{"id":355057,"date":"2025-07-30T18:30:16","date_gmt":"2025-07-30T13:00:16","guid":{"rendered":"https:\/\/www.scconline.com\/blog\/?p=355057"},"modified":"2025-07-30T18:13:34","modified_gmt":"2025-07-30T12:43:34","slug":"carried-interest-identity-crisis-or-identity-in-abundance","status":"publish","type":"post","link":"https:\/\/www.scconline.com\/blog\/post\/2025\/07\/30\/carried-interest-identity-crisis-or-identity-in-abundance\/","title":{"rendered":"Carried Interest — Identity Crisis or Identity in Abundance"},"content":{"rendered":"
\n

In 17th century England, there existed a tax system based on the number of stoves and fireplaces. The more the stoves and fireplaces, the more the tax. The stove tax was replaced by a tax system where the tax was computed based on the number of windows. The higher the number of windows, the higher the tax.1<\/sup><\/a> The \u201cmore\u201d and \u201chigh\u201d often drew the attention of tax authorities in historical times. So is true in modern times. Higher returns in the hands of investment managers, in the AIF (alternative investment funds) space, have all the attention of the goods and services tax (GST) authorities, resulting in issuance of notices, taxing a \u201cvalue\u201d which is referred to in business\/commercial parlance as \u201ccarried interest\u201d or just \u201ccarry\u201d.<\/p>\n

In the wake of these notices, we critically analyse the nature and character of \u201ccarried interest\u201d for ascertaining its levy under the GST laws. Since much ink is spilled decrypting the equation of funds, its manager, and the investors, in light of the doctrine of mutuality, we restrict our analysis to the identity of \u201ccarried interest\u201d.<\/p>\n

Carried interest \u2014 Meaning and purpose<\/h2>\n

The etymology of \u201ccarried interest\u201d stems from medieval profit-sharing arrangements between merchants and ship captains, where merchants could offer profit-sharing incentives to ship captains to encourage them to take transportation risks (such as storms, pirates, shipwrecks, etc.).2<\/sup><\/a> This gave rise to the term \u201ccarried interest\u201d, as the profit share was metaphorically \u201ccarried\u201d by the captain in return for bearing the risk.<\/p>\n

Managers in AIF (\u201cfund\u201d, for short) with a similar underlying purpose are mandatorily required to hold investment in the funds by virtue of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 20123<\/sup><\/a>. These investments are made by managers by purchasing (or subscribing) units of funds. FAQ (frequently asked questions) issued by the Securities and Exchange Board of India (SEBI)4<\/sup><\/a> clarifies that in order to ensure that the interest of the manager is aligned with the interest of the investors in the AIF, the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 require that the manager shall have a continuing interest in the AIF which shall not be through the waiver of management fees. Manager’s \u201cskin in the game\u201d ensures the alignment of his interest with that of the AIF.<\/p>\n

Carried interest \u2014 Consideration for supply of services or returns on investment<\/h2>\n

Contractual identity<\/p>\n

The Relationship between the fund and the manager is governed by the Investment Management Agreement (IMA). In accordance with IMA, a manager is under the obligation to organise, operate, and manage the fund in the interest of unit holders in line with the private placement memorandum (PPM).5<\/sup><\/a> Manager is expected to act in a fiduciary capacity towards its investors and shall disclose to the investors all conflicts of interests as and when they arise or seem likely to arise.6<\/sup><\/a> His responsibilities are laid out in the IMA, which also specifies a predetermined fee (management fee) for providing his services to manage the investments of the funds.<\/p>\n

In addition to the management fee, a manager is also paid \u201ccarried interest\u201d. As stated above, a manager, by virtue of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 is expected to have continuing interest in the funds, mandatorily requiring him to hold an investment of a certain percentage of the fund. Subscription to units by manager (or issue of units by the fund) is done by way of a contribution agreement or a subscription agreement. The terms of subscription agreement between the fund and the manager are required to be aligned with the terms of PPM and cannot go beyond the terms of PPM.7<\/sup><\/a><\/p>\n

The investment made by the manager is akin to an investment made by any other investor. Corollary that follows: the return on investment in the hands of manager is akin to the return on investment in the hands of any other investor.<\/p>\n

