1. INTRODUCTION
1.1. India has emerged as the fastest-growing major economy in the world and is projected to become one of the top three economic powers within the next 10 (ten) to 15 (fifteen) years. This transformation is reinforced by a robust democratic framework and strong international partnerships. Amid global unpredictability and volatility, India's appeal as an investment destination has significantly strengthened. This is evidenced by the record amounts raised by India-focused funds in 2022, reflecting growing investor confidence in the "Invest in India" narrative.1 Mr. Shaktikanta Das, Governor of Reserve Bank of India ("RBI") had projected India's growth potential to be over 7.5% (seven-point five percent), slightly higher than the RBI's current estimate of 7.2% (seven-point two percent) growth for financial year 2024-2025. 2
1.2. Alternative Investment Funds ("AIFs") play a crucial role in driving capital formation in the Indian economy, supporting infrastructure development, and nurturing startups, thereby contributing to overall economic growth. In recent years, AIFs have become an important asset class, attracting domestic and global investors seeking diversified investment options in India beyond traditional stocks and bonds. These funds encompass a wide range of investment strategies, presenting both unique opportunities and challenges. The regulatory framework established by the Securities and Exchange Board of India ("SEBI") aims to strike a balance between facilitating market growth and ensuring investor protection.
1.3. This Info Alert, being first in a series of alert on AIFs, seeks to summarise key tax considerations for each of the three categories of AIFs in India.
2. WHAT ARE AIFS AND THEIR REGULATORY FRAMEWORK
2.1. Definition of AIF AIF means3 any fund established or incorporated in India in the form of a trust or a company or a limited partnership firm or a body corporate which is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefits of its investor and registered with SEBI under Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 ("AIF Regulations").
2.2. Fundraising Mechanism and Investment Structure AIFs can raise capital from investors whether resident or non-resident (subject to applicable regulatory framework), typically by way of issuance of units through private placement facilitated by an information memorandum or private placement memorandum. An AIF may launch schemes, subject to filing of private placement memorandum, before the SEBI. All AIFs and their schemes shall state their investment strategy, investment purpose and its investment methodology in its placement memorandum.
The minimum corpus for each AIF scheme is set at INR 200 million (Indian National Rupees Two Hundred Million), except for angel funds and social impact funds. Each AIF scheme can accommodate up to 1,000 (one thousand) investors, except for angel funds, which are limited to 200 (two hundred) investors. The minimum investment required from investors is INR 10 million (Indian National Rupees Ten Million), though employees or directors of the investment manager of the AIF or the AIF must invest a minimum of INR 2.5 million (Indian National Rupees Two Point Five Million). For social impact funds that invest in not-for-profit organizations registered or listed on a social stock exchange, the minimum investment from an individual investor is INR 0.2 million (Indian National Rupees Zero Point Two Million).
2.3. Categories of AIF
As per AIF Regulations, AIF shall seek registration in one of the three following categories:
(a) Category I ("CAT-I") AIF4 which invests in start-up or early-stage ventures or social ventures or social and medium enterprises ("SMEs") or infrastructure or other sectors or areas deemed socially or economically desirable by the government or regulators. This category shall include venture capital funds, SME funds, social impact funds, infrastructure funds, special situation funds, and such other AIFs as may be specified. CAT-I AIFs are closed-end funds with a minimum tenure of 3 (three) years.
(b) Category II ("CAT-II") AIF5 which does not fall in Category I and III and does not undertake leverage or borrowing other than to meet day-to-day operational requirements and as permitted in AIF regulations. Examples include private equity funds and debt funds, which are not entitled to specific incentives or concessions from the government or regulators. CAT-II AIFs are also closed-end funds with a minimum tenure of 3 (three) years.
(c) Category III ("CAT III") AIF6 which employs diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. This category encompasses hedge funds and funds aimed at generating short-term returns. CAT-III AIFs can be either open-ended or closed-ended and are not eligible for specific government incentives or concessions.
3. TAXATION OF AN AIF
3.1. Taxation of CAT-I and CAT II AIF
3.1.1. Taxability of income other than business income of CAT- I and CAT II AIF
The Income-tax Act, 1961 ("the Act") vide Finance Act 2015, granted tax pass-through status7 to SEBIregistered CAT-I and CAT-II AIFs for income that is not categorized under the head "profits and gains from business or profession" (i.e., business income). According to Section 115UB of the Act, income other than business income accruing or arisen to, or received by, a person, being an investor, out of investment made in AIF, is taxable in the hands of the investors in the same manner as it were the income accruing or arising to, or received by, investors had the investments, made by the said AIFs, been directly made by the investors. In other words, the income paid or credited or deemed to be credited by such CAT-I and CATII AIFs shall be deemed to be of the same nature and in the same proportion in the hands of the investors as if it had been received by, or had accrued or arisen to, such AIFs.
