for support and maintenance, and such trust is the
only trust so declared by him :
Provided also that in a case where the whole or any part of the relevant income is not exempt under section 11
or section 12 by virtue of the provisions contained in clause (c) or clause (d) of sub-section (1) of section 13,
tax shall be charged on the relevant income or part of relevant income at the maximum marginal rate.]]
53[Explanation1.—For the purposes of this section,—
(i) any income in respect of which the persons mentioned in clause (iii) and clause (iv) of sub-section (1)
of section 160 are liable as representative assessee or any part thereof shall be deemed as being not
specifically receivable on behalf or for the benefit of any one person unless the person on whose
behalf or for whose benefit such income or such part thereof is receivable during the previous year is
expressly stated in the order of the court or the instrument of trust or wakf deed, as the case may be,
and is identifiable as such on the date of such order, instrument or deed ;
(ii) the individual shares of the persons on whose behalf or for whose benefit such income or such part
thereof is received shall be deemed to be indeterminate or unknown unless the individual shares of
the persons on whose behalf or for whose benefit such income or such part thereof is receivable, are
expressly stated in the order of the court or the instrument of trust or wakf deed, as the case may be,
and are ascertainable as such on the date of such order, instrument or deed.
Explanation 2.— [Omitted by the Direct Tax Laws (Amendment) Act, 1987, w.e.f. 1-4-1989.]
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30. Substituted by the Finance Act, 1970, w.e.f. 1-4-1971.

31. For the meaning of the terms/expressions "charge", "for the benefit of", "any one person" and
"beneficiaries", see Taxmann's Direct Taxes Manual, Vol. 3.
32. For relevant case laws, see Taxmann's Master Guide to Income-tax Act.
33. Restored to its original expression by the Direct Tax Laws (Amendment) Act, 1989, w.e.f. 1-4-1989.
Earlier, it was substituted by the Direct Tax Laws (Amendment) Act, 1987, with effect from the same
date.
34. Substituted for the portion beginning with "tax shall be charged" and ending with "more beneficial to
the revenue" by the Finance (No. 2) Act, 1980, w.e.f. 1-4-1980.
35. For the meaning of the expression "maximum marginal rate", see Taxmann's Direct Taxes Manual, Vol.
3.
36. Substituted for "(i) none of the beneficiaries has any other income chargeable under this Act; or" by the
Finance (No. 2) Act, 1980, w.e.f. 1-4-1980.
37. Restored to its original expression by the Direct Tax Laws (Amendment) Act, 1989, w.e.f. 1-4-1989.
Earlier, it was substituted by the Direct Tax Laws (Amendment) Act, 1987, with effect from the same
date.
38. Substituted for "a trust declared by will" by the Finance (No. 2) Act, 1980, w.e.f. 1-4-1980.
39. For the meaning of the term "declared", see Taxmann's Direct Taxes Manual, Vol. 3.
40. Substituted for "Income-tax" by the Direct Tax Laws (Amendment) Act, 1987, w.e.f. 1-4-1988.
41. Substituted for "as if the relevant income or part of relevant income" by the Finance (No. 2) Act, 1980,
w.e.f. 1-4-1980.
42. Restored to its original expression by the Direct Tax Laws (Amendment) Act, 1989, w.e.f. 1-4-1989.
Earlier, it was substituted by the Direct Tax Laws (Amendment) Act, 1987, with effect from the same
date.
43. Inserted by the Finance Act, 1984, w.e.f. 1-4-1985.
44. Reintroduced by the Direct Tax Laws (Amendment) Act, 1989, w.e.f. 1-4-1989. Earlier, it was omitted
by the Direct Tax Laws (Amendment) Act, 1987, with effect from the same date.
45. Inserted by the Finance Act, 1972, w.e.f. 1-4-1973.
46. Inserted by the Finance Act, 1983, w.e.f. 1-4-1984.
47. Inserted by the Finance Act, 1984, w.e.f. 1-4-1985.
48. Inserted by the Finance Act, 1983, w.e.f. 6-10-1984.
49. Substituted for the portion beginning with "is not specifically receivable" and ending with "whichever
course would be more beneficial to the revenue:" by the Finance (No. 2) Act, 1980, w.e.f. 1-4-1980.
50. Substituted for "(i) none of the beneficiaries in respect of the part of the relevant income which is not
applicable to charitable or religious purposes has any other income chargeable under this Act; or" by
the Finance (No. 2) Act, 1980, w.e.f. 1-4-1980.
51. Substituted for "a trust declared by will" by the Finance (No. 2) Act, 1980, w.e.f. 1-4-1980.
52. Substituted for "Income-tax" by the Direct Tax Laws (Amendment) Act, 1987, w.e.f. 1-4-1988.
53. Inserted by the Finance (No. 2) Act, 1980, w.e.f. 1-4-1980.
54. Inserted by the Finance Act, 1984, w.e.f. 1-4-1985.

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 MUMBAI SI LI C O N VALLE Y BAN G A LO RE SI N G A P O RE MUMBAI BKC NEW DELHI MUNICH NE W YO RK

Social Impact
Investing in India
A Supplement to Corporate
Social Responsibility & Social
Business Models in India :
A Legal & Tax Perspective

July 2018

© Copyright 2018 Nishith Desai Associates www.nishithdesai.com

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social
Busi-ness Models in India : A Legal & Tax Perspective

July 2018

ndaconnect@nishithdesai.com

© Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

Contents
1. INTRODUCTION 01

2. EVOLUTION OF SOCIAL IMPACT INVESTING IN INDIA 03

3. ALTERNATIVE INVESTMENT FUNDS IN INDIA 04

4. SOCIAL VENTURE FUNDS 05

I. Laws Relating to Social Venture Funds in India 05

II. Characteristics of Social Venture Funds 05

5. MARKET OPPORTUNITIES 06

I. Investment Strategy 06
II. SME Financing 06
III. Affordable healthcare 06
IV. Trends in Impact Investing 06
V. Management Fee 07
VI. Expenses 07
VII. Waterfall 07
VIII. Giveback 08

6. FUND DOCUMENTATION 09

I. At The Offshore Fund Level 09

II. At The Onshore Fund Level 09

7. MANAGEMENT OF THE FUND 11

I. The Board 11
II. Investment Advisor 11
III. The Investor Panel 11
IV. The Sub-advisor 11
V. The Administrator 11
VI. Investment Process 11
VII. Sourcing Strategy 11
VIII. Evaluation Process 12
IX. Operational Engagement 12
X. Exit 12

© Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

8. WAYS TO ENHANCE CREDIT FOR IMPACT INVESTMENT 13

9. SOCIAL IMPACT BONDS 15

I. The potential of SIBs in India 16

II. Structure of the SIB PPP Model 18
III. Steps involved in channelization of funds 18
IV. The possible limitation of SIBs in the context of India 18
V. Regulatory and tax issues in SIBs 19
VI. Tax uncertainty 19
VII. Tax exemption 19

© Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

1. Introduction
The social sector plays a vital role in supporting This is in sharp contrast to other developing
various social and economic needs in India economies like Indonesia, Brazil and China, for
through a field-based approach. In the context of where the earnings in the top bracket were five to
India, where economic growth has not been able six times higher than those in the bottom rung.3
to cross the last mile and with socio-economic
Given the existing income inequality which
disparities widening, the social sector has now
can lead to market distortions and slowdown
started to explore the market-based approach to
in domestic demand, inclusive growth will
tackle the challenges of inclusive growth and
become an important tool to achieve long-term
sustainable development.
economic dividends. To achieve this, the key
The decade from 2002 to 2012 was arguably drivers are likely to be:
the fastest growing in India’s post-liberalized
ƒThe Agrarian sector, and in particular,farm
economic history, as GDP grew at 7.6 percent
productivity. Increasing investment in the
annually. During this high growth phase,
infrastructural side of the agrarian sector,
household consumption too saw a healthy rise
improving access to market, rationalization
in real terms. Fixed investment too reached
of price supports, expanding the adoption
an all-time high of almost one-third the GDP.1
of new technologies, and streamlining
India’s rapid economic growth made it one of
agricultural administration and extension
Asia’s most promising markets.
services can help to achieve annual yield of
With the change in government at the 5.5 percent.4
Centre, there has been rising expectations and
ƒHealthcare and sanitation: Improvement
aspirations and India’s growth is expected to
in health and sanitation facilities is one of
further strengthen to reach up to 7.5 percent
the key drivers of the economy. There is an
in 2016. India’s growth is likely to benefit from
urgent need to accelerate improvement in
strong domestic demand, policy reforms on ease
access to and utilization of health, family
of doing business, foreign direct investment,
welfare and nutrition services with a special
and lower petroleum prices and manageable
focus on under-served and underprivileged
inflation. India is expected to continue to be
population. According to D&B’s forecasts,
a major economy and a serious player in
total government expenditure on health is
emerging market economies.2
expected to remain low at 1.5% of GDP in
The economic growth has been quite lop-sided FY20 and infusion of private capital is going
with regions and demographics witnessing var- to be the key driver.5
ied levels of economic well-being and depriva-
ƒFinancial inclusion. India needs to infuse
tion. The highest paid working class population
the market with 0.10 billion new non-
(which is almost 10% of the entire wage earning
agrarian jobs over the next 10-15 years to
population) currently earns 14-15 times more
accommodate a growing population which
than the least paid working class population.
is educated and unemployed. India also
needs to reduce its employment generation’s

3. Special Focus: Inequality in Emerging Economies, OECD

2011
4. McKinsey Global Institute Report February 2014: From
1. McKinsey & Company Insights India Report October 2014: poverty to empowerment: India’s imperative for jobs, growth,
India’s economic geography in 2025: states, clusters and cities and effective basic services
2. IMF: World Economic Outlook, October 2015 5. D&B India 2020 Economy Outlook

© Nishith Desai Associates 2018 1

 Provided upon request only

over-dependence on agriculture.6 Promoting It is this systemic underperformance that

small entrepreneurial and small scale impact investing tries to resolve by infusing
employability through better access to credit capital along with business-management
will be a key determinant.7 practices so that organizations are able to
maximize their resources and achieve the
In most cases, social sector organizations face
desired outcomes. Impact investment into social
resource constraints and are not always equipped
entrepreneurial approaches, with appropriate
to replicate the successes of modern business
scale, scope and focus can go a long way in
approaches. Lack of business expertise, coupled
complementing social sector organizations in
with underutilization of resources leads to
bringing about sustainable development. Given
systemic underperformance. As marketsexpand ,
the priority sector requirements and significant
new opportunities for generating livelihoods and
deficiencies in public spending, there are
sustainability begin to emerge. The introduction
multiple market opportunities for investments,
of capital typically is a precursor to the expansion
collaborations and exits for social entrepreneurs
of consumer choices. Thus, meeting the socio-
to develop innovative and differentiated
economic demands in itself is a prime driver
businesses to foster inclusive growth.
for creating social impact. It is, therefore, no
surprise that the market opportunity for impact Impact investing looks at raising funds and
investment is vast. A recent study examined five making investments in entrepreneurs who
sectors of special importance to wage-earners work to solve socio-economic challenges using
living on less than $250 per month (water, health, market economy. Social impact investing drives
housing, education and financial services). The entrepreneurs to build self-sustaining systems
study estimated that, over the next decade and to serve a wide array of the population and
a half, these sectors could absorb $400 billion to provide returns (both social and capital) on
$1 trillion in capital and generate $183 billion to such investments. The ability to deliver benefits
$667 billion in profits.8 South Asia is one among on a large scale is the wellspring of impact
the top three regions where impact investment investment’s appeal.
commitments are expected to witness a steep rise.

6. McKinsey Global Institute Report February 2014: From

poverty to empowerment: India’s imperative for jobs, growth,
and effective basic services
7. IMF Financial Access Survey, 2011
8. Impact Investing: Harbinger of a Brighter Future and a
Friendlier Bond Market? ISBInsight

2 © Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

2. Evolution of Social Impact Investing in India

India is considered a breeding ground for (social) India is certainly one of the most vibrant
impact investing due to the enormous size of economies in the world and the rise of the
its demography and the unfulfilled demands entrepreneurial eco-system has allowed
for social and economic services. The reduced impact investing to set its foot firmly here.
public investment in priority sectors like Recent studies indicate that impact equity
primary education, health, housing, water and accounted for almost one-fifth of overall equity
sanitation etc. has allowed the growth of the transactions in India in 2014-15. In fact, impact
private entrepreneurial space. In recent past, equity investments are expected to grow by
private capital has flowed into key sectors of the 30% in coming years.9 Survey results show that
economy with special focus on microfinance, impact investment in India, going forward, will
health services, education and other allied target livelihood, education and health services.
sectors. The impact investing space also saw few
key players like Incube, Charioteer and Unitus
Seed Fund partaking substantial investments,
thereby further signaling the availability of
private capital for long-term sustainability
goals. While there has been no apparent dearth
of private capital to spurt social innovations,
the emergence of dedicated social investment
funds is a rightful recognition of the importance
of social impact funds to India’s economy and
job creation. There are certainly some unique
characteristics of these new impact funds, and
have been able to make a policy impetus in areas
that require a dedicated flow of investments.

