Category III AIFs – journey well begun yet half done

The Alternative Investment Fund (AIF) industry in India is seen to be growing at a rapid pace. As of 30 September 2020, AIFs have invested over INR 1,650 billion into the Indian market out of which approximately 22 percent has come from Category III AIFs. However, the core of the global fund industry still remains on the more refined financial hubs in jurisdictions such as Mauritius, Singapore, Hong Kong, etc.

The sentiment behind the success of these financial hubs is conducive regulatory and tax regime and ease of doing business that extended through the well-developed infrastructure of financial services centers. Even as we see the escalation of AIF presence in India, the infrastructure, ease of doing business in India and tax regime for the fund industry is still being formulated and it is expected that India would also have a globally competitive regime in the next few years.

In order to create business opportunities related to financial globalisation, the Government of India had set up an International Financial Services Center (IFSC) in 2015 with the objective of encouraging the fund industry to undertake such financial services transactions from India that were earlier being carried from outside India by overseas financial institutions and overseas branches/ subsidiaries of Indian financial institutions. The Government has also taken significant steps to incentivize the setting up of units in IFSC. More specifically, in recent times, special focus has been retained on incentivizing Category III AIFs set up in IFSC.

In 2019, exemptions were provided under Income Tax laws to Category III AIFs located in IFSC on income arising from the transfer of specific capital assets only. The availability of exemption was subject to fulfillment of certain other conditions such as the consideration being paid in convertible foreign exchange and that the units of the AIF should be held by non-residents other than units held by the sponsor or manager. However, the current fiscal year, as momentous as it has been due to the much-publicized pandemic, heralded further reliefs for Category III AIFs. The scope of the exemption has now been expanded to include income arising to Category III IFSC AIFs on the transfer of any securities (other than shares in an Indian company).

The scope of exemption has also been extended to Category III IFSC AIFs for any income from securities issued by non-residents that do not accrue or arise in India or any business income from a securitization trust which to the extent that such income is attributable to units held by non-residents.

Apart from the above incentives, the Category III IFSC AIFs have been brought at par with foreign portfolio investors (FPIs) by extending the special taxation regime of FPIs to Category III AIFs located at IFSC which qualify for exemptions mentioned above. In fact, Category III IFSC AIFs are now at a greater benefit considering that interest or dividends are taxable at a more beneficial rate for them as against FPIs. Further, while FPIs may still be subject to tax on transfer of debt securities and derivatives issued by Indian companies, Category III IFSC AIFs would be exempt from the same given the expanded scope of exemptions.

Not just this, the Amendment Act also exempted the income accruing or arising or received by unit holders of Category III AIFs located in IFSC on the transfer of such units in said AIFs.

There is no denying that last two financial years have been crucial for Category III AIFs based out of the IFSC. As stated above, Category III AIFs located in the IFSC have now been brought at par with FPIs with some more incentives. This incentivizing is bound to encourage the relocation of foreign funds to the IFSC.

Another benefit that comes from the recent incentivization of Category III IFSC AIFs is the definition of a taxation regime for such AIFs. However, these incentives are restricted to only Category III AIFs of IFSC which qualify certain criteria. Apart from them, the taxation regime already accords special pass-through status to Category I and Category II AIFs. However, the taxation regime for Category III AIFs in general still awaits structural defining.

No specific provisions governing the taxation of Category III AIFs, in general, are currently provided under the Indian tax laws. Typically, Category III AIFs are structured as trusts and the provisions governing the taxation of trusts apply while determining the taxability of Category III AIFs. However, in order to achieve certainty with respect to the tax regime of AIFs and minimize litigation, the Government may consider either providing a tax regime for taxation of

Category III AIFs or accord a pass-through status to them along with Category I and II AIFs.

While India has come a long way to streamline and provide a conducive environment for the fund industry and more specifically the Category III AIFs from a tax perspective, most of these measures seem to be provided in bits and pieces and based on the demands received from the concerned players.

It may now be the time for the Government to start thinking out of box and provide a better regime for the deserving players on a wholistic basis so that India can be a real competition to other players because many other countries are also thinking along the same lines and trying to attract investments and talent their way!