This article is written by Rohit Gupta pursuing  Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.com.

Introduction

We have seen that for the progressive growth of an economy, the capital infusion is a major element. If the industry doesn’t have adequate capital within the system, it would impact the production of goods and services and which would and hence affect the flow of funds in the economy. With an increased capital infusion, one can witness growth across various sectors of the economy. 

In India, in 1996, Securities and Exchange Board of India (venture capital funds) Regulations were framed in order to encourage entrepreneurs to fund early-stage companies. However, there were many funds that were operating which could not be classified as Domestic venture capital funds(VCF), Foreign Venture Capital Investors (FVCI), or Foreign Institutional Investor (FII). Further, as these alternative funds were not registered with the Securities and Exchange Board of India, there was a regulatory gap that needed to be bridged.

Hence, to regulate and bring under the ambit of law, Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 was introduced. Hence, we can say that they are an extension of an existing investment.

What are Alternative Investment Funds

Alternative Investment Funds (AIF) are a pool of private funds, which have been established or incorporated in India, collected from various investors, whether Indian or foreign. These pooled funds are invested in accordance with the defined investment policy for the benefit of its investor. Please note that these funds are not available through initial public offerings(IPO) or any other forms of a public issue that are applicable under the mutual funds or collective investment schemes or any   other regulations of the board to regulate fund management activities

The registration process of Alternative Investment Funds

Regulation 3 to Regulation 8 of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012, clearly defines the process of registration, eligibility criteria, information to be furnished, conditions and grant of certificate, and even procedure for the refusal of the certificate. The overview of the AIF registration process would be:

• An application should be submitted to the board at its head office in Mumbai in form A along with complete details with respect to the applicants being a trust or a company or an LLP or a body corporate and the category being applied along with a non-refundable application fee of INR 1,00,000/-. 
• In form A, applicants need to ensure that all details are furnished along with the details of sponsors, manager, business plan, and investment strategy. All the pages have to number along with the original signature/stamp on each page of the form.
• One has to ensure that the covering letter of the application should state whether it is registered with SEBI as a venture capital fund or it has been undertaking the activities of an AIF prior to such application. If yes, provide details or it is applying for registration of a new fund.
• After form A along with requisite documents and fees are submitted, the board normally takes 21 days to share their reply either by granting the certificate or declining the registration. 
• Once approved, the board would grant the Certificate of Registration in form B after requisite registration fees are paid as the category of AIF for the details are:

Fees	Amount
Registration Fee for Category I Alternative Investment Funds (other than Angel Funds)	INR 5,00,000/-
Registration Fee for Category II Alternative Investment Funds (other than Angel Funds)	INR 10,00,000/-
Registration Fee for Category III Alternative Investment Funds (other than Angel Funds)	INR 15,00,000/-
Re-registration Fee (If the applicant is registered with SEBI as a venture capital fund)	INR 1,00,000/-
Registration Fee for Angel Funds	INR 2,00,000/-

• If the Board is of the opinion of not granting the certificate, the decision shall be communicated within 30 days and giving the applicant a reasonable opportunity of being heard.

Key features and general conditions of Alternative Investment Funds

Regulation 9 to Regulation 16 of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012, defines some of the key features and general conditions for the AIF. Here are some of the key features and general conditions which are outlined as:

1. AIF would not have more than 1000 investors per scheme and in the case of Angel Fund, it would be 200.
2. The investment value would not be less than INR 1 crores from an investor. However, in the case of investors who are employees or directors of AIF or managers, the minimum value of the investment would be INR 25 lakhs.
3. The minimum corpus for any scheme would be INR 20 crores and in the case of Angel Fund, it would be INR 5 crores.
4. AIF shall raise funds through private placement only. AIF would issue Information Memorandum or Placement Memorandum which contains all material information about the AIF.
5. An Indian, foreign national, and non-residential qualify as eligible investors.
6. Investment in securities of foreign companies allowed subject to conditions imposed by RBI. The un-invested investible fund may be invested in liquid mutual funds, or other liquid assets like treasury bills, commercial papers, etc.
7. The manager or sponsor shall disclose their investment in the Alternative Investment Fund. Also, terms of co-investment in an investee company by manager or sponsor shall not be favourable than offered to AIF. 
8. The manager or sponsor shall have a continuing interest in the Alternative Investment Fund would be 2.5% of corpus or INR 5 crores (whichever is lower). However, in category III, the continuing interest would be 5% of corpus or INR 10 crore (whichever is lower).

