How taxation works for AIFs

Alternative Investment Funds (AIFs) have emerged as financial powerhouses, capturing the attention of seasoned investors seeking to diversify their portfolios and potentially reap substantial rewards.

What is an AIF?

According to the Securities and Exchange Board of India (SEBI), an AIF is a fund established or incorporated in India, which is a privately pooled investment vehicle that collects funds from investors, whether Indian or foreign, to invest in accordance with a defined investment policy for the benefit of its investors.

How are they different from Mutual Funds?

Unlike Mutual Funds, which are widely available to any kind of investor, AIFs cater to a more exclusive clientele, typically high-net-worth individuals (HNIs). AIFs offer exposure to alternative asset classes, providing investment opportunities beyond traditional stocks and bonds. They are structured for more experienced investors with a high-risk tolerance and a desire for potentially higher returns. These funds often have longer lock-in periods, restricting investor liquidity. In exchange, AIFs offer access to unique investment opportunities unavailable to the general public.

Types of AIFs

There are three main categories of AIFs where one can invest:

Category I: 

These AIFs channel investments into high-growth sectors like startups, SMEs, social ventures, and infrastructure. They often stimulate economic growth and can benefit from government incentives. Category I AIFs are typically structured as closed-end funds with a mandatory three-year lock-in period.

Category II: 

Category II AIFs encompass private equity and debt funds that operate without government incentives or regulatory concessions. These funds focus on generating returns through medium to long-term investments in unlisted companies. Like Category I, they also maintain a closed-end structure, often with a minimum three-year tenure.

Category III: 

Category III AIFs employ sophisticated trading strategies, often leveraging investments in listed or unlisted derivatives. This category includes hedge funds and funds focused on short-term returns. Unlike the previous categories, Category III AIFs can be either open-ended or closed-ended.

Limits

SEBI mandates that a maximum of 1,000 investors can participate in an AIF, except for Angel funds, where a maximum of 49 angel investors are permitted. AIFs cannot publicly solicit investments; fundraising is restricted to private placements.

Growth

AIFs have surged in popularity, with assets under management (AUM) skyrocketing 36% to Rs. 11.35 lakh crore in the past year. This rapid growth has made AIFs a prime choice for HNIs seeking diverse investment opportunities.

Taxability

The taxation of AIF depends on the category of the fund and the type of income, such as capital gains, business profits or other sources.  AIFs can either follow a pass-through model, where investors are directly taxed, or experience trust-level taxation (where the fund itself pays). 
 

The framework of AIF’s taxation aims to balance investor protection with revenue collection, along with achieving efficiency across categories.
 

Category I and II AIFs

These funds benefit from the pass-through status under Section 115UB of the Income Tax Act. Income apart from business is taxed in the hands of investors as per their tax slabs. Whereas, business income is taxed at the fund level at the maximum marginal rate of about 42.7%. This structure makes AIF taxation in these categories relatively simple and investor-friendly.
 

Category III AIFs (Domestic)

Domestic Category III AIFs do not have pass-through benefits, but capital gains and business income are taxed at the fund level of 42.7%. Besides that, investor distributions are exempt from double taxation. This occurrence highlights the heavier taxation of AIF under the domestic Category III regime.
 

Category III AIFs (IFSC)

Category III funds are located in International Financial Services Centres, such as GIFT City, which receives generous incentives. These have special tax advantages, including a 10-year tax holiday for fund managers, reduced taxation on other income, and no capital gains tax.  Moreover, they are exempt from paying GST.
 

Comparative Overview

Here is a quick comparison between all of these category AIFs:

Emerging Trends

SEBI has announced plans to introduce a "new asset class" akin to AIFs, currently under consultation. Some analysts believe it will attract investors interested in AIFs due to potential tax advantages, particularly compared to Category III AIFs. 

The new asset class is expected to have a lower tax rate, possibly similar to Mutual Funds, with 12.5% for long-term holdings, whereas Category III AIFs can be taxed as high as 40% at the fund level. With a minimum ticket size expected to start at Rs. 10 lakh compared to AIFs' usual Rs. 1 crore, this new asset class could allow investors to diversify across multiple asset classes and spread their risks. Notably, this new asset class will also be allowed to invest in equities and derivatives, although with some restrictions.

Who can invest in an AIF?

SEBI permits AIFs to be open to Indian residents, Non-Resident Indians (NRIs), and foreign nationals. Joint investments are allowed among spouses, parents, and children. The minimum investment is typically around Rs. 1 crore, though this can be reduced to Rs. 25 lakh for directors, employees, and fund managers.

Conclusion

AIFs offer a compelling investment opportunity for those seeking to diversify their portfolios and potentially achieve higher returns. By investing in alternative asset classes such as hedge funds, real estate, and private equity, AIFs help investors reduce their exposure to traditional market fluctuations.

However, it's important to note that higher returns often come with increased risk. Additionally, AIFs typically require substantial initial investments, making them more suitable for HNIs with a long-term investment horizon.

AIFs are ideal for investors with large sums and long-term visibility of their income levels. Compared with Mutual Funds, AIFs offer greater transparency, providing direct insights into the shares or assets being bought and sold, and keeping investors fully informed. They also provide more detailed updates, sometimes even offering rationales for their decisions. However, AIFs often have lock-in periods of three years, unlike Mutual Funds that typically impose a penalty for exits within a year. Additionally, while direct Mutual Funds have low expense fees, AIFs, dealing with more complex assets, can have much higher fees, around 2.5% of the portfolio, along with additional taxes.