AIF Registration

Income Tax on Alternate Investment Fund (AIF)

Income Tax

The Alternate Investment Fund (AIF) has been a lucrative option for high-net-worth individuals (HNIs) to diversify their investments by participating in the securities market in India. AIF is a privately pooled investment vehicle that works by pooling the funds of investors and investing it in accordance with the defined investment policy. AIF can be in the form of a trust, company, body corporate, or limited liability partnership (LLP). The SEBI (Alternate Investment Fund) Regulation, 2012 differentiates AIFs into three categories i.e. Category I, Category II, and Category III. The investor has to decide which category of AIF to invest in depending on his investment objectives. The income tax implication on AIFs also plays an important role in deciding which category of AIF to invest in. Each category of AIF is a different investment vehicle therefore it is also taxed differently. So it becomes important to understand the income tax implication of AIFs.

Category-wise Income Tax Implication on AIFs

  • Category I and II

A special taxation regime was introduced by the Finance Act of 2015 which grants a pass-through to Category I and Category II AIFs. Pass-through means that the income generated by the fund will be taxed in the hands of the investor and not at the fund level. It means that in Category I and II AIF, the tax liability on the income generated from the investment will be borne by the investor. The AIF is exempt from all tax obligations on the investment income. Business income is excluded from tax under Category I and II AIF and is taxed in the hands of the fund. The duration for which the fund is invested is also important as long-term capital gains tax and short-term capital gains are different. Long-term capital gains are taxed at the rate of 20% along with indexation benefits whereas short-term capital gains are taxed at the rate of 15%. In addition to the tax rates, there are surcharge and cess charges also applicable above the tax rates.

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Nature of IncomeTax Liability
Capital Gains or any income other than Business IncomeAIFs are not liable for tax. The burden to pay tax is on the investor.
Business IncomeTaxed in the hands of AIF.

Income Tax Implication on AIF Investors

Type of InvestmentType of Investor and Income Tax Implication on AIF Category I and II
Long-term capital gains (LTCG):
Listed sharesWhether it is an individual, HUF, LLP, Private Trust, or a Domestic company, the tax levied would be at the rate of 10%.
Unlisted sharesWhether it is an individual, HUF, LLP, Private Trust, or a Domestic company, the tax levied would be at the rate of 20% + indexation benefit.
Other assetsWhether it is an individual, HUF, LLP, Private Trust, or a Domestic company, the tax levied would be at the rate of 20% + indexation benefit.
Short-term capital gains (STCG):
Listed shares15%
Unlisted shares and other assetsIndividual: Maximum Marginal Rate (MMR) Ranges between 32.34% to 42.744%. Firm: 34.95% Trust: MMR 32.34% to 42.744% Company; 29.12% to 34.944%
Dividend IncomeIndividual: MMR Ranges between 32.34% to 35.88%. Firm: 34.95% Trust: MMR 32.34% to 42.744% Company; 29.12% to 34.944%
Other IncomeIndividual: Maximum Marginal Rate (MMR) Ranges between 32.34% to 42.744%. Firm: 34.95% Trust: MMR 32.34% to 42.744% Company: 29.12% to 34.944%
Surcharge rates:
Individual/HUFFor gains >Rs. 50 lacs but < Rs. 1 crore – 10%. For gains > Rs. 1 crore – 15%
Firm/LLP12%
CompanyUnder the new regime – 10% Under the old regime: If total income > Rs. 1 crore but < Rs. 10 crores – 7% If total income > Rs. 10 crores – 12%
Education Cess is applicable at the rate of 4% on individuals, HUFs, Firms, LLPs, or companies.

The above rates are prescribed under the Income Tax Act, 1961[1]. It may be replaced by rates agreed to by the two countries in the Double Taxation Avoidance Agreements (DTAAs) if those provisions are beneficial for the investor. In addition to tabular data, if any income apart from business income is distributed by Category I and II AIF to its investors, it shall be subjected to a withholding tax at the rate of 10% for resident investors and for non-resident investors, the withholding tax rates shall be either as provided under the Act or DTAA whichever is beneficial.

  • Category III
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Under this category, the investment income is taxed in the hands of the AIF. The pass-through tax regime has not been extended to Category II AIFs. Due to such disparity, the income earned by Category III AIF is taxed at the AIF level. The tax of four types of income is borne by the AIF that too at different rates. It has been described in a tabular form below:

Type of IncomeType of Tax along with Tax Rate
Long-Term Capital GainBasic Tax Rate- 10% MMR- 11.96% Surcharge- 15% Education cess- 4%
Short-Term Capital GainBasic Tax Rate- 15% MMR- 17.94% Surcharge- 15% Education cess- 4%
Business IncomeBasic Tax Rate- 30% MMR- 42.74% Surcharge- 37% Education cess- 4%
Dividend IncomeBasic Tax Rate- 30% MMR- 42.74% Surcharge- 37% Education cess- 4%

Category III AIFs may face challenges regarding the classification of income under the head business income or capital gains. In addition to the previous challenge, the indirect transfer provisions under section 9 of the Income Tax Act, 1961 as per which the transfer of shares or interest in an offshore entity whose value has been derived from assets in India will be treated as indirect transfers and be subjected to capital gains tax in India. For Category, I and II AIFs exemptions have been granted from indirect transfer provisions. To keep parity among all the categories of AIFs, Category III AIF should also be kept outside the ambit of indirect transfer. Further, Category III investors are also not covered under the concessional tax regime applicable to foreign debt instruments such as FPIs. Some exemptions have to be provided to Category III AIFs to bring parity in income tax implication on AIFs. Category III AIFs are also excluded from the pass-through provisions without any reasonable explanation. A significant reason to call for “Pass-through” provisions to be applied to Category III AIF is the instances of double taxation. To avoid double taxation and to facilitate investments in Category III AIFs, pass-through provisions are required for Category III AIFs.

READ  Alternative Investment Fund Regulations

Conclusion

AIFs are simple and sophisticated investment vehicles. The tax rules make them complicated and confusing. For Category I and II AIFs, the tax is to be borne by the investor, and for Category III AIF, the fund has to bear the tax liability. To this extent, it seems simple, but as we get into the intricacies, the taxation rules become complex and unclear. So if an investor is investing in Category I and II AIFs then he has to know the income tax implication on AIFs which will be applicable to him. Even for Category III AIFs, where the investor is not concerned about the payment of tax, he should know the income tax implications as it is an important factor for deciding which asset to invest in. To understand the income tax implication on AIFs, a professional must be consulted.

Also Read: Alternate Investment Fund Category I Regulations

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