9. A Natural Destination, Asia Asset Management Journal, June

2014 Vol. 19 No.6

© Nishith Desai Associates 2018 3

 Provided upon request only

3. Alternative Investment Funds in India

In the year 2012, SEBI enacted the Alternative i. is a privately pooled investment vehicle
Investment Funds (AIF) Regulations which which collects funds from investors,
included ‘social venture funds’. AIFs are funds whether Indian or foreign, for investing
established in India for the purpose of pooling it in accordance with a defined investment
capital from Indian and foreign investors for policy for the benefit of its investors; and
investing as per a pre-decided social impact
ii. is not covered under the Securities and
policy. Subject to certain exceptions, the ambit
Exchange Board of India (Mutual Funds)
of the AIF Regulations is to regulate all forms
Regulations, 1996, Securities and Exchange
of vehicles set up in India for pooling of funds
Board of India (Collective Investment
on a private placement basis. To that extent, the
Schemes) Regulations, 1999 or any other
AIF Regulations provide the bulwark within
regulations of the Board to regulate fund
which the Indian fund industry is to operate.
management activities.
An AIF means any fund established or
Figure 1: The following diagram depicts the
incorporated in India in the form of a trust or a
social venture fund that is set up in the form
company or a LLP or a body corporate which:
of a trust

Investors Sponsor

Contribution Agreement Contribution Agreement

(Sponsor-commitment)

Management
Fund services Investment Manager

Eligible Investments

4 © Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

4. Social Venture Funds

Although existent in practice, it is only under ƒAllowed to receive grants (in so far as they
the AIF Regulations that social venture funds conform to the above investment restriction)
were formally recognized. Under the AIF and provide grants. Relevant disclosure in
Regulations, a social venture fund is defined as, the placement memorandum of the fund
“an alternative investment fund which invests will have to be provided if the social venture
primarily in securities or units of social ventures fund is considering providing grants as well
and which satisfies social performance norms
ƒAllowed to receive muted returns
laid down by the fund and whose investors may
agree to receive restricted or muted returns.”
Typically, social venture funds tend to be impact
II. Characteristics of Social
funds which predominantly invest in sustainable Venture Funds
and innovative business models. The investment
manager of such a fund is expected to recognize Social venture funds tend to be different from
that there is a need to forecast social value, track venture capital funds or private equity funds not
and evaluate performance over time and assess just in the investments that they make, but also
investments made by such funds. in the nature of commitments that they receive
from their limited partners / investors. The
following is a list of some of the characteristics
I. Laws Relating to Social that a social venture fund may expect to have:
Venture Funds in India
ƒInvestors making grants (without expectation
of returns) instead of investments;
Offshore social venture funds tend to pool capital
(and grants) outside India and make investments ƒThe Fund itself provides grants and capital
in India like a typical venture capital fund. Such support considering social impact of such
offshore funds may not directly make grants to participation as opposed to returns on
otherwise eligible Indian opportunities, since investment alone;
this may require regulatory approval.
ƒFund targeting par returns or below par
Onshore social venture funds are required to be returns instead of a fixed double digit IRR;
registered as Category I AIFs under the specific
ƒManagement team of the Fund participating
sub- category of social venture funds. In addition
in mentoring, “incubating” and growing their
to the requirement to fulfill the conditions set out
portfolio companies, resulting in limited token
in the definition (set out above), social venture
investments (similar to a seed funding amount)
funds under the AIF Regulations are subject to the
with additional capital infused as and when the
following restrictions and conditions:
portfolio grows;
ƒRequirement to have at least 75% of their
ƒModerate to long term fund lives in order
investible funds invested in unlisted securities
to adequately support portfolio companies.
or partnership interest of ‘social ventures’10
Social venture funds also tend to be aligned
towards environmental, infrastructure and socially
10. Regulation 2(1)(u) of the AIF Regulations states – “social relevant sectors which would have an immediate
venture fund” means a trust, society or company or venture
capital undertaking or limited liability partnership formed impact in the geographies where the portfolio com-
with the purpose of promoting social welfare or solving panies operate.
social problems or providing social benefits and includes -
i. public charitable trusts registered with Charity Commissioner;
ii. societies registered for charitable purposes or for promotion
of science, literature, or fine arts; 1956/Section 8 of the Companies Act, 2013;
iii. company registered under Section 25 of the Companies Act, iv. micro finance institutions.

© Nishith Desai Associates 2018 5

 Provided upon request only

5. Market Opportunities
Typically a social impact fund (“Impact Fund”)
is like a growth partner with limited shelf-life.
III. Affordable healthcare
The Impact Fund makes investment in growth
With dismal investment in public healthcare
stage companies in priority sector. The promoter
and a huge demand for quality healthcare
of the Impact Fund could also be a not-for-profit or
services, there is a high demand-supply gap in
a foundation that supports and nurtures socio-
the healthcare sector. The total GDP allocation
economic inclusion through targeted grants.
towards healthcare is dismal is India, while
The Impact Fund is focused on investing in the out-of-pocket expenditure by households
business models that work with the lower was close to 70 per cent. Surprisingly, health
income group across financial inclusion, insurance caters to less than 10% of the
priority sector lending, healthcare, education, population. Social impact funds could look
livelihood etc. The Impact Fund invests in at financing affordable healthcare service
early and growth stage investments in priority providers.11 Thus, the investment approach
sector. While making majority investment, the for a Fund should be centered on access,
Impact Fund fund also uses the balance amount affordability and quality.
for expenses and follow-on investments. With
timely financial support, most of the investees
manage to grow substantially and yield positive
IV. Trends in Impact
social and economic returns. In many cases, the Investing12
projected exit proceeds from the investment
portfolio yield better than expected returns in on The standard of what constitutes an ‘alignment
the invested capital w.r.t cash-on-cash returns. of interests’ between fund investors (LPs) and fund
managers (GPs) India-focused fund or India-based
fund has undergone some degree of change over
I. Investment Strategy the years. Typically, LP participation in
a fund is marked by a more hands-on approach
Based on the market scenario, am Impact
in discussing and negotiating fund terms which
Fund would typically focus on priority sector
by itself is influenced by a more comprehensive
enterprises to develop a diversified portfolio
due diligence on the track record of the GP and
across the following sub-segments, for example:
the investment management team. This chapter
ƒSME financing; provides a brief overview of certain fund terms
that have been carefully negotiated between LPs
ƒAffordable healthcare;
and GPs in the Indian funds context.
Investment Committee and Advisory Board
II. SME Financing Sophisticated LPs insist on having a robust
decision- making process whereby an
India has a huge entrepreneurial class of people
investment manager will refer investment and
who run their business with no formal source
/ or divestment proposals along with any due
of financing. Thus, there is a great demand-
diligence reports in respect of such proposals
supply gap which needs to be tapped. There is
to an investment committee comprising
a tremendous opportunity in the SME financing
representatives of the LPs as well as the GP.
segment with products such as asset financing,
working capital financing, venture debt,
loan against mortgage etc.
11. McKinsey Report 2012: India Healthcare: Inspiring possibili-
ties, challenging journey
12. Fund Structuring & Operations, Nishith Desai Associates

6 © Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

The investment committee is authorized to VI. Expenses

take a final decision in respect of the various
proposals that are referred to it. In view of this, LPs express concern with respect to the kind
the composition of the investment committee of expenses that are charged to the fund (any
and the nature of rights granted to certain by extension, to their capital contributions).
members can become very contentious. The With a view to limiting the quantum of
investment committee is also empowered to expenses that are paid by the fund, LPs insist
monitor the performance of investments made on putting a cap on expenses. The cap which is
by the fund on an on-going basis. Separately, generally expressed as a percentage of the size
any transaction that could involve a potential of the fund or as a fixed number can become a
conflict of interest is expected to be referred for debatable issues depending on the investment
resolution to an advisory board consisting of strategy and objective of the fund. Separately,
members who are not associated with the GP. as a measure of aligning interests, LPs insist
that allocations made from their capital
contributions towards the payment of expenses
V. Management Fee should be included while computing the hurdle
return whereas the same should not be included
In keeping with the global trend, there appears
while determining management fee after the
to be less tolerance among India-focused LPs to
commitment period.
invest in a fund that provides a standard ‘2-20’
fee – carry model. Since management fees bear
no positive correlation to the performance VII. Waterfall
of the investments made by the fund, LPs
can be circumspect about the fee percentage. A typical distribution waterfall involves
Further, issues may arise with respect to the a return of capital contribution, a preferred
base amount on which the management fee is return (or a hurdle return), a GP catch-up and
computed. During the commitment period, fee a splitting of the residual proceeds between the
is calculated as a percentage of the aggregate LPs and the GP. With an increasing number of
capital commitments made to a fund. After GPs having reconciled themselves to the shift
the commitment period, fee is calculated as from the 20% carried interest normal, a number
a percentage of the capital contribution that of innovations to the distribution mechanism
has not yet been returned to the LPs. The fee have been evolved to improve fundraising
percentage itself is generally a function of opportunities by differentiating product
the role and responsibilities expected to be offerings from one another. Waterfalls have
discharged by a GP. It is not uncommon to see been structured to facilitate risk diversification
early stage capital and venture capital funds by allowing LPs to commit capital both on
charging a management fee that is marginally a deal-by- deal basis as well as on a blind pool
higher than the normal. basis. Further, distribution of carried interest
has been structured on a staggered basis such
that the allocation of carry is proportionate
to the returns achieved by the fund.

© Nishith Desai Associates 2018 7

 Provided upon request only

VIII. Giveback or a cap on the giveback amount. However,

this may not be very successful in an Indian
While there have been rare cases where some context given that the tax authorities are given
LPs have successfully negotiated against the relatively long time-frames to proceed against
inclusion of a giveback provision, GPs in the taxpayers. As bespoke terms continue to emerge
Indian funds industry typically insist on an LP in LP-GP negotiations, designing a fund may
giveback clause to provide for the vast risk of not remain just an exercise in structuring.
financial liability including tax liability. The LP The combination of an environment less
giveback facility is a variant to creating reserves conducive for fund raising and the change in
out of the distributable proceeds of the fund in legal, tax and regulatory environment besides
order to stop the clock / reduce the hurdle return continuously shifting commercial expectations
obligation. With a view to limiting the giveback requires that fund lawyers provide creatively
obligation, LPs may ask for a termination of the tailored structural alternatives.
giveback after the expiry of a certain time period

8 © Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

6. Fund Documentation
Fund counsels are now required to devise
innovative structures and advise investors
D. Advisory Agreement
on terms that meet LP expectations on The board of an offshore fund may delegate
commercials, governance and maintaining its investment management / advisory
discipline on the articulated investment responsibilities to a separate entity known
strategy of the fund. All these are to be done in as the Investment Advisor or the Investment
conformity with the changing legal framework. Manager. The Investment Advisory Agreement
contains the general terms under which such
investment advisor render advice in respect of
I. At The Offshore Fund Level the transactions for the fund’s board.

A. Private Placement Memorandum II. At The Onshore Fund Level

The PPM is a document through which the
interests of the fund are marketed to potential A. Private Placement
investors. Accordingly, the PPM outlines the Memorandum
investment thesis of a fund, summarizes the
key terms on which investors could participate AIF Regulations require that a concerned fund’s
in the fund’s offering and also presents the PPM should contain all material information
potential risk factors and conflicts of interest about the AIF, including details of the manager,
that could arise to an investor considering an the key investment team, targeted investors,
investment in the fund. fees and other expenses proposed to be charged
from the fund, tenure of the scheme, conditions
or limits on redemption, investment strategy,
B. Constitution risk factors and risk management tools, conflicts
A constitution is the charter document of an of interest and procedures to identify and
offshore fund in certain jurisdictions. It is a binding address them, disciplinary history, terms and
contract between the company (i.e. the fund), conditions on which the manager offers services,
the directors of the company and the shareholders affiliations with other intermediaries, manner
(i.e. the investors) of the company. of winding up the scheme or the AIF and such
other information as may be necessary for
an investor to take an informed decision
C. Subscription Agreement as to whether to invest in the scheme of an AIF.
The subscription agreement is an agreement
that records the terms on which an investor will
subscribe to the securities / interests issued by
B. Indenture of Trust
an offshore fund. The subscription agreement
The Indenture of Trust (Indenture) is an
sets out the investor’s capital commitment to
instrument which is executed between a settlor
the fund and also records the representations
and a trustee whereby the settlor conveys an
and warranties made by the investor to the
initial settlement to the trustee towards creating
fund. This includes the representation that the
the assets of the fund. The Indenture also
investor is qualified under law to make the
specifies various functions and responsibilities
investment in the fund.13
to be discharged by the appointed trustee.

13. In case the fund is set up in the format of a limited

partnership, this document would be in the format of a
limited partnership (with the ‘general partner’ holding the
management interests).

