The past few months have been a period of significant change for Alternative Investment Funds (AIFs). Amongst others, the regulatory landscape governing funds has been greatly reformed by the introduction of four major reforms, which have been introduced by the Securities and Exchange Board of India (SEBI), the Bombay Stock Exchange and the National Stock Exchange (collectively, Stock Exchanges) and the Central Board of Direct Taxes, Government of India (CBDT). The rapid pace of reformation in the field has been largely brought out by the release of recommendations suggested by the Alternative Investment Policy Advisory Committee (AIPAC), which was constituted by SEBI for this very purpose. After its first report led to an overhaul of the angel funds regime, amongst others, the second report, released in December 2016, has culminated in a wider set of reforms in 2017, which have been implemented not only by SEBI, but by other regulatory bodies as well.

Accordingly, we have summarised the key regulatory and tax updates relevant to the AIF regime, along with our analysis, in the following four sections:

Category III AIFs and Commodity Derivatives

SEBI Circular

On 21 June 2017, SEBI vide its circular on 'Participation of Category III Alternative Investment Funds (AIFs) in the Commodity Derivatives Market' permitted Category III AIFs to participate in all commodity derivatives products that are traded on commodity derivatives exchanges in India, thus opening up the market to institutional investors. Category III AIFs will be treated as 'clients' and hence, will be subject to all regulations applicable to clients on commodity derivative exchanges.

The SEBI circular reiterates certain conditions that are already applicable to Category III AIFs under the SEBI (AIF) Regulations, 2012 (AIF Regulations). Thus, when participating in commodity derivative products that are traded on commodity derivatives exchanges in India, Category III AIFs may engage in leverage or borrow, subject to consent from the investors in the fund and subject to a maximum limit specified by SEBI. Further, no more than 10% of the investable funds of such Category III AIFs can be invested in 1 (one) underlying commodity.

Requirement to Give Exit Opportunity to Dissenting Investor

Category III AIFs will also be required to make disclosure(s) in the private placement memorandum (PPM) issued to investors about investment in commodity derivatives. If the existing Category III AIFs intend to invest in commodity derivatives, they shall seek consent of existing investor(s) and they are mandated to provide exit opportunity to dissenting investor(s).

In the past also, SEBI had notified (vide Circular dated 19 June 2014) the requirement to provide exit opportunity to dissenting investors in case of material changes to PPM. However, based on market inputs, SEBI had subsequently (vide Circular dated 18 July 2014) provided an exemption from offering exit to dissenting investor in certain cases, i.e. if the change is approved by 75% of unit holders by value of their investment in AIF. However, this exemption does not appear to have been extended to investment in commodity derivatives by existing Category III AIFs, even though past experience shows that the market prefers such an exit option to be available to it.


SEBI had cited reasons of lack of desired liquidity and depth for efficient price discovery and price risk management for this regulatory change. It also hopes that deepening the market for hedgers will help reduce the risks of defaults and volatility. This is a welcome move for market participants as it can be expected that institutional participation will make the markets more reliable and in line with the goals of SEBI, the commodity derivatives market may be opened further for other institutional investors such as mutual funds and Foreign Portfolio Investors (FPIs).

This step taken to permit Category III AIFs to invest in the commodity derivatives market is also one of the crucial steps towards further integration of the commodities market with the securities market from the financial investor perspective, ever since SEBI subsumed the role of the Forward Markets Commission in India. This change will surely usher into the commodities market an institutional platform which it had lacked for all these years. This move will also help expand the bouquet of products offered by managers to investors.

As of date, almost all Category III AIFs have foreign investment in them, including investment by Non-Resident Indians (NRIs). Given that as per Schedule 11 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (TISPRO Regulations), a Category III AIF with foreign investment is permitted to make portfolio investment in only those securities or instruments in which a Registered FPI is allowed to invest under the TISPRO Regulations, the SEBI Circular permitting Category III AIFs to invest in commodity derivatives is a non-starter, as currently, FPIs are not permitted to invest in commodity derivatives.

In addition to the above, a number of other reforms are required to ease the norms governing Category III AIFs. For instance, while 'Fund of Funds' (FoF) structure is available to Category III AIFs, such FoF structures may invest only in units of Category I and Category II AIFs. This limits the scope of a FoF registered as a Category III AIF by a huge margin. Accordingly, this restriction ought to be done away with, as it will help such FoF structures invest in Category III AIFs and diversify risk.

Moreover, unlike Category I and Category II AIFs, Category III AIFs have not been given a tax pass-through status, thus making it less attractive to fund managers and investors as opposed to the other two categories. We hope that in line with the increasing liberalisation of the AIF regime this year, measures to implement these much-needed reforms will also be undertaken in the coming months of 2017.

