Alternative Investment Funds (AIF) industry in India has gained impetus with liberalization of foreign investments in AIFs, recent amendment to Indo-Mauritius Treaty and pro-business environment in the country. These pooling vehicles (i.e. AIFs) have the ability to provide for long term, and stable risk capital, thus are considered to be an effective alternative to the traditional methods of funding. AIFs are regulated by the capital market regulator vide SEBI (Alternative Investment Funds) Regulations, 2012 (‘AIF Regulations’). Prior to AIF Regulations, the pooling of funds was regulated by SEBI vide SEBI (Portfolio Managers) Regulations, 1993 (PMS Regulations) and erstwhile SEBI (Venture Capital) Regulations, 1996. However, with coming up of AIF Regulations, pooling under the PMS Regulations have gradually reduced.

Setting up AIFs needs to be carried out within the contours of AIF Regulations, exchange control regulations and taxation laws. Set out below are key factors that need to be taken into consideration whilst setting up a domestic alternative investment fund.

Firstly, nature of AIF to be decided. AIF Regulations contemplate establishment of an AIF in the form of a Trust or a company or a Limited Liability Partnership or a body corporate. However, in India, most preferred form of setting up an AIF is the trust route as against company or LLP or LLC for an offshore fund. This is due to simplicity and flexibility in incorporation, management and governance of the trust as well as minimal statutory disclosure requirements in comparison to a company or LLP. Also, increase in clarity on the trust taxation over a period of time has acted like a catalyst to this choice of trust route.

Secondly, depending upon the investment objective/criteria of the AIF, the AIFs are required to be registered under one of the following categories prescribed under the AIF Regulations: (a) Category I AIF: to invest in start ups, early stage ventures or SME funds or social ventures or infrastructure or other socially/economically desired sectors; (b) Category II AIFs: Is a residuary category - includes funds that fall neither under Category I AIFs nor Category III AIFs (e.g. Private Equity funds and Debt funds etc); (c) Category III AIFs: Includes hedge funds or funds, which trade for short term returns, or open ended funds, for which no specific incentives or concessions are given by the government.

Thirdly, depending upon the nature of investors i.e. non-residents, residents, institutional, individuals etc., one needs to structure the AIF. Post RBI Notification dated November 16, 2015, persons resident outside India are permitted to invest in AIFs directly under the automatic route. The said notification further clarifies that only if the sponsor and/or the investment manager are Indian “owned and controlled” downstream investment by an AIF will not be treated as foreign investment. One needs to borne in mind that AIF Regulations prescribe a minimum ticket size of 1 Crore for investors. However, Report of Alternative Investment Policy Advisory Committee' (AIPAC) chaired by N.R. Narayan Murthy has recommended that the said minimum ticket size should be reduced so as to benefit the more number of investors. Also, the AIF is permitted to invest in offshore companies subject to prior approval from SEBI and in compliance with the investment conditions as set out in SEBI circular dated October 1, 2015.

Fourthly, if substantial portion of investment is through non-residents and depending upon AIF’s investment objective, one may contemplate going through a unified model or co-invest model. However, with liberalization of foreign investments in AIFs, necessity of these structures would have to be examined especially from a tax standpoint on fund and limited partners.

Finally, based on the above factors, to understand, tax implication on funds of an AIF. Category I AIF and Category II AIF enjoy the tax benefits of pass-through status which provides that any income accruing or arising to, or received by, a unit-holder of Category I AIF and Category II AIF shall be chargeable to income-tax in the hands of unitholder in the same manner as if it were the income accruing or arising to, or received by such unitholder, had the investments made by the investment fund been made directly by the unitholder. However, tax pass through status has not been accorded to Category III AIF. Note that, however, AIPAC report has recommended that tax pass through status should be awarded to Category III AIF as well. Also, withholding tax implications on non-residents (with or without treaty benefits) and residents needs to be addressed in accordance with clarification issued in the Finance Act, 2016. Further, to accelerate growth of AIF industry, the government has notified safe harbor rules which may also be taken into consideration for structuring.

Additionally, AIF Regulations provide for restrictions on investments, minimum ticket size, fund corpus, minimum manager/sponsor commitment, investor reporting etc. In addition to the aforementioned criteria, it is imperative to have fund documentation that is comprehensive from a legal, commercial and tax perspective. Also, implementation of recommendations made in AIPAC report is expected to further boost and grow the AIF industry.