As per SEBI (AIF) regulations, 2012 AIFs are classified into 3 categories for fund registration.

• Category-1: Funds in this category invests in new business opportunities which have high growth potential, mainly in start- ups, SME’s or any other sector which Govt. considers economically and socially viable. The government promotes and incentivizes investments as these projects have multiplier effect on the economy in terms of growth and job creation. Venture capital fund, Infrastructure fund, Angel fund and Social venture funds comes under this category.
• Category-2: Funds in this category includes private equity, debt and fund of funds. Major investment goes into equity and debt securities. There are no specific incentives or concessions are given by the government or any other regulator.
• Category-3: Funds in this category aims at short term returns with various complex and diverse trading strategies. There are no specific incentives or concessions are given by the government or any other regulator. Hedge and PIPE (Private Investment in Public Equity) funds comes under this category.

There are different types of investments which are managed portfolios such as Mutual Funds, PMS, Unit Linked Insurance Plans and Alternate Investment Funds. There are many similarities among these but each of them is different with its own unique caterings and suitability to certain types of investors. Some advantages of AIF are –

• Pooling of funds but from limited like-minded and risk-tolerant investors
• By the diversity of the portfolio and asset allocation, they are not correlated to markets
• Holding of real assets and certain investment not traded publicly; hence not relatively volatile
• Potential to earn higher returns in comparison to stocks, bonds, and other managed portfolios
• Suitable for high net-worth individual investors due to high risk ~ high return ~ high investment
• Increasing stringent regulations by SEBI to protect investors interests

Alternative investments are riskier and more complex than regular investments such as equity shares, bonds, realty and gold etc. They may contain illiquid investments, which makes it difficult to sell them whenever desired or needed. With the potential for higher return comes inherent risk. Some of the risks one must be wary of, before making an investment are –

• Management risk – as these are complicated and the investment is made in varieties of asset classes, the management team must be highly educated and experienced in the management of various asset classes. Also, the assets managed under these schemes can be very high running into billions of rupees, which gives more reason to look for the fund manager’s investment management history and success. While the fund management is the responsibility of the manager of the AIF, selection of the fund is the responsibility of the investor (as he bears the risk solely). Consulting a professional adviser is hence imperative.
• Financial risk – One wrong call of the manager can have a great impact on the returns earned from other assets or investments in the portfolio, eating into the positive returns or even affecting the principal. What if the fund invests in a company that is raising a capital and falls short of the target? What measures does the fund take to protect the investors money should a venture fail to survive, let alone succeed?
• Transparency risk – some funds may not hide certain information from the investors, but they may not disclose certain material information that may be critical for investors to take informed decisions, in the absence of advice from a professional.
• Liquidity risk – inability of the fund to sell certain assets at the right time can impact the overall performance of the investment. Alongside liquidity, they may also be exposed to marketability risk, meaning the fund may fail to find a buyer for the any price, let alone the right price.
• Regulatory risk – in spite of present regulations, as the product is relatively new in the Indian investment arena, there may still be a lot of scope to scrutinize the management of alternate investment funds, to improve their compliance with regulations, and to manage underlying portfolios.

Under the provisions of the Income Tax Act, 1961, an investment fund established or incorporated in India and registered with the Securities and Exchange Board of India (SEBI) as a Category I AIF is accorded tax pass through status, i.e., income of the AIF shall be chargeable to tax directly in the hands of its investors as per Section 115UB of the Act. In this context, the income chargeable under the head capital gain income and interest will be exempt in the hands of the AIF and same will be taxable in your hands to the extent of 5% of the income under the head capital gains and interest income

• Category I and II are tax pass-through vehicles. TDS will not be deducted.
• 10% withholding is done while making distributions
• The rate of withholding for offshore investors will be determined based on DTAA

Under the old regime venture capital funds had tax pass on their incomes. The income of a VCF was exempt from tax in the hands of the fund, while it was taxable in the hands of the investors. Later, this tax pass-through limited only to income from venture capital funds that operated in specific sectors. In 2012, the taxability was reverted to the earlier position through the finance bill by extending the benefit to all sector in which a venture capital fund invests.

As per SEBI (Alternative Investment Funds) Regulations 2012, the tax ‘pass-through’ status was only accorded to Category I AIF but later extended to Category II also. For this purpose, investment in AIF is supposed as directly made by the investor without any intermediary. The Fund must comply with the Sec 10(23FB) of the Income Tax Act 1961 to avail this benefit.

No pass-through has been granted to Category III AIF. Hence, the income from of AIF is taxed twice, first when the income arises or accrues in favour of the AIF and second, when it is in favour of individual investors. As per the Income Tax Act 1961, VCF is exempt from tax for the income earned on the investments. For the purpose, it must be registered as a trust before May 21, 2012 under Old VCF regulations.