While a typical IMA (being a service document of the manager) may envisage a clause for carried interest and the manner of its distribution to the manager, it does not, however, create a substantive right, contractual or otherwise, insofar as carried interest is concerned.8<\/sup><\/a> Contractual right of the manager under the IMA is limited only to a predetermined \u201cmanagement fee\u201d. Contractual right over carried interest is conferred to the manager through the contribution agreement. Interestingly, in the entire gamut of schemes, the manager switches its position from being a service provider under IMA to a service recipient under the contribution agreement.<\/p>\n

What transpires from the foregoing discussion is that carried interest does not form part of the consideration for the service rendered by the manager under the IMA. It is rather a return on investment made in terms of the contribution agreement. Contractual identity of carried interest is that of return on investment.<\/p>\n

Form over substance or substance over form<\/p>\n

One may argue that the entire scheme is so structured that it camouflages higher earnings of the manager as return on investment as opposed to consideration for services. The argument, however, would not hold much water. Firstly, because mandatory investment is a requirement of the law, and secondly, the proposition of substance over form is applicable to ascertain the nature of the contract and not the consideration of the contract. Let us understand this with two very recent judgments of the Supreme Court.<\/p>\n

In CCE & Service Tax<\/span> v. Northern Operating Systems (P) Ltd.<\/span>9<\/sup><\/a>, the Supreme Court applied the test of substance over form to ascertain whether the contract was an employment contract, or a contract for service.<\/p>\n

When the question remained that of ascertaining consideration for services, to determine the value to be taxed under the service tax laws, the Supreme Court in CST<\/span> v. Bhayana Builders (P) Ltd.<\/span>10<\/sup><\/a>, in categorical terms, ruled that it is not open for anybody to look beyond the contract.<\/p>\n

Going beyond the contours of the covenant, let us discuss carried interest from the perspective of Income-tax Act, 1961<\/a>11<\/sup><\/a>.<\/p>\n

Under the income tax laws<\/h2>\n

Carried interest has more than one identity under the scheme of income tax, viz., as dividends during the period when the manager holds the units and as capital gains when the manager makes the exit by selling his units.<\/p>\n

Funds, typically structured as trusts, have been granted a pass-through status12<\/sup><\/a> under Indian tax law. What therefore accrues to the manager is dividend income. Dividend is defined13<\/sup><\/a> as a return of accumulated profits to shareholders and is taxed in the hands of the unit holders. If the carried interest is to be considered as accrual on account of services of the manager, then profits and gains of business or profession14<\/sup><\/a> would be a more conforming identity. This aspect of the matter is a potential dispute that would attain finality only at a higher level.<\/p>\n

When the manager sells the units that he holds, at the time of exit, the sales proceeds are taxed under the income tax laws under the head of capital gains.15<\/sup><\/a> The very fact that carried income is on account of the sale of units, it presupposes that the ownership of the units remained with the manager. Something which remained with the manager cannot be later bestowed upon the manager by the fund as a consideration for services.<\/p>\n

Interpretation under the Income-tax Act, 1961<\/a> would be the litmus test for ascertaining the real identity of carried interest. As far as the levy of carried interest under the GST laws is concerned, it is analysed as under.<\/p>\n

Conclusion \u2014 Levy under the GST laws<\/h2>\n

GST is a levy on the supply of goods and\/or services.<\/p>\n

Section 716<\/sup><\/a> of the Central Goods and Services Tax Act, 196117<\/sup><\/a> defines supply to include all forms of supply of goods or services or both, such as sale, transfer, barter, exchange, licence, rental, lease or disposal made or agreed to be made for a consideration18<\/sup><\/a> by a person in the course or furtherance of business.19<\/sup><\/a> Two very crucial factors in a supply determination are consideration and business. In light of the foregoing analysis, a fair ascertainment reveals that carried interest does not qualify as consideration for services.<\/p>\n

Insofar as the business aspect of the definition of supply is concerned, it would remain an academic exercise to ascertain whether the manager is engaged in the business of investment or the business of investment management.<\/p>\n

