Understanding Alternative Investment Funds: Types, Compliance & Taxation

Introduction: Alternative Investment Funds (AIFs) have gained prominence as investment vehicles that cater to a niche segment of sophisticated investors. In this comprehensive guide, we’ll delve into the world of AIFs, exploring their types, registration process, compliance requirements, and taxation implications.

WHAT IS AN ALTERNATIVE INVESTMENT FUND?

An Alternative Investment Fund (AIF) is a type of investment vehicle that is distinct from traditional investment options like stocks, bonds, and mutual funds. AIFs are typically designed for sophisticated investors, both domestic and foreign, and they pool together funds to invest according to a specific investment strategy or policy. AIFs offer investors access to a wide range of alternative investments beyond the conventional asset classes.

TYPES OF AIFS

There are three main categories of AIFs in India, each with its own investment focus and regulatory framework:

1. Category I AIFs: These AIFs invest in sectors or areas that the government or regulators consider socially or economically desirable. They may invest in:

• Start-up or early-stage ventures
• Social ventures
• Small and Medium Enterprises (SMEs)
• Infrastructure projects

Examples of Category I AIFs include venture capital funds (including angel funds), SME funds, social venture funds, and infrastructure funds.

2. Category II AIFs: Category II AIFs primarily invest in equity and debt securities, and they do not fall under the Category I or III classification. These funds often focus on:

• Real estate investments
• Private equity investments
• Funds targeting distressed assets

Examples of Category II AIFs aim to provide diversification and alternative exposure to traditional asset classes.

3. Category III AIFs: Category III AIFs employ diverse or complex trading strategies, including the use of leverage, and may invest in both listed and unlisted derivatives. These funds are suitable for investors seeking exposure to more sophisticated and potentially higher-risk strategies.

Examples of Category III AIFs include hedge funds and Investment in Public Equity Funds (PIPE funds).

COMPARATIVE STUDY:

REGISTRATION PROCESS FOR AIFs:

The registration process for an Alternative Investment Fund (AIF) in India involves several steps and compliance with the regulations set forth by the Securities and Exchange Board of India (SEBI). Here is a summary of the registration process:

1. Online Application Submission: All applicants seeking registration as an AIF must submit their applications online through the SEBI Intermediary Portal. The portal’s URL for online application submission is https://siportal.sebi.gov.in.

2. Private Placement Memorandum (PPM): The Private Placement Memorandum is a critical document that provides detailed information about the AIF to prospective investors. SEBI has mandated a specific template for the PPM, which must be used. You can find the template for PPM for Category I & II AIFs at https://www.sebi.gov.in/sebi_data/commondocs/feb-2020/an_2_p.pdf and for Category III AIFs at https://www.sebi.gov.in/sebi_data/commondocs/feb-2020/an_2_p.pdf.

3. Scheme Launch and SEBI Registration: AIFs are required to launch their scheme(s) subject to filing the PPM with SEBI through a SEBI registered Merchant Banker. Additionally, a due diligence certificate should accompany the submission.

4. First Close of the Scheme: The AIF must declare the “First Close” of its scheme(s) within 12 months from the date of SEBI communication for taking the PPM of the scheme on record. The “First Close” signifies that the AIF has started attracting investors, and it must meet the minimum corpus requirement specified in the AIF Regulations for the respective category or sub-category of the AIF. This minimum corpus requirement ensures that the AIF has a sufficient pool of capital to operate effectively.

5. For Category III AIFs: In the case of open-ended schemes of Category III AIFs, the “First Close” refers to the close of their Initial Offer Period. This is when the initial subscription period for investors to participate in the AIF ends.