© Nishith Desai Associates 2018 9

 Provided upon request only

C. Investment Management E. Investor Side Letters

Agreement It is not uncommon for some investors to ask
for specific arrangements with respect to their
The Investment Management Agreement is participation in the fund. These arrangements
entered into by and between the trustee and are recorded in a separate document known
the investment manager (as the same may be as the side letter that is executed by a specific
amended, modified, supplemented or restated investor, the fund and the investment
from time to time). Under the Investment manager. Typically, investors seek differential
Management Agreement, the trustee appoints arrangements with respect to management
the investment manager and delegates all its fee, distribution mechanics, participation in
management powers in respect of the fund, investment committees, investor giveback,
(except for certain retained powers that are etc. An investor may also insist on including
identified in the Indenture) to the investment a ‘most favored nations’ (MFN) clause to prevent
manager. any other investor being placed in a better
position than itself. An issue to be considered
is the enforceability of such side letters unless
D. Contribution Agreement it is an amendment to the main contribution
The Contribution Agreement is to be entered into agreement itself.
by and between each contributor (i.e. investor),
the trustee and the investment manager (as the
same may be amended, modified, supplemented
F. Agreement with Service
or restated from time to time) and, as the context Providers
requires. The Contribution Agreement records the
Sometimes, investment managers may enter
terms on which an investor participates in a fund.
into agreements with placement agents,
This includes aspects relating to computation
distributor and other service providers with
of beneficial interest, distribution mechanism,
a view to efficiently market the interests of the
list of expenses to be borne by the fund, powers
fund. These services are offered for
of the investment committee, etc. A careful
a consideration which may be linked to the
structuring of this document is required so that
commitments attributable to the efforts of
the manager /trustee retain the power to make
the placement agent/distributor.
such amendments to the agreement as would
not amend the commercial understandings
with the contributor.

10 © Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

7. Management of The Fund

I. The Board V. The Administrator
Consisting of its members, (the “directors”) is The Fund can delegate certain administrative
responsible for the management of the affairs duties with respect to the Fund to the
of the Fund. To assist them with the operations administrator. The administrator carries out
of the Fund, the Directors can appoint an the day-to-day administrative activities of the
investment advisor. Further, the directors can Fund and, subject to the board’s supervision,
delegate certain administrative duties to the has responsibility for the administration of
administrator. the Fund’s affairs, except with respect to the
investment advisory responsibilities performed
by the investment advisor. These administrative
II. Investment Advisor responsibilities include receiving and processing
subscriptions for shares, arranging and issuing
Pursuant to an investment advisory agreement
capital call notices to investors, arranging for
among the fund and the investment advisor,
the payment of the Fund’s expenses, processing
the investment advisor provides the board
transfers of shares, maintaining the Fund’s
with non-binding, non-exclusive advice and
books and records, including the register of
recommendations regarding the management
shareholders, coordinating with the Fund’s
and operations of the fund. Typically, advice
auditors for the audit of the Fund’s books and
and recommendations of the investment
the preparation of its statutory and tax filings,
advisor are subject to the final decision of the
if any, and preparing and distributing reports
board. Pursuant to the advisory agreement, the
to each shareholder.
investment advisor receives an advisory fee
from the Fund. With respect to actions taken The administrator receives a fee for the services
by the investment Advisor in its capacity as it provides to the Fund, which is paid by or
investment advisor, the Fund would indemnify on behalf of the Fund. The Administrator
the investment advisor for losses and expenses may subcontract with other parties for
in connection therewith. administrative and certain other services.

III. The Investor Panel VI. Investment Process

The Fund would constitute an investor panel Investment process consists of investment
which will comprise representatives of the opportunities, evaluation and engagement
investors. with portfolio companies, post investment
and planning of exit.
IV. The Sub-advisor
VII. Sourcing Strategy
The sub-advisor provides non-binding, non-
exclusive advice and recommendations to the The promoter can explore opportunities
investment advisor in respect of the investment through various means, including:
fund advised or managed by the investment
ƒDirect relationship with entrepreneurs
advisor. At its discretion, the investment advisor
may reject the advice and recommendations ƒIndustry networks
provided by the sub-advisor.
ƒIncubators
ƒInvestment bankers

© Nishith Desai Associates 2018 11

 Provided upon request only

VIII. Evaluation Process X. Exit

A strong assessment process can be created Based on investment returns, market scenario
followed by due diligence. Once the deal is and potential of scalability, an exit option can
sourced, it needs to be put through the be exercised either through a strategic sale
following stages: or by sale to financial investors. The decision
to exit is based on multiple factors, including
i. Initial screening
performance, position of the company vis-à-
ii. Investment analysis vis industry structure, any material change
in regulations, external market sentiments,
iii. Investment Committee deliberation
appetite of incoming investors/buyers, etc.
iv. Elaborate due diligence
v. Approval of the Board

IX. Operational Engagement

The operational engagement encompasses
business and financial monitoring, strategic
advisory, capacity building and case-specific
involvement.

12 © Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

8. Ways to Enhance Credit For Impact

Investment
As social impact investing espouses muted a number of recent transactions have used the
returns in order to achieve greater social impact, CFLC model in reducing capital risk, advancing
investors have been increasingly looking at social goals using commercially scalable capital
leveraging credit enhancement mechanisms and stimulating investment opportunities and
to catalyze the participation of co-investors. activities in untapped markets.
Investors, therefore, have been using a broad
Figure 2: Catalytic first-loss capital
range of tools to boost credit enhancement for

(INVESTORS/GRANT MAKERS/SPONSOR) (CO-INVESTORS)

take first-loss or subordinated position Protected by credit enhancement/first-loss

INVESTEE
(Funds, mission-driven organization, projects)

their co-investors and one innovative tool which CFLC has three distinct features:
has been used quite successfully is catalytic first-
ƒIt identifies the principal i.e. the investor
loss capital (“CFLC”).
that will bear first losses
CFLC refers to socio-economically driven The amount of loss covered is set out in the
credit enhancement which is pumped into the investment document and is agreed upon upfront
impact fund by an investor. Using this credit
ƒIt is catalytic
enhancement mechanism, the principal
By improving co-investors’ risk-return profile,
other investors are catalyzed into participating
investor agrees to bear first losses in an
in the fund
investment in order to catalyze the participation
of co-investors that otherwise would not feel ƒPurpose-driven
encourage to co-invest into the fund. CFLC channelizes capital towards attaining
certain socio-economic outcomes as well as
The CFLC has gained wider recognition in impact demonstrate the commercial viability of
investing discourse, especially among investors investing into a hitherto untapped market
who are mission driven and intending to use their
existing capital to achieve more impact. In fact, CFLC is a tool that can be used in the impact
fund structure through a range of instruments
as indicated in the table below:

© Nishith Desai Associates 2018 13

 Provided upon request only

INSTRUMENT DESCRIPTION

Equity By taking the most junior equity position in the overall capital structure,
the principal investor takes first losses (also seeks riskadjusted returns);
this includes common equity in structures that include preferred equity
classes

Grants A grant provided for the express purpose of covering a set amount of first-
loss

Guarantees A guarantee to cover a set amount of first-loss

subordinated debt The most junior debt position in a distribution waterfall14 with various
levels of debt seniority (with no equity in the structure)15

Source: Global Impact Investing Network Thus, the principal investor in the impact fund,
14 15 by offering protection to other investors can
enhance capital inflow and also afford to take
greater financial risk in return for social impact.
Using CFLC mechanism, investors having
deeper knowledge of sectorial nuances are
able to make informed investments.
Given their sectorial knowledge, these investors
are typically international funding agencies,
high-net worth individuals, governments and
development finance institutions (DFIs).

14. A type of scheme in which higher-tiered investors receive

payment (interest/principal/dividends) in full first before the
next tier receives any payment
15. Even if there is no equity in the structure, there may be a
reserve account

14 © Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

9. Social Impact Bonds:

Social Impact Bonds (“SIBs”) arose as a potential arrangement in which impact investors
answer to several issues faced by social sector provide the upfront risk capital either by way
organizations and institutional challenges of pooled-capital or through upfront capital
faced by funding agencies. It is no secret that funding to fund social projects. Further, the
non-profits constantly face operational and government agency and/or philanthropic bodies
financial strain due to limited capital flow and could play the role of outcome payers where
funding agencies are often dependent on the re-payments to be made only if social outcomes
government for local support, which more often are achieved. In Indian context, domestic
than not, is mired with lack of transparency, government agencies and/or outcome funders
risk aversion, lack of expertise and red-tapism. may identify a social issue that it wants to focus
on such as prevention of early child marriages
These multiplicity of institutional deficiencies
or primary education or public health etc.
impede social outcomes and end up leakages in
funders’ and tax-payers’ money towards social The intermediary organization raises funds from
programs. As an impact investor and/or a funding risk investors and also appoints service providers
agency, it was imperative for a more robust to implement the program. The outcome funder
system where stakeholders carried the right skill then enters into an agreement with the aforesaid
set with appropriate financial understandings intermediary organization. Furthermore,
of social projects, with efficient execution of an independent project evaluator is also
projects coupled with financial disbursements identified and appointed to conduct and
that would be directly linked to successful verify the outcome-metrics.
achievement of social outcomes.
Upon successful achievement and verification
Thus, with countries, governments and funding of the outcome-metrics, the outcome funders/
agencies struggling to find innovative and government agencies makes payment to the
effective ways to fund social projects, a new type investors through the intermediaries. The
of financial mechanism is emerging in the form outcome payment typically consist of the
of SIBs. Though relatively new, SIBs have gained original investment coupled with returns on
reasonable traction among various quarters, such investments. However, if the desired social
including government bodies, multi-lateral donor outcomes are not achieved, the government
agencies and financial institutions across the globe. agencies/outcomes funders may choose to not
make any payments to the intermediary and
SIBs are structured to enable flow of private
the investors may risk losing their investments
investment into socially relevant interventions
in part or full, depending on the terms of the
or programs that provide tangible returns
SIB arrangements.
to risk investors and yield cost-saving social
outcomes. Most of the SIBs follow a standard Thus, in a typical SIB Pay for Success model,
template wherein payment is tied to investors the outcome funder generally shifts the risk
achieving desired social outcomes solely within of economic loss from non-performance of
the parameters and controls set forth by the the contract to risk/private investors through
funding agencies. the intermediaries. But in certain cases the SIB
model may also tweaked to shift the risk of loss
Although a typical SIB model is often referred to
from the outcome funder to service providers.
as “Pay for Success” payments, there could be
Thus, many subtle variations in SIB models
different variations of this model. For example,
remain which may be due to country-specific
in the context of India, SIB could be modelled
market needs and investors’ risk appetite.
as a Pay-for-Success multi-stakeholder

© Nishith Desai Associates 2018 15

 Provided upon request only

Risk Investors

1. Capital 7. Repayment of
Investment Principal & Returns
6. Pay for
Success
Government Agency/ Programs
Intermediary Social Service
Outcome Funder Providers
2. Structure,
Co-ordinate
and fund 3. Deliver
5. Measure &
Services
Validate

Independent 4. Achieve Outcomes Target Population

Evaluator

Figure 3: Pay for Success Model16

16

with an increased risk tolerance on investments

I. The potential of SIBs by such private investors, it depoliticizes the
in India funding processes that funding agencies have
hitherto faced in relation to foreign contribution
SIBs have tremendous potential to solve regulations in India. As the outcome funding
India’s tethering social problems. And given under the SIB model is always tied towards social
the underfunding that social sector outcomes, the risk of politicization gets heavily
organizations are currently undergoing due to discounted and ensures smooth flow of funds.
certain foreign contributions restrictions, the
It can also allow the outcome funders the
SIB structure has the potential to infuse funding
flexibility to focus on multiple social projects
into these social projects through private
per their liking and priority instead of putting
investments in a more efficient and effective
all their funding into a single recipient basket.
manner. In fact, SIBs in India have the potential
This type of multiple outcome-focused
to unlock additional and alternate source of
arrangement can enable the service providers
funding and stay clear of regulatory hassles that
to work on multiple social projects with project
traditional donor-donee organizations face.
intermediaries in a more targeted manner.
For instance, the SIB structure can incentivize In order to manage risk capital, private investors
sophisticated investors to pool in funds either can also conduct due diligence and mandate
at an off-shore as well as on-shore level for certain quality controls to be implemented by
financing social projects and ensure financial service providers.
returns on their investments. In addition, the
In the context of India, the SIB model could
service providers can receive the capital upfront
be re-modelled as a Public Private Partnership
from the investors, which in a way also hedges
Project (“PPP Project”) with government
them against irregular and unpredictable
agencies and/or India-based funders playing
government support or a decline in charitable
the role of domestic outcome funders.
donations due to regulatory factors. Furthermore,

16. Diagram adopted from What is Pay for Success? NONPROF-

IT FIN. FUND, http://www.payforsuccess.org/learn/ba-
sics/#what-is-pay-for-success [https://perma.cc/KX4U-RMME].

