In a recent decision the Karnataka High Court has held that a Venture Capital Fund (‘VCF’) is not liable for service tax on carried interest. The decision reversed Customs, Excise & Service Tax Appellate Tribunal’s (‘CESAT’) ruling which was under appeal. CESAT had held that service tax was payable by the VCF primarily on the grounds that a VCF constituted as trust can be considered a person and that the doctrine of mutuality was not applicable to it since it further invests the money of its contributors with third parties, breaching the mutuality. The High Court viewed the VCF as a pass-through entity and viewed the asset management company appointed by trustee as the service provider. The decisions take contrary stands on whether VCF constituted as a trust is a person, its role, and the applicability of doctrine of mutuality. And while we do seem to have some answers about the taxability of carried interest under service tax regime, the same issue under GST regime remains an open question. I focus on the role of trusts and doctrine of mutuality in this article.
Role of VCFs and Investment Managers
The appellants before the Karnataka High Court were established as a trust under the Indian Trusts Act, 1882 and registered as a VCF with Securities and Exchange Board of India (‘SEBI’). The appellants were managed and represented by a trustee. The terms and conditions in the formation of the appellant’s trust were contained in the Indenture of Trust, an offer document inviting subscribers and contributors to be part of the trust. The trust in turn appointed an investment manager to handle the funds of contributors. The Revenue Department demanded service tax on the expenses incurred by the trust – which they argued should have been characterized as service income as well as service tax on disbursement of carried interest to Class C unit holders in the VCF, i.e., typically the investment manager itself, among other trust expenses which were sought to be characterized as income of the VCF. Service was demanded under the head of ‘banking and financial services’ under Sec 65, Finance Act ,1994.
Returns on investments are termed as carried interest, and as per the Indenture of Trust, the contributors receive the same as per the terms stated in the trust. Since the investment manager can and does invest alongiwth the contributors, it becomes entitled to carried interest on its investment in addition to the performance fee charged by it for its services. The former money is paid to it in its capacity as an investor and the Revenue’s case was that it should be subjected to service tax, though the applicability of service tax on the latter was not in dispute. CESAT’s understanding of the arrangement was that the trust was engaged in asset management and was responsible for managing the funds of contributors until delegated to the investment manager. (para 40.2) The Karnataka High Court, on the other hand, observed that VCF does not make any profit or provide any service and merely acts as a ‘pass through’ wherein funds from contributors are consolidated and invested by investment managers. VCF acts a trustee holding the money on behalf of the contributors and invests the money as per advice of the investment manager. (para 21) The latter understanding is proximate to the real nature of transaction and it was influential in the High Court’s conclusion that no service tax was payable by VCF. However, CESAT in overemphasizing the role of trust in the entire transaction arrived at the questionable conclusion that trust was providing banking and financial services by indulging in asset management of its contributors. CESAT was persuaded by the Revenue’s argument that carried interest paid to investment manager was a disguised performance fee and should be subject to service tax, an argument that – if one reads the two decisions – is not entirely proven by facts.
Trust as a Person and Doctrine of Mutuality
The appellant’s argued that trust was not recognized as a person and thus cannot be held liable to tax. The appellant’s further argument was that VCF, constituted as trust, was not providing any service to the contributors, and expenses incurred by the trust cannot be considered as consideration for ‘services’. Also, the appellant added, assuming but conceding, that the trust was providing a service – no service tax was payable due to the doctrine of mutuality. There was complete identity between the trusts and its contributors. The appellants relied on the jurisprudence of doctrine of mutuality, with the Calcutta Club case being the focal point of reference. The doctrine of mutuality postulates that when persons contributed to a common fund in pursuance of a scheme for their mutual benefit, having no dealings or relations with any outside body, they cannot be said to have traded or made profit from such mutual undertaking since there the identity of the persons and the mutual undertaking is the same.
