Service tax cannot be imposed on expense amount retained by venture capital funds: Karnataka High Court

The Karnataka High Court recently held that service tax cannot be imposed on the amount retained by venture capital funds (VCFs) as expenses before the distribution of returns to investors [ICICI Econet International and Technology Fund v. Commissioner of Central Tax]..The ruling by Chief Justice PS Dinesh Kumar and Justice Umesh M Adiga effectively held that as long as a VCF is not recognised as a “person” under the Finance Act for the purpose of taxation, it cannot be imposed with such a service tax burden. .The Court passed the ruling on a batch of appeals challenging a 2021 ruling by the Customs Excise & Service Tax Appellate Tribunal (CESTAT) which had upheld service tax demands made against several VCFs managed by ICICI Venture Funds.The tax authorities had opined that the portion of distributable income retained by VCFs appeared to be a “service charge or a fee” for having managed the assets of the funds, on which service tax should be paid. This service tax demand was upheld by the CESTAT..However, the Court disagreed with the CESTAT’s finding that these VCFs should be treated as “juridical persons for taxation” since they were established as trusts under the Indian Trusts Act, 1882, and since a “trust” is treated as a juridical person by the Securities and Exchange Board of India (SEBI).“This view of the CESTAT is untenable because, for the purpose of levy of tax, the entity has to be recognized under the said Act (Finance Act),” the Court held in its February 8 ruling. .The Court proceeded to find merit in an argument made by the appellant (various VCFs represented through its investment manager, ICICI Venture Funds) that these VCFs held a pass-through status, meaning that there was no need to tax the VCF itself as they operated through their investment manager.It may be noted that the pass-through principle in taxation is generally invoked to avoid double taxation. In the present case, the Court held,“The assessee (VCFs) acts as a ‘pass through’, wherein funds from contributors are consolidated and invested by the investment manager. It acts as a trustee holding the money belonging to contributors to be invested as per the advice of the investment manager. Accordingly, we answer the second question in the affirmative and in favour of the assessee.”.Finally, the Court found merit in the appellants' contention that those contributing money (for investment) to the VCFs and the VCFs cannot be dissected as two different entities since the “contributors’ investment is held in trust by the fund and it is invested as per the advice of investment manager.”“In substance, (the) fund does nor do an act. Hence, (there can be) can be no service to self. Therefore the doctrine of mutuality must apply in the instant case,” the Court added..Arguments for the appellant/assessee were led by Senior Advocate G Shivadass, briefed by Advocate GL Mohan Maiya.Additional Government Advocate Jeevan J Neeralgi represented the Commissioner of Central Tax, Bangalore. .[Read Judgment]