16 © Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

Philanthropic
Outcome
Foundations, Investors Various Jurisdictions
HNWIs, etc. Funders

Grant for designing Participating Off-shore

1
and managing Shares jurisdiction
educational
outcomes through Feeder Entity
Impact Bonds.
Payments on Investor Units
2
Outcome achievement of pre-
Funders: defined outcomes; Management Investment
Domestic based on PFS Services Manager
(including agreement signed for Investor
Impact
CSR) each impact bond with Units
Bond Investors
annual payouts bond
Fund 2
with annual payouts

A tax-exempt
entity
[FCRA
1 compliant]
Entity 1

Independent
Evaluation 5 SPVs
Agreem ent earmarked for
Entity 2 Entity 4
(Fee for each of the
3 projects
Services)

Entity 3

Outcomes Evaluator
Grants to NGOs and Services
4 Agreement with for-profit impact
enterprises.

NGOs and other

eligible opportunities

Illustration 2: India-centric SIB PPP Model

© Nishith Desai Associates 2018 17

 Provided upon request only

II. Structure of the SIB PPP (existing or new LLPs and companies, as the case
Model may be) by way of grants to NGOs and enter into
services arrangements with for-profit impact
enterprises. In parallel, the tax-exempt entity
The above model represents a collaborative
enters into a Payment for Success Agreement
effort among domestic and foreign outcome
for each impact bonds with annual payouts
funders, government agencies, intermediaries,
with the project specific entities.
risk investors, NGOs and project evaluators.
Step 5:Upon objective determination of achieving
In the current model, the outcome funders
agreed-upon outcomes, the tax-exempt entity
could potentially be: (i) domestic funder(s);
makes payment for each project which consist of
(ii) foreign funders; (iii) government
original capital plus a return on their investment.
departments or agencies. The present model is
structured in a way to enable leveraging funds
from domestic as well as overseas outcome
IV. The possible limitation
funders. Availability CSR money due to of SIBs in the context of
mandatory allocation towards CSR under the India
Companies Act, 2013 provide for an additional
source of capital. If tapped rationally, the To begin with, how does one define and
SIB-financed programs emanating out of CSR measure social outcomes that are non-
allocations can potentially make a meaningful partisan, independent and full proof needs to
impact on a range of social issues. be addressed. As the outcome payment will
be intrinsically linked to social outcomes, the
objective measurement and assessment by
III. Steps involved in independent evaluators should be thorough
channelization of funds and reliable. Further, unlike traditional
philanthropic funding where disbursements
Step 1: Global Outcome funders as well as are tied to social inputs or outputs, the Pay-for-
domestic funders may pool-in grant and provide Success should tie payments solely to results.
funds to a non-profit tax-exempt entity in India.
As many outcome funders may want to
The tax-exempt entity plays the dual role of
simply reward inputs and outputs, the service
fiscal agent as well as project manager.
providers should stay clear of such pitfalls
The tax-exempt entity should be eligible to
of merely increasing the volume of inputs/
receive foreign contributions.
outputs and focus more on achieving social
Step 2: Off-shore investors (from various outcomes. Furthermore, it should be ensured
jurisdictions) can pool capital and make that stakeholders from the investors as well as
investments into am off-shore feeder entity. the outcome side should be totally excluded
At On-shore level, an Impact Bond Fund (“IBF”) from the project evaluation process to avoid any
can be set up where domestic investors would conflict of interest and collusion issues.
directly contribute to the Onshore Fund/
Another potential issue with the SIB model in
SVF while overseas investors will pool their
India could be due to involvement of multiple
investments in an offshore vehicle which,
outcome funders and the complexity of
in turn, invests in IBF.
identifying and measuring outcomes for each
Step 3: the tax-exempt entity appoints of these projects. In fact, given the scale and
an independent evaluator to measure the priorities of different outcome funders, the flow
outcome-metrics on a pre-determined of outcome funds may come in a non-linear
rigorous methodologies. fashion and at different stages of the project
cycle. Thus, any scope of standardization of the
Step 4: The SVF may make grants and cash
project to rationalize operational costs will have
allocations to project specific entities
to well thought-out and implemented.

18 © Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

V. Regulatory and tax issues Surprisingly, the SIB arrangement may also
in SIBs be considered as a derivative instrument
as it contains several key elements that
The tax consequences for investors who would are common to derivatives. Firstly, the SIB,
participate in a SIB-funded program are not clear similar to a derivative instrument, seeks to
under the existing provisions of the Income-tax shift financial risk to another party. The SIB,
Act, 1961 (“ITA”). Under the current laws, the SIBs similarly, computes outcome payments based
are treated as tax-favored investments and may on the value of the underlying transaction,
not benefit from preferential tax rates, tax-exempt and requires the risk investor to undertake
treatment, or be allowed charitable deductions on deployment of a fixed principal amount upfront,
providing grants to the pooled vehicle. while the outcome funder is contractually
obligated to make future (and variable)
payments basis the value of the underlying
VI. Tax uncertainty transaction at a particular date.
The current provisions of the ITA does
not specifically address the taxation of SIB VII. Tax exemption
investments, their tax treatment should be
distinguished from applicable rules governing The provisions of ITA provides for exemptions
financial instruments. In fact, for the purposes on paying taxes on interest earned from tax-free
of taxation under the ITA, the characterization bonds, currently the same is not envisaged for
of instrument is significant. Thus, SIBs can SIBs. Under the ITA, bonds that are tax-free
plausibly be characterized basis different are typically issued by the government and is
interpretations and treatments under the not envisaged to inure benefits to any private
provisions of ITA. This may expose SIB risk business or persons. However, considering
investors to unpredictable tax compliance risks the uniqueness of the SIB model where the
and liability. government may end being one of the primary
outcome funder, it will be interesting to see
For instance, it needs to be seen whether the
whether any tax-exempt status may also be
ITA would treat SIBs as a debt or as a financial
awarded to SIBs. It may also be interesting
instrument. As SIBs are suffixed as “bonds”, and
to see whether the tax incentives that are
the rate of return prescribed are generally “muted”,
currently extended to charitable donations for
it may be characterized as debt. As SIB payments
government recognized social projects are also
to intermediaries are made upon achievement of
extended to donations made towards vehicle
a pre-agreed outcome, the method of repayment
carrying out SIBs investments.
may be considered akin to debt.
While SIBs have tremendous potential for cater
Alternatively, SIBs may also be characterized
to social sector needs, tapping private capital
as equity. The reason being, SIBs may not
in an effective and efficient manner is going
necessarily provide an unconditional promise to
to be important. Government’s willingness
pay the investors at a fixed maturity date, which
to participate in SIB projects may prove to be
becomes an important factor in characterizing
the real litmus test for private risk investors in
whether it would be a debt or equity. As
trying to re-shape social sector ecosystem in
outcome payment is dependent on successful
India. While there certainly is a need to treat
delivery of social outcomes, the payment for
SIB investments on a more charitable footing
which is certainly not unconditional. Further,
w.r.t ITA, the current laws in India does not
the risk investors may or may not receive profits
necessarily discourage the growth of SIB backed
out of the outcome payments, which also gives
social projects. With the additional capital
SIB an equity flavor.
pool that SIBs can bring, large scale social
interventions with meaningful fiscal prudence
can be achieved.

© Nishith Desai Associates 2018 19

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

About NDA
At Nishith Desai Associates, we have earned the reputation of being Asia’s most Innovative Law Firm
– and the go-to specialists for companies around the world, looking to conduct businesses in India
and for Indian companies considering business expansion abroad. In fact, we have conceptualized
and created a state-of-the-art Blue Sky Thinking and Research Campus, Imaginarium Aligunjan, an
international institution dedicated to designing a premeditated future with an embedded strategic
foresight capability.
We are a research and strategy driven international firm with offices in Mumbai, Palo Alto
(Silicon Valley), Bangalore, Singapore, New Delhi, Munich, and New York. Our team comprises
of specialists who provide strategic advice on legal, regulatory, and tax related matters in an
integrated manner basis key insights carefully culled from the allied industries.
As an active participant in shaping India’s regulatory environment, we at NDA, have the expertise and
more importantly – the VISION – to navigate its complexities. Our ongoing endeavors in conducting
and facilitating original research in emerging areas of law has helped us develop unparalleled
proficiency to anticipate legal obstacles, mitigate potential risks and identify new opportunities
for our clients on a global scale. Simply put, for conglomerates looking to conduct business in the
subcontinent, NDA takes the uncertainty out of new frontiers.
As a firm of doyens, we pride ourselves in working with select clients within select verticals on
complex matters. Our forte lies in providing innovative and strategic advice in futuristic areas of
law such as those relating to Blockchain and virtual currencies, Internet of Things (IOT), Aviation,
Artificial Intelligence, Privatization of Outer Space, Drones, Robotics, Virtual Reality, Ed-Tech, Med-
Tech & Medical Devices and Nanotechnology with our key clientele comprising of marquee Fortune
500 corporations.
The firm has been consistently ranked as one of the Most Innovative Law Firms, across the globe. In
fact, NDA has been the proud recipient of the Financial Times – RSG award 4 times in a row, (2014-
2017) as the Most Innovative Indian Law Firm.
We are a trust based, non-hierarchical, democratic organization that leverages research and knowledge
to deliver extraordinary value to our clients. Datum, our unique employer proposition has been
developed into a global case study, aptly titled ‘Management by Trust in a Democratic Enterprise,’
published by John Wiley & Sons, USA.
A brief chronicle our firm’s global acclaim for its achievements and prowess through the years -

ƒAsiaLaw 2019: Ranked ‘Outstanding’ for Technology, Labour & Employment, Private Equity,
Regulatory and Tax

ƒRSG-Financial Times: India’s Most Innovative Law Firm (2014-2017)

ƒMerger Market 2018: Fastest growing M&A Law Firm
ƒIFLR 1000 (International Financial Review - a Euromoney Publication): Tier 1 for TMT,
Private Equity

ƒIFLR: Indian Firm of the Year (2010-2013)

ƒLegal 500 2018: Tier 1 for Disputes, International Taxation, Investment Funds, Labour &
Employment, TMT

ƒLegal 500 (2011, 2012, 2013, 2014): No. 1 for International Tax, Investment Funds and TMT

© Nishith Desai Associates 2018

 Provided upon request only

ƒChambers and Partners Asia Pacific (2017 – 2018): Tier 1 for Labour & Employment, Tax, TMT
ƒIDEX Legal Awards 2015: Nishith Desai Associates won the “M&A Deal of the year”, “Best Dispute
Management lawyer”, “Best Use of Innovation and Technology in a law firm” and “Best Dispute
Management Firm”

© Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

Please see the last page of this paper for the most recent research papers by our experts.

Disclaimer
This report is a copy right of Nishith Desai Associates. No reader should act on the basis of any
statement contained herein without seeking professional advice. The authors and the firm expressly
disclaim all and any liabilitytoanypersonwhohasreadthisreport,or otherwise, in respect of anything,
and of consequences of anything done, or omitted to be done by any such person in reliance upon the
contents of this report.

Contact
For any help or assistance please email us on ndaconnect@nishithdesai.com
or visit us at www.nishithdesai.com

© Nishith Desai Associates 2018

 Provided upon request only

The following research papers and much more are available on our Knowledge Site: www.nishithdesai.com

Fund Formation: Social Impact The Curious Case

Attracting Global Investing in India MUMBA I SI L IC O N VALLE Y BAN G ALORE SI N G AP ORE MU MBAI BKC NEW DELHI M U NIC H N E W YO RK

of the Indian
Investors Gaming Laws
The Curious Case
of the Indian
Gambling Laws
Legal Issues Demysitified

February 2018

March 2018 © Copyright 2018 Nishith Desai Associates www.nishithdesai.com

July 2018 February 2018

Corporate Social Incorporation of Outbound

MU M B A I S IL IC O N VA L L E Y B A NG A LO R E S ING A PO RE M U M B A I B KC NE W D E L H I M U NIC H NE W YO RK

Responsibility & Company LLP in Acquisitions by

Social Business India India-Inc
Models in India
Corporate Social
Responsibility & Social
Business Models in India
© Copyright 2018, Nishith Desai Associates.

