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Hedge funds record slowest growth in inflows on higher tax

It has seen the slowest half-yearly growth in investments made during the July-Dec period of 2019.

, ET Bureau|
Last Updated: Feb 21, 2020, 11.34 AM IST
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Assets grew 7.7% in the second half of 2019, as products were impacted by increasing tax burdens.
India’s hedge fund industry has witnessed the slowest half-yearly growth in investments made during the July-December period of 2019.

Assets grew 7.7 per cent in the second half of 2019, as products were impacted by increasing tax burdens.

An additional surcharge introduced by the government for wealthy investors and companies has increased the capital gains tax payable by investors of alternative investment funds (AIFs) to 43 per cent for the fiscal year started in April 2019. If the same investors use other routes such as portfolio management scheme (PMS) or mutual funds, the tax outgo could reduce to as low as 30 per cent.

Hedge funds in India are registered as Category-III AIFs and invest in securities traded on stock exchanges, including equity shares and derivatives.

Category-III AIF investments totalled Rs 35,777 crore as on December 31 against Rs 33,208 crore at the end of June 2019 and Rs 27,661 crore in December 2018, data from the Securities and Exchange Board of India showed.

The blow came at a time when the Indian hedge fund industry was growing at a robust pace. Total investments of Category-III AIFs grew 20 times during the four-year period between June 2015 and June 2019. The average halfyearly growth is 72 per cent since 2013, when Sebi introduced the concept of AIFs.

“Although AIFs enjoy a lot of freedom when it comes to investments, they are being taxed at an exorbitant rate,” said the chief executive officer of a leading AIF. “On the tax surcharge front, almost every category of institutional investors including FPIs and mutual funds have got relief but AIFs didn’t.”

There are three categories of AIFs as per Sebi rules. Category-I funds invest in social and infrastructure projects while Category-II are private equity investors who put money in the unlisted space.

The growth in Category-III AIFs even underperformed the overall industry growth in the six months through December. The overall AIF industry grew a little over 20 per cent during the period.

“The Cat-III AIF does not get the pass-through benefit under tax laws,” Shardul Amarchand Mangaldas partner Amit Singhania said. “If such AIFs are structured as discretionary trust, then the tax rate on dividend income could be as high as 43 per cent.”

The tax pass-through status allows a fund to pass on the tax obligations to the investors. Hence, they can pay the investors in full leaving the investors to pay tax on the gains based on their personal income brackets. However, since the Category-III AIFs don’t enjoy this status, they deduct taxes on behalf of the investors and that too at the highest rate. So, even if an investor has less than Rs 1 crore income in a year, he would end up paying tax at a rate that is applicable to people earning Rs 5 crore and above.

Even the latest budget announcement to tax dividends in the hands of investors has come as a bane for the hedge funds since a tax surcharge will apply on dividends, too.

AIFs are products designed for ultra-rich investors. These come with a minimum ticket size of Rs 1 crore. However, unlike mutual funds that are subject to serious investment restrictions, AIFs enjoy a liberal regime.

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