Category II AIF Regulations & Taxation

Category II AIF Regulations & Taxation

AIF (Alternative Investment Fund) means any Indian investment vehicle that collects funds from sophisticated investors, whether Indian or foreign, for investing in accordance with a defined investment policy. The AIF structure is growing at a fast pace in India with many start ups and investment funds are coming to India for investment opportunities. Thus, AIFs has gained huge importance as a structured product for investments in the recent times. It becomes important to understand the nuances related to AIF regulations and taxation in India. This article throws light on the regulations and taxations of Category II AIFs specifically.

Categories of Alternative Investment Funds:

  1. Category I AIF:

Invests in start-up, early-stage ventures, social ventures, SMEs, Infrastructure or other areas which are considered socially or economically desirable by the government/regulators. It includes : Venture Capital Funds, Small and Medium Enterprises Fund, Social Venture Funds, Infrastructure Funds, Angel Fund and such other AIFs as may be specified.

  1. Category II AIF:

These are the funds for which no specific incentives or concessions are given by the government/ regulators. They do not take undertake leverage/borrowing other than to meet day to day operational requirements. It includes Private Equity Funds, Debt Funds, Real Estate Funds, Funds for distressed assets and other funds that are not classified as Category I and Category III.

  1. Category III AIF:

These are the funds that trade with a view to make short term returns, employ diverse or complex trading strategies and may employ leverage including through in listed or unlisted derivatives. It includes Hedge Funds.

   AIF Category II Regulations:

  1. Category of Investors: Any Investors, resident or non-resident.
  2. Sponsor: Sponsor would be responsible to maintain a continued interest in the AIF, by way of an investment as prescribed under the regulations
  3. Fund Manager: Trustee (on behalf of AIF) shall enter into an investment management agreement with the Fund Manager
  4. Prior consent of all Investors: No
  5. Minimum Corpus: INR 20 crores (per scheme.
  6. Minimum Investment: INR 1 crore per investor and INR 25 lakhs (per employee/director of a fund/Manager)
  7. No of Investors: Minimum: 2 ; Maximum: 1,000
  8. Listing: Permissible for close ended AIF.
  9. Schemes: Can launch schemes subject to filing of Private Placement Memorandum at least 30 working days prior to launch.
  10. Co-investment by sponsor/manager: Permissible but not in terms more favourable than those offered to the fund – sharing of losses by manager/sponsor to be pro-rata.
  11. Tenure: Minimum 3 years. Extension permitted up to 2 years subject to approval of 2/3rd of unit holders by value.
  12. Lock in: Not applicable.
  13. Investment per investee company: Maximum 25% of the Investible funds in 1 investee company.
  14. Un-invested portion: Permitted to be invested in liquid assets of high quality as per the AIF Regulations.
  15. Sponsor commitment: Continuing interest of 2.5% of the corpus of the fund/scheme of INR 50 million, whichever is lower. Investment through waiver of management fees prohibited.
  16. Leverage and Hedging: Shall not borrow funds directly or indirectly or engage in leverage except for meeting temporary fund requirements. 1.) not exceeding 30 days, 2.) not more than in 4 occasions in a year and 3.) not more than 10% of the investable funds.
  17. Investment strategy: Through Private Placement by issue of Information Memorandum. The requirement is to state its investment strategy, investment purpose and business model in Information Memorandum. Change in category would require prior approval of the Board. Material change in the fund strategy shall require approval of at-least 2/3rd of the unit holders (values).

AIF Category II Taxation:

The Income of Category II AIF would be pass through with respect to income from Investments -Capital gains, dividends and interest.

  1. Income to be calculated at the AIF level.
  2. Characterisation of income in the hands of investors same as that in the hands of AIF.
  3. Loss(other than business loss) shall be allowed to its unit holders, if such loss is in respect of a unit held by the unit holder for a period of at least 12 months.
  4. AIFs to withhold tax at 10% on pass through income credit/ distributed to resident investors and for non-residents withholding rate would be as per rates in for or DTAA(Double Taxation Avoidance Agreements):
  5. No withholding on payments by Investee Companies to AIF.
  6. No pass through, if income characterised as business income or loss -such income taxable at AIF level.

  Taxation in the hands of Fund:

  1. Recipient: Fund
  2. Business Income (if any): Taxable in the hands of the Trustee as a representative assessee of beneficiaries at 40%
  3. Interest Income: Exempt in the hands of Fund. However, Fund is required to withhold tax from payments to unit holders: 1.) Residents at 10%; 2.) Non residents, as per rates in Force or DTAA.
  4. Dividend Income: Exempt in the hands of Fund. However, Fund needs to withhold taxes from payment to unit holders: 1.) Resident investors at 10%. 2.) Non-residents, as per the rates in Force or DTAA.
  5. Sale of shares of Investee Company: Exempt in the hands of Fund. However, Fund is required to withhold tax from payments to unitholders :1.) Residents at 10%; 2.) Non-residents, as per the rates in Force or DTAA.

Taxation in the hands of non-resident investors subject to Treaty Benefits:  

  1. Recipient: Unit holders.
  2. Business Income: Distribution of business income are not subject to tax in the hands of investors.
  3. Interest Income: Taxable at applicable rates (refer table below)
  4. Dividend Income: Taxable at applicable rates (refer table below).
  5. Capital Gains: Subject to Capital gains tax depending on holding period.
  • Short term: Applicable rates (refer table below)
  • Long term: Applicable rates, subject to treaty benefit (refer table below).

Credit of withheld tax by AIF available.

Rates of Tax as per ITA and tax treaty: 

Stream of Income




Interest Income




Dividend (From 1st April,20)(2)



10% or 15%

Gains on transfer of securities of portfolio companies.

Short Term

Long Term

Gains on shares subject to tax in India on prescribed rates under under the ITA.

1.Listed Shares



Gains on securities other than shares not taxable in India.

2. Unlisted Shares




3.Listed debt securities




4.Unlisted debt securities




*plus, applicable surcharge and cess.



Karan Vakharia

Partner at MASD & Co |   Email:   |   LinkedIn Profile

Palash Jain

Associate at MASD & Co |   Email:        | LinkedIn Profile

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