AIF Registration

Foreign Investments in Category III Alternative Investment Funds

Foreign Investments in Category III

The industry of Alternative Investment Funds (AIF) has skyrocketed in a matter of few years despite it being in its early stages. AIFs has significantly impacted the Indian market and has gained tremendous significance. AIFs are privately pooled investment vehicles that invest funds of high-net-worth individuals majorly from foreign countries, as per the specified investment policy. In India, AIFs can be established in the form of a company, an LLP, a trust or a body corporate. AIFs are only governed under the Securities Exchange Board of India (Alternative Investment Fund) Regulations, 2012. The Regulation prescribes three categories of AIFs namely; Category I, Category II and Category III. Each category has a different impact on the economy. Where Category I has the tendency of positive spill over effect on the economy, Category II tends to give rise to negative externality as it undertakes leverage and also because trading under this category is done to make short-term returns. Further, Category III funds employ diverse and complex trading strategies to trade in securities having diverse risks.

Earlier investments in AIF were limited only to Indians. Foreign Investments were limited only to venture capital funds (VCFs) that to when such VCFs were structured as trust and approval was granted by the Foreign Investment Promotion Board (FIPB) on a case-to-case basis. In addition to this foreign investments were also subject to the applicable Foreign Direct Investment (FDI) Regulations. As per the FDI Regulations, venture capital funds were not permitted to directly invest in the e-commerce sector. However, by way of amendment to the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India), 2015 and Foreign Exchange Management (Permissible Capital Account Transactions) (Fourth Amendment) Regulations, 2015 issued by the Reserve Bank of India (RBI), foreign investments were allowed in AIFs under the automatic route.

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Eligibility criteria for making foreign investments in Category III AIFs

  1. Should be registered as a Foreign Portfolio Investors
  2. Person should be resident outside India
  3. Non-Resident Indian (NRI) or an overseas citizen of India (OCI) subject to the conditions prescribed.
  4. Resident Indians other than individuals can also invest in Category III AIF if the contribution of such residents is up to 5% of the corpus of the applicant or USD 15,00,000, whichever is lower.
  5. Should be a resident of a country who is a signatory to the International Organization of Securities Commission MOU or a signatory to bilateral MOU with SEBI.
  6. The applicant should not be a resident of a country identified under the public statement of the Financial Action Task Force of that country to have deficiencies in its Anti-Money Laundering laws or a country that has not made sufficient progress in addressing such deficiencies.
  7. The applicant should be fit and proper;
  8. The applicant must satisfy any other criteria as may be prescribed by SEBI from time to time.
  9. If the investor subsequently fails to meet the conditions prescribed then the manager of AIF shall prevent such investor to make further capital contribution until the investor meets the conditions again.

Even the extent of foreign investment in the corpus of the AIF is no longer a determining factor whether the investment constitutes foreign investment or not. This implies that in the current scenario, an AIF or scheme of AIF in India can have a majority or even entirely foreign investment and still purchase businesses where foreign ownership is restricted. The funds will be considered domestic as long as the sponsors and managers are Indians. So what matters is that ownership and control should be with Indian sponsors and managers whereas the investment in AIF can solely be made by foreign investors. AIFs with foreign investments are allowed to invest in all sectors as there are no bars or sectoral restrictions imposed under the FDI rules. Even investments in sectors such as e-commerce, insurance, retail, defence, etc which were earlier restricted have now been permitted to make investments.

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Foreign Investment in Category III AIF

When it comes to Category III AIF, it has made less progress as compared to Category I and II AIF. This is possibly because foreign investments are allowed to make portfolio investments only in such securities which are registered Foreign Portfolio Investor (FPI) are permitted to invest. Hence, to understand the foreign investment opportunities under Category III AIF, it is imperative to understand the investment options available to registered FPIs. To understand the type of instruments in which registered FPIs can invest, we need to look at Regulation 20 (1) of the SEBI (Foreign Portfolio Investors) Regulations, 2019[1] (FPI Regulations) which provides the types of instruments in which registered FPIs can invest which are as follows:

  1. Shares, debentures and warrants issued by a body corporate either in listed or to be listed on a recognized stock exchange in India;
  2. Units of schemes launched by mutual funds;
  3. Units of schemes floated by a Collective Investment Scheme;
  4. Derivatives traded on a recognized stock exchange;
  5. Units of real estate investment trusts, infrastructure investment trusts and units of Category III AIF registered with SEBI;
  6. Indian Depository Receipts;
  7. Any debt securities or instruments permitted by RBI from time to time;
  8. Any other instrument as specified by SEBI from time to time.

RBI’s move to encourage foreign investments in Category III AIFs

RBI issued a circular dated 21st April 2016 extending foreign investments in instruments for registered FPIs which include unlisted debt securities as well. Registered FPIs are allowed to invest in primary issuances by public companies of unlisted non-convertible debentures thereby extending investment opportunities available to Category III AIFs with foreign investments.

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Tax liability of Category III AIFs

Tax liability for foreign Investments in Category III AIFs is borne by the AIF itself and not by the investor as in the case of Category I and II AIFs. Category I and II AIFs have been accorded the tax ‘pass-through’ status which shifts the burden of tax from the fund to the investor. The impact of this is that in Category III AIF, the fund is not exempt from tax unlike in Category I and II where the income of the investment fund is exempt from tax and is chargeable to income tax in the hands of the unit-holder as if the investment was directly made by the unit holder. This is another reason that has impaired the development of Category III AIFs.


The introduction of foreign investments in AIFs is relatively new so a proper analysis of growth can only be possible after a couple of years. Category III has made less development due to the restrictions and also because it still needs to enhance the investment mechanism and make suitable reforms in tax laws. Apart from the restrictions and risk intensive involved in Category III AIFs, extending the availability of foreign investments to Category III AIF has surely been a positive step.

Also Read:
Alternative Investment Fund: Category II vs Category III
Rules for Category III AIFs and Co-Investment by Investors of Alternative Investment Funds

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