In recent times, Special purpose vehicles (SPV) have attracted the attention of regulators, professionals and investors across the countries

It would be useful to understand how these SPVs can be used for certain sophisticated structuring and tax planning.

SPVs are very useful tools for the purpose of raising capital and to pool funds from investors in mutual funds and other collective investment schemes, private equity funds/ venture capital funds and asset securitisation transactions.

The raising of money from the investors and aggregation of the assets/receivables in an SPV, though done for different reasons, has one primary objective, that of creating an additional layer between the investors and the assets for administrative convenience.

A SPV acts as a conduit to channelise the funds at one end and spreading of investment related risks at the other end.

In case of mutual fund and other collective investment schemes, an investor is able to diversify his risk at a relatively low cost.

In case of a securitisation transaction, an SPV is used because there is a need for a bankruptcy remote entity where the receivables reside, and to securitise the receivables (that is pooling the assets and selling ownership instruments to investors which represent a part of the assets held by the SPV) to the investors.

There may be derivative structures where rights of the investors may vary depending on the terms of the ownership instrument. However, the key concept is ownership or derivative ownership in the assets held by the SPV by the investor.

In case of a venture capital fund /venture capital company (VCF/ VCC), there is a pooling of money from various investors at the level of the VCF/VCC which is used to invest in shares and other securities of the portfolio companies.

The income in form of dividend or sale proceeds is then passed on to the investors of the VCF/VCC after deducting expenses, management fees and carried interest.

n case of VCF/VCCs, an SPV is very often used to pool funds from offshore and domestic investors, thereby giving them the benefit of a unified structure.

Legal recognition of SPVs and tax treatment of income received by SPVs poses a challenge to the regulators in almost all jurisdictions.

While the legal fiction of `separate juristic entity’ stops regulators from extending the liability of the SPVs to the deeper pockets of the investors, in order to avoid double taxation, `pass-through’ treatment is a must from taxation perspective.

`Pass-through’ treatment basically means that the income of the SPV is not taxed at the SPV level, but is taxed directly in the hands of the respective investors qua their pro-rata share in the SPV.

Most jurisdictions around the world offer such `pass-through’ treatment to the SPVs set up for pooling funds from investors. However, taxation of the SPVs under the Indian Income-Tax Act,1961(I-T Act), has been a somewhat confused concept.

While the SPVs set up in the form of the trust qualify for “automatic” pass-through treatment as per the provisions of I-T Act, SPVs set up in non-trust form (like in case of an SPV set up as a company) need to be given a special legislative exemption to avoid double taxation.

In case of an SPV set up as a non-discretionary, specific trust, where the beneficiaries are identifiable and their shares are determinate at the time of setting up the trust, the trust is treated as a ‘pass-through’ and the beneficiaries are taxed in respect of income arising to the trust.

Even where the trustees are taxed, they are taxed in the same manner and to the same extent as the beneficiaries.

The exception to this treatment is in case of trusts which are held to be carrying on business. If the income of the trust includes profits and gains from business, entire income of the trust is taxed at the maximum marginal rate.

Thus, in the event the trust is held to carry on business then the pass-through status may be lost. The I-T Act currently provides special exemption in the case of all incomes of mutual funds (which can be set up only in the form of a trust) and in case of venture capital funds (which can be set up either in the form of a trust or in the form of a company).

While this exemption is superfluous in case of mutual funds, which would have in any case been eligible for the ‘pass-through’ treatment, it very crucial for the venture capital funds set up in the form of a company.

Whilst there are no special provisions for extending the ‘pass-through’ treatment to securitisation SPVs, similar tax treatment will be available to them, so long as they are set up in the form of specific revocable trusts, subject to certain conditions.

Thus, it emerges that regulators have to balance conflicting factors in order to evolve a law, which gives boost to certain industries for which SPVs are unavoidable. This will also further investor confidence and attract investments in such collective investment vehicles.