A Legal & Tax Perspective

March 2018
Corporate Social Responsibility & Social Business Models in India

© Copyright 2018 Nishith Desai Associates www.nishithdesai.com

September 2014
March 2018 April 2017

Internet of Things Doing Business in Private Equity

India and Private Debt
Investments in
India

September 2018
January 2017 March 2018

NDA Insights
TITLE TYPE DATE
Blackstone’s Boldest Bet in India M&A Lab January 2017
Foreign Investment Into Indian Special Situation Assets M&A Lab November 2016
Recent Learnings from Deal Making in India M&A Lab June 2016
ING Vysya - Kotak Bank : Rising M&As in Banking Sector M&A Lab January 2016
Cairn – Vedanta : ‘Fair’ or Socializing Vedanta’s Debt? M&A Lab January 2016
Reliance – Pipavav : Anil Ambani scoops Pipavav Defence M&A Lab January 2016
Sun Pharma – Ranbaxy: A Panacea for Ranbaxy’s ills? M&A Lab January 2015
Reliance – Network18: Reliance tunes into Network18! M&A Lab January 2015
Thomas Cook – Sterling Holiday: Let’s Holiday Together! M&A Lab January 2015
Jet Etihad Jet Gets a Co-Pilot M&A Lab May 2014
Apollo’s Bumpy Ride in Pursuit of Cooper M&A Lab May 2014
Diageo-USL- ‘King of Good Times; Hands over Crown Jewel to Diageo M&A Lab May 2014
Copyright Amendment Bill 2012 receives Indian Parliament’s assent IP Lab September 2013
Public M&A’s in India: Takeover Code Dissected M&A Lab August 2013
File Foreign Application Prosecution History With Indian Patent
IP Lab April 2013
Office
Warburg - Future Capital - Deal Dissected M&A Lab January 2013
Real Financing - Onshore and Offshore Debt Funding Realty in India Realty Check May 2012

24 © Nishith Desai Associates 2018

 Social Impact Investing in India

A Supplement to Corporate Social Responsibility & Social Busi-ness Models in India : A Legal & Tax Perspective

Research @ NDA
Research is the DNA of NDA. In early 1980s, our firm emerged from an extensive, and then pioneering, research
by Nishith M. Desai on the taxation of cross-border transactions. The research book written by him provided the
foundation for our international tax practice. Since then, we have relied upon research to be the cornerstone of our
practice development. Today, research is fully ingrained in the firm’s culture.
Our dedication to research has been instrumental in creating thought leadership in various areas of law and
public policy. Through research, we develop intellectual capital and leverage it actively for both our clients and
the development of our associates. We use research to discover new thinking, approaches, skills and reflections
on jurisprudence, and ultimately deliver superior value to our clients. Over time, we have embedded a culture
and built processes of learning through research that give us a robust edge in providing best quality advices and
services to our clients, to our fraternity and to the community at large.
Every member of the firm is required to participate in research activities. The seeds of research are typically
sown in hour-long continuing education sessions conducted every day as the first thing in the morning. Free
interactions in these sessions help associates identify new legal, regulatory, technological and business trends
that require intellectual investigation from the legal and tax perspectives. Then, one or few associates take up
an emerging trend or issue under the guidance of seniors and put it through our “Anticipate-Prepare-Deliver”
research model.
As the first step, they would conduct a capsule research, which involves a quick analysis of readily available
secondary data. Often such basic research provides valuable insights and creates broader understanding of the
issue for the involved associates, who in turn would disseminate it to other associates through tacit and explicit
knowledge exchange processes. For us, knowledge sharing is as important an attribute as knowledge acquisition.
When the issue requires further investigation, we develop an extensive research paper. Often we collect our own
primary data when we feel the issue demands going deep to the root or when we find gaps in secondary data. In
some cases, we have even taken up multi-year research projects to investigate every aspect of the topic and build
unparallel mastery. Our TMT practice, IP practice, Pharma & Healthcare/Med-Tech and Medical Device, practice
and energy sector practice have emerged from such projects. Research in essence graduates to Knowledge, and
finally to Intellectual Property.
Over the years, we have produced some outstanding research papers, articles, webinars and talks. Almost on daily
basis, we analyze and offer our perspective on latest legal developments through our regular “Hotlines”, which go
out to our clients and fraternity. These Hotlines provide immediate awareness and quick reference, and have been
eagerly received. We also provide expanded commentary on issues through detailed articles for publication in
newspapers and periodicals for dissemination to wider audience. Our Lab Reports dissect and analyze a published,
distinctive legal transaction using multiple lenses and offer various perspectives, including some even overlooked
by the executors of the transaction. We regularly write extensive research articles and disseminate them through
our website. Our research has also contributed to public policy discourse, helped state and central governments
in drafting statutes, and provided regulators with much needed comparative research for rule making. Our
discourses on Taxation of eCommerce, Arbitration, and Direct Tax Code have been widely acknowledged.
Although we invest heavily in terms of time and expenses in our research activities, we are happy to provide
unlimited access to our research to our clients and the community for greater good.
As we continue to grow through our research-based approach, we now have established an exclusive four-acre,
state-of-the-art research center, just a 45-minute ferry ride from Mumbai but in the middle of verdant hills of
reclusive Alibaug-Raigadh district. Imaginarium AliGunjan is a platform for creative thinking; an apolitical eco-
system that connects multi-disciplinary threads of ideas, innovation and imagination. Designed to inspire ‘blue
sky’ thinking, research, exploration and synthesis, reflections and communication, it aims to bring in wholeness
– that leads to answers to the biggest challenges of our time and beyond. It seeks to be a bridge that connects the
futuristic advancements of diverse disciplines. It offers a space, both virtually and literally, for integration and
synthesis of knowhow and innovation from various streams and serves as a dais to internationally renowned
professionals to share their expertise and experience with our associates and select clients.

We would love to hear your suggestions on our research reports. Please feel free to contact us at

research@nishithdesai.com

© Nishith Desai Associates 2018 25

MUMBAI S I L I C O N VA L L E Y BANGALORE

93 B, Mittal Court, Nariman Point 220 California Avenue, Suite 201 Prestige Loka, G01, 7/1 Brunton Rd
Mumbai 400 021, India Palo Alto, CA 94306-1636, USA Bangalore 560 025, India
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S I N G A P O RE MUMBAI BKC NE W DELHI

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Social Impact Investing in India

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 Proud Moments
Funds Hotline
Chambers and Partners Asia Pacific
......................................................................................................................................................................................... 2019: Band 1 for Employment,
Lifesciences, Tax and TMT
August 01, 2014
AsiaLaw 2019: Ranked ‘Outstanding’
for Technology, Labour &
TAX PAS S T H R O UG H FO R ALT ER N AT IVE IN VES T M EN T FUN D S : CLAR IFICAT IO N N EED S LIT T LE
M O R E CLAR IT Y Employment, Private Equity,
Regulatory and Tax
CBDT issues circular seeking to provide clarity on the tax treatment of alternative investment funds
IFLR 1000 Asia Pacific 2019: Tier 1
that are set up as trusts.
for TMT, Private Equity
In order to qualify as a ‘determinate trust’, the names of all investors in an AIF and their beneficial
interests should be expressly stated in the trust deed on the 'date of its creation’. RSG-Financial Times: India’s Most
'Date of creation' needs greater clarity as the fund formation requires multiple closings and investors Innovative Law Firm (2014-2017)
get added from time to time.
AIFs which do not fulfill the requirements laid down by the CBDT will be taxed at the maximum
marginal rate in the hands of the trustee of the AIF. Ambiguity around the applicable rate of tax for Research Papers
capital gains
CBDT circular to impact the availability of treaty benefits to offshore investors in an AIF and impact Building a Successful Blockchain
fund raising and fund operations of AIFs. Ecosystem for India (Limited
Where capital is raised both offshore and onshore, co-investment structures may be preferred in Edition)
comparison to unified investment structures going forward. December 31, 2018

The Blockchain: Industry

The Central Board of Direct Taxes (“CBDT”) issued a circular1 dated July 28, 2014 (“Circular”) to
Applications and Legal
provide ‘clarity’ on the taxation of alternative investment funds (“AIFs”) that are registered under the
Perspectives
Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“AIF
November 26, 2018
Regulations”).
The Indian Pharmaceutical Industry:
The Circular states that if ‘the names of the investors’ or their ‘beneficial interests’ are not specified in
Business, Legal & Tax Perspective
the trust deed on the ‘date of its creation’, the trust will be liable to be taxed at the ‘maximum marginal
November 23, 2018
rate’.

This poses some serious questions for the Indian fund industry that typically have multiple ‘closings’
where where subsequent round investors participate in the fund, may be impacted. Further, even with Research Articles
a single closing, owing to natural and other consequences such as termination of an investor’s
participation in distributions made by the fund where they default in making contributions or transfer of The Tips and Traps to Avoid When
fund units from one investor to another, there could be revisions in the beneficial interests of investors. Investing in India
December 31, 2018
BACKG R O UN D
Evolving HR Law: Giving GCs
A ‘trust’ is a vehicle of choice when setting up pooling structures in India. This is largely driven by the
Sleepless Nights?
fact that the Indian Trust Act, 1882 allows a trust to be effectively structured as a functional equivalent
June 01, 2017
of a limited partnership, as available in other jurisdictions.
India confirms intent to sign BEPS
The AIF Regulations provide the regulatory framework for privately placed domestic funds in India and
multilateral instrument curbing tax
was introduced by Securities and Exchange Board of India (“SEBI”) to recognize AIFs as a distinct
avoidance
asset class. SEBI classifies AIFs in 3 distinct categories to tie concessions and incentives to
May 17, 2017
investment restrictions.

Category I AIFs encompass AIFs with a defined investment strategy focusing on Venture Capital
Funds, Small and Medium Enterprises Funds, Social Venture Funds and Infrastructure Funds, which in Audio
SEBI's view, lead to "... positive spillover effects on the economy".
Round Table + Webinar: Social
Category II AIFs encompass AIFs that may not need any focused incentives. These would include
Impact Bonds and Impact
private equity funds and debt funds.
Investments in India: Opportunities
Category III AIFs could be used to set up an onshore hedge fund structure with prescribed levels of and Misconceptions
leverage. December 06, 2018

Webinar: New opportunities open up

PO S IT IO N O F TAX FO R AIFS
for funds in IFSC
Post the Finance Act, 2012, income is made taxable directly in the hands of investors (of Venture December 04, 2018
Capital Funds) on an accrual basis and the pooling vehicle is not to be subject to any tax.
Webinar: Bilateral Arbitration
The AIF Regulations and the Finance Act, 2013 limit the benefit of this 'pass - through' only to the Treaties A better fit than BITs for
Venture Capital Fund sub-category of Category I AIF. Therefore, the pass-through status is limited only dispute resolution
to AIFs, which invest primarily in unlisted securities of start-ups, emerging or early stage ventures November 15, 2018
mainly involved in new products, new services, technology or intellectual property right based
activities or a new business model. There are no explicit provisions that allow various other funds,
such as Social Venture Funds, Infrastructure Funds and SME Funds, which also fall within AIF NDA Connect
Category I to get a pass-through benefit. Further, Category II and III AIFs will also not be entitled to the
tax pass-through status. Connect with us at events,
conferences and seminars.
Consequently, a majority of AIFs are structured as trusts to avail of tax pass-through under general
trust taxation provisions. In such a scenario, the concerned funds rely and seek to be taxed as per the
general principles of taxation of trusts viz. sections 161 to 164 of the Income Tax Act, 1961 (“Tax Act”)
which allow for a pass-through taxation for determinate trusts.
NDA Hotline
As per Explanation 1 to section 164 of the Tax Act, a trust is considered to be a determinate trust if it Click here to view Hotline archives.
fulfills the following two conditions:

Beneficiaries of the income arising to the trust are identifiable on the date of the trust deed; and
The share of income of each beneficiary is ascertainable on the date of the Indenture.
Video
Where the trust (the fund) is determinate, i.e., the beneficiaries are identifiable with their shares being
determinate, the trustee is assessed as a representative assessee and tax is levied on and recovered Webinar: Social Impact Bonds and
from them in a like manner and to the same extent as it would be leviable upon and recoverable from Impact Investments in India:
the person represented by them (i.e. the investors to the concerned fund). In the case of AIG (In Re: Opportunities and Misconceptions
Advance Ruling P. No. 10 of 1996), the Authority for Advanced Rulings (“AAR”) held that it is not
Webinar : New Opportunities Open
required that the exact names of all the beneficiaries are stated in the trust deed or the exact shares of
up for Funds In IFSC
the beneficiaries be specified for a trust to be considered a determinate trust; as long as there is no
uncertainty regarding the beneficiaries and no uncertainty regarding the share of income to which they Webinar: Bilateral Arbitration
are entitled, the trust will still be treated as a determinate trust even if there is a pre-determined formula Treaties: A Better FIT than BITs for
by which distributions are made and pre-determination of the class of persons who become Dispute Resolution?
beneficiaries of the trust. If a trust is not considered to be determinate, the income of the trust will be
taxed at the maximum marginal rate in the hands of the trustee in its capacity as the representative
assesse of the beneficiaries.

Several participants of the onshore funds industry have been making representation to the tax
authorities seeking clarity on various issues relating to the taxation of onshore funds that are excluded
from the coverage of Section 10(23FB) of the Tax Act including the requirements that need to be
fulfilled to qualify as a determinate trust.

PO S IT IO N O F LAW O UT LIN ED IN T H E CIR CULAR

What attributes ‘determinate’ status to an AIF and position of tax if a concerned AIF is not ‘determinate’:
The Circular provides that in situations where the trust deed of an AIF on the date of its creation either
(1) does not name the investors (i.e. the beneficiaries) or (2) does not specify the beneficial interests of
such investors, the provisions of section 164(1) of the Tax Act would come into play and the entire
income of the AIF shall be liable to be taxed at the maximum marginal rate in the hands of the trustee
of the AIF in its capacity as ‘representative assessee’ of the trust.

If part or all of the income of the AIF is in the nature of business income: The Circular states that where
the income of an AIF consists of, or includes, profits and gains of business, section 161(1A) of the Tax
Act would take effect and the whole of the income of the AIF would be taxed in the hands of the trustee
in its capacity as a ‘representative assessee’ of the AIF at the maximum marginal rate even where the
AIF is determinate.

