Carried Interest Taxation: Bridging the Gap Between India and the US: Lessons and Way Forward

[Yadu is a student at Symbiosis Law School Pune.]

On 1 February 2025, the Government of India released the memorandum explaining the Finance Bill 2025 bringing securities held by Categories I and II alternative investment fund (AIF) within the definition of 'capital asset' under clause (b) of Section 2(14) of the Income Tax Act 1961 (Act). This essentially meant treating all income from the transfer of securities held by Categories I and II AIFs as a capital gain. Consequentially, it has also clarified that carried interest shall be treated as capital gains. A week after this announcement, in stark contrast to India’s move, the USA Government headed by President Trump proposed the elimination of capital gains tax treatment on carried interest along with Democrats in the House and Senate introducing bills to eliminate the same.

The post aims to analyze this dissonance in the regulatory approach taken by the USA and India in taxing carried interest by first, giving an overview of the tax treatment of carried interest in India. Second, it delves into the motive and implications of the USA’s move to abandon the preferential tax treatment to carried interest. It then highlights how India's classification is misplaced, due to reasons like conflicting with principles of equity, efficiency, and the definition of capital gains. It concludes by discussing alternative taxation models, such as hybrid approaches, extended holding periods, and loan-based taxation, referencing global practices from Luxembourg, Spain, and the UK and highlighting the need for India to adopt a balanced tax policy that minimizes avoidance while maintaining a competitive investment climate.

Taxation of Carried Interest in India: A Backdrop

Carried interest is the share of a fund’s profits granted to its managers contingent on it achieving returns exceeding the agreed minimum return rate. Managers earn a portion of their compensation through 'carried interest', which includes returns on their investments and a share of the fund’s profits as compensation for investment management services. Having a pass-through status, AIFs I and II do not pay taxes directly and instead pass it to partners, who are thereafter taxed. While there existed no specific provisions under the Act and Goods and Services Tax (GST) Act 2017 to deal with taxation of carried interest, such income derived by fund managers / sponsors were treated as 'capital gains' arising from investment in the units of the AIF. It was accordingly offered to tax under Section 45 of the Act in consideration with Section 48 of the Act.

In 2012, the Bengaluru Customs, Excise, Service Tax Appellate Tribunal (CESTAT) order ruled that AIFs must pay service tax on the expenses incurred by it in the form of carried interest as under Rules 1, 2, and 5 of Service Tax Determination of Value Rules. The reasoning was that such amounts retained by the AIF were neither interest nor return on investment but a portion of the consideration for the services rendered by funds to the investors and passed on as a return on investment to the managers. While this was later overturned by the Karnataka High Court order and confirmed by the Supreme Court through its order, they limited themselves to resolving the taxation status of investments at the hands of the AIF, refraining from delving into the characterization of carried interest at the hands of the fund managers. 

USA Scrapping the Taxation Benefits  

In the USA, investment funds operate as partnerships, where investors are limited partners, and managers act as the general partner. General partners receive a part of their compensation in the form of carried interest and since investment fund profits often come from long-term capital gains, the managers re-characterize their compensation as return on investment resulting in a lower tax rate than what regular workers’ pay. Hence, this taxation of performance fees less heavily than other forms of compensation is against the principles of equity and efficiency, which are widely, underscored principles in US tax reforms.

To counter this, on 6 February 2025, the Democratic Senators and representatives proposed the Carried Interest Fairness Bill 2025. It introduces Section 710 in the Internal Revenue Code of 1986, through which any income, which is received from partnerships, as capital or otherwise in compensation for services, shall be tax-treated as ordinary income. Therefore, managers of investment partnerships who receive a carried interest as compensation will pay ordinary income tax rates instead of capital gain rates to the extent that it represents fees in return for management services and not the amount they have invested in the partnership.

Lessons for India

By matching the lines between India’s amendments to Section 2(14) of the Act to the USA’s recent bill against preferential tax treatment on carried interest, it can be inferred that the characterization of carried interest as capital gains at the hands of the managers appears to be misplaced for a variety of reasons. 

