Carried Interest & Management Fees: Tax Treatment for Foreign Fund Managers in India

Why Tax Treatment of Fund Manager Compensation Matters

Foreign fund managers investing in India face a complex intersection of Indian tax law, FEMA regulations, and bilateral tax treaty provisions. The two primary components of fund manager compensation — carried interest (the performance-linked share of profits) and management fees (the fixed annual fee) — receive fundamentally different tax treatment in India.

Getting the classification wrong can result in a tax rate differential of 20-30 percentage points. Carried interest taxed as capital gains attracts rates of 10-20%, while the same income classified as business income or fees for technical services (FTS) could be taxed at 35-35% plus surcharge and cess.

The Union Budget 2025 brought significant clarity by codifying that carried interest distributed by Category I and II Alternative Investment Funds (AIFs) retains its character as capital gains in the hands of the fund manager, even when the distribution is disproportionate to the manager's unit holding. This article examines the complete tax framework for both carried interest and management fees from the perspective of foreign fund managers.

Understanding Carried Interest in the Indian Context

Carried interest is the fund manager's share of profits earned by the fund, typically calculated as a percentage (usually 20%) of the fund's profits above a hurdle rate (usually 8-10% IRR). Unlike management fees, carried interest is performance-linked — if the fund does not generate returns above the hurdle, the manager earns no carry.

How Carry Is Structured in India

In the Indian context, carried interest is typically structured through one of two mechanisms:

• Disproportionate distribution to sponsor/manager units — The fund manager holds units in the AIF (often a small percentage of the corpus, say 2-5%) but receives a disproportionately large share of profits (20% of profits above the hurdle). The AIF's LPA (Limited Partnership Agreement) specifies this waterfall structure.
• Separate carry vehicle — A separate entity (the carry vehicle) holds units in the AIF alongside the main fund, and profits flow to the carry vehicle according to the waterfall distribution.

The critical tax question is: when the fund distributes profits disproportionately to the manager, does that distribution retain its character as capital gains (from the fund's investment activities), or does it get recharacterized as business income or salary?

Section 115UB: The Pass-Through Framework for AIFs

Section 115UB of the Income Tax Act provides the foundational tax framework for AIFs in India. It accords pass-through status to Category I and Category II AIFs for income other than business income.

How Pass-Through Works

Under Section 115UB, income in the nature of interest, dividends, or capital gains earned by the AIF is not taxed at the fund level. Instead, it passes through to the unit holders and is taxed in their hands, retaining the same character. If the fund earns long-term capital gains from selling shares, the unit holders are taxed on their share of those gains as long-term capital gains — not as income from other sources.

Category III AIFs: The Exception

Category III AIFs (hedge funds, PIPE funds) do not receive pass-through treatment. Income earned by Category III AIFs is taxed at the fund level at the maximum marginal rate (currently 42.744% including surcharge and cess for non-corporate entities). This makes Category III structures significantly less tax-efficient for foreign investors.

Business Income: Taxed at Fund Level

Even for Category I and II AIFs, business income is taxed at the fund level, not passed through to investors. This is why the characterization of carried interest — as capital gains (passed through) versus business income (taxed at fund level) — has been such a critical issue.

The 2025 Budget Amendment: Codifying Capital Gains Treatment

The Union Budget 2025 introduced a landmark amendment to Section 115UB, effective from April 1, 2025 (Assessment Year 2026-27). The key changes are:

Securities Held by AIF = Capital Assets

The characterization of securities held by Category I and II AIFs is now brought at par with Foreign Portfolio Investors (FPIs). Securities held by these funds are classified as capital assets, not stock-in-trade. This means gains from their disposal are always capital gains, regardless of the holding period or trading frequency.

Carried Interest Retains Capital Gains Character

When the fund distributes consideration from the transfer of securities to the fund manager, the nature of such distributed income in the hands of the fund manager is also capital gains. Critically, this characterization is not affected by the fact that the distribution to the fund manager is disproportionate to the units held by the manager.

This amendment resolves the long-standing uncertainty about whether disproportionate distributions to carry holders could be recharacterized as business income or salary. The legislative intent is clear: carried interest is capital gains.

Tax Rate Implications

For a foreign fund manager earning INR 10 crore in carried interest from long-term investments in unlisted Indian companies, the difference between capital gains treatment (12.5%) and business income treatment (approximately 39%) is INR 2.65 crore in additional tax.