Category II AIFs and one-year lock-in on Share Capital post-IPOs


Currently, Regulation 37 of the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2009 (ICDR Regulations) mandates a one-year lock-in period for the entire pre-issue capital held by non-promoters in case of initial public offers (IPOs). Employee stock option/purchase schemes and venture capital funds were exempted from the one‑year lock-in period of equity shares in case of initial public offerings. With the AIF Regulations replacing the erstwhile SEBI (Venture Capital Funds) Regulations 1996 in 2012, SEBI also included Category I AIFs in this exemption. Therefore, in cases of IPOs, the entire pre-issue capital held by Category I AIFs, venture capital funds and foreign venture capital investors is not subject to the lock-in period of 1 (one) year, provided that such equity shares are held for a period of at least 12 (twelve) months from the date of purchase by the Category I AIF, venture capital fund or foreign venture capital investor.

Approved Change

In a Board Meeting held on 21 June 2017 (Board Meeting), SEBI approved a proposal to extend this exemption to Category II AIFs, citing reasons of uniformity, ease of business and expanding the investor base available for raising capital. Once this amendment to the ICDR Regulations is notified, Category II AIFs will also be able to freely trade equity shares within the one-year period right after the IPO.


The proposed change, while not implemented yet, has brought a lot of cheer to Category II AIFs. A majority of companies at the pre-IPO stage across the world are backed by private equity (i.e. Category II AIFs). Thus, the relaxation of the lock-in period will facilitate time-bound exits and allow more flexibility, raising greater capital for pre-IPO stage stocks. These attractive terms of investment will help incentivise private equity investors to go through the funds route for investing in IPOs, as opposed to direct investment. This may result in more investment into private equity funds, and also increase returns for the funds from their investments in pre-IPO stage stocks.

Listing Guidelines for AIFs


The AIF Regulations provide flexibility for a close-ended AIF to list its units after the final close of the fund or scheme, subject to a minimum tradeable lot of INR 1,00,00,000 (Rupees One crore). In consideration of the aforementioned flexibility of close-ended AIFs to list, the Stock Exchanges, on their websites, recently set out the process and procedures to be followed for listing of units of a close-ended AIF.

Regulatory change, Process and Documentation

Recently, the Stock Exchanges, in pursuance of the permission provided under the AIF Regulations to list their units, released a set of listing guidelines for such AIF units. The process set out by the Stock Exchanges involves 2 (two) steps:

  1. Obtaining in-principle approval of Stock Exchanges for listing of units by an AIF; and
  2. Listing and trading of units.

The Stock Exchanges require AIFs to submit a certified true copy of certain set of documentation during the in-principle approval process and during the listing of units which are, inter alia, set out below.

For In-principle approval

listing and trading
(post allotment)

Draft copy of information / private placement memorandum (PPM)

Investment Management Agreement

Registration details of AIF

Trust Deed/MoA & AOA

Resolution passed by trustee / Board of directors / partners (as the case may be) approving listing of units of AIF.

An undertaking from the CEO/ compliance officer that AIF is in compliance with AIF Regulations.

Any other document as requested by the exchange

Custodian Agreement / Registrar & Transfer Agent (RTA) Agreement

Letter of Application for listing of units

Details of the applicant, copy of observations received from SEBI on the placement memorandum

Final PPM

Unitholding pattern of Unitholders of the Scheme

Confirmation from the CEO / compliance officer regarding allotment of units and the actual no. of units allotted

Statement of collection details

Confirmation from CEO / compliance officer regarding compliance with the provisions of AIF Regulations.

Confirmation from NSDL and CDSL (ISIN activation)

Confirmation from RTA on the final number of units to be allotted with NSDL, CDSL and under physical form


It remains to be seen if the AIF listing guidelines will be adopted by AIFs with much gusto, going by the experience of venture capital funds under the erstwhile SEBI (Venture Capital Funds) Regulations, 1996 (VCF Regulations). Under the VCF Regulations, the listing guidelines provided received a lukewarm response from the funds industry, such that till date, there is not even one venture capital fund which is listed on a stock exchange in India. This was primarily due to the fact that investors were unsure of the creation of liquidity through the listing of their units, and absence of any definitive guidelines for listing. However, given the large number of AIFs that have been set up since the notification of the AIF Regulations in 2012, alongside the number and variety of products that are being offered by them, the AIF listing guidelines is a great move towards developing a secondary market for such products, and hence, will per se support and strengthen the evolution of the AIF regime in India.

Amendment to Section 10(38) of the Income Tax Act, 1961


Until 31 March 2017, long-term capital gains arising on the transfer of listed equity shares were exempt from tax in India under section 10(38) of the Income Tax Act, 1961 (ITA) if such transfer was undertaken on a recognized stock exchange and Securities Transaction Tax (STT) was paid on the same.

