Background
In recent times, alternative investment funds (AIFs) are gaining popularity as an investment vehicle. As the statistics indicate AIFs have grown in terms of funds raised and the investments made by them (see graph below). The growth of the industry stands at about 7 times in the last 5 years. Looking at annual statistics, the assets under the AIF industry have grown at a rate of 38%, which surpasses the growth of the mutual fund industry, which stood at a growth rate of 22%. With the sharp rise, we see many entities entering the space – while the total number of AIFs in the year 2020 stood at 683, the same has been increased to approximately 999 funds in 2022.
As AIFs grow, the capital markets regulator has introduced various reforms in the governing laws in order to ensure that it is developed in a healthy and well-regulated manner (see brief here). In view of the aforesaid, it becomes important to analyze the entire ecosystem in which AIFs operate.
In this article, we first delve into the scope of AIFs and the intricacies of their structure. Moving on, we understand various aspects of AIF such as its classification and its taxation aspects.
Meaning
An AIF is an investment vehicle that is financed by a small pool of investors – primarily non-retail investors (Minimum investment by investors - refer here). Like other investment vehicles, a group of people come together and pool their funds to invest in accordance with a pre-defined investment strategy. The underlying idea behind this concept is akin to that of mutual funds and collective investment schemes – i.e., to pool in funds and invest towards a particular objective in order to attain high returns. However, AIFs are distinguished by the capital markets regulator from its counterparts, as the definition of AIF expressly excludes mutual funds and CIS from the scope of AIFs. An AIF is described under Regulation 2(f) of the SEBI (Alternative Investment Funds) Regulations, 2012 (‘AIF Regulations’) as follows:
From the above definition, it is evident that an AIF has the following features:
The legal structure of the AIF: In India, an AIF has to be formed as a trust/company/limited liability partnership/body corporate. The most preferred form of structure in India is that of a trust as it does not have stringent tax and regulatory requirements when compared to other structures. This distinguishes an AIF from a mutual fund - i.e., while an AIF can be incorporated in any of the aforesaid structures, a mutual fund (Refer Regulation 2(q) ) or a CIS (Refer Regulation 16) can be incorporated in the form of a trust only.
In the US, the permitted AIF structures are in the form of a limited partnership or a limited liability company. However, there are no restrictions on the legal structure of the AIF in the UK.
The AIF should be privately pooled: The AIF collects funds from a private pool of non-retail investors (discussed above). Pursuant to Regulation 10(f) of the AIF Regulations, an AIF can collect investments from at most 1000 investors. Further, the AIF is permitted to raise funds only by way of a private placement indicating investment only by a limited number of investors. The pooling of funds gives the fund a fungible nature wherein funds of all the investors are accumulated and invested towards the pre-determined investment strategy (discussed below). This distinguishes an AIF from a mutual fund and a CIS - i.e., though an AIF can avail funds only from private investors, the mutual funds or a CIS can raise funds from the public as well.
The investment policy has to be predefined: The investors are informed about the investment strategy prior to their investment in the AIF. Regulation 9 of the AIF Regulations provides that the AIFs shall state investment strategy, investment purpose, and investment methodology in its placement memorandum to the investors. The disclosure of investment strategy acts as vital information to the investors, thus contributing to efficient investment decisions. Efficient investment decisions are of great importance as they commit a significant sum to the AIF.
The AIF should not fall in the scope of a mutual fund or collective investment scheme or other restricted forms : The AIF is a residuary category, which comprises investment vehicles that are not CIS or mutual funds. Pondering upon the exceptions, the distinction has been made because the exceptions though are akin to the functioning of AIFs, they are governed by specialized legislations and are differentiated by minute differences.
How the AIF functions
An AIF incorporated in the form of trust functions in the following manner:
As seen from the above figure, an AIF typically has the following parties:
Investors or limited partners: Investors/limited partners invest in the AIF and in lieu, get the units of the AIF. Their participation in the AIF is limited to the amount of funds invested in the AIF and they do not participate in the regular functioning of the AIF, as the same is handled by the investment manager and the trustee. However, the AIF Regulations provide for certain material decisions wherein the consent of the investors is mandatory. For instance, an extension of the valuation of Category I and Category II AIFs by one year requires the approval of at least 75 percent of the investors. The participation of investors in crucial decisions ensures that the managers follow governance standards throughout the currency of the AIF, which is of extreme importance considering the restricted liquidity of the investors.