CESAT rejected all the above appellant’s arguments. CESAT noted that VCF is registered as a fund under the SEBI VCF Regulations and under the Regulations it is treated as a body corporate and it should be treated as such for tax purposes too. CESAT held that:
As the Trusts are treated as juridical persons for the purposes of SEBI Regulations, we do not find any reason as to why they should not be treated so for the purpose of taxation. (para 37.4)
On the same issue, the Karnataka High Court took an opposite view and held that while SEBI and other legislations may treat a trust as a juridical person, the relevant statute for the purpose of service tax liability is Finance Act, 1994 and the latter does not treat trust as a juridical person. The High Court held that definitions of each statute must be read with the object and purpose of that statute as intended by the legislature and accordingly refused to treat trust as juridical person for the purpose of Finance Act, 1994. (para 15)
The Karnataka High Court’s emphasis on the intent and context of each legislation is vital. It is important to note that courts should be circumspect before importing definitions of one statute into another, unless there is complete silence on the issue in the latter. In the context of tax, the issue is even more vital as the general rule of construction of tax statutes is that a burden cannot be imposed on an assessee, unless expressly stated in the statute. It thus follows that if an entity is not expressly regarded as an assessee, it cannot be subjected to tax.
As regards the applicability of doctrine of mutuality, the Karnataka High Court gave a succinct and correctfinding. The High Court observed that the trust and its contributors cannot be dissected into two distinct entities because the contributors investment is held in trust by the fund and investments the money on the advice of investment manager. Thus, the trust cannot be held liable for providing service to itself. CESAT had a different opinion and noted the doctrine of mutuality as applied in various cases in India was in the context of member clubs where the contributions were made by members and the clubs were not pursuing profits. While in the impugned case the main purpose of VCF was to earn profits. The CESAT observed that VCF had violated the principle of mutuality by engaging itself in commercial activity and using its discretionary powers over funds to benefit a certain class of investors. Relying on the Calcutta Club case, the CESAT rejected the applicability of the doctrine of mutuality.
While attributing profit to VCF was not incorrect, CESAT’s understanding of the scope of discretion VCF possessed over the funds of its contributors and the importance placed to profit motive is perhaps misplaced. Profit motive of an entity that collects funds does not per se rule out the applicability of the doctrine of mutuality. And if the trust in this case was retaining some money as expenses for holding the money, it was per the terms of trust and that factor also is relevant but not determinative in ruling out the doctrine of mutuality. While it is important to understand the context of previous decisions, the scope and applicability of the doctrine needed a better articulation in the CESAT’s decision.
Finally, CESAT relied on ‘common parlance’ to state that no common man would consider VCF trusts like clubs. Here again, the reliance on a common man’s view of the role, object, and relevance of VCF is inaccurate as the tribunals are bound to consider the statutory definitions and not rely on an elastic and ambiguous understanding of entities as adopted in common usage.
GST and Doctrine of Mutuality
The doctrine of mutuality already has a small history under the GST regime. In reaction to the Supreme Court’s decision in Calcutta Club case, the definition of supply was amended – with retrospective effect – and the following clause was added via Finance Act, 2021:
(aa) the activities or transactions, by a person, other than an individual, to its members or constituents or vice-versa, for cash, deferred payment or other valuable consideration.
The Explanation stated that notwithstanding anything contrary contained in any judgment or decree, the person and its members or constituents shall be deemed to be two separate persons and the supply of activities or transactions inter se shall be deemed to take place from one person to another. While the above clause, does signal to a significant extent that doctrine of mutuality is truly buried, and has not survived the 46th Constitutional Amendment, despite the Supreme Court holding otherwise, its applicability to the specific context of VCFs and carried interest remains uncertain and untested. This also because trust is included in the definition of a person under Section 2(84)(m), CGST Act, 2017 meaning that arguments relevant in the impugned case may not be entirely transferable to similar demands of tax under GST.
Conclusion
CESAT’s decision created turmoil as VCFs have never been understood to be service providers, but only conduits for channeling the investments and holding the money in trust. The actual investment advice is provided to the contributors by the investment management company. CESAT overemphasized the role of trust, to some extent misunderstood the nature of payments, and decided that trust was acting as a service provider. The Karnataka High Court has corrected this position, but its applicability and relevance is for service tax levied under the Finance Act, 1994. We yet do not know if similar demands will made under GST and their likely fate.