However, this exemption was being abused by many, such that unaccounted income was declared as exempt long-term capital gains by entering into sham transactions. Accordingly, in order to prevent such misuse, the Finance Act, 2017 amended Section 10(38) with effect from 1 April 2017, to limit the benefit of this provision to transactions where STT was also paid at the time of acquisition of the shares sought to be transferred, provided such shares were acquired on or after 1 October 2004, subject to certain exemptions as may be prescribed (Amendment).

To protect genuine cases, it was clarified that the Indian Government would notify those acquisitions to which the Amendment shall not apply.

The CBDT Notification

The CBDT notification dated 5 June 2017 ( Notification) sets out a negative list and provides that except for certain transactions of acquisition of equity shares (entered on or after 1 October 2004) which are covered in that list, the acquisition of shares under all other transactions which did not result in payment of STT at the time of acquisition, would be eligible for the long-term capital gains tax exemption, provided STT was paid at the time of transfer of such shares. The Notification provides, inter alia, that acquisition of listed equity shares by a Category I AIF, Category II AIF or venture capital fund (as defined under the ITA) will be exempt from the requirement of having paid the STT at the time of acquisition of listed shares of a company, to be able to avail the long-term capital gains tax exemption under Section 10(38). The Notification has come into force with effect from 1 April 2017.


The Notification has brought much needed cheer to Category I and Category II AIFs, as it ensures that they can avail the capital gains tax exemption under Section 10(38) and are not subject to tax on long-term capital gains due to non-payment of STT at the time of acquisition of such listed shares. It was realised by the Government, upon urging by stakeholders, that given the nature of Category I and Category II AIFs, wherein they invest primarily in unlisted securities (i.e. at least 51%) as per the AIF Regulations, STT would not have been paid when shares held by such Category I and Category II AIFs are sold/transferred on the Stock Exchanges. Such a case, wherein STT has not been paid, was due to circumstances arising from the nature of the AIF Regulations and hence, should not come under the ambit of transactions where Section 10(38) was abused.

While it has been a favourable Amendment for Category I and Category II AIFs, Category III AIFs have been given the step-motherly treatment by not being included in the Notification alongside Category I AIFs and Category II AIFs. This is a huge disincentive for fund managers hoping to set up a Category III AIF in India, as it disentitles Category III AIFs from claiming long term capital gains tax exemption under Section 10(38) unless such Category III AIF has paid STT at the time of acquisition of shares, as opposed to Category I and Category II AIFs.

Amendment in rules for valuation of unquoted equity shares


Section 56(2) of the ITA provides that the difference between the Fair Market Value (FMV) and the consideration paid/payable, would be regarded as income from other sources in the hands of the recipient. Such income is taxed at the tax rate applicable to the recipient on its ordinary income. The Finance Act 2017, had introduced section 50CA of the ITA, to tax the seller of an unquoted equity share on the fair market value on a deemed basis, where the sale consideration was less than the FMV.

In this regard, Rule 11UA of the Income-tax Rules, 1962 (IT Rules) provided the mechanism to arrive at the FMV for unquoted equity shares, which was based on the book value of net assets of the company, the shares of which were transferred. The CBDT has recently amended the rules for valuation of unquoted equity shares with effect from 1 April 2017 (Amended Valuation Rules). The Amended Valuation Rules apply to valuation under both section 56 and section 50CA of the ITA.

As per the Amended Valuation Rules, the value of an equity share shall depend on the asset composition of the target company and is to be computed basis, inter alia: (a) stamp duty value of immovable property; (b) fair value of shares and securities, artwork, paintings, jewellery; and (c) book value of other assets (subject to prescribed adjustments), owned by the target. Further, such valuation is required to be carried out on the basis of audited financial statements of the target company, as on the date of transfer of the shares.


It needs to be seen whether the sale consideration agreed between by the PE investor for unquoted equity shares met the FMV test under the Amended Valuation Rules for unquoted shares transferred between 1 April 2017 and 13 July 2017 (the date on which the Amended Valuation Rules were notified) and transfer of unquoted shares going forward. It is vital that the sale consideration meets the FMV as per the Amended Valuation Rules since the difference between the FMV (determined in accordance with the Amended Valuation Rules) and the sale consideration would be taxable in the hands of the purchaser at the applicable slab rate, which would be 40% (plus applicable surcharge and cess) if the purchaser is a foreign company. Also, the seller would be taxable on the FMV of such shares on deemed basis under Section 50CA of the ITA, where the sale consideration is less than the FMV.

Though the rules require the valuation to be as on the date of transfer, however, if this is not practically feasible, the valuation may be carried out based on the latest available financial statements with factual confirmations from management that no significant changes have taken place in such values.

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