Further, any loss other than business loss arising at AIFs level shall be allowed to be passed through to the investors, provided the units of such AIFs are held for a period of twelve months or more. CAT-I and CATII AIFs are also required to withhold tax from the payment of income other than business income to the investors at the rate of 10% (ten percent) in case of resident investors and at the rate in force in case of nonresident investors in accordance with the provision of Section 194LBB of the Act (i.e., after considering tax treaty benefits, if any).
3.1.2. Taxability of business income of a CAT- I and CAT II AIF
In instances where the income of the CAT I or CAT II AIF is characterized as "business income", such income should be taxable (on a net basis) in the hands of the AIF as per applicable rates if it is structured as a Company or a Firm. If the AIF is structured as a trust, the business income will be taxable at the maximum marginal rate i.e. 42.744%8 (forty-two point seven four four percent) on a net basis. Tax pass through is not available to AIF in respect of business income. Business losses, if any, can be carried forward by the AIF for offset against future business income for a period of 8 (eight) years. Since the business income is taxed in the hands of AIFs, such business income is thereafter treated as exempt in the hands of investors, effectively ensuring that the business income is not taxed twice.
3.2. Taxation of CAT-III AIF
While there is a specific tax framework for CAT-I and CAT-II AIFs, a similar tax framework does not exist for CAT III AIFs. The income of the CAT III AIF is taxable as such and there is no pass-through status available. The tax liability for CAT-III AIF is based on the applicable rates corresponding to their constitution and the nature of the income.
Since CAT-III AIF does not have pass-through status, these AIFs are usually structured as a trust. Taxation of (such) trust and beneficiaries is based provisions contained in Section 161 to 164 of the Act (as it typically applies to family trusts). Under the Act, trust is not treated as a separate taxable entity. Where the trust is specific and determinate trust (i.e., where beneficiaries are identifiable with their share being determinate), the income of the trust is assessed in the hands of trustee, as a representative assessee, in a like manner and to the same extent as it would be assessable in the hands of person represented by them, that is, beneficiaries. This ensures that benefits available to beneficiaries (such as a tax treaty exemption) will continue to be available, even though the trustee is assessed albeit in a representative capacity.
Any distribution of income by CAT-III AIF established in the form of a company or a partnership firm is taxable in the hands of investors in accordance with the applicable provision of the Act9.
3.3. Characterization of income of an AIF
3.3.1. Taxation of income generated by an AIF depends upon the characterization of income. Gain arising from the transfer of securities held in the portfolio companies may be classified as 'capital gains' or as 'business income', depending upon whether such security was held as capital asset or trading asset, that is, stock in trade. The issue of characterization of gain or loss (whether taxable as business income or capital gains) has been subject matter of litigation with the tax authorities.
3.3.2. Central Board of Direct Taxes ("CBDT"), the apex tax administrative body, has laid down the following guidance:
(a) CBDT Circular No. 6/2016 dated February 20, 2016: This circular provides that listed shares or securities held for more than 12 (twelve) months would be treated as capital gains unless the taxpayer itself treats the same as stock in trade. The aforesaid circular also provides that a position once adopted by the taxpayer would not be allowed to be changed and it would be applicable for the subsequent years. It is however clarified that the principle as outlined in the circular shall not be applicable in cases where genuineness of transactions itself is questionable.
(b) CBDT Instruction dated May 02, 2016: Regarding the characterization of gains from the transfer of unlisted shares, the CBDT instruction (dated May 02, 2016) provides that that income from unlisted shares (for which no formal market exists for trading) shall be treated as capital gains income, except in certain specified circumstances such as: (i) the genuineness of transactions in unlisted shares itself is questionable; or (ii) the transfer of unlisted shares is related to an issue pertaining to lifting of corporate veil; or (iii) the transfer of unlisted shares is made along with the control and management of underlying business.
(c) CBDT Circular dated January 24, 2017: In this circular, the CBDT clarified that the exception provided CBDT instruction dated May 2, 2016, in clause (iii) (regarding transfer of unlisted shares along with control and management of the underlying business), would not apply in the case of CAT-I and CATII AIFs. CBDT clarified this point on the basis that the investment by AIFs is predominantly in the unlisted shares of ventures, many of which are new set-ups or start-ups, and thus, some form of 'control and management of the underlying business' may be required to be exercised by such AIFs to safeguard the interest of the investors.
3.3.3. The characterization of income depends on the cumulative effect of all relevant criteria as applied to the specific facts of each case; and hence, should be closed assessed on an annual basis.
