Siddharth: Welcome to Spectrum, a podcast by Khaitan and Co. Hello, everyone. I'm Siddharth Shah, partner in the funds practice at Khaitan and Co.
Today, we are diving into a topic that has been making headlines in the world of private equity and venture capital, which is carried interest. We will look at its origins, its structure in India and the recent tax and regulatory changes both here and abroad. Joining me in my colleague Bijal Ajinkya, partner in the direct tax practice.
Bijal: Thank you, Siddharth. It's great to be a part of this conversation. Carried interest is not only topical but also complex from a tax standpoint.
And I'm really looking forward to unpacking some of these nuances.
Siddharth: Likewise. So let's start with the basics. What exactly is carried interest? Put simply, it is a share of profits of an investment fund that is paid to the fund's manager as compensation linked to the performance of the fund. It is a way to incentivize fund managers to perform well and generate strong returns for their investors.
Bijal: That’s right. The concept actually has a fascinating history. It traces its roots back to the 16th century when European ship captains would take a 20 percent share of the profits from the goods they carried across the oceans. It was a reward for the risk they took.
Today, that same 20 percent figure is still a common benchmark for carried interest in the private equity and venture capital world. Isn't that fascinating? Absolutely.
Siddharth: So, let's say let's now examine how this works in India, especially for alternative investment funds or what we call AIFs. In India, AIFs are typically structured as trusts. The investors, also known as limited partners or referred to as limited partners, commit capital to the fund. The fund is managed by an investment manager.
As for the regulatory and commercial norms, the sponsor or the manager of the AIF is expected to put some skin in the game, as the saying goes, alongside other investors in the AIF. Typically, the carried interest is generally distributed to the fund sponsors and managers in the form of additional profits from the trust on the units that they hold, which are often represented to a different class. The additional distribution to the carry unit is typically distributed after the investors have received back their initial capital contribution plus a specified minimum return, also known as the hurdle rate.
Bijal: Interestingly, in other parts of the globe, fund structures are typically organized in the form of limited partnerships with limited partners who are investors and a general partner or partners who typically takes on unlimited liability and for which it receives a disproportionate share of profits from the limited partnership as carried interest. GP interest is generally subscribed to by the investment manager. However, as the limited partnership structure is not available in India, the above structure is effectively mirrored to a trust with different class of units, except that there is no unlimited liability for the general partner.
Siddharth: That's a good point, Bijal. Now, one of the key developments that has been in the news is the tax controversy involving ICICI ventures. Can you please elaborate on that?
Bijal: Absolutely, Siddharth. This case was in the context of GST, that is indirect tax, and has been a major point of discussion for a while. The core issue was whether carried interest should be treated as a return on investment and therefore no GST should be applicable or if it is a fee for services rendered by the fund manager, making it liable for taxes under GST regime. The Customs, Excise and Service Tax Appellate Tribunal, that is the SESTA in Bangalore, ruled against ICICI ventures, characterizing carried interest as a performance fee and subject to service tax.
This created a lot of uncertainty in the fund formation space. The case on appeal to the Supreme Court was remanded back to the assessing officer for further consideration and the issue of characterization of carried interest remained unsettled. In the meanwhile, in relation to another matter where SESTA has also claimed to charge GST to the trust in respect of capital contributions made by the contributor, important to note it is not with respect to carried interest, it is with respect to capital contributions itself, the Karnataka High Court passed a ruling stating that the fund being a trust is a pass-through entity and therefore it cannot be said that the contributor and the trust are two different entities accordingly.
It cannot be said that the fund is rendering services to the investor and thus the return of capital should not attract a service fee or a service tax. Though the issue of GST on carried interest paid to the investment manager and the ruling of the Karnataka High Court may not be linked directly, but the industry seems to have drawn some inference that the pass-through argument should also extend to the distribution of carried interest to the sponsor or investment manager.
Siddharth: So that's a good segue into another important development which is the recent circular from SEBI. Now SEBI has been very active on this front. In its December 2024 circular, the market regulator introduced guidelines to ensure pari passu rights for all participants in the AIF, which means equal rights for all unit holders in an AIF including on distribution. Of course after industry representations, the SEBI circular explicitly carved out an exception for distribution of carried interest.
It now states that the requirement for pari passu rights does not apply to distribution of carried interest units held by the investment manager or the sponsor. While this was welcome exception, unfortunately the SEBI circular does not explicitly carve out carry units being offered to other stakeholders such as employees or employee trust, other advisors or in some cases even some anchor LPs. So, it would be important for SEBI to clarify that as long as it is not affecting the pro-rata interest of other limited partners, the investment manager should be free to share carried interest units with other key stakeholders.
So, more clarity on this is awaited from SEBI.
Bijal: Definitely many eyes are on SEBI for more clarity on that front. However moving beyond India, carried interest is a topic of intense debate globally as well, especially in key financial centres.
The globe trend is a shift towards a more stringent tax regime for carried interest. For a long time, carried interest was taxed at the lower long-term capital gains tax rate in many jurisdictions. However, that's slowly changing.
For example, in the UK there has been a significant shift. Starting from April 2026, cashed interest will be taxed as trading profits, which are subject to a much higher income tax rate, potentially up to 45% plus national insurance contributions. This is a big move away from the traditional capital gains tax treatment.
Luxembourg is another good example. They are trying to attract fund managers, so they have introduced a new and competitive tax regime for carried interest. Under their new rules, which are expected to apply from 2026 again, carried interest will be taxed at a much lower rate, which is almost quarter of the regular income tax rate.
This is designed to make Luxembourg an attractive hub for AIF managers. FITBOR has always been known for its pro-business and pro-investment policies. While it has a good tax framework, it's carefully watching global development.
Generally, carried interest is considered a performance fee and is subject to income tax. However, there are exceptions and concessions for fund managers that meet specific criteria. That said, the US law still provides that where the carry relates to assets which have been held for at least 36 months, such gains are taxed at preferential long-term capital gains rates, and where they have been held for less than 36 months, they are treated as short-term gains and taxed at ordinary income at the rate of 37% plus 3.8% net investment income tax.
Siddharth: So, it seems like we are seeing two distinct approaches. On one hand, some jurisdictions are moving to increase the tax burden on carried interest, while others, like Luxembourg, are trying to be more competitive.
Bijal: Exactly, Siddharth. And this, of course, will always depend on how important the role played by the private equity industry is important to the economic development of that particular country. This also highlights the ongoing tension between governments trying to increase tax revenue and jurisdictions aiming to attract global capital and talent.
Siddharth: Well, as always, a difficult balance to achieve.
Players will continue to keep an eye on major developments across the globe, as well as closer home. That brings us to the end of our discussion. It's clear that the landscape for carried interest is constantly evolving with both regulatory and tax bodies in India and around the world paying close attention.
Thank you very much for your valuable insights, Bijal.
Bijal: Likewise, I am so glad to be a part of this engaging discussion. Thank you so much.
