AIF fund-of-funds (FoF) structures involve complex fee arrangements between multiple related parties: the fund-of-funds, the underlying funds, and the respective managers. These arrangements raise significant transfer pricing concerns under the Direct Tax Code (DTC) 2025. This guide analyses the transfer pricing implications of AIF FoF structures and provides strategies for compliant fee arrangements.
Understanding AIF Fund-of-Funds Structures
What is a Fund-of-Funds?
A fund-of-funds is an investment strategy where a fund invests in other funds rather than directly in securities or assets. In the AIF context, a FoF may:
- Invest in multiple underlying AIFs
- Provide diversification across strategies, managers, and asset classes
- Offer access to funds that may otherwise be closed to new investors
Fee Arrangements in FoF Structures
Typical fee arrangements in FoF structures include:
- FoF Management Fees: Fees charged by the FoF manager to the FoF investors
- Underlying Fund Management Fees: Fees charged by the underlying AIF managers
- Performance Fees: Performance-based fees at both the FoF and underlying fund levels
- Administration Fees: Fees for administration, custody, and other services
Related Parties in FoF Structures
Related parties in FoF structures may include:
- The FoF manager and the underlying fund managers (if affiliated)
- The FoF and the underlying funds (if the FoF has a controlling interest)
- The FoF manager and the FoF investors (if the manager has a substantial interest)
- Different funds within the same group
Transfer Pricing Concerns in FoF Structures
International Transactions
If the FoF manager and the underlying fund manager are in different jurisdictions, the fee arrangements constitute international transactions under Section 163. Similarly, if the FoF and the underlying fund are in different jurisdictions, the investment transactions may be international transactions.
Specified Domestic Transactions
If the aggregate value of related-party transactions in a FoF structure exceeds ₹20 crore in a tax year, the transactions may constitute specified domestic transactions under Section 164, subject to transfer pricing rules.
Related Party Fee Arrangements
The key transfer pricing concerns in FoF structures relate to:
- Management Fees: Are the management fees charged by the FoF manager at arm's length?
- Underlying Fund Fees: Are the fees charged by the underlying fund manager at arm's length?
- Fee Waivers: Are fee waivers between related parties at arm's length?
- Cost-Sharing: Are cost-sharing arrangements between related parties at arm's length?
Determination of Arm's Length Price
Section 161 — The Arm's Length Principle
Section 161(1) requires that "Any income arising from an international transaction or a specified domestic transaction shall be determined having regard to the arm's length price". Section 161(2) extends this to "Any allowance for any expense or interest".
Applicable Methods for FoF Fees
Section 165(1) prescribes six methods for determining the ALP. For FoF fee arrangements, the most appropriate method depends on the nature of the services:
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Comparable Uncontrolled Price Method (CUP): May be applicable where there are comparable FoF fee arrangements in the market
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Transactional Net Margin Method (TNMM): May be appropriate for FoF management fees, comparing the net profit margin of the FoF manager with that of comparable independent FoF managers
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Profit Split Method: May be applicable where there are unique and valuable contributions by each party to the FoF structure
Benchmarking Considerations
- Functional Analysis: What functions does the FoF manager perform? Manager selection, due diligence, allocation, monitoring, administration?
- Asset Analysis: What assets are employed? Intellectual property, proprietary systems, relationships?
- Risk Analysis: What risks are assumed? Investment risk, operational risk, key person risk?
Specific Transfer Pricing Issues in FoF Structures
1. Management Fee Duplication
Where both the FoF and the underlying fund charge management fees, the question arises: Is the total fee at arm's length? The transfer pricing analysis must consider:
- Whether the services provided at each level are distinct
- Whether there is duplication of services
- Whether the total fee is comparable to market practice
2. Fee Waivers
Where the FoF manager waives management fees in exchange for a higher share of carried interest or performance fees, the arrangement must be at arm's length:
- Is the waiver comparable to market practice?
- Is the economic substance of the arrangement consistent with its legal form?
- Is the arrangement designed to avoid tax?
3. Cost-Sharing Arrangements
Where the FoF manager and the underlying fund manager share costs (e.g., research, administration), the allocation must be:
- Based on the benefits received by each party
- Documented in a cost-sharing agreement
- At arm's length
4. Carried Interest
Carried interest allocated between the FoF manager and the underlying fund manager must be at arm's length:
- Is the allocation comparable to market practice?
- Is the economic substance of the arrangement consistent with its legal form?
- Is the arrangement designed to avoid tax?
5. Performance Fees
Performance fees charged by the FoF manager and the underlying fund manager must be at arm's length:
- Is the performance fee structure comparable to market practice?
- Is the performance fee based on genuine performance?
- Is the performance fee designed to avoid tax?
Documentation Requirements
Section 171 — Documentation
Every person who has entered into an international transaction or specified domestic transaction shall keep and maintain prescribed information and documents. For FoF structures, this includes:
- Description of the ownership structure
- Profile of the multinational group
- Description of the business and industry
- Nature and terms of the international transaction
- Functional analysis
- Method selection and application
Section 172 — Report from an Accountant
Every person who has entered into an international transaction or specified domestic transaction shall obtain a report from an accountant and furnish it on or before the specified date.
Penalties for Non-Compliance
Failure to Maintain Documentation
Section 442 provides for a penalty of 2% of the value of each international transaction or specified domestic transaction for failure to keep and maintain documentation.
Failure to Furnish Information
Section 457 provides for a penalty of 2% of the value of the transaction for failure to furnish any information or document as required under Section 171(2).
Practical Compliance Strategies
1. Conduct a Transfer Pricing Study
Conduct a comprehensive transfer pricing study documenting:
- The FoF structure and fee arrangements
- The functional analysis of each party
- The benchmarking analysis
- The ALP determination
2. Document the Commercial Rationale
Document the commercial rationale for the FoF structure and fee arrangements:
- Why was the FoF structure chosen?
- Why are the fees structured in this way?
- What is the economic substance of the arrangement?
3. Use Arm's Length Comparables
Use reliable comparables for FoF fee arrangements:
- Industry surveys (e.g., Preqin, Hedge Fund Research)
- Publicly available data on FoF fee arrangements
- Third-party FoF arrangements
4. Maintain Robust Documentation
Maintain robust documentation as required under Section 171:
- Ownership structure
- Business description
- Transaction details
- Functional analysis
- Method selection and application
5. Consider an APA
Consider an APA under Sections 168–169 for certainty on the arm's length price of FoF fee arrangements.
Expert Legal Guidance
Anuj Desai & Associates provides comprehensive legal advisory services on transfer pricing for AIF fund-of-funds structures. Our direct tax experts help fund sponsors and managers develop compliant fee arrangements, prepare TP studies, and navigate the regulatory framework. We assist in structure review, documentation preparation, and representation before income-tax authorities.
Disclaimer: This article provides general information and does not constitute legal advice. For specific guidance on transfer pricing or any other direct tax matter, please consult qualified legal professionals.
Need Expert Legal Guidance?
Navigating the complex transfer pricing framework for AIF fund-of-funds structures requires experienced legal counsel. At Anuj Desai & Associates, we provide comprehensive direct tax advisory services, including:
- Structure Review: Transfer pricing risk assessment for FoF structures
- TP Study Preparation: Assistance with transfer pricing documentation
- Benchmarking: Guidance on comparable selection and analysis
- Representation: Representation before Transfer Pricing Officers
Contact us for expert legal guidance on your fund-of-funds matters.