Under Section 45 of the Act, capital gains arise from the transfer of 'capital assets', defined in Section 2(14) as any property held by an assessee. However, carried interest received by a manager does not fully qualify as arising from the transfer of a capital asset—while one part is a return on their investment, the other is compensation for fund management services. Also, a catena of judgments including Arunima Adcon Services v. ACIT, CIT Jaipur-II v. Smt. Renuka Ajay Maroo and  Smt. Swatiben Anilbhai Shah, Ahmedabad v. DCIT, Central Circle emphasizes that the intent to remain invested, rather than using the asset for business profits, determines whether income is capital gains or business income. While part of carried interest aligns with this requirement, the portion received as performance-based compensation does not and, therefore, cannot be classified as capital gains. Further, the intention of flat tax rates on capital gains as revealed in the Memorandum explaining the Finance Bill 2014, has been to minimize economic distortions and curb erosion of tax base, to which this classification carried interest does not contribute. Accordingly, they must be taxed as profits and gains of business or profession under Section 28 of the Act, similar to the tax treatment of freelance service providers and consultants.

Also, treating carried interest at the hands of managers as capital gains resultantly means wrongfully availing lower tax rates than equivalent amounts classified as profit or gains from business or profession. This runs against the principles of vertical and horizontal equity and efficient taxation, which can be traced back to Articles 14 and 21 of the Constitution of India. In R And B Falcon (A) Pty. Ltd. vs. Commissioner of Income-Tax, the apex court upheld the objective of fringe benefit tax in ensuring horizontal equity and economic efficiency. Similarly, in DCIT v. Ace Multi Axes Systems Limited, the court emphasized vertical equity, affirming that a higher tax burden on those with greater income or capacity is reasonable. Some other cases where the courts have emphasized the importance of tax fairness include Commissioner of Income Tax-I, New Delhi v. Vartika Township, Union of India v. NS Rathnam and Sons, Kesar Enterprises Limited v. State of UP, etc. 

Herein, it is worth noting that, although the 2012 CESTAT order had erred in its assumptions on the taxation structure of AIFs, certain points it raised were valid. This includes how carried interest was not interest or a return on investment but a fee retained by VCFs for services provided to investors and passed to AMCs under the guise of investment returns. CESTAT was right when it viewed this structure as a tax-avoidance mechanism, reclassifying service fees as returns on securities.

Lastly, with the introduction of the GST Act in 2017, replacing the earlier service tax regime, 'trusts' are now recognized as persons under the CGST Act. Additionally, Section 7(1)(aa) classifies activities by trusts, societies, and similar entities as a supply. The explanation to Section 7(1) further establishes that a trust and its members or constituents are considered separate entities, regardless of any other law or court order, implying that GST applies to both funds and their managers. This raises the need for clarity on the applicability of GST to fund managers and funds. 

Conclusion and Way Forward

India’s decision to classify carried interest as capital gains represents a significant shift in taxation policy, aligning it with traditional capital asset treatment. However, as observed in US tax reforms, carried interest is not solely an investment return but also compensation for fund management services. This distinction is crucial to ensure fair taxation and prevent an undue tax advantage for fund managers compared to other professionals earning performance-based income.

If a complete shift to ordinary income taxation is not feasible, alternative measures may be considered. A hybrid approach could involve taxing a portion of carried interest as ordinary income while treating the remainder as capital gains. Another option is extending holding periods for capital gains treatment, as seen in the US, where the threshold was raised from one to 3 years under the Tax Cuts and Jobs Act (2017), with proposals to extend it to 5 years. Additionally, loan-based taxation could be implemented by treating carried interest as a loan from limited partners to general partners, with taxation on the interest differential, as was proposed in the Ending Carried Interest Loophole Act of 2023.

India can also draw lessons from international taxation frameworks. In Luxembourg, carried interest enjoys capital gains treatment but is subject to a progressive income tax structure up to 45.78%. Spain’s venture capital law requires a minimum holding period of five years for carried interest to be tax-favored, ensuring genuine investment incentives. The UK’s Disguised Investment Management Fee rules classify portions of carried interest as either capital gains or income, depending on their nature.

A well-calibrated approach will ensure that India’s taxation of carried interest is equitable, minimizes tax avoidance, and maintains a competitive investment climate. By adopting global best practices, policymakers can achieve a balance between revenue considerations and fostering investment growth.