All You Need to Know About Category-II AIF

Margesh Rai

15 Jul, 2024

If you want to expand your portfolio beyond standard stocks and bonds, Alternative Investment Funds (AIFs) are a great option. SEBI has classified these funds into three groups: Category I, Category II, and Category III.

Out of these to know about Category-II AIF stands out as a top pick for investors seeking to take advantage of non-traditional market opportunities. While Category-I AIFs are motivated by specific social or economic objectives, and Category-III AIFs are known for their focus on quick and high-risk investments, Category-II AIFs provide a balance between the two. They do not receive particular incentives or concessions but are also not as actively speculative as Category-III funds.

Discovering Category II AIFs: Your Ultimate Insight

SEBI categorizes AIFs as Category-II if they do not fit into Category-I or III, and do not use leverage or borrowing except for operational expenses.

Unlike Category-I AIFs, these funds do not receive any particular government incentives or benefits. They function under regular market conditions with no specific advantages. Category-II AIFs possess a moderate level of risk and have a predetermined duration lasting anywhere from a few years to ten years.

Within Category-II AIFs, it is possible to invest in a range of different asset categories, such as:

· Private Equity Funds

These funds usually invest in private companies that are not listed on the stock exchange to make money through future exits, such as initial public offerings, repurchases, or selling to other investors. Private equity funds offer the possibility of greater profits but also involve greater risks and require longer time commitments for investments.

· Fund of Funds

Rather than directly investing in stocks, bonds, or other securities, the fund of funds (FoF) invests in various other AIFs. It doesn’t possess its investment portfolio but places investments in a portfolio comprising other investment funds. However, it should be noted that while FOFs under mutual funds issue units publicly, FOFs of AIFs do not.

· Debt Funds

Category-II AIFs specialising in debt funds predominantly invest in debt securities issued by unlisted companies. This can include bonds, debentures, and other types of fixed-income investments. These funds usually provide more consistent returns than funds focused on stocks and are appropriate for investors with less risk tolerance.

Key Investment Limits for Category-II: Maximize Returns

Although Category II AIFs provide various investment possibilities, they also have specific limitations set by SEBI to guarantee investors’ safety.

Below are some of the main investment limitations for Category II AIFs:

1. The new policy will be implemented next month. Investments in this class should be limited to securities that are not listed. This aligns with the fund’s goal of exploring non-traditional investment options outside the traditional stock market.
2. These funds are limited to borrowing money for short-term needs only. Borrowing is limited to 30 days and up to 4 times per year. Also, the amount that is borrowed cannot exceed 10% of the funds available for investment.
3. The children ran excitedly towards the playground. These funds can avoid Insider Trading Regulations by investing in SMEs on the SME Exchange and retaining the securities for at least one year.
4. The dog ran quickly across the field. Category II AIFs can hedge their investments and participate in an IPO by agreeing with the merchant banker to invest in any remaining unsubscribed portion.

Category II AIF Taxation: Strategic Financial Insights

Category II Alternative Investment Fund has a pass-through designation. This indicates that the fund’s income is not subject to taxation at the fund level but instead is transferred to the investor. The investor will be taxed based on their tax bracket and the type of income they receive. The Fund is responsible for deducting 10% tax (TDS) for residents and full tax for NRIs (except beneficial jurisdiction).

The Fund is not responsible for paying taxes at the Fund level; Investors must pay taxes on their share of Fund income after the Fund withholds taxes, according to the applicable rates.

Below is the taxation level for investors:

· Short-term Capital Gains

Typically, listed shares, bonds or debentures are taxed at 15% according to the investor’s tax bracket.

· Long-term Capital Gains

A 10% tax rate applies to publicly traded shares, bonds, and debentures, while unlisted securities are taxed at a rate of 20%.

Conclusion

Category-II Alternative Investment Funds provide a distinct and varied opportunity for investors seeking to explore options beyond conventional investment. The wide variety of funds in this category allows for the successful diversification of portfolios and customized investment tactics.

FAQ’s