Surat Investment：Alternative Investment Funds - Overview Of Tax Considerations

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.

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

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.

2.1. 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 theirSurat Investment

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.

3.1. 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

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

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

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

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:

Transfer before July 23,

Transfer on or after July 23,

Listed securities (including shares,

units of mutual funds but other than units of listed business

Unlisted securities (other than

debentures, bonds and shares)10

36 (thirty-six) months

24 (twenty-four) months

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:

Transfer before July 23, 2024

Transfer on or after July 23, 2024

Long-term capital gains under applicable

to NRIs (on certain specified assets)

12.5% (twelvepoint five percent)

Long-term capital gains for

non-residents on transfer on unlisted shares or securities

36 (thirty-six) months

24 (twenty-four) months

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

Long-term capital gains on transfer of

any other longterm capital asset (other than unlisted debentures or

20% (twenty percent)

12.5% (twelvepoint five)

Long-term capital gains on transfer of

unlisted debentures or bonds (now deemed short-term capital

20% (twenty percent)

Applicable tax rates

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)

Other short term capital gains

Applicable tax rates

Applicable tax rates

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 complexChennai Stock

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.

3. Defined in Regulation 2(b) of AIF

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

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

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

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

The content of this article is intended to provide a general

guide to the subject matter. Specialist advice should be sought

about your specific circumstances.

Varanasi Wealth Management