Also, would like to highlight that under Regulation 23 of the SEBI (Alternative Investment Funds) Regulations, 2012, it has been mentioned that the Alternative Investment Fund shall provide a description of its valuation procedure and methodology for valuing assets to its investors. 

Categories of Alternative Investment Funds

According to the Securities and Exchange Board of India, the AIF has been classified into three different investment structures – category I, category II, and category III. 

Category I of Alternative Investment Funds

Investment of funds in start-ups or early stage ventures or small and medium enterprises(SMEs) or any other sector considered as economically or socially viable by the government are part of this category. As they have a multiplier effect on the economy when it comes to growth and job creation, the government promotes and incentivizes such kinds of investment in these projects. 

Venture capital fund

venture capital funds primarily invest in start-ups that have high growth potential but facing capital issues in the initial phase and require funds to establish or expand their business.  

SME fund 

The fund usually invests in unlisted private companies which are micro, small, and medium enterprises, and incorporated under the Micro, Small, and Medium Enterprises Development Act, 2006.

Infrastructure fund

The fund invests in the development of public assets such as road and rail infrastructure, airports, communication assets, etc, and if are socially desirable or viable projects. Further, as these funds are being invested in the development of public assets, the government may also extend tax benefits on such investments. 

Social venture fund

The funds are invested typically in companies that have a strong social backing and are looking forward to bring real change in society. These companies work on solving environmental and social issues simultaneously and even focus on generating profits as well.

Angel fund

In this fund managers pool money from numerous angel investors. Further, it is invested in start-ups (which are funded by established venture capital funds because of their growth uncertainty) for their development and in return, units are issued to the angel investor. 

Category II of Alternative Investment Funds

Those Alternative Investment Funds which are not described under category I and category III come under category II. Under this category, funds are invested in various private equity funds or debt funds and do not undertake leverage or borrowing other than to meet day-to-day operational requirements. The government does not provide any incentive or concession on investment in these funds.

Private equity fund

Private equity funds take a share in the ownership against the investment made and invest largely in unlisted private companies. They usually have a fixed investment horizon which is ranging from 4 to 7 years.

Debt fund

Debt fund as the name itself speaks invests in debt instruments of companies that are listed as well as unlisted. As per the regulations, debt funds, cannot be utilised for the purpose of giving loans.

Real estate fund

As the name suggests, this fund invests through structured debt instruments focusing on real estate projects. 

Fund of funds 

Fund of funds is created with the combination of various AIF. The strategy in the fund of funds is to invest in a portfolio of other funds rather than making their own portfolio or decide what specific sector to invest in.

Category III of Alternative Investment Funds

Are the funds which apply complex or diverse trading strategies and leverage through investment in listed or unlisted derivatives. The funds aim at short-term returns and there is no specific concession or incentives being provided by the government on investment in these funds.

Hedge fund

Hedge funds are pooled capital from institutional and accredited investors which primarily invest in domestic as well as international markets to generate high. They have aggressive management of their investment portfolio and use leverage strategies. 

Private investment in public equity(PIPE) fund

These are pools of funds for public equity investments being privately managed. Under PIPE, the investor purchases a stake in the company which is publicly traded, and in turn, the company selling the stakes receives capital for the growth of its business. 

Stamp duty on Alternative Investment Funds

SEBI has directed that the sale, transfer, and issue of units of AIF are subject to stamp duty from July 01, 2020, as per the provision of the Indian Stamp Act, 1899. It has been clarified that the issuance of AIF units will attract a stamp duty of 0.005% of the market value of units i.e. the investment made by the investor excluding charges such as service charge, management fees, GST, etc. Further, the transfer of units on a delivery basis will attract a stamp duty of 0.015%, whereas transfer on a non-delivery basis, will attract a stamp duty of 0.003% in each case on the transfer consideration. No stamp duty would be payable on redemption of the unit. The contribution agreement and unit certificate/statement of account will be considered as two separate instruments and hence, will need to be stamped separately as separate transactions.

