Basics of Alternative Investment Funds (AIFs) in India

Basics of Alternative Investment Funds (AIFs) in India

Investing isn’t just about stocks and mutual funds. There are other options that can help grow wealth, and one of them is Alternative Investment Funds (AIFs). These funds bring together money from investors—both in India and abroad—and invest it based on a clear strategy.

AIFs are designed for those who want to explore beyond traditional investments. They offer unique opportunities but also come with their own risks and structures. Whether you’re looking for higher returns, portfolio diversification, or access to specialised investment strategies, AIFs can be worth considering.

This article breaks down how AIFs work, what makes them different, and the types available in India. If you’re thinking about expanding your investment options, understanding AIFs can help you make informed choices.

Why Consider Investing in AIFs?

Alternative Investment Funds (AIFs) offer a different way to grow your money, giving you access to opportunities beyond regular stocks and mutual funds. Here’s why they might be worth considering:

  1. No Need for a Demat Account

    Unlike stocks and other market investments, AIFs don’t require a Demat account. This means you can invest without the extra steps of setting one up or managing it. The process is simpler, making it easier to get started.

  2. Access to Unique Investment Options

    AIFs open doors to investments that aren’t easily available to regular investors. These funds allow you to put your money into high-potential opportunities that go beyond the usual stocks and bonds. This could mean investing in start-ups, private companies, or other less-explored markets with strong growth potential.

  3. Diversification Beyond Traditional Markets

    AIFs let you spread your investment across different asset classes, reducing risk and increasing potential returns. You can invest in private equity, real estate, distressed assets, and more. Instead of relying on just one type of investment, your money is spread across various areas, helping to balance risks and rewards.

  4. More Flexibility with Investment Strategies

    AIFs offer investment strategies that aren’t possible in highly regulated traditional markets. You can explore long-short strategies, structured deals, and other advanced methods without facing many of the restrictions that apply to regular investment funds. This gives fund managers more room to make strategic decisions that can lead to better returns.

Who Can Invest in an AIF?

Alternative Investment Funds (AIFs) are open to individuals and entities looking to expand their investment portfolio. However, there are certain conditions that investors must meet before they can invest in these funds.

  • Eligible Investors: AIFs are available to resident Indians, Non-Resident Indians (NRIs), and foreign nationals who meet the investment criteria.
  • Minimum Investment Requirement: Most investors need to invest at least ₹1 crore to participate in an AIF. However, for directors, employees, and fund managers associated with the fund, the minimum investment requirement is lower at ₹25 lakh.
  • Lock-in Period: AIFs typically require a minimum investment commitment for at least three years. This ensures stability in the fund and aligns with the long-term nature of such investments.
  • Investor Limit Per Scheme: Each AIF scheme can have a maximum of 1,000 investors. However, angel funds, which focus on investing in early-stage startups, have a lower investor cap of 49 participants.

These criteria help maintain the exclusivity and structured nature of AIFs, making them suitable for investors with a long-term vision.

Types & Categories of Alternative Investment Funds (AIFs)

Parameter Category I AIF Category II AIF Category III AIF
Definition This category includes funds that invest in areas that promote economic or social development. These may include start-ups, early-stage businesses, small and medium enterprises (SMEs), infrastructure projects, and social initiatives. The government or regulatory authorities recognize these sectors as important for growth and provide incentives for such investments. This category consists of funds that invest in unlisted companies and other businesses which aren’t falling under Category I or Category III. These funds do not use leverage or borrowing except for operational needs, within limits set by regulations. Most funds in this category focus on long-term investments and are structured as private equity or debt funds. This category includes funds that take a more flexible approach to trading and investment. They often use leverage and invest in a mix of listed and unlisted securities. The goal is usually to generate returns through strategies like short-term trading, arbitrage, and derivatives.
Examples
  • Venture Capital Funds (Angel Funds fall under this)
  • SME Funds
  • Social Impact Funds
  • Infrastructure Funds
  • Special Situation Funds
  • Private Equity Funds
  • Debt Funds
  • Hedge Funds
  • Funds that trade in derivatives and other complex financial instruments
Minimum Investment Requirement INR 1 crore INR 1 crore INR 1 crore
Minimum Fund Size INR 20 crore INR 20 crore INR 20 crore
Fund Structure Close-ended, meaning investors cannot withdraw funds before a specified period. Close-ended, with funds locked in for a fixed period. Can be either open-ended (allowing withdrawals at intervals) or close-ended (locked in for a set period).
Minimum Investment Period At least 3 years At least 3 years No minimum tenure required
Sponsor / Manager’s Contribution
(Also called “skin in the game”)
The sponsor or manager must contribute the lower of:

  • 2.5% of the total fund size
  • INR 5 crore
The sponsor or manager must contribute the lower of:

  • 2.5% of the total fund size
  • INR 5 crore
The sponsor or manager must contribute the lower of:

  • 5% of the total fund size
  • INR 10 crore
Investment in Foreign Markets Allowed with prior approval from SEBI. Allowed with prior approval from SEBI. Allowed with prior approval from SEBI.
Investment Limits per Company A single company cannot receive more than 25% of the total fund size. A single company cannot receive more than 25% of the total fund size. A single company cannot receive more than 10% of the total fund size.
Borrowing Rules Borrowing is restricted, except for short-term needs:

  • Funds can be borrowed for a maximum of 30 days.
  • Borrowing cannot happen more than four times in a year.
  • The borrowed amount must not exceed 10% of investable funds.
Borrowing is restricted, except for short-term needs:

  • Funds can be borrowed for a maximum of 30 days.
  • Borrowing cannot happen more than four times in a year.
  • The borrowed amount must not exceed 10% of investable funds.
Borrowing and leverage are allowed, as long as they follow regulatory limits.
Compliance Requirements Compliance requirements are lower compared to other categories. Compliance requirements are moderate. Compliance requirements are higher due to the nature of trading and leverage.
SEBI Registration Fee INR 5,00,000 INR 10,00,000 INR 15,00,000
Fee for Each Scheme Application INR 1,00,000 INR 1,00,000 INR 1,00,000

Taxability of AIFs

  1. Category I and II AIFs

    For those investing in Category I and II Alternative Investment Funds (AIFs), taxation works a bit differently. These funds have what’s called a pass-through status, meaning the income they generate (except business profits) isn’t taxed at the fund level. Instead, the tax responsibility shifts to the investors, just as if they had earned this income directly from their investments.

    If the fund incurs losses (other than business losses), investors may be able to offset them against their own income—but only if they have held their AIF units for at least 12 months. This can help reduce overall tax liability, making it an important factor to consider when investing in these funds.

    Tax on Distributions:
    Whenever a Category I or II AIF distributes income to investors, a certain amount is withheld as tax before it reaches them. For resident investors, the withholding tax rate is 10%. For non-resident investors, the tax is withheld at the rate applicable to them under Indian tax laws or as per the tax treaty between India and their country of residence.

    Tax on Business Income:
    If the fund earns business income, it doesn’t get the pass-through benefit. Instead, this income is taxed at the maximum marginal rate (MMR) of 30%, plus any applicable surcharge and cess. Once this tax is paid by the fund, investors don’t have to pay tax on the same income again.

  2. Category III AIFs

    Category III AIFs do not get the same tax benefits as some other investment funds. These funds are usually set up as determinate and irrevocable trusts, which means the beneficiaries (investors) are clearly identified, and their share in the trust’s income is fixed. Because of this structure, the tax responsibility can either fall on the trustee or the investors.

    In most cases, the trustee takes care of the tax payment on behalf of the investors, similar to how investors would be taxed if they received the income directly. However, there is an exception—if the trust earns business income, it is taxed at the Maximum Marginal Rate (MMR), which is the highest tax rate that applies.

    The tax authorities have the right to collect taxes either from the trustee or directly from the investors. To simplify the process, the trustee may choose to pay the full tax amount at the fund level. At the same time, the law allows the trustee to recover these taxes from the investors later. This setup ensures that the tax liability is settled while giving the trustee the flexibility to manage payments efficiently.

    For investors, understanding these tax rules is essential, as it affects how much of the returns they actually get to keep. Proper planning can help in making the most of the tax benefits that come with investing in AIFs.

Closing Thoughts

AIFs offer a way to explore investments beyond traditional options, but they come with their own risks and structures. Understanding how they work, the categories available, and the tax rules can help in making informed decisions. These funds suit investors looking for diversification and unique opportunities. Weigh the benefits and risks before committing to an AIF.

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