Section 9A: Safe Harbour for Offshore Funds

Section 9A of the Income Tax Act addresses a separate but related concern: whether the presence of a fund manager in India creates a permanent establishment (PE) or business connection in India for the offshore fund itself.

The Problem Section 9A Solves

Without Section 9A, an offshore fund managed by an Indian fund manager could be deemed to have a business connection in India under Section 9(1)(i) of the IT Act. This would make the fund's global income attributable to India taxable in India — a catastrophic tax outcome for funds that invest across multiple countries.

Conditions for Safe Harbour

An offshore fund qualifies for Section 9A protection if it meets all of the following conditions:

1. Tax treaty jurisdiction — The fund is resident in a country with which India has a DTAA (Double Taxation Avoidance Agreement), or a country notified by the government.
2. Resident Indian investment cap — Aggregate participation by Indian residents does not exceed 5% of the fund corpus (with certain relaxations).
3. Regulatory compliance — The fund is subject to investor protection regulations in its home jurisdiction.
4. Minimum membership — The fund has at least 25 members who are not connected persons.
5. Arm's length remuneration — The management fee paid to the Indian fund manager meets the minimum threshold prescribed under Rule 10V of the Income Tax Rules (calculated based on a specified formula linked to the fund corpus and nature of investments).
6. Fund manager registration — The fund manager is registered with SEBI as a portfolio manager or investment adviser.

CBDT Approval Option

Funds can seek advance approval from the CBDT (Central Board of Direct Taxes) to confirm their eligibility under Section 9A. Once approved, the safe harbour applies prospectively for succeeding years and cannot be denied unless the approval is withdrawn.

Management Fees: Tax Treatment for Non-Resident Fund Managers

Management fees are the fixed annual fees (typically 1.5-2.5% of committed capital or assets under management) paid by the fund to the fund manager for investment management services. Unlike carried interest, management fees are contractually guaranteed regardless of fund performance.

Domestic Law: Section 9(1)(vii) — Fees for Technical Services

Under Indian domestic law, management fees paid to a non-resident fund manager are typically classified as Fees for Technical Services (FTS) under Section 9(1)(vii) of the Income Tax Act. FTS includes payments for managerial, technical, or consultancy services. Investment management services fall squarely within the "managerial" category.

The domestic withholding tax rate on FTS paid to non-residents is 10% plus applicable surcharge and cess (effective rate approximately 10.4-10.92%, depending on the surcharge bracket).

DTAA Relief: The Make-Available Test

Several of India's DTAAs — notably with the United States, United Kingdom, and Singapore — include a "make-available" test for FTS. Under these treaties, a payment qualifies as FTS only if the services make available technical knowledge, experience, skill, know-how, or processes that enable the payer to apply them independently.

Investment management services typically do not make available any technical knowledge to the fund — the fund cannot replicate the manager's investment decision-making after the engagement ends. Therefore, under treaties with the make-available test, management fees may not qualify as FTS and could be taxable only as business profits — which are taxable in India only if the fund manager has a PE in India.

Section 9A and Management Fees

If the offshore fund qualifies under Section 9A, the fund manager's presence in India does not create a PE for the fund. However, Section 9A does not exempt the fund manager itself from Indian taxation. The management fees received by the fund manager (if the manager is an Indian entity) are taxable as business income in India at corporate tax rates (25% for domestic companies with turnover up to INR 400 crore, or the concessional rate of 22% under Section 115BAA).

If the fund manager is a non-resident entity, the management fees are subject to withholding tax under domestic law or the applicable DTAA, whichever is more beneficial.

IFSC (Gift City) Fund Managers: The Tax Holiday

Fund managers operating from India's International Financial Services Centre (IFSC) in Gift City, Gujarat, enjoy significant tax advantages:

• 10-year tax holiday — Fund management entities in IFSC can claim a 100% tax holiday on their income for 10 consecutive years out of the first 15 years of operation under Section 80LA.
• Reduced tax rate — After the tax holiday, income is taxed at concessional rates.
• Exemption from GST — Services provided by IFSC entities to offshore funds are exempt from GST.

For foreign fund managers evaluating whether to establish their India operations, the IFSC structure offers a compelling tax-efficient alternative to a mainland India setup.

Withholding Tax Obligations on Management Fee Payments

When an AIF or offshore fund makes a management fee payment to a non-resident fund manager, the payer must deduct tax at source under Section 195 of the Income Tax Act.

