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LibraryimgBlogimgWhat to expect from the upcoming Union Budget as an AIF Asset Manager

What to expect from the upcoming Union Budget as an AIF Asset Manager

  • January 30, 2023
  • By vivriti

The journey of the Alternative Investment Funds (AIFs) industry in India since the Securities and Exchange Board of India (SEBI) came up with the regulatory framework in 2012 is nothing less than extraordinary. It opened a whole new door to sophisticated investors looking to invest in products other than traditional asset classes and in varied sectors. When it comes to products in the private debt space, the ability of AIFs to go much deeper in the market has attracted a lot of investors’ attention, resulting in deeper segmentation of risk and return in the balance sheets of institutional investors, family offices, and HNIs.

The above factors led the total number of AIF schemes in the country to more than quadruple from 250 in FY18 to over 1,000 in the present financial year. The commitments raised, which denotes the amount clients are willing to invest in AIFs, clocked a 5-year CAGR of ~50% to ~INR 7 lakh crores as of Jun 2022.

Despite the regulatory leeway, more is expected from the governing bodies in the upcoming Union Budget to sustain the interest in AIFs and hasten the pace of its growth. Some clarifications are needed with respect to AIFs set up both domestically and in International Financial Services Centre (IFSC), a specialized designated area in a Special Economic Zone (SEZ) located in GIFT City, Gujarat.

AIFs set up in India are registered under SEBI (AIF) regulations, 2012 and are classified as Category I, II, and III AIFs depending on the investment objective and strategy. These AIFs are considered Indian resident investment vehicles from both exchange control and taxation perspectives. From an Income tax perspective, Category I and II AIFs are accorded a tax pass-through status, whereas Category III AIFs pay tax at the fund level at the maximum marginal rate.

On the other hand, AIFs set up in IFSC are regulated by a unified regulator, International Financial Services Centres Authority (IFSCA) under IFSCA (Fund Management) Regulations, 2022. The Investment Manager in IFSC (called a ‘Fund Management Entity or FME’) is required to obtain an FME license, which is a key distinction between IFSCA and SEBI regulations. Interestingly, AIFs in IFSC are considered non-resident from the standpoint of exchange control, though they continue to be treated as residents from the standpoint of Income tax. These AIFs are also registered as Category I, II, and III AIFs and are intended to be taxed in the same manner as SEBI-regulated AIFs.

Criticality for India’s financial inclusion

India is a country where debt capital markets have not succeeded in replacing banks for critical areas such as project and infrastructure finance, or in developing the mid-market space. Today, the share of sub-AA ratings accounts for sub-5% of bond markets. To correct this, it is essential for the AIF industry to develop as pooled investment products that are the safest and best way to direct household savings to debt capital markets.

Therefore, there is a critical need for the Government and regulators to support and promote AIFs as a path toward financial inclusion and the development of capital markets. Below we discuss suggestions to achieve the same.

