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Taxation of AIF and their investors in India

India is witnessing a boom in start-ups seen over the past decade, start-ups require capital to establish and grow and Alternative Investment Funds or AIF form some of the most credible means of acquiring funds for such start-ups.

There are three categories of AIFs being :

Category I AIF

This is used for Angel Funds, Venture capital funds, Social Venture Funds, SME funds and the like. AIFs in this category cannot

Category II AIF

This a residual category that covers all funds excluded from categories I and II and includes debt funds, PE funds, and real estate funds.

Category III AIF

The category covers AIFs that employ complex trading strategies and includes such as Hedge funds and Long/long-short traders that also deploy considerable leverage.

Foreign Investment in AIF

Prior to 2015 Foreign direct investment (FDI) in funds used to be subject to government approval. However in November of 2015 these limits were abolished and 100% FDI through the automatic route is now permitted in alternative investment funds.

With respect to downstream investments made by an AIF, as long as the sponsor or the investment manager of the AIF is Indian owned and controlled the investment is not be considered FDI and therefore is not be subject to FDI caps subjected by the FDI policy.

The extent of foreign investment therefore is not a factor to determine the nature of downstream investment made by the AIF

Taxation of AIF

AIFs are accorded pass through status thanks to section 115UB of the Income Tax act 1961 which provides that incomes earned by an AIF will be taxed in the hands of the investors in the AIF as if the investment had accrued to the investors directly at rates generally applicable to such investors. This is applicable even if the profits have not actually been distributed by the AIF to the investors.

Losses of the AIF however cannot be passed on to the investors but can be carried forward for set off in subsequent financial years.

Since the provisions of Chapter XIID and XIIE are not applicable to category I and II AIFs they are not required to withhold taxes while distributing such profits to domestic investors.

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