Tax pass through for AIFs: A vexed issue for investors

Ayear ago the Securities and Exchange Board of India (SEBI) introduced the Alternative Investment Funds Regulations, 2012, which replaced the SEBI (Venture Capital Funds) Regulations, 1996. The aim was to bring in regulations that encompassed all forms of private equity and also introduced a regime for the formation of alternative investment funds (AIFs) and domestic hedge funds. This step marked the next phase of evolution of the domestic private equity industry in India.

The AIF regulations do not exist in a vacuum and in order to achieve their objectives, synchronization between the AIF regulations and other relevant legislation/regulations is imperative. Section 10(23FB) of the Income Tax Act, 1961, is a case in point, since it affords a “tax pass through” to all venture capital funds (VCFs) registered under the erstwhile VCF regulations, whereas in the case of AIFs the pass through has only been extended to a sub-category of Category I AIFs and that too with additional conditions and riders.

Category I

Category I AIFs are those which invest in start-up or early-stage ventures, social ventures, small and medium enterprises (SMEs), infrastructure, or other sectors or areas considered socially and economically desirable. The sub-categories of Category I AIFs include VCFs (including the sub-category of angel funds), SME funds, social venture funds and infrastructure funds. The AIF regulations clarify that such funds which are formed as trusts or companies will be construed as a venture capital company or a VCF as specified under section 10(23FB) of the act.

Thus, the intent behind the AIF regulations is to encourage and provide incentives for Category I AIFs irrespective of their sub-category, as long as they have a positive spillover effect on the economy.

Bijal Ajinkya is a partner and Abhay Sharma is a principal associate at Khaitan & Co. The views of the authors are personal, and should not be considered as views of Khaitan & Co.