Tax pass – through status: Given the position under the Circular, it would appear that in respect of AIFs
other than Category I AIFs (in the venture capital fund sub-category) to whom the provisions of section
10(23FB) of the Tax Act applies, a position of tax ‘pass – through’ can be maintained if (1) the AIF is
determinate (i.e. the names of the investors and their beneficial interests are stated in the trust deed
‘on the date of its creation’) and (2) the income of the AIF does not consist of or include profits and
gains of business.

Interestingly, it has also been provided that the clarifications contained in the Circular shall not be
operative in an area falling in the jurisdiction of a High Court which has taken or takes a contrary
decision on the issue.

IM PACT O N IN CO M E S T R EAM S

The Circular is likely to impact the tax treatment applicable to certain kinds of income streams of an
AIF. For instance, long-term capital gains arising to an AIF on the transfer of unlisted securities is
typically taxed at the rate of 20% (with indexation benefits). Similarly, long-term capital gains arising to
an AIF on the transfer of listed securities on which securities transaction tax (“STT”) has not been paid
is taxed at the lower rate of 10% (without indexation benefits) or 20% (with indexation benefits). As a
consequence of the Circular, such income may now potentially be taxed at the maximum marginal rate
in the hands of the representative assessee (i.e. the trustee).
Offshore investors: Investors (including feeder funds) based out of a jurisdiction which has a
favourable tax treaty with India may not be able to place reliance on the provisions of the applicable
tax treaty unless the AIF meets the requirements of being ‘determinate’ as clarified by the Circular,
failing which, the AIF will not be regarded as a tax pass-through entity. Ideally, both for computation of
income and determination of tax on the computed income, the characterization of income in the hands
of the trustee to the AIF should be the same as in the hands of the beneficiary (i.e. each investor to the
AIF).

CO M M ER CIAL IM PLICAT IO N S FO R AIFS

The clarification provided under the Circular on the requirements to be fulfilled to qualify for
‘determinate trust’ status may have implications on the operation of AIFs. Some of the possible
implications are discussed below.

Multiple closings

As per the Circular, an AIF that is looking to qualify as a determinate trust is required to state the
names of its investors and their beneficial interests in the trust deed on the date of creation of the trust.
Accordingly, such AIF may not be able to on-board new investors at a subsequent closing since this
will require the trust deed to be amended and this is turn would mean that the identities of the
investors and their beneficial interests will not be the same as on the date of creation of the trust.

Change in beneficial interests of investors

In an AIF, there are several circumstances in which the beneficial interests of investors could vary. For
instance, part transfer of unit holding from one investor to another would alter the beneficial interests of
both investors in the AIF. Further, the termination of a defaulting investor’s participation in an AIF
would result in a realignment of beneficial interests of the remaining investors. On June 19, 2014,
SEBI issued a circular stating that where there was a material change in the placement memorandum,
AIFs would be required to provide an exit option to investors who did not wish to remain invested in
the fund. To the extent that any investor availed the exit option, there would be a realignment of the
beneficial interests of the remaining investors.

Impact on fundraising

Since an AIF will retain its status as a determinate trust only if the names of the investors and their
beneficial interests are known on the date of creation of the trust, an AIF (seeking to qualify as a
determinate trust) may be restricted with respect to the innovations to the distribution and fee
mechanisms that it can offer investors.

In particular, the use of opt-in and opt-out clauses may trigger taxation at the maximum marginal rate
in the hands of the trustee. Such AIFs will need to raise its entire corpus at the initial closing so as to
ensure that the names of its beneficiaries and their beneficial interests are known on the date of
creation of the trust.

CO N CLUS IO N

The Circular may have been issued with an intention to clarify the tax position for onshore funds set up
as AIFs. At present, a substantial majority of AIFs have been structured as trusts and map the identities
and beneficial interests of their investors, based on the principles laid down in AIG (In Re: Advance
Ruling P. No. 10 of 1996) i.e by providing for the manner of determining the beneficiaries (such
persons who sign up the contribution agreement) and for determining their beneficially interest
through a formula based approach. Such AIFs may be impacted by the clarification provided by the
Circular.

Globally, investment funds rely on a 'tax pass-through status' wherein the income of the investment
fund is taxed directly in the hands of its investors, but not at the level of the fund itself. This provides
fiscal neutrality to the funds as it eliminates tax at the pool level while maintaining taxation at the
investor level.

Accordingly, what is required to be clarified now in the context of trusts is ​if the beneficiaries can be
identified ‘at any point in time’ and their shares are ascertainable, the trust should be considered pass
through. This would be in line with ruling laid down by the AAR in AIG. The requirement laid down in
the Circular of explicitly stating the names of the investors of the AIF and their beneficial interests on
the date of creation of the trust creates ambiguity. In fact the AIG ruling had specifically commented on
each of these aspects in great detail which ought to have been replicated in the Circular in order to
remove all ambiguities on the issue.

One open alternative that may still be available in a fund context is that in the event that the capital
contributions of the investors in an AIF are treated as revocable, then as per the provisions of section
61 of the Tax Act, any income of the AIF is taxable directly in the hands of such investors. This could
also help in making out a defendable case for treating such structures as being tax pass-through,
though there are no decisions in the context of funds that are available today in this regard. It was
hoped that the Circular would provide finality and remove all ambiguities on the pass through
treatment for AIFs, but instead we are left with a situation where there are more questions that are
being raised.
– Adhitya Srinivasan, Richie Sancheti & Rajesh Simhan
You can direct your queries or comments to the authors

1
Circular No. 13 / 2014 dated July 28, 2014

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the need to refer to the original pronouncements.
 TAXATION OF ALTERNATIVE INVESTMENT FUNDS

1. INTRODUCTION

Securities and Exchange Board of India (“SEBI”), in 2012, took steps to completely overhaul the regulatory
framework for domestic funds in India and introduced the Securities and Exchange Board of India (Alternative
Investment Funds) Regulations, 2012 (“AIF Regulations”). Among the main reasons cited by SEBI to highlight
its rationale behind introducing the AIF Regulations was to recognize AIFs as a distinct asset class; promote
start-ups and early stage companies; to permit investment strategies in the secondary markets; and to tie
concessions and incentives to investment restrictions. Further, it brought the already registered Venture
Capital Funds (“VCF”) within its ambit, and provided that, all new and existing funds that are not registered
under any regime would now be required to get registered under the AIF Regulations.

2. ALTERNATIVE INVESTMENT FUNDS

Subject to certain exceptions, the ambit of the AIF Regulations is to regulate all forms of vehicles set up in
India for pooling of funds on a private placement basis. To that extent, the AIF Regulations provide the bulwark
within which the Indian fund industry is to operate.

An AIF means any fund established or incorporated in India in the form of a trust or a company or a limited
liability partnership (“LLP”) or a body corporate which: 1

a. is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for
investing it in accordance with a defined investment policy for the benefit of its investors; and

b. is not covered under the SEBI (Mutual Funds) Regulations, 1996, SEBI (Collective Investment Schemes)
Regulations, 1999 or any other regulations of the Board to regulate fund management activities.

Additionally, it is provided that, family trusts set up for the benefit of relatives, ESOP trusts, employee welfare
trusts or gratuity set up for the benefit of the employees, holding companies, specified special purpose
vehicles (“SPV”), funds managed by RBI registered securitisation company or reconstruction company and any
pool of funds directly regulated by any other regulator in India, shall not be considered as AIF under the AIF
Regulations.2

3. CLASSIFICATION OF ALTERNATIVE INVESTMENT FUNDS

With the intent to distinguish the investment criteria and relevant regulatory concessions that may be allowed
to AIFs, and to effectively channelize the incentives, the AIF Regulations have classified the AIFs into three

1 Regulation 2(1)(b) of the AIF Regulations.

2 Proviso to Regulation 2(1)(b) of the AIF Regulations.
separate categories. Consequently, an AIF shall seek registration with SEBI either as, Category-I AIF, Category-II
AIF or Category-III AIF.

A description of the various categories of AIFs along with the investment conditions and restriction relevant to
each category is summarized below:

CATEGORIES CATEGORY-I AIF CATEGORY-II AIF CATEGORY-III AIF

(Close ended, minimum (Close ended, minimum (Open/Close ended)
tenure of 3 years) tenure of 3 years)
TYPES OF  Funds with strategies to  Funds which cannot  Funds which employ
INVESTORS3 invest in start-up or early be categorized as complex or diverse
stage ventures or social Category-I AIFs or trading strategies.
ventures or small and Category-III AIFs.
medium enterprises  Includes Hedge funds
(“SME”) or infrastructure  Includes private equity or funds which trade
or other sectors or areas funds or debt funds for with a view to make
which the government or which no specific short-term returns or
regulators consider as incentives or such other funds which
socially or economically concessions are given are open ended and for
desirable. by the Government of which no specific
India or any other incentives or
 Includes, VCF or SME regulator. concessions are given
Funds or Social Venture by the Government of
Funds or Infrastructure India or any other
Funds and such other as regulator.
may be specified.
INVESTMENT  Cannot invest more than  Cannot invest more  Cannot invest more
RESTRICTIONS 25% of investible funds than 25% of investible than 10% of investible
in one investee funds in one investee funds in one investee
company.4 company.7 company.10

 Shall invest in investee  Shall invest primarily  May invest in securities

companies / Venture in unlisted investee of listed or unlisted
Capital Undertakings / companies or in units investee companies or
SPVs / LLPs / units of of other AIF.8 derivatives or complex
other AIF.5 or structured

3 Regulation 3(4) of the AIF Regulations.

4 Regulation 15(1)(c) of the AIF Regulations.
5 Regulation 16(1)(a) of the AIF Regulations.
7 Regulation 15(1)(c) of the AIF Regulations.
  Do not undertake products.11
 Do not undertake leverage or borrowing
leverage or borrowing other than to meet  May employ leverage
other than to meet day- day-to-day operational including through
to-day operational requirements.9 investment in listed or
requirements.6 unlisted derivatives.12

4. TAXATION OF ALTERNATIVE INVESTMENT FUNDS

4.1 TAXATION OF CATEGORY-I AND CATEGORY-II AIFs

4.1.1. Through the Finance Act, 2015, the tax pass through status was extended to Category-I and Category-II
AIFs. It included a proviso to section 10(23FB) of the Indian Income Tax Act, 1961 (“ITA”), pursuant to
which, the registered Category-I and Category-II AIFs under the AIF Regulations, are taxed according to
the rules set forth in the newly introduced Chapter XII-FB of the ITA.

4.1.2. The Finance Act, 2015 provides that any income accruing or arising to, or received by, a unit-holder of
an „investment fund‟ out of investments made in the „investment fund‟ shall be chargeable to income-
tax in the same manner as if it were the income accruing or arising to, or received by such person, had
the investments made by the „investment fund‟ been made directly by the unitholder. 13 “Investment
fund” is defined to mean a fund that has been granted a certificate of registration as a Category-I or a
Category-II AIF.14

4.1.3. However, the ITA contemplates that income chargeable under the head „Profits and gains of business
and profession‟ will be taxed at the investment fund level and the tax obligation will not pass through
to the unit- holders. In order to achieve this, the ITA introduces two provisions:

a. Section 10(23FBA) which exempts income of an investment fund other than income chargeable
under the head „Profits and gains of business or profession‟; and

b. Section 10(23FBB) which exempts the proportion of income accruing or arising to, or received by,
a unit-holder of an investment fund which is of the same nature as income chargeable under the
head „Profits and gains of business or profession‟.

8 Regulation 17(a) of the AIF Regulations.

10 Regulation 15(1)(d) of the AIF Regulations.
6 Regulation 16(1)(c) of the AIF Regulations.
9 Regulation 3(4)(b) of the AIF Regulations
11 Regulation 18(a) of the AIF Regulations.
12 Regulation 3(4)(c) of the AIF Regulations.
13 Section 115UB of the ITA.
14 Explanation 1 to Section 115UB of ITA.
4.1.4. Further, the Finance Act, 2015, provides that where the total income of an investment fund in a
previous year (before making adjustments) is a loss which cannot be, or is not wholly set-off against
any heads of income, then such loss can be carried forward and set-off in accordance with Chapter VI
(Aggregation of Income and Set Off or Carry Forward of Loss), and shall not pass over to the unit
holders.

4.1.5. Moreover, the Central Board of Direct Taxation (“CBDT”) has notified15 that income received by
investment funds would be exempted from Tax Deducted at Source by portfolio companies.

4.1.6. The Finance Act, 2016 has amended section 194(LBB) of the ITA to enable deduction of withholding
tax for non-residents at a rate which is in accordance with the provisions of the Double Taxation
Avoidance Agreement (“DTAA”) if they are eligible to DTAA benefits. However, it keeps the withholding
rate unchanged for resident investors.