Taxation of Alternative Investment Funds

Category I and category II of Alternative Investment Funds

Funds in category I and category II have been provided pass-through status under the Section 115UB of Income Tax Act, 1961. Under this, any income/loss generated from the investments made by these funds shall be taxable in the hands of the investor in the same manner and under the same head as it would have been if the income had been earned by the investor directly. 

However, if the income of the fund includes business income then such income is not permitted to be passed through to the unit holders and the funds pay tax on such income. The rate of the tax would depend on the form of the funds i.e. if it’s a company, then it would be 25% plus surcharge (as of 2020 and subject to turnover rules), if its an LLP, then it would be 30% plus surcharge and trust are taxed as per income slabs at maximum marginal rate (MMR).

Further, AIF under category I and category II are compulsorily required to file their yearly returns under Section 139 (4F) of the Income Tax Act, 1961.

Category III of Alternative Investment Funds

Category III funds have not been provided pass-through status. Hence, all income generated through category III funds would be taxed at the fund level itself. The rate of the tax would depend on the legal form of the fund as the investment part would be treated as capital gains and the trading account will be treated as business income. Below is the calculation of tax slabs for reference:

Taxability of offshore investments by non-residents through AIF

As per the circular issued by the Central Board of Direct Taxes on July 03, 2019, it has been clarified that the income earned by the non-resident from the capital contributions of an AIF made overseas, would not be taxed in India under Section 5(2) of Income Tax Act, 1961. 

However, income received by a non-resident becomes chargeable to tax where the capital contributions of an AIF are made within the domestic market.

TDS Deduction on Alternative Investment Funds

As per Section 194LBB of the Income Tax Act, 1961, the TDS of 10% shall be deducted on all income other than business profits payable by an investment fund to investors being residents of India. However, no surcharge or education cess shall be added to it.

In case of a non-resident, not being a company or a foreign company, the TDS would be deducted at 10%. However, surcharge, wherever applicable plus education cess and SHEC shall be added to the above rate.

Conclusion

In the end, we can summarize that Alternative Investment Funds (AIF) are a pool of private funds being collected from various investors, whether Indian or foreign, which have been established in India and have been divided under three categories i.e. category I, category II, and category III depending on the deployment of funds and class of funds. 

Category I and category II investments have been given a pass-through status under Income Tax Act, 1961. However, in category III, the income generated would be taxed at the fund level, and then it passes to the investors. Also, the income other than business profits being transferred to the investor is applicable for TDS deductions.

From time to time, there have been changes in the framework of AIF, as the government has been proactive to have it incentivized. There have been recent developments like pass-through of losses incurred by AIFs to its investor, tax treatment of offshore investments, and revision of Angel Tax Provisions wherein exemption has been given to investments received by category II Funds as well which was earlier for category I fund only under the section 56(2)(viib) of Income Tax Act, 1961.

References

• SEBI | Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 [Last amended on January 08, 2021]

• SEBI | Collection of stamp duty on issue, transfer, and sale of units of AIFs

• 215223.pdf (gazette.nic.in)

• Indian Stamp Act, 1899 (bareactslive.com)

• Tax Laws & Rules > Acts > Income-tax Act, 1961 (incometaxindia.gov.in)

• Microsoft Word – How to get registered as an Alternative Investment Fund.docx (sebi.gov.in)

• AIFs: Indian Experiments & Way Forward with Tax Efficiency (taxguru.in)

• Alternative Investment Funds: Meaning, Types of AIF’s, Benefits, Taxation & More (koppr.in)

• Alternative Investment Fund – Know Types, Taxation Rules, List of Best AIF (paisabazaar.com)

• SEBI issues circular on payment of stamp duty on issue, transfer and sale of AIF units (argus-p.com)

• How taxation works for AIF and PMS investors » Capitalmind – Better Investing
• tax treatment of dividend received.pdf (incometaxindia.gov.in)

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