This article would remain incomplete without the discussion on ICICI Econet Internet and Technology Fund v. Commr. of Central Tax<\/span>20<\/sup><\/a> which was reversed by the Karnataka High Court in India Advantage Fund III v. Commr. of Central Tax<\/span>21<\/sup><\/a>. The Karnataka High Court ruled that the contributors and the trust could not be dissected as two different entities, invoking the doctrine of mutuality. The issue has attained finality, as the appeal against the Karnataka High Court\u2019s order was dismissed by the Supreme Court in Commr. of Central Tax v. India Advantage Fund<\/span>22<\/sup><\/a>. Given that the cardinal principles of supply of service under the present GST laws and provision of service under the erstwhile service tax laws are similar, the principles laid down in the above case should apply equally under the current regime.<\/p>\n<\/div>\n

\n

*Partner, JSA Advocates & Solicitors.<\/span><\/strong><\/p>\n

**Principal Associate, JSA Advocates & Solicitors.<\/span><\/strong><\/p>\n

1.<\/a> Dominic Frisby, Daylight Robbery<\/span>, pp.1-5.<\/p>\n

2.<\/a> Edward J. McCaffery and Darryll K. Jones, \u201cThe Curiouser and Curiouser Case of Carried Interests\u201d, (2024) 66 Arizona Law Review 357, 365.<\/p>\n

3.<\/a> Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012<\/a>.<\/p>\n

4.<\/a> Frequently Asked Questions, available at: <https:\/\/www.sebi.gov.in\/sebi_data\/attachdocs\/1471519155273.pdf>.<\/p>\n

5.<\/a> Securities and Exchange Board of India, Master Circular, Alternative Investment Funds, SEBI\/HO\/AFD-1\/AFD-1-PoD\/P\/CIR\/2024\/39 (Issued on 7-5-2024)<\/a>.<\/p>\n

6.<\/a> Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012, Regn. 21(1)<\/a>.<\/p>\n

7.<\/a> Securities and Exchange Board of India, Master Circular, Alternative Investment Funds SEBI\/HO\/AFD\/PoD1\/P\/CIR\/2023\/130 (Issued on 31-7-2023)<\/a>.<\/p>\n

8.<\/a> Carried interest is generally paid to the manager\/sponsor after a hurdle rate, achieved by the fund.<\/p>\n

9.<\/a> (2022) 17 SCC 90<\/a><\/p>\n

10.<\/a> (2018) 3 SCC 782 <\/a><\/p>\n

11.<\/a> Income-tax Act, 1961<\/a>.<\/p>\n

12.<\/a> Pass-through status is a tax treatment where income of an entity is not taxed at the entity level. Instead, income is passed through the investors or owners, who are then taxed on their share of the income.<\/p>\n

13.<\/a> Income-tax Act, 1961, S. 2(22)<\/a>.<\/p>\n

14.<\/a> Income-tax Act, 1961, S. 28<\/a>.<\/p>\n

15.<\/a> Income-tax Act, 1961, S. 111-A<\/a>; Income-tax Act, 1961, S. 112<\/a>.<\/p>\n

16.<\/a> Central Goods and Services Tax Act, 2017, S. 7<\/a>.<\/p>\n

17.<\/a> Central Goods and Services Tax Act, 2017<\/a>.<\/p>\n

18.<\/a> Central Goods and Services Tax Act, 2017, S. 2(31)<\/a>.<\/p>\n

19.<\/a> Central Goods and Services Tax Act, 2017, S. 2(17)<\/a>.<\/p>\n

20.<\/a> (2021) SCC OnLine CESTAT 334<\/a>.<\/p>\n

21.<\/a> (2024) SCC OnLine Kar 119<\/a>.<\/p>\n

22.<\/a> (2024) SCC OnLine SC 3065<\/a>.<\/p>\n","protected":false},"excerpt":{"rendered":"

by Shareen Gupta* and Rajan Mishra**<\/p>\n","protected":false},"author":67011,"featured_media":355058,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[20271,71727],"tags":[86310,36777,86309,86313,35487,6241,51086,86314,86311,86312,41404,3208,55467,75870],"class_list":["post-355057","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-experts_corner","category-jsa","tag-aif","tag-alternative-investment-funds","tag-carried-interest","tag-form-over-substance","tag-goods-and-services-tax","tag-gst","tag-income-tax-act-1961","tag-investment-management-agreement","tag-investment-managers","tag-mutuality-doctrine","tag-sebi-regulations","tag-service_tax","tag-substance-over-form","tag-venture-capital-funds"],"yoast_head":"\nCarried Interest: Identity Crisis or Identity in Abundance | SCC Times<\/title>\n<meta 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