4.1.7. Besides, CBDT vide a press release dated May 2, 2016, 16 clarified that income arising from transfer of
unlisted shares would be taxed as capital gains under the ITA irrespective of the period of holding,
except in the following cases where the Assessing Officer shall take the appropriate view:

a. genuineness of the transaction is questionable; or

b. the transfer of unlisted shares is related to an issue pertaining to lifting of corporate veil; or
c. the transfer of unlisted shares is made along with the control and management of underlying
business.

It was in this regard that CBDT issued a subsequent clarification17, clarifying that exception (c.) above
shall not apply to Category-I and Category-II AIFs.

4.2 TAXATION OF CATEGORY-III AIFs

4.2.1. AIFs are usually set up as trusts and are therefore subject to the tax framework that is applicable to
trusts in India. Taxation of trusts is laid down in sections 161 and 164 of the ITA, where trust is not
considered a separate taxable entity.

4.2.2. Further, as per section 161, the income tax officer is free to levy tax either on the beneficiary or on the
trustee in their capacity as representative assesse, however, it must be done in the same manner and
to the same extent that it would have been levied on the beneficiary. This essentially means that,
when the trustee is assessed as a representative assessee, they would generally be able to avail of all
the benefits / deductions etc. available to the beneficiary, with respect to that beneficiary‟s share of
income.

15 Vide Notification No. 51 / 2015 dated June, 2015.

16 F.No.225/12/2016/ITA.II.
17 CBDT F.No.225/12/2016/ITA.II, dated January 24, 2017.
4.2.3. On July 28, 2014, CBDT issued a circular stating that if „the names of the investors‟ or their „beneficial
interests‟ are not specified in the trust deed on the „date of its creation‟, the trust will be liable to be
taxed at the „maximum marginal rate‟.

4.2.4. Additionally, the Bangalore Income Tax Appellate Tribunal in the case of DCIT v. India Advantage Fund
– VII18, while laying down the position of taxing investors based on their status, held, that income
arising to a trust where the contributions made by the contributors are revocable in nature, shall be
taxable at the hands of the contributors. The ruling comes as a big positive for the Indian fund
industry, as it offers some degree of certainty on the rules for taxation of domestic funds that are set
up in the format of a trust by regarding such funds as fiscally neutral entities.

Globally, funds have been accorded pass through status to ensure fiscal neutrality and investors are
taxed basis their status. This is especially relevant when certain streams of income maybe tax free at
investor level due to the status of the investor, but taxable at fund level. Funds, including AIFs that are
not entitled to pass through status from a tax perspective (such as Category III AIFs) could seek to
achieve a pass through basis of tax by ensuring that the capital contributions made by the contributors
is on a revocable basis.

Taxation of Investment Funds

1.1. Introduction
India has been one of the important emerging markets for investment purposes. Taxation rates,
however, remain relatively high and the tax regime is both complicated and rather uncertain. The tax
system is largely based on residence and source rules.

Thus, based on the place of incorporation or establishment of the pooling vehicle and its place of
effective management, investments funds may be classified as onshore or offshore funds. Pooling
vehicles that are established in India could be set up as a domestic venture capital fund (DVCF), AIF,
REIT or InvIT. such pooling vehicles are under the regulatory purview of SEBI and thus subject to
conditions and guidelines in the relevant VCF, AIF, REIT or InvIT Regulations.

411.1. Taxation of income of domestic investment funds

A domestic investment fund is a fund established in India. This section covers the taxation of an
investment fund in India set up as a mutual fund, DVCF, AIF, REIT or InvIT in India. The taxation of an
investment fund in India can be categorized under two heads:

(i) tax on income received by an investment fund and

18 ITA No.178/Bang/2012.
(ii) tax on income distributed by an investment fund.

Provisions for taxation of income received and income distributed by an investment fund vary,
depending on the type of domestic fund (whether mutual fund, DVCF, AIF, REIT or InvIT) and the form
in which they are established (whether company, LLP or trust) and thus entitlement to a pass-through
status. The provisions relating to taxation of the aforementioned investment funds are contained in
various sections of the Income Tax Act, 1961 (Income Tax Act). Section 115U provides for tax on
income received from VCFs; section 115UB provides for tax on income of AIFs and income received
from AIFs and section 115UA provides for tax on income of unitholders and business trusts, i.e. REITs
and InvITs.

1.1.2 Funds established as a company or LLP

As discussed an AIF can be set up as a trust, company or LLP. When an AIF is set up as a company
outside India, the test of place of effective management (POEM) becomes a significant factor in
determining the taxability of such fund. The test of POEM was introduced by the Finance Act, 2015 to
determine the residential status of companies that are not incorporated in India, with effect from 1
April 2015. The Finance Act, 2016 deferred the application of the test of POEM by 1 year, i.e. to be
effective from 1 April 2016, and it is currently in force. Companies that are incorporated in India are
always deemed to be resident in India.

As taxability of income received and distributed by a Category I or Category II AIF established in India
as a company is governed by the beneficial provisions contained in section 115UB of the Income Tax
Act. The provisions of dividend distribution tax (DDT) under section 115-O of the Income Tax Act do not
apply to the income paid by Category I and Category II AIFs to its unit holders, which means that AIFs
are not subject to any tax on dividend distributed by such AIFs to their unit holders.

1.1.3. Special features private equity and venture capital funds

Domestic VCFs
Tax on income received by a domestic VCF
Section 10 of the Income Tax Act exempts certain income from levy of income tax in India. Section
10(23FB) of the Income Tax Act exempts any income of a venture capital company (VCC) or VCF from
investment in a venture capital undertaking (VCU). A VCC and a VCF are defined under section
10(23FB) of the Income Tax Act to mean a company (in the case of a VCC) and a fund operating under
a trust deed that is registered under the Registration Act, 1908 (in the case of a VCF), which has been
granted (i) a certificate of registration, before 21 May 2012, as a VCF and regulated under the VCF
Regulations, or (ii) a certificate of registration as a subcategory of Category I AIFs and regulated under
the AIF Regulations. A VCU is defined to mean (i) a VCU as defined in paragraph 2(n) of the VCF
Regulations or (ii) a VCU as defined in paragraph 2(1)(aa) of the AIF Regulations.
For the purpose of availing the tax exemption under section 10(23FB), a VCC or VCF is required to
fulfill the following conditions:
- the fund must have invested at least two thirds of its investible funds in unlisted equity shares or
equity-linked instruments of VCUs;
- the fund should not have invested in any VCU in which the trustee or settlor of the fund holds either
individually or collectively equity shares in excess of 15% of the paid-up equity share capital of such
VCU; and
- the units issued by the fund should not be listed on any recognized stock exchange.
VCCs/VCFs covered by section 10(23FB) are accorded “pass-through” status. Thus, income earned by
a domestic VCF (DVCF) from investments in VCUs would be exempt from tax in the hands of the
VCC/VCF subject to fulfillment of the above-stated conditions. Such income of a VCC is directly taxed
in the hands of the investors of the VCC/VCF in accordance with the provisions contained in section
115U of the Income Tax Act. Section 115U provides that any income accruing or arising to or received
by a person out of the investments made in a VCC or VCF shall be chargeable to tax as if it were the
income accruing or arising to or received by such person had he made investments directly in the VCU.
A DVCF would generally earn income in the nature of (i) dividends, (ii) interest and/or (iii) capital gains.
Dividend income received by a DVCF on which dividend distribution tax has been paid by the investee
company (VCU) would be tax free in the hands of investors under section 10(34) of the Income Tax
Act.
Interest income would be taxed in the hands of the investor. The rate of tax and surcharge and thus
the effective rate of tax on such interest income earned by the investor would depend on the kind of
investor.
Furthermore, gains from the sale of the shares of the investee company (VCU) are subject to capital
gains tax in the hands of the investor. The taxability of the capital gains depends on the period of the
holding of shares. The taxation of capital gains and the interest income in the hands of the investor.

Tax on income distributed by a DVCF

In terms of section 115U(1) of the Income Tax Act, an investor in a VCC or VCF will be taxed at the time
when income has been accrued to or received by the investor from such VCC or VCF. Section 115U(4)
of the Income Tax Act provides that provisions for tax deduction at source (withholding tax) in the
Income Tax Act shall not apply to DVCFs. Thus, DVCFs are not required to withhold any tax on
distribution of income to investors.

Taxation of VCFs (after 21 May 2012)

It is relevant to note here that the AIF Regulations have replaced the VCF Regulations from 21 May
2012. Therefore, the AIF Regulations now regulate all privately pooled investment vehicles that collect
funds from investors for investments in accordance with a predefined investment policy for the benefit
of its investors. An AIF can be a fund established or incorporated in the form of a trust, company, LLP
or body corporate. The AIF Regulations categorize investment funds broadly into three categories – I, II
and III. From a taxation perspective, VCCs/VCFs that were registered prior to 21 May 2012 under the
VCF Regulations will continue to be governed by the provisions of section 10(23FB) read with section
115U of the Income Tax Act. The impact on AIFs registered on or after 21 May 2012 under the AIF
Regulations is as follows:
- VCFs registered as a subcategory of Category I AIFs are eligible for tax exemption under section
10(23FB) read with section 115U until the financial year 2014/15.
- From the financial year 2015/16 onwards, such VCFs registered as a subcategory of Category I AIFs
(and also Category II AIFs) will be governed by the new special tax regime introduced by the Finance
Act, 2015.
Alternate investment funds (AIFs) Category I and Category II AIFs
The Finance Act, 2015 has inserted chapter XII-FB titled “Special provisions relating to tax on income
on investment funds and income received from such funds” to the Income Tax Act. An investment fund
is granted partial pass-through status under the special tax regime contained in section 115UB of the
Income Tax Act. However, the existing pass-through regime under section 115U read with section
10(23FB) would continue to apply to VCFs/VCUs that had been registered under the VCF Regulations.
Any VCF being part of Category I AIFs and also Category II AIFs, registered under the AIF Regulations
shall be subject to the new pass-through regime contained in section 115UB read with sections
10(23FBA) and 10(23FBB) of the Income Tax Act, which basically means that the VCFs/VCCs that
were already registered under the VCF Regulations before these were replaced by the AIF Regulations
in May 2012 will not be affected by the introduction of new chapter XII-FB by the Finance Act, 2015
and such VCFs/VCCs will continue to be eligible for pass through status under section 115U read with
section 10(23FB) of the Income Tax Act. The other VCFs being part of Category I AIFs and Category II
AIFs shall be subject to the new pass-through regime.
Explanation 1(a) to section 115UB of the Income Tax Act defines “investment fund” as any fund
established or incorporated in India in the form of a trust, company, limited liability partnership or
body corporate that has been granted a registration as a Category I or Category II AIF and is regulated
under the AIF Regulations.

Special tax regime on income received by an investment fund – Section 115UB

The investment fund is taxed in respect of its income in the nature of “profits and gains of a business
or profession”, while any income in the hands of the investment fund other than income from “profits
and gains of a business or profession” (e.g. income by way of capital gains or from other sources that
have a pass-through status, i.e. taxable in the hands of the investor is exempt from tax under section
10(23FBA) of the Income Tax Act.
Section 115UB (4) of the Income Tax Act provides that the total income of the investment fund shall
be chargeable to tax at (i) the rate or rates specified in the Finance Act of the relevant year, where the
investment fund is a company or a firm and (ii) in any other case, at the maximum marginal rate
(which is 30% for the current financial year 2016/17).
Section 115UB(2) allows the investment fund to set off any loss in a financial year against any other
head of income, subject to general provisions in respect of set-off and carry-forward of losses
contained in the Income Tax Act. The provisions of section 115UB (2) provide that where the net result
of computation of total income of the investment fund (including income exempted under section
10(23FBA) of the Income Tax Act) is a loss under any head of income and such loss cannot be or is
not wholly set off against income under any other head of income in the relevant financial year, then
such loss shall be allowed to be carried forward and be set off by the investment fund in accordance
with the provisions in respect of set-off of losses contained in the Income Tax Act. It may be noted,
however, that such loss cannot be carried forward through to the investor.

Tax on income distributed by a Category I or II AIF investment fund

Section 115UB of the Income Tax Act provides that any income accruing or arising to a person being a
unit holder of investment fund, out of the investments made in the investment fund shall be
chargeable to income tax in the same manner as if it were the income accruing or arising to, or
received by, such person had the investments made by the investment fund been made directly by
him. Thus, pass-through status has been accorded to the investment fund in respect of its income,
other than income from “profits and gains of a business or profession” under section 115UB (1) read
with section 10(23FBA) of the Income Tax Act.
Such income that is accorded pass-through status in the hands of the investment fund is taxed
correspondingly in the hands of the unit holder under section 115UB (1) of the Income Tax Act. If,
however, the income accruing or arising to, or received by, an investment fund during a financial year
is not credited /paid to the unit holder, the income would be deemed to be credited to the account of
the unit holder on the last day of the financial year in the same proportion in which such unit holder
would have been entitled to receive such income had it been paid in that financial year, in accordance
with the provisions of section 115UB (6) of the Income Tax Act.
It is worth noting that the income paid or credited by the investment fund is deemed to be of the same
nature and in the same proportion in the hands of the unit holder as had it been received by or had
accrued or arisen to the investment fund during the relevant financial year.
Any income of an investment fund, other than “profits and gains of a business or profession” that is
payable to a unit holder in respect of units of a Category I or Category II AIF is subject to tax deduction
at source (withholding tax) under section 194LBB of the Income Tax
Act. Section 194LBB requires the person responsible for paying any income other than “profits and
gains from a business or profession” to a unit holder to withhold tax at the below stated rate at the
time of credit of such income to the account of the payee or at the time of payment thereof:
- In the case of a resident unit holder – at the rate of 10%.
In the case of a non-resident unit holder – at the rates in force (i.e. the rate provided under the Income
Tax Act or under the relevant double taxation agreement (DTA). Any income which is not chargeable to
tax under the provisions of the Income Tax Act will not be subject to withholding tax.
An investment fund is not required to pay DDT on distribution of dividends to its unit holders. The
taxation of the unit holder of the investment fund in respect of the distributions made by an
investment fund.

