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Earlier only Mutual Funds and Fixed Deposits were available as investment vehicles. Within a decade new and unconventional investment avenues such as Alternate Investment Funds (AIF), Foreign Portfolio Investor (FPI) and Portfolio Management Services (PMS) have developed. Each avenue has to be carefully analysed by the investor in terms of the investment objective, size, structure, portfolio diversification, etc. However, prior to investing, one of the primary things on which emphasis must be laid is tax efficiency and applicability. As the tax structure of different investment vehicles is different, it is important to do a tax comparison to make a proper investment decision. The tax advantage of a particular route affects the investor’s post-tax yield. Under the prevailing tax framework, PMS and MFs have been accorded the ‘pass-through’ status. With respect to AIFs, Category I and II have been accorded the ‘pass-through’ status whereas Category III is yet to be accorded the ‘pass-through’ status. Further, taxes on FPIs are payable in the hands of investors at the effective rate. Therefore, a tax comparison of each investment avenue is essential for decision-making. Let’s do a tax comparison of AIF, PMS, FPI and MF.
Based on investment strategy, there are three categories of AIFs: Category I, Category II and Category III. For investing in AIF, an investor has to consider the tax on returns. Two factors predominantly affect the taxation of AIF. First, the classification of the fund into one of the category and second, the legal structure of the AIF which can be in the form of a trust, company, LLP or body corporate. Category I and II funds are set up are accorded the tax ‘pass through’ status which implies that any gains or loss arising from the investment made will be taxed in the hands of the investor as if the investments were directly made by the investor himself. This also means that no tax shall be charged at the fund level. So if any income or gain arises from the investment made by AIF on behalf of the investor, it will be taxable in the hands of the investors. An exception to ‘pass through’ status under Category I and Category II is business income. However, unlike Category I and II AIF, Category III has not been accorded pass-through status so income arising from Category III AIF will be taxed at the fund level at the rate of tax as applicable to the legal form of that fund. Further, Category III has four types of income i.e. business income, short-term capital gain, long-term capital gain, and dividend income and the rate of tax applicable is different for different incomes. As we discussed, the tax implications among the different categories of AIFs are different which makes tax comparison among the three categories of AIFs essential.
PMS is a customized investment service including fixed-income securities, unlisted securities, equities, and structured products. PMS can be either discretionary or non-discretionary professional management. Tax comparison between discretionary or non-discretionary PMS has to be analyzed by the investor. In PMS, the investor owns the securities in his personal capacity which is not so in the case of AIF. In AIF, the investor passively owns the securities. In PMS, the investor pays tax at the income tax slab rate applicable. In this regard, it can be said that PMS is tax-friendly when compared to AIF. This implies that the tax ‘pass-through’ status is also applicable to PMS like Category I and II AIF. It can be said that the income from PMS is taxed in a fairly straightforward manner and does not depend upon the legal structure of the PMS. However, if the PMS fund undertakes any tax-unfriendly task then scrutiny will be on the investor and not on the fund.
GST is liable to be paid for providing management services to foreign investors through a domestically pooled AIF managed by a fund manager. GST is applicable irrespective of the fact whether the investors are residents or non-residents. However, if the PMS is directly provided to the foreign investor then no GST is to be paid.
FPI includes foreign investors buying financial assets in India. The different instruments in which FPIs can be made are stocks, bonds and other financial assets. The Income Tax Act, 1961 (IT Act) provides the framework for the taxation of FPI in India. The type of income earned by FPIs can be categorized into gain from the transfer of securities, interest and dividend income. Income transfer of securities is termed as ‘capital gain’. Dividend and Interest income come under ‘income from other sources’. The tax rates as specified under the IT Act shall apply to the FPIs.
Usually, payments made to non-residents are subject to TDS, however, capital gains earned by FPIs are not subjected to TDS. This is so because income earned by FPIs is subjected to advance tax which is to be discharged before the repatriation of such income before the specified due dates. However, if any other income accrues to FPIs it will be subjected to TDS at the rates specified. All this makes the tax structure of FPI very dynamic and complex.
Mutual Funds are the most popular type of investment vehicle as they are simple and have low initial commitment requirements. Mutual Funds are used to perform Systematic Investment plans (SIP), Systematic Transfer Plans (STP) and Systematic Withdrawal Plans (SWP). It is the most preferred choice for a majority of investors including high-net-worth individuals. When it comes to taxes, they are quite effective. The debt funds have long-term capital gains benefit and equity funds are taxed only on redemption and not at the time of change in portfolio. This makes mutual funds a highly tax-efficient vehicle.
The decision to invest between AIF, PMS, Mutual Fund, or FPI depends upon the risk tolerance and financial objective of the investor. Some investors opt for a mixture of two or three investment vehicles. AIFs are pooled investment vehicles where wealthy individuals including foreign investors can invest. PMS gives the benefit of availing of specialized portfolio manager services. Mutual Funds are a simple and easy-to-operate investment vehicle. Whereas for foreign investors FPIs are more suitable. Tax comparison helps the investor understand which investment will lead to a greater post-tax return. Tax comparison also helps understand the tax disparity among different investment vehicles.
Also Read:Corporate Tax in India: Everything you need to knowDrawing a Comparison between Old and New Income Tax Regime
Ankita is an Advocate and has joined Enterslice as a Legal Researcher. Her work focuses on General Civil and Commercial laws, Corporate Taxation Laws, Labour and Employment Laws and Dispute Resolution. She is a law graduate from School of Law, University of Petroleum and Energy Studies. Prior to joining Enterslice, Ankita has the experience of practicing law in Delhi and Odisha.
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