DE-TRUSTIFYING AIFS: SECTION 57A’S MISSING TAX COMPANION

This post is authored by Moksha Pancholi, fourth-year B.B.A. LL.B student at OP Jindal Global University.

Introduction

The Corporate Laws (Amendment) Bill, 2026 proposes a new section 57A in the Limited Liability Partnership Act, 2008, accompanied by a new Fifth Schedule. The provision allows a “specified trust” the one constituted under the Indian Trusts Act, 1882 (or any Central or State enactment) and registered with SEBI or the IFSCA to convert into a limited liability partnership (“LLP”) on the consent of three-fourths of investors by value. Assets, liabilities, contracts, and proceedings vest in the resulting LLP by operation of law; the converting trust stands dissolved. The reform targets the Alternative Investment Fund (“AIF”) industry, where over 95 per cent of funds are structured as private trusts.

Industry commentary has welcomed section 57A as a long-overdue structural fix, but the fix is incomplete. Section 57A operates only on the form that whether the conversion is fiscally workable depends on the Income Tax Act, 1961,  and its successor, the Income Tax Act, 2025(in force from 1^st April 2026), which the Bill does not touch. Two specific gaps render the reform structurally inert. First, no provision in section 47 of the Income Tax Act recognises a trust-to-LLP conversion as tax-neutral, exposing the conversion itself to capital gains tax. Second, the Fifth Schedule’s restriction on the initial partner base imports the control-liability decoupling that justified the reform. Each is examined in turn. 

The Structural Problem Section 57A Addresses

A trust under the Indian Trusts Act is not a juridical person. Trustees own the trust property, and beneficiaries hold a beneficial interest. A counterparty contracts with the trustee as representative, not with the “fund” as a separate entity. In an AIF, this produces a recurring asymmetry. The investment manager takes the commercial decisions, but regulatory responsibility flows to the trustee under Regulation 20(1) and 20(2) of the SEBI (Alternative Investment Funds) Regulations, 2012. The Securities Appellate Tribunal’s decision in Catalyst Trusteeship Limited v. SEBI (Appeal No. 182 of 2024, order dated 13 March 2024) , this decision illustrates the asymmetry directly. In a trust-structured AIF, the investment manager drives all commercial decisions, while a trustee bears regulatory liability; the decision maker and the accountable party are structurally different. Catalyst Trusteeship, the successor trustee of a category II AIF, was penalised by SEBI for the fund’s failure to achieve its mandated second close, a failure rooted in the investment manager’s conduct, not the trustee’s own decision. The tribunal rejected Catalyst’s contention that the accountability lay exclusively with the manager. Though the penalty was reduced on mitigation grounds, the principle was affirmed. Trustees carry independent fiduciary obligations under the regulations regardless of where commercial control actually sits. Section 57A purports to dissolve this asymmetry by converting the trust into an LLP, a body corporate with a legal identity distinct from its partners.

The Section 47 Gap

Section 45 of the Income Tax Act, 1961, charges capital gains on every “transfer” of a capital asset. Section 2(47) defines “transfer” expansively. Explanation 2, inserted by the Finance Act, 2012, captures any disposal of an asset “or any interest therein… directly or indirectly, absolutely or conditionally, voluntarily or involuntarily”.  The Conversion decision requires three-fourths investor consent and it is voluntary, but the consequent vesting of assets into the LLP occurs automatically by operation of the Fifth Schedule; no further act of disposal is needed. Explanation 2 covering transfers "by way of an agreement or otherwise” catches both the consensual decision and the automatic vesting, bringing it within section 2(47) and squarely within the charge under section 45.

Indian courts have consistently held that extinguishment of any right in a capital asset constitutes a transfer under section 2(47), attracting section 45. Whether from reduction of share capital, Kartikeya V, Sarabhai v. CIT (1997) or extinguishment of amalgamation, CIT v. Grace Collis (2001)) on a section 57A conversion, two transfers therefore arise. The underlying capital assets of the trust pass to a separate legal person, the LLP. Each beneficiary’s beneficial interest is simultaneously extinguished and replaced by a partnership interest in the LLP. The first is a transfer at the fund level. The second is a transfer at the investor level. The problem compounds further: the same appreciation is taxed once the funds level when assets vest into the LLP, and again at the investor level when the beneficial interest is extinguished. Two tax events, one an economic transaction, no relief. Where the converting vehicle is a Category I or II AIF enjoying pass-through treatment under section 115UB read with section 10(23FBA), the same economic appreciation may ultimately be exposed to tax through both the fund-level transfer and the extinguishment of investors' beneficial interests.