1.1.4. Entitlement to tax credits

The fund can claim credit for the taxes paid in the foreign country on foreign-source income (which is
taxed at fund level) in accordance with the provisions of the applicable DTA. If, however, the fund has
suffered taxes in the foreign country with which India does not have a DTA, credit for taxes paid in the
foreign country will be available to the fund in accordance with the provision of section 91 of the
Income Tax Act.
In the absence of well-laid out rules, it was practically difficult for taxpayers and the tax authorities to
agree on credit claims, which led to uncertainty and litigation. To attain more uniformity and clarity on
the procedure of obtaining foreign tax credits in India of the foreign taxes paid, in June 2016, the
CBDT notified rules for granting a foreign tax credit in respect of taxes paid by resident taxpayers in
foreign countries (Foreign Tax Credit Rules). The Foreign Tax Credit Rules set out the mechanism for
computation and conditions for claiming foreign tax credits. The Foreign Tax Credit Rules took effect
from 1 April 2017 and are therefore applicable in respect of income for the financial year 2016/17
and subsequent financial years.

1.1.5. Entitlement to DTAs

Section 90 of the Income Tax Act provides an assessee to whom a DTA applies with an option to
choose between the provisions of the Income Tax Act or the provisions of the DTA, whichever is more
beneficial. The DTA provisions would not apply to an investment fund established in India where the
fund makes investments in India since the income would be Indian-source income of an Indian
resident.
However, in respect of any income earned by the fund from investments outside India (i.e. the foreign-
source income), the fund will be entitled to DTA benefits.

Taxation of foreign investment funds

Foreign investment funds (i.e. investment funds where the investment pooling vehicle is situated
outside India) can bring in investment into India under the FDI, FVCI, FII/FPI routes (see section 2.2.).
The taxation of such funds would thus depend on the route adopted for investing in India and the
nature of the income derived by them in India. Generally, the income derived by an offshore fund
would be in the nature of dividend income, interest income and/or gains from the transfer of Indian
securities.

An offshore fund is defined in the explanation to section 115AB of the Income Tax Act as a fund,
institution, association or body, whether incorporated or not, established under the laws of a country
outside India that has entered into an arrangement for investment in India with any public-sector
bank, public financial institution or mutual fund in an arrangement approved by SEBI.
To qualify as equity instruments under the FDI Regulations, foreign investment funds are only allowed
to invest in Indian companies by way of equity shares, compulsorily convertible preference shares
(CCPSs) or compulsorily convertible debentures (CCDs).
Also, an offshore fund may invest in India through an Indian DVCF/AIF, which in turn invests in Indian
securities. In such cases, the return could be in the form of dividends/distributions from DVCFs/AIFs.
Investment routes
Private equity and VCFs typically adopt one of the following modes when investing into India: (i) direct
investment in the Indian portfolio company or (ii) investment in an Indian investment fund vehicle.
Direct investment by an Offshore Fund in Indian securities
When an Offshore Fund invests directly in Indian securities, income derived by such fund would
typically be in the nature of (i) interest, (ii) Dividends and/or (iii) capital gains. Income in the nature of
interest derived by an Offshore Fund would be subject to tax at the rate of 40% (plus applicable
surcharge[44] and education cess).However, interest income from foreign currency loans approved by
the central government after 1 July 2012 but before 1 July 2017 will be taxed at a lower rate of 5%
and at the rate of 20% (plus applicable surcharge and education cess) in case of any other foreign
currency loan under section 115A(1)(a) of the Income Tax Act.
In respect of dividend income, if the investee company distributing dividends has paid DDT under
section 115-O of the Income Tax Act, the Offshore Fund will not be liable to further tax. However, if
DDT is not paid, dividends will be taxed under section 8 of the Income Tax Act at a rate of 20% (plus
applicable charge and education cess) under section 115A(1)(a) of the Income Tax Act. In respect of
gains arising from the transfer of Indian securities, the gains derived by an Offshore Fund would be
subject to tax in India, based on the period of holding of such securities and the route adopted for
investing in India. However, an Offshore Fund (being a non-resident) would be entitled to choose the
provisions of the Income Tax Act or the applicable DTA, whichever is more beneficial to it, under the
provisions contained in section 90(2) of the Income Tax Act. Thus, an Offshore Fund may avail itself of
the benefits of a DTA subject to satisfaction of certain conditions stated therein.
Investment through an onshore fund
An investor incorporated and established outside India, which intends to make investments in VCFs or
VCUs in India, is required to be registered with SEBI as an FVCI under the FVCI Regulations. An FVCI is
also allowed to invest under the FDI route subject to the applicable FEMA regulations and FDI policy.
The taxation of FVCIs in India would be as follows:
Where the FVCI is eligible for exemption under section 10(23FB), provided it satisfies the conditions
stated therein the income of the FVCI would not be subject to tax in India. However, the investors in
the FVCI would be subject to tax in India in respect of the income received from the FVCI in the same
manner as if they had directly made the investment in India. Where the FVCI does not qualify for
exemption under section 10(23FB), it would be taxed directly in respect of any income deemed to
accrue/arise or received by it in India. No further tax would be charged at the time of distribution of
income to the investors.
Where the FVCI has made investments into Indian securities through onshore funds, income derived
by the FVCI could be in the form of (i) dividend, (ii) interest and/or (iii) business income and/or capital
gains arising on a transfer of Indian securities. The tax implications for these would be:
- Dividend income will be tax exempt if received from a domestic company that has paid DDT.
- Interest income would be subject to tax at the rate of 40% (plus applicable surcharge and education
cess). This rate may be reduced, however, if the investment is made through a jurisdiction that offers a
lower rate under the applicable DTA.
- Business income/capital gains – Any gains arising on exit/transfer of Indian securities could be
characterized either as business income of the FVCI or as capital gains. It should be noted that
characterization of income as business income or capital gains would depend on the facts and
circumstances of each case and has been a subject of debate between taxpayers and the tax
authorities in India.
If the income on the transfer/sale of Indian securities is regarded as business income, the income will
not be taxed in India unless the FVCI has a permanent establishment (PE) in India. In this case, the
income would be regarded as business income of the FVCI and taxable at the rate of 40% (plus
applicable surcharge and education cess). On the other hand, if the income on a transfer/sale of India
securities is characterized as capital gain, such income would be taxable either as LTCG or STCG
depending upon the period of holding of such securities.
The Income Tax Act provides for different rates of tax for STCG and LTCG based on the nature of
securities held, the type of entity, etc.
It is noted here, however, that FVCIs may opt to be governed by the provisions of the applicable DTA in
case the DTA has more beneficial capital gains tax provisions. Thus, income of the FVCI would be
subject to tax in India as per the provisions of the Income Tax Act or as per the provisions of the
applicable DTA, if more beneficial.

Tax on indirect transfers

It is also pertinent to note here the amendment made by the Finance Act, 2012 of adding new
explanations 4 and 5 to section 9(1)(i) of the Income Tax Act relating to the levy of capital gains tax on
income arising from a transfer of shares/interest in a company/entity organized outside India that
derive, directly or indirectly, their value substantially from the assets located in India. It is therefore a
possibility that the Indian tax authorities may seek to tax the transfer of shares in an offshore fund by
a foreign investor to either a resident or a non-resident if the shares of the offshore fund derive their
value substantially from an Indian source. The share or interest shall be deemed to derive its value
substantially from assets (whether tangible or intangible) located in India if, on the specified date, the
value of such assets:
- exceeds the amount of INR 10 crore (100 million); and
- represents at least 50% of the value of all assets owned by the company or entity.
In this context, it may also be of interest to take note of a recent amendment by the Finance Act, 2017
whereby a proviso has been inserted to explanation 5 to section 9(1)(i), clarifying that the above-
stated provisions will not apply to a non-resident who holds an asset or capital asset by way of
investment directly or indirectly in (i) an FII as referred to in clause (a) of the explanation to section
115AD for an assessment year commencing on 1 April 2012 but before 1 April 2015 (with
retrospective effect from 1 April 2012) and (ii) a Category I or Category II FPI under the FPI Regulations
made under the SEBI Act (with retrospective effect from 1 April 2015).

Taxation of the fund management

1.2.1. Management fee
The management fee paid by an investment fund is taxed in the hands of the fund manager. If the
fund manager (being an individual) is resident in India, he will be taxed based on the income tax slab
rates applicable to him for the relevant financial year.
1.2.2. Performance fees/carried interest/hurdle rates
Performance fees or carried interest is taxed in the hands of the fund manager as income from a
business or profession at the applicable rate of tax for the relevant financial year.
 NALSAR University of Law
Justice City :: Shameerpet :: Hyderabad
Examination Section

Faculty Option Form for Elective Courses (Form-2)– January-April, 2019 Semester
Name of the Faculty: ALOK VERMA

Taxation of structured funds

COURSE TITLE:

COURSE OFFERED TO
Elective for LL.B.
INSTRUCTOR:
ALOK VERMA

NUMBER OF CREDITS: 3 credit

DURATION 40 Hours

The shift in legal paradigm in which an investment fund

operates requires that attention be given to articulating
disclosures in fund documents and intelligently planning
investment asset-holdings to lower regulatory burden. In
our experience, fund documentation is critical in ensuring
protection for fund managers from exposure to legal, tax
and regulatory risks. Fund counsels are now required to
devise innovative structures and advise investors on terms
for meeting investor’s expectations on commercials,
governance and maintaining GP discipline on the
articulated investment strategy of the fund. All these are to
be done in conformity with the changing legal framework.
The objective of this course is to bring to focus, the
BRIEF DESCRIPTION
structural and taxation aspects that need to be considered
(MAXIMUM 500 WORDS)
while setting up India focused funds and some of the
recent developments that impact the fund management
industry and its implication on large tax outflows.
 Open Book Exam (Mid Semester + End Semester) and a research
paper
SCHEME OF EVALUATION:

SELECTION CRITERIA (IF ----

ANY)

Broad Course Description

Concept and overview, legal nature of trust, need for tax transparency
UNIT I: INTRODUCTION OF of investment vehicles, registration of trust, overview of larger tax
BUSINESS TRUST implications on business trust, taxation of revocable/irrevocable trust,
determinable and indeterminable trust.
Overview, AIF structures, various categories, categorization of
income, exemption of income of category I&II AIF, exemption of
income in the hand of unit holders, pass through taxation, TDS
UNIT II: TAXATION OF
provisions and its applicability on AIF qua unit holder, Other key tax
AIF
implication on transfer of dividend, interest and gain on transfer of
securities, return of income , reporting requirement , applicability of
indirect transfer provisions, impact of GST Laws
Background, taxation framework history; position prior to Finance
Act, 2013 Position between 2013-2016, Implication of amendment
UNIT III: TAXATION OF brought by Finance Act, 2016, Exemptions, taxability of income in the
SECURITISATION TRUST hand of securitization trust, taxability of income in the hand of
investor, return of income, reporting of income, impact of GST on
securitization transactions
Overview, History of ReITs in India, Nature of income / investment by
ReITs and unit holders, tax on distribution of income, taxation of
UNIT IV: TAXATION OF REAL
rental income earned by ReITs, tax on sale of property by ReITs, tax
ESTATE INVESTMENT TRUST
implication for sponsors, tax implication for unit holders, return filling
(REITS)
and reporting aspects of ReITs, transfer pricing requirement and
treatment under GST for real estate sector
Overview, concept, structure of InvITs, deemed income on purchase
of infra assets, income from infra assets, capital gain implication on
UNIT V: TAXATION OF
transfer of infra assets, taxation of income in the hand of sponsor and
INFRASTRUCTURE
unit holders, implication on interest, dividend, withholding tax
INVESTMENT TRUST
compliance, practical issue/challenges in holding company and SPV
structures, GST implication on InvITs.
Overview, FPI / FDI structures, various categories, categorization of
UNIT VI: TAXATION OF income, special taxation regime under Section 115AD, return of
OFFSHORE INDIA FOCUSSED income , reporting requirement, applicability of indirect transfer
FUNDS provisions, applicability of GST laws (export of services relaxation for
Indian sub-advisors), Safe harbor provisions (Section 9A)