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Venture Capital Funds (VCFs), operating in the country, will have to pay service tax on gains they make on managing investors' money as a tribunal has rendered their operation akin to taxable service of banks and financial institutions.

The Bengaluru bench of the Customs, Excise and Service Tax Appellate Tribunal (CESTAT), in the case of a taxpayer, has confirmed service tax demand in the hands of the VCFs as they manage investor money.

The tribunal, in its ruling, said that service tax demand is confirmed on the portion of earnings that are retained by debiting expense from the value of the investments made in the VCFs, and the distribution of carried interest to a specified class of unit holders.

The matter was remanded back to the adjudicating authorities for re-calculation of the gross value of the taxable services, considering the availability of CENVAT credit, it said.

The service tax authorities contended that the VCFs were managing the money of the contributors/investors/ beneficiaries. The deductions, in terms of various expenses, carried interest paid to class C unit holders, are simply consideration for providing investment management services to the investors, and hence, liable to service tax.

The CESTAT observed that VCFs have an independent identity and a distinct personality of their own. The activities of the VCFs of distributing dividends and other amounts to the respective unit holders was clearly mentioned in the private placement memorandum and other scheme documents, which evidenced the profit motive of the VCFs. The funds undertook the KYC process for their contributors, thereby, indicating that they are independent of their investors.

The CESTAT seems to have examined the matter only from the Service Tax Law perspective, PwC said a note on CESTAT ruling. The matter may now lead to a debate on the position generally adopted by the fund that it does not undertake any activity but is only a pooling vehicle. Additionally, the findings on carried interest call for a re-examination of the tax positions and documentation. This ruling also exposes fund structures, with potential litigation, it said.

VCFs are investment pooling vehicles established as a trust, under the provisions of the Indian Trust Act, 1882 and are registered as VCFs with the Securities and Exchange Board of India (SEBI) under the SEBI (VCF Regulations), 1996. VCFs are represented and managed through 'trustees'.