Domestic funds under SEBI

  • Regulation of the Asset Manager: Globally, fund managers are regulated by the securities regulator, with requirements of minimum capitalisation, compliance, disclosures as well as corporate governance. This provides more comfort to investors as well as ensures a certain level of quality amongst the players in the market. Given the growing size of the AIF industry, it is about time that asset managers are regulated.
  • Increasing investor participation – Harmonising ticket size of investment: India provides various opportunities for investors to partake in debt or debt-like opportunities. However, the ticket sizes of investments vary. For direct bond investments, the minimum ticket size has been lowered by SEBI to INR 1 lakh recently. For ReITs and InvITs, the minimum ticket sizes stand at INR 50,000 and INR 1 lakh, respectively. For PMS, the same is INR 50 lakhs. However, for AIFs, the minimum ticket size stands at INR 1 crore and INR 25 lakh for an accredited investor. It would be useful to have parity between these options on the basis of risk and return. Pooled investment opportunities with professional managers offer diversification and essentially lower risk – hence, it would stand to reason that the ticket size should be lower than for direct bonds.
  • Accreditation can be transformational: Accreditation of investors has been introduced by SEBI as a way to determine investor maturity and therefore reduce investment ticket size. With the increase in private wealth and the growth of HNIs, it is necessary to provide a significant policy push to this initiative. If accreditation becomes “digital” and hence instantaneously verifiable, the impact on deepening AIF penetration could be transformational.
  • Provide Asset Managers the option to self-select and structure: The Cat I/II/III framework was useful in setting an initial framework for creating the AIF industry. However, the utility has run its course. There is now a need to permit Asset Managers to self-select (one time at the time of fund creation) the fund structure on:
    • Pass through taxation versus fund-level taxation. For fund-level taxation, the tax rate should be in line with that for companies at 25%
    • Leveraging the fund versus not, in line with risk guidelines – e.g., higher leverage allowed for lower risk strategies
    • Open-ended versus close-ended structure
  • Management fee and fund expenses: Management fee and fund expenses are expenses of an AIF incurred exclusively for the purpose of making investments and generating returns for the investors – such as paying the Asset Manager, Auditors, Rating Agencies, etc. Currently, there is a need to clarify that such expenses are tax-deductible when income earned by AIFs is in the nature of investment income (i.e., capital gains or other sources). In the case of Category I and II AIFs, although the management fee is paid out of income earned by investors, it is however not considered tax-deductible by the investment managers for TDS purposes. It will be useful to get clarity in this budget on this matter.
  • GST on Carried interest: The SEBI (AIF) Regulations require an investment manager or their affiliates to act as a ‘sponsor’ and provide a minimum sponsor commitment to ensure a certain ‘skin-in-game.’ Further, an investment manager may be required to contribute alongside the investors as part of commercial arrangements with investors. This results in the locking up of funds for the sponsor as well as carrying risk attached to the investments. To adequately incentivise a sponsor, a carried interest is paid out of the additional returns generated by the investors over and above a certain pre-agreed hurdle rate/ minimum expected return. Carried interest is therefore a return on investment (ROI) allocated to the sponsor and is independent of the fact whether such contribution is made by the fund manager or not. However, following a ruling in 2021 involving various venture capital funds, carried interest was considered neither interest nor ROI but consideration retained by funds/ trusts for the services rendered by them to investors. This gave rise to uncertainties surrounding the taxability of carried interest from a GST perspective. It is therefore crucial that certain clarification is issued to remove the ambiguity around the treatment of carried interest.

Funds under IFSCA

  • Clarity of taxation of IFSCA AIFs: While IFSCA regulations have demarcated AIFs into categories similar to SEBI regulations, there is a lack of a specific tax chapter that deals with IFSCA-incorporated AIFs. Further, as argued above, there is a need to replace the earlier AIF categorisations with a different structure that provides the Asset Manager with the ability to self-select the fund structure and choose appropriate taxation. This is all the more critical for IFSCA AIFs given the much higher complexity of the domicile of intended investors in the AIF.
  • Management of multiple funds: Since IFSC has been demarcated as an SEZ, entities set up there can enjoy 100% tax exemption on business income for 10 consecutive years out of 15 years (aka Tax Holiday). As per 80LA of the IT Act, a certificate of registration is required for each unit with SEZ authorities. However, IFSC recognizes FME as a registered entity operating a single scheme. Thus, to qualify for the Tax Holiday, separate unit registration for funds/ schemes regulated under the IFSCA (FME) Regulations would be required. But in the case of AIFs, separate offices may not be required considering that the funds can be managed from the same office of the investment manager. Therefore, for AIFs, relaxations should be allowed under the IT Act for separate registration of schemes and the SEZ approval process should be removed.
  • Rationalisation of Surcharge rates: There is a discrepancy in the surcharge rate applicable in the case of LLP AIF (which is 12%) and Trust AIF (which is 37%), even though both may be formed for the same purpose. Hence, there should be a consistent surcharge of 12% applied to all IFSC AIFs, irrespective of how they are formed as legal entities.

The above concerns if taken up for resolution in the upcoming Union Budget or near term will not only aid the next level of growth in the AIF asset base but also remove several operational hurdles and the scope of any litigation.


The article has been covered in ET Markets (Online) on January 30, 2023. You can read it here:

What to expect from the upcoming Union Budget 2023 as an AIF Asset Manager



The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.