COMPLIANCE FRAMEWORK

To Investors: The manager is required to provide the following reports or disclosures to the investors of the AIF

 To the Trustee and Sponsor:

To SEBI: Prior Approval/Intimation to SEBI

 Direct Tax Compliances

FEMA and Other Regulatory Compliance

Constitution of Investment Committee:

• Purpose: The Investment Committee is established to approve investment decisions made by the AIF. It plays a crucial role in the decision-making process regarding the allocation of funds and investment strategies.
• Composition: The Investment Committee may include both internal members, such as employees, directors, or partners of the AIF manager, as well as external members. The committee typically consists of individuals with expertise in finance, investments, and relevant sectors.
• Function: The Investment Committee’s primary function is to review and approve investment proposals, ensuring that they align with the AIF’s defined investment policy and objectives. Their decisions are vital in managing the AIF’s portfolio effectively.

Investor Charter and Disclosure of Complaints:

• Investor Charter: The Investor Charter is a concise document that outlines important information and services provided to investors. It includes details about the grievance redressal mechanism, investors’ responsibilities, and other relevant information. The goal is to provide investors with clear and easily accessible information.
• Inclusion in PPM: AIFs are required to include the Investor Charter in the Private Placement Memorandum (PPM). By doing so, investors receive essential information about the fund’s operations and their rights in a readily understandable format.
• Transparency in Investor Grievance Redressal: AIFs are also mandated to enhance transparency in their investor grievance redressal mechanism. They are required to maintain records of investor complaints and their resolutions. This data should be compiled and disclosed as a separate chapter in the PPM.
• Reporting Frequency: AIFs should update this information regularly, with data on investor complaints and their status compiled no later than seven days after the end of each quarter. This helps investors understand how grievances are being addressed by the AIF.

ISSUANCE OF UNITS OF AIFS IN DEMATERIALISED FORM

AIFs shall issue units in dematerialized form subject to the conditions specified by SEBI from time to time.

All schemes of AIFs shall dematerialize their units in the following time frame:

Taxation of Alternative Investment Funds (AIFs):

The taxation of Alternative Investment Funds (AIFs) in India is governed by specific provisions outlined in the Income Tax Act, 1961. These provisions provide for a “pass-through” status for Category I and Category II AIFs but not for Category III AIFs. Here’s a breakdown of the tax treatment for these categories:

i. Taxation of Category I and Category II AIFs:

• • Pass-through Status: Category I and Category II AIFs that are registered with the Securities and Exchange Board of India (SEBI) enjoy a pass-through status for income tax purposes. This means that any income (other than business income) earned by the AIF is exempt from tax at the AIF level.
  • Taxation at Investor Level: Instead of being taxed at the AIF level, the income earned by Category I and Category II AIFs is directly taxable in the hands of the investors of the AIF under Section 115UB of the Income Tax Act. Investors are liable to pay tax on their share of income in the same manner as if they had made the investments directly.
  • No Dividend Distribution Tax (DDT): Category I and Category II AIFs are not liable to pay Dividend Distribution Tax (DDT) under Section 115-O of the Act on any income distributed to investors.
  • TDS by Investment Fund: The AIF is required to deduct Tax Deducted at Source (TDS) at a rate of 10% under Section 194LBB of the Act on any income distributed to investors, except for business income.
  • Treatment of Losses: In case there is a loss at the AIF level, such losses are not passed through to the investors. Instead, they are carried forward at the AIF level to be set off against future income in accordance with the provisions of the Income Tax Act.
  • Filing of Tax Return: Investment funds that operate as Category I or Category II AIFs are required to file their tax returns under Section 139(4F) of the Income Tax Act.

ii. Taxation of Category III AIFs: Category III AIFs do not enjoy pass-through status for income tax purposes. This means that the income earned by Category III AIFs, particularly under the head “Profits or gains from business or profession,” is taxed at the investment fund level. The tax obligation does not pass through to unit holders.

Income earned by Category III AIFs is subject to tax at the fund level at the marginal rate of tax applicable to such income. The taxation is similar to the taxation of regular business income in India.

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Disclaimer: This article provides general information existing at the time of preparation and we take no responsibility to update it with the subsequent changes in the law. The article is intended as a news update and Affluence Advisory neither assumes nor accepts any responsibility for any loss arising to any person acting or refraining from acting as a result of any material contained in this article. It is recommended that professional advice be taken based on specific facts and circumstances. This article does not substitute the need to refer to the original pronouncement