Documentation Required

• Tax Residency Certificate (TRC) — The non-resident fund manager must provide a valid TRC from their home country to claim DTAA benefits.
• Form 15CA/15CB — The payer must file Form 15CA (online declaration) and Form 15CB (CA certificate) before making the remittance.
• PAN — The non-resident must obtain an Indian PAN. Without PAN, the withholding rate increases to 20% under Section 206AA.

Withholding Rate Summary

Practical Structuring Considerations for Foreign Fund Managers

Fund Domicile Selection

The choice of fund domicile significantly impacts the tax treatment of both carried interest and management fees. Funds domiciled in Singapore, Mauritius, and Luxembourg are common for India-focused strategies because of favorable DTAA provisions. Post-2017 amendments to the India-Mauritius DTAA, capital gains from Indian investments are now taxable in India, reducing Mauritius's historic tax advantage for equity investments.

Manager Entity Location

Foreign fund managers must decide whether to base their India investment team through an Indian subsidiary (subject to Indian corporate tax on management fees), an IFSC entity (10-year tax holiday), or a non-resident entity with Indian employees/secondees (PE risk analysis required).

Transfer Pricing Considerations

Management fee arrangements between the offshore fund and its Indian fund manager are subject to transfer pricing norms under Sections 92-92F of the Income Tax Act. The fee must be at arm's length price, benchmarked against comparable uncontrolled transactions. For Section 9A purposes, the management fee must also meet the minimum remuneration threshold under Rule 10V.

FEMA Considerations for Foreign Fund Flows

Beyond income tax, foreign fund managers must navigate FEMA regulations governing the flow of capital into and out of India. FDI in AIFs is permitted under the automatic route, but the fund must comply with reporting requirements including FC-GPR filings within 30 days of unit issuance to non-resident investors.

Repatriation of Carried Interest

When the AIF distributes carried interest to a non-resident fund manager, the remittance requires compliance with FEMA current account and capital account transaction norms. The AD (Authorized Dealer) bank will require a CA certificate confirming tax deduction at source, the applicable DTAA provisions, and Form 15CA/15CB documentation before processing the outward remittance.

Capital Gains Repatriation

Non-resident investors (including foreign fund managers holding units) can repatriate capital gains from AIF investments after payment of applicable taxes. The repatriation is processed through the AD bank upon submission of CA certificates confirming tax compliance. There is no separate RBI approval required for repatriation of post-tax investment returns through the automatic route.

Compliance Checklist for Foreign Fund Managers

Our tax advisory team regularly assists foreign fund managers with structuring their India operations. Based on that experience, here is a practical compliance checklist:

• AIF registration with SEBI — Ensure the fund is registered as a Category I or II AIF if pass-through treatment is desired. Category III registration results in fund-level taxation.
• Section 9A qualification — Verify all six conditions are met before claiming safe harbour. The 5% Indian resident cap and 25-member minimum are the most commonly failed conditions.
• LPA waterfall documentation — The carried interest waterfall must be clearly documented in the Limited Partnership Agreement, specifying the hurdle rate, catch-up provisions, and distribution mechanics.
• Transfer pricing documentation — Maintain contemporaneous transfer pricing documentation for management fee arrangements, including benchmarking analysis under Rule 10V.
• Withholding tax compliance — Deduct TDS under Section 195 on management fee payments to non-residents. File Form 15CA/15CB before each remittance.
• FEMA reporting — File FC-GPR for unit issuances to non-residents within 30 days. File the Annual Return on Foreign Liabilities and Assets (FLA) by July 15 each year.
• PAN for non-residents — Obtain Indian PAN for all non-resident fund managers and key investors to avoid the punitive 20% withholding rate under Section 206AA.

Key Takeaways

• The 2025 Budget amendment codifies that carried interest distributed by Category I and II AIFs retains its character as capital gains — even when the distribution is disproportionate to the manager's unit holding.
• Capital gains treatment means carried interest is taxed at 10-12.5% (long-term) instead of 35-39% (business income), saving fund managers 20+ percentage points.
• Section 9A safe harbour protects offshore funds from Indian PE exposure through their Indian fund managers, subject to meeting specific conditions including the 5% Indian resident cap and minimum 25 members.
• Management fees paid to non-resident fund managers are subject to 10% withholding as FTS under domestic law, but may be exempt under DTAAs with the make-available test.
• IFSC Gift City offers a 10-year tax holiday for fund management entities, making it the most tax-efficient location for India-focused fund management operations.