AIF Units as ‘Securities’ and its Ripple Effect on Taxation

[Priya Maharishi and Vansh Singla are 4th B.A. LL.B. (Hons.) students at Jindal Global Law School, Sonepat]

With the growth of start-ups and early-stage companies, there is a continuous need for long-term capital investments and management expertise. Pooled investment funds can fulfil this need as they have forbearance unlike other sources of capital like public funding. These pooled investment funds include alternative investment funds (“AIFs”). Investments in the Indian economy from AIFs alone is up to INR 1.8 Lakh Crores as of December 2020.

However, through Finance Act, 2021, an amendment under section 148(ii)(b) was introduced in the Securities Contracts (Regulations) Act, 1956 (“SCRA”), which includes AIF units in the definition of “securities”. This post will examine the implication of the amendment through the perspective of double taxation in the hands of the unitholder, who is an investor in the AIF, under the Income Tax Act, 1961 (“ITA”). It will also discuss the challenges faced by the AIFs regarding their valuation, which now needs to be issued or transferred at fair market value (“FMV”) according to section 56(2)(x)(c) of the ITA.

Law Governing AIFs

In 2012, the Securities Exchange Board of India (“SEBI”) transformed the domestic investment funds industry through the introduction of the Securities Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”). A specific set of regulations for AIF aimed to introduce it as a specific distinct asset class. Regulation 2(b) of the AIF Regulations defines AIF as a ‘privately pooled vehicle’ that collects monies from investors to invest in portfolio companies. It could be established or incorporated in form of a company, a body corporate, a trust, or a limited liability partnership, and its management shall not be regulated by any other SEBI regulations. An AIF is categorised under regulation 3(4) as (i) Category I AIF which invests in start-ups or early-stage companies; (ii) Category II AIFs investing in equities or debt securities of unlisted companies or other AIFs and do not partake in borrowings except to meet usual management needs; (iii) Category III AIFs invest in securities of listed or unlisted securities through complex trading strategies. Each category has specific concessions and regulatory framework.

For taxation, Categories I and II AIFs enjoy the benefit of being a ‘pass-through entity’ under section 115UB of the ITA. Accordingly, any income accruing or arising out of or received in the hands of a person out of the investments made by the investment fund for being a unitholder of the fund shall be taxed as if the investments of the fund were made by it directly. Explanation I under section 115UB defines ‘investment fund’ as a fund incorporated in India as Category I or Category II AIF, and ‘unit’ as a ‘beneficial interest of an investor in the investment fund’. It does not consider the action of subscription to units of an AIF by the unitholder but considers the investments made by the AIF as if they were made by the unitholder directly; hence, not taxing the issuance of AIF units but only the income from the investments made by the AIF.

However, the Indian Stamp Act, 1899 (“ISA”) provided for payment of stamp duty on the sale or issuance of the AIF unit. It aimed to encourage ease in doing business, standardise stamp duty on securities and develop the Indian securities market. Section 2(23A) of the ISA defines securities as (i) securities under the SCRA; (ii) a debt instrument; (iii) derivatives in terms of the Reserve Bank of India Act, 1934; (iii) any other instrument declared by the Central Government to be a security. Conversely, AIF units could not be interpreted as a security under any of them.

AIF Units as ‘Securities’

Consequently, to rectify this irregularity, the Central Government, through the Finance Act, 2021 inserted sections 2(d)(a) and 2(h)(ida) in the SCRA. They define a ‘pooled investment vehicle’ as a fund established in India in the form of a trust or otherwise, and could be an AIF which collects capital from investors for investment and included AIF units as securities, respectively. It includes AIF units issued by domestic AIF under units of a pooled investment vehicle. Hence, AIF units are securities and are subjected to the taxation law for issuance or transfer of securities.

Ripple Effect on Taxation of AIF Units

The inclusion of AIF units under the definition of securities has a ripple effect on taxation of Category I and II AIFs units in the hands of the unitholder, when they are issued and inter se transferred at the valuation below the FMV under section 56(2)(x)(c) of the ITA. The section provides for taxation on any property, except the immovable property, including securities when received for less than the FMV under the head of ‘income from other sources’. This interpretation also leads to rigidity in the methodology used for the calculation of the valuation of the AIF.

Section 115UB of the ITA governing the taxation on AIF units is a ‘non obstante’ provision. Nevertheless, as AIF units are securities, the law can be interpreted in favour of imposing a tax on the consideration paid for the AIF units if they are transacted or issued for less than the FMV of the AIF units by an amount exceeding fifty thousand rupees under section 56(2)(x)(c) of the ITA.

When the law allows for taxation of such transactions, it hinders the general practice of the industry and brings into its realm bonafide transactions. Section 56(2)(x)(c) is an anti-abuse provision for taxing fraudulent, spurious capital building transactions against a ridiculous consideration. If the securities of private companies are issued at less than FMV to the AIF, the same is taxed in the hands of the unitholder. Earlier, tax on issuance or transfer of AIF units was not chargeable. Currently, when AIF units are issued or transferred for consideration less than their aggregate FMV, the transaction is taxed in the hands of the unitholder under section 56(2)(x)(c). The unitholder will be taxed again for the transaction if the consideration is less than the FMV for such investments, disregarding the AIF as a pass-through entity under section 115UB. Additionally, the valuation of an AIF unit is not in hands of the unitholder. This leads to double taxation in the hands of the investors, thereby hindering efficiency, and the development of the AIF industry.

Valuation of AIF

As AIF units are securities, they are subjected to the rules for the valuation of securities. For valuation of securities, the adjusted book value method is applicable under rule 11UA of the Income Tax Rules, 1962. This application creates rigidity for the valuation of an AIF, which has multiple investments