4. KEY AMENDEMENDS MADE BY THE FINANCE (NO. 2) ACT, 2024 ("the FA 2024")
There have been significant amendments made by the FA 2024 with respect to capital gain tax which affect the tax outflow both in the hands of the investors and the AIFs. Some of the key amendments have been discussed as under:
4.1. Capital gain arising on sale of securities:
4.1.1. In accordance with the applicable provision of the Act, taxability of capital gains in the hands of AIF or investors depends upon the nature of securities and period of holding. In order to rationalize and simplify the capital gain tax regime, the FA 2024 has reduced the number of holding periods used for classification of a capital asset as long-term or short-term from three to two. The amended applicable provisions with respect to holding period are tabulated as under:
| S.No | Nature of capital asset | Transfer before July 23, 2024 | Transfer on or after July 23, 2024 |
|---|---|---|---|
| 1. | Listed securities (including shares, units of mutual funds but other than units of listed business trust) | 12 (twelve) months | 12 (twelve) months |
| 2. | Unlisted securities (other than debentures, bonds and shares)10 | 36 (thirty-six) months | 24 (twenty-four) months |
| 3. | Unlisted shares | 24 (twenty-four) months | 24 (twenty-four) months |
4.1.2. Additionally, the capital gain tax rates with respect to both long term and short-term capital assets have been changed. The tax rates11 applicable on short-term capital gains and long-term capital gains, are tabulated as under:
| S.No | Nature of gains | Transfer before July 23, 2024 | Transfer on or after July 23, 2024 |
|---|---|---|---|
| 1. | Long-term capital gains under applicable to NRIs (on certain specified assets) | 10% (ten percent) | 12.5% (twelvepoint five percent) |
| 2. | Long-term capital gains for non-residents on transfer on unlisted shares or securities | 36 (thirty-six) months | 24 (twenty-four) months |
| 3. | Long-term capital gains on transfer on listed equity share or unit of an equity-oriented fund or unit of business trust (subject to securities transaction tax) | 10% (ten percent) [in excess of INR 0.1 million (Indian National Rupees Zero Point One Million )] | 12.5% (twelvepoint five percent) [in excess of INR 0.125 million (Indian National Rupees Zero Point One Two Five Million)] |
| 4. | Long-term capital gains on transfer of any other longterm capital asset (other than unlisted debentures or bonds) | 20% (twenty percent) | 12.5% (twelvepoint five) |
| 5. | Long-term capital gains on transfer of unlisted debentures or bonds (now deemed short-term capital gains) | 20% (twenty percent) | Applicable tax rates |
| 6. | Short-term capital gains on transfer on listed equity share or unit of an equity-oriented fund or a unit of business trust (subject to securities transaction tax) | 15% (fifteen percent) | 20% (twenty percent) |
| 7. | Other short term capital gains | Applicable tax rates | Applicable tax rates |
5. CONCLUSION
As India continues to strengthen its position as a leading investment destination, AIFs will play an increasingly pivotal role in shaping the future of capital formation and economic development. As AIFs gain prominence, understanding tax implications and possible fund / investment structures is crucial for fund managers and investors looking to navigate this complex terrain.
The significant amendments introduced by the FA 2024, particularly regarding capital gains tax, underscore the government's commitment to simplifying the investment process and enhancing clarity in tax obligations.
In the next series of Info Alerts, we will cover tax aspects of carried interest and certain key tax considerations for setting up funds in GIFT City12.
Footnotes
1. https://www.ibef.org/economy/indian-economy-overview
2. https://www.ibef.org/news/india-s-growth-potential-is-above-7-5-rbi-governor-mr-shaktikanta-das
3. Defined in Regulation 2(b) of AIF Regulations
4. Regulation 4(a) of AIF Regulations
5. Regulation 4(b) of AIF Regulations
6. Regulation 4(c) of AIF Regulations
7. Section 10(23FBA) read with Section 115UB of the Act
8. As per Finance Act 2024, in case of individual, association of person, body of individuals, Hindu undivided family and artificial juridical persons, subject to tax as per lower slab rates prescribed under section 115BAC of the Act, the rate of surcharge applicable on the amount of income-tax shall not exceed 25% (twenty five percent) and consequently, the highest tax rate applicable to such person could be considered 39.00% (thirty nine percent)
9. As per Section 10(2A) of the Act, share of partner in the total income of the partnership firm or limited liability partnership firm is exempt in the hands of partner, subject to prescribed limit.
10. Gains arising from transfer of unlisted debentures or bonds treated as "short term capital gains" even if the period of holding is more than 24 months.
11. Plus, applicable surcharge and cess
12. Gujarat International Finance Tec-Cit
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