The legislative architecture of section 47 confirms the position. Parliament has historically inserted a tax-neutrality clause every time a new corporate-law conversion route was opened. Section 47(xiii) was added by the Finance Act, 1999 to cover the conversion of a firm into a company. Section 47(xiiib) was added by the Finance Act, 2010 to cover conversion of a private or unlisted public company into an LLP. The Memorandum to the Finance Bill, 2010 expressly recorded that, absent the carve-out, the conversion would attract capital gains tax. Schemes of amalgamation, demerger, and business-trust unit consolidation all received corresponding clauses. The pattern is settled as a corporate-law conversion mechanism without a parallel section 47 amendment is fiscally porous. Trust-to-LLP conversion is not in section 47, and the Finance Act, 2026 which is the most recent vehicle for income-tax amendments has not addressed the omission.

The practical consequence is acute for established trust-AIFs holding appreciated unlisted securities. Conversion would crystallise unrealised gains that the fund cannot economically distribute. A formal exercise becomes an immediate fiscal event. The likely counterargument is that the conversion involves no consideration and therefore no realisation. The response lies in section 48 as capital gains are computed by reference to the “full value of consideration received or accruing”, an expression read broadly by Indian courts (Kartikeya V. Sarabhai v. CIT, [1997] ; CIT v. Grace Collis, (2001) to include the value of substituted rights. The partnership interest received in exchange for the extinguished beneficial interest cannot plausibly be valued at zero. Take an investor whose beneficial interest costs ₹ 2 crore but is worth ₹ 10 crore. On conversion, section 48 computes gain on the fair market value of the partnership interest received of ₹ 10 crore. Capital gains of ₹8 crore arise with no cash changing hands.

The Trustee-As-Partner Paradox

Paragraph 3 of the proposed Fifth Schedule restricts the initial partner base of the resulting LLP to the trustees of the converting trust. This drafting choice undermines the governance proposition on which the reform rests. AIF trustees are typically professional debenture-trusteeship companies, they do not run the fund, the investment manager does. A trustee-only initial partnership replicates the Catalyst-type decoupling on day one. The LLP’s structure permits liability to be shifted, unlike the trust but only after post-conversion restructuring the Bill does not facilitate. The defect is therefore transitional, not permanent the LLP Act supplies the tools, but the Bill leaves funds to assemble them unaided. The Fifth Schedule additionally preserves trustee liability for pre-conversion obligations, layering surviving fiduciary exposure on top of new partner exposure for the same individuals or entities.

Section 57A’s governance promise can be realised only through post-conversion restructuring. The partner base would have to be restructured whether by inducting manager-affiliated designated partners or otherwise under the LLP Act. The Bill does not address that transition. Ordinary partner-substitution mechanics under the LLP Act apply, with the attendant filings, fees, and potential stamp-duty exposure depending on where the LLP’s assets sit. A reform aimed at simplifying fund structures should not leave its principal beneficiaries to navigate a multi-step workaround.

The Way Forward

The Joint Parliamentary Committee currently scrutinising the Bill should recommend a parallel insertion in section 47 of the Income Tax Act, 1961 (and, on its notification, the corresponding provision of the Income-tax Act, 2025). A new clause modelled on section 47(xiiib) should exclude from the meaning of “transfer” any conversion of a specified trust into an LLP under section 57A read with the Fifth Schedule, subject to four cumulative conditions. First, all assets and liabilities of the trust become assets and liabilities of the LLP. Second, every beneficiary becomes a partner in the same proportion as their beneficial interest; any reallocation would itself be a separate taxable transfer, defeating the carve-out's neutrality. Third, no benefit accrues to a beneficiary other than the partnership interest. And fourth, the resulting LLP retains valid SEBI or IFSCA registration as an AIF for a prescribed minimum period, with a clawback if registration lapses. A separate clarification to the Fifth Schedule should permit post-conversion induction of new partners, in particular, the manager and its affiliates, without re-triggering the three-fourths investor-consent threshold. Requiring a fresh vote for every governance-driven change would render the restructuring unworkable; disclosure protects investors without that deadlock.

Without these companion provisions, section 57A risks becoming a paper option: structurally elegant but fiscally inert, used (if at all) only by funds with negligible unrealised appreciation. The Bill rewrites the form. The Income Tax Act must be invited to do the same.