The investors may be bifurcated in the following manner:
Regular Investors: The regular investors are non-retail investors (discussed above).
Accredited Investors: The framework for accredited investors was introduced by the SEBI vide notification dated Aug 26, 2021, with a view to bring experienced and qualified investors in the AIFs’. The following criteria is to be satisfied by the accredited investors to qualify as such.
Angel Investors: The framework for investment by angel investors has been inserted vide SEBI (Alternative Investment Funds) (Amendment) Regulations, 2013 under Chapter III A of the AIF Regulations. An angel investor is only permitted to invest in angel funds (see meaning of angel funds here). The following criteria is to be satisfied by an investor to qualify as an angel investor.
Managers or general partners: The managers’ primary role is to manage and regulate the functioning of the fund. The managers make investment decisions on behalf of the investors since the latter has limited powers in the decision-making of the fund. It is noteworthy that the sponsor of the AIF may act as the manager as well.
Regulation 10(d) of the AIF Regulations requires the manager or the sponsor to maintain a continuing interest of 2.5% of the corpus or Rs. 5 crores, whichever is lower in the case of Category I and II AIF; and 5% of the corpus or Rs. 10 crore, whichever is lower in case of category III AIF. The same has been prescribed to ensure that the managers or sponsors maintain a skin in the game and make sensible investment decisions.
Trustees: A trustee acts as a steward to the fund. He acts in a fiduciary capacity, on behalf of the investors and ensures that the latter' investments are safeguarded. Essentially, his functions include supervision and oversight of the functions of the AIF.
Sponsor: The AIF is the brainchild of the sponsor. The sponsor(s) conceive the idea of the AIF and brings it to inception. As per the AIF Regulations, a “sponsor” means any person or persons who set up the Alternative Investment Fund and includes a promoter in the case of a company and a designated partner in the case of a limited liability partnership. A sponsor may act as the manager of the fund and is required to have a continuing interest in the AIF (discussed above).
Branches of AIF
The AIF Regulations bifurcate AIFs into three segments, based on the permitted investment avenues. The categories are bifurcated in the following manner:
Foreign Investments in AIF
When we talk about foreign investments in the AIF segment, we have a two-way investment i. e - the inward investments (when foreign entities invest in India) and outward investments (when Indian funds invest in overseas entities).
Inward Investment
Investments in India by persons resident outside India are primarily governed by Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules) and the respective FDI Policy. Rule 6(c) r.w. Schedule 8 to the NDI Rules provides for a framework by which persons resident outside India (other than persons or entities in Pakistan and Bangladesh) can invest in units of an investment vehicle in India.
An AIF being classified as an “investment vehicle” (meaning of investment vehicle - refer here) by virtue of Rule 2(ae) of the NDI Rules, foreign investments in the AIF will be governed by the aforesaid laws.
Pure off-shore structure
Under the pure off-shore structure, foreign investors pool money into an offshore investment vehicle. The offshore investment vehicle now invests in Indian investment avenues. The investments can be made in the form of FDI, FPI or FVCI (Distinction between FDI, FPI and FVCI - refer here).
The investment decisions made by the offshore fund are backed by advice from the offshore investment manager, who acts on the basis of advice received by the investment advisor situated in India.
In this structure, all the funds are pooled outside India i.e., the funds are not pooled in India and only the investments are made in India.
Unified Investment Structure
Under this structure, the investment in the AIF is done by both - offshore as well as onshore investors. Here, the funds are pooled at two levels - the off-shore level by collecting funds from investors globally and the on-shore level - by collecting funds from Indian residents as well as the off-shore fund.
While the on-shore investors directly invest in the AIF, the off-shore investors pool their funds in an off-shore fund, and thereafter, the off-shore fund invests in the AIF (the latter is also known as a master fund). The AIF thereafter invests in the relevant investment avenues.
Co-investment / Parallel Investment Structure
As the name indicates, under this structure, the off-shore fund as well as the on-shore fund parallelly invests in the Indian investment avenues. Usually, the investment manager in India suggests the off-shore fund of the relevant investment opportunities in which both - the off-shore and on-shore fund can invest parallelly.
Similar to the unified investment structure, the pooling of funds happens at two levels - at the on-shore level as well as the off-shore level. However, in this case, the off-shore funds do not divert their pool to the on-shore fund.
Rather, it straight-away makes investments in the Indian investment avenues without merging into the on-shore vehicle. In this way, it is similar to the first structure (pure off-shore structure).
From the above structures, we observe that the common trait of all the structures is, that the foreign investors pool their funds outside India and thereafter the investments in India are made by the investment pool located outside India. However, the distinction lies on the basis of how the investment is directed into India. Under the Pure Off-shore Structure, the fund outside India makes investments into India by FDI/FPI/FVCI while in the Unified Investment Structure, the fund outside India makes investments to the master fund instead of investing directly in Indian investment avenues. In the case of Co-investment / Parallel Investment Structure, the fund outside India directly invests in Indian avenues, however, the investment is made parallelly with the Indian fund.
Outward Investment
The SEBI had to vide circular dated October 1, 2015 introduced the framework for overseas investment by AIFs. Initially, the SEBI had allocated a blanket limit of USD 500 million for all the AIFs and Venture Capital Funds intending to make overseas investments. Further, the AIFs were only permitted to invest in companies having Indian connection, that too with a cap of maximum 25% of the investible funds of the AIF.
Later, by circulars dated July 3, 2018 and then subsequently May 21, 2021, the blanket limit was increased to USD 750 million and USD 1500 million respectively.
In a series of further liberalisation, the SEBI vide circular dated August 17, 2022 waived off the mandatory requirement of investee companies to have an Indian connection. Instead, restrictions were placed on jurisdictions of the investee companies. For instance, an AIF is permitted to invest only in an overseas investee company, which is incorporated in a country whose securities market regulator is a signatory to the International Organization of Securities Commission’s Multilateral Memorandum of Understanding (Appendix A Signatories) or a signatory to the bilateral Memorandum of Understanding with SEBI. Further, investment in investee companies incorporated in countries lacking anti-money laundering provisions was also restricted.
The progressive amendments to the ODI framework indicates the gradual opening up of domestic investment vehicles to foreign exposure. The alignment of the ODI framework with global standards and adoption of parameters like compliance with money laundering standards, as a measure of integrity of the investee companies indicates a constructive amendment to the framework. The liberalisation norms will open up productive investment avenues for the investment vehicles, which were otherwise restricted to investee companies having Indian connection. At the same time, as we see above, adequate safeguards have been laid down to ensure that the AIFs do not invest in investee companies located in nations having low credibility or make excess investments in one entity.
Taxation of AIF
Category I and Category II AIF
Incidence of tax: The taxation of the income of an investment fund (meaning of investment fund - refer here) is governed by Section 115UB of the Income Tax Act. According to the said section, Category I and II AIFs have been accorded the pass through status - i.e., any income (other than gains from business and profession (‘PGBP income’)) passing to the investors through the AIF shall not be taxed in the hands of the AIF, but the investors. Such income will be deemed to arise in the hands of the investor at the first instance and accordingly, the investors will pay the respective tax liability.
However, the pass through status is not relevant in case of PGBP income of the AIF - i.e., such income will be taxable in the hands of the AIF. Accordingly, the investors will not be required to pay the tax on such income when it is passed to the investors as it has been already taxed in the hands of the AIF.
Rate of tax: In case the AIF is in the form of a company or firm, it shall be charged as per the notified tax rates for the respective year. In other cases, the income will be charged at minimum marginal rate.
Carry-forward and set off losses: In case certain losses remain even after setting off losses from the current year’s income, then the losses will be carried forward in the following manner:
Losses will be carried forward by the investors (holding the units for a period of 12 months or more) in case the losses are from sources other than PGBP.
Losses will be carried forward by the AIF in case the losses arise from PGBP.
Earlier, the investors were not entitled to carry any losses in their books. However, vide Finance Bill, 2019, the investors were given the right to carry forward losses (other than PGBP losses) in their books and set them off in accordance with the Income Tax Act.
Category III AIFs
As we see above, a tax pass-through status to “investment vehicles” AIFs has been granted by the virtue of Section 115 UB of the Income Tax Act. However, since category III AIF is not categorised as an “investment vehicle”, it has not been granted the pass-through status i.e., the income of the AIF is taxable at the fund level and accordingly, the income is not taxable in the hands of the investors.
The taxation of the income will be determined by the structure of the AIF- as it can be organized as a trust or a company or an LLP, the tax treatment of the AIFs’ income will vary accordingly.
Stamp Duty Aspects
A framework for payment of stamp duty on issue, transfer and sale of units of an AIF was put in place by the virtue of amendments to the Indian Stamp Act vide the Finance Act, 2019 r.w. SEBI’s notification dated June 30, 2020. The stamp duty on transactions of AIF units is payable in the following manner:
Closing Thoughts
The alternative investment funds ecosystem is continuously evolving and this growth is primarily incubated by the rapid, progressive amendments in the regulatory framework for AIFs. There is a constant upgradation to address the issues faced by the operators during practical functioning. As a consequence, the investments in AIF segments steadily rise (as we have seen in the introduction to the article).
References
Minimum investment by investors - Regulation 10(c) of the AIF Regulations stipulates that the minimum investment by an investor in the AIF shall be Rs. 1 crore. The amount is reduced to Rs. 25 lakhs in case the investors are employees or directors of the Alternative Investment Fund or employees or directors of the Manager.
Meaning of angel funds - “angel fund” means a sub-category of Venture Capital Fund under Category I- Alternative Investment Fund that raises funds from angel investors and invests in accordance with the provisions of this Chapter.
Meaning of investment vehicle - “investment vehicle” means an entity registered and regulated under the regulations framed by the Securities and Exchange Board of India or any other authority designated for that purpose and shall include, namely:- (i) Real Estate Investment Trusts (REITs) governed by the Securities and Exchange Board of India (REITs) Regulations, 2014;(ii) Infrastructure Investment Trusts (InvIts) governed by the Securities and Exchange Board of India (InvIts) Regulations, 2014 (iii) Alternative Investment Funds (AIFs) governed by the Securities and Exchange Board of India (AIFs) Regulations, 2012 ;and (iv) mutual funds which invest more than fifty percent in equity governed by the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 (amendment vide Foreign Exchange Management (Non-debt Instruments) (Amendment) Rules, 2019.
Foreign Direct Investment - means investment through equity instruments by a person resident outside India in an unlisted Indian company; or in ten per cent or more of the post issue paid-up equity capital on a fully diluted basis of a listed Indian company ('Rule 2(r)');
Foreign Portfolio Investment - means any investment made by a person resident outside India through equity instruments where such investment is less than ten percent of the post issue paid-up share capital on a fully diluted basis of a listed Indian company or less than ten percent of the paid-up value of each series of equity instrument of a listed Indian company (Rule 2(t));
Foreign Venture Capital Investor - means a Foreign Venture Capital Investor incorporated and established outside India and registered with the Securities and Exchange Board of India under the Securities and Exchange Board of India (Foreign Venture Capital Investors) Regulations, 2000 (Rule 2(n));
Meaning of Investment fund under the Income Tax Act - “investment fund” means any fund established or incorporated in India in the form of a trust or a company or a limited liability partnership or a body corporate which has been granted a certificate of registration as a Category I or a Category II Alternative Investment Fund and is regulated under the Securities and Exchange Board of India (Alternative Investment Fund) Regulations, 2012, made under the Securities and Exchange Board of India Act, 1992 (15 of 1992);
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