Tax Treatment of Alternate Investment Funds

Ankita Tiwari

13 Apr, 2023

Investment in Alternate Investment Funds (AIF) is done in a similar manner as any other fund. The pros and cons are evaluated and compared with other investment option available to make an investment decision. AIF provides various advantages to investors. Investors also have options to select an AIF scheme from the three Categories of AIF. The tax treatment of AIFs is an important aspect of the decision making process preceding the investment in an AIF. This blog focuses on the tax treatment of AIFs and investors under the Income Tax Act of 1961^[1] (“IT Act”).

1. Tax Deducted at Source (TDS) from AIF Units
   Where any income is payable to a unit holder regarding units of an investment fund prescribed under clause (a) to Explanation 1 to section 115UB of the IT Act, then the person responsible for making such payment shall deduct income tax at the time of credit of such income to the unit holder or at the time of making payment either in cash or by the issue of cheque or draft or by any other mode, whichever is earlier. This is provided under section 194LBB of the IT Act and came into force on 1^st June 2015. However, the income generated shall be any income other than an income which is in the nature of income derived from profits and gains from business or profession.
   If the unit holder is a resident, then AIF is required to deduct tax at the rate of 10% of the income whereas if the unit holder is a non-resident or a foreign company, then the deduction is done as per the rate prevalent during the relevant financial year or the rate specified in the Double Taxation Avoidance Agreement (“DTAA”) entered into between India and the non-resident’s or foreign company’s country of residence. TDS is deducted at the time of payment to the unit holder.
   In addition to the above, the redemption proceeds if any, arising from redeeming the minimum commitment made by a sponsor can be invested in liquid investments or even fixed deposits and the interest income or any other income arising from such investment if paid to the sponsor shall be subjected to tax under section 194LBB. TDS is deducted from such income and the sponsor shall be liable to pay income tax on the income to the extent TDS has not been deducted.
2. Different Tax Rates for listed and unlisted securities
   There is a disparity in the tax rate applicable to capital gains arising from listed securities vis-a-vis unlisted securities. This disparity is prevalent in both long-term capital gains as well as a short-term capital gains.
   • The applicable rate of tax for Long Term Capital Gains (LTCG):
     LTCG arising from unlisted securities is taxable at the rate of 20% exclusive of surcharge & cess. However, as per section 112A of the IT Act, if the LTCG arising from the transfer of listed equity share in a company or a unit of an equity-oriented fund or a unit of a business trust exceeds Rs. 1,00,000/- then it is taxed at the rate of 10% exclusive of surcharge & cess. 
   • The applicable rate of tax for Short Term Capital Gains (STCG):
     STCG arising from unlisted securities is charged to tax at the income tax slab rate applicable to the investor. However, the STCG arising from the transfer of listed equity share in a company or a unit of an equity-oriented fund or a unit of a business trust shall be taxed at the rate of 15% exclusive of surcharge & cess. Category III AIF has a tax advantage as compared to Category I and Category II AIF as Category III AIF invests majorly in listed securities.
3. Pass-through provisions for AIF
   Pass-through tax treatment of AIFs has been accorded to Category I & Category II AIF vide the Finance Act of 2015. In pass-through status, the obligation to pay tax on any income other than business income arising from AIF shall be on the investor. In simple words, the income is passed through to the investors of AIF and income arising from AIF shall be taxable in the hands of the investor as if the income accrued from investments directly made by the investor. This “pass-through” status was introduced by the Government of India to bring the SEBI (AIF) Regulations, 2012 at par with global laws. Initially, the “pass-through” status applied only to the profits of the AIF. Later the Finance Bill of 2019 paved the way for the pass-through of losses accrued in AIF allowing the investors to pay taxes on capital gains of AIF after deducting the losses incurred by the AIF. So investors holding Category I and Category II AIF units for a period greater the 12 months are eligible for the ‘pass-through’ status of losses incurred by AIF.
   The pass-through status has not been extended to Category III AIF despite various contemplation and anticipation therefore, the income arising from Category III AIF is liable to be taxed in the hands of the AIF fund itself. So the taxation of AIF depends on whether it has been set up as a company, LLP, trust or body corporate. The purpose of not extending the pass-through provisions to Category III is that Category III faces much lesser restrictions when compared to Category I & II. They mostly invest in listed securities on a short-term basis so the income arising from Category III investment is usually in the form of business income. Therefore, the pass-through status if at all is extended to category III will not be beneficial.
4. POEM and PE for AIF
   All AIFs in India are registered with SEBI either in the form of a company, LLP, trust or body corporate making every AIF an Indian Resident. Many of these AIFs receive investments from overseas investors by way of feeder funds set up outside India by the Investment Manager of the AIF. The tax treatment of AIF will be as per the IT Act, if substantial decisions regarding the feeder funds are taken in India. If major management decisions relating to such feeder funds are taken in India then such feeder fund is considered to have a place of effective management (POEM) in India and would be taxed in India as an Indian resident. Further, even if the AIF’s overseas feeder fund is not considered an Indian Resident, it would be deemed to have a Permanent Establishment (PE) in India if such feeder funds meet the threshold under section 9(i). In addition, section 9A of the IT Act creates a safe harbor for India-based managers but to be eligible for the safe harbor rules the eligible investment fund should not carry on or control or manage either directly or indirectly any business in India or from India or have any business connection in India. In simple words, a resident investment manager in India who is managing an off-shore fund and not investing in India would be safe from the incidence of income tax if various conditions specified under section 9A are met.

Conclusion

The various tax treatment of AIFs as prescribed under the IT Act, 1961 has to be considered for making investments in AIF. The tax treatment of AIFs is different depending on their category. An investor has to compare the various tax treatment of AIFs to decide which category of AIF to invest in.

Also Read:
Income Tax on Alternate Investment Fund (AIF)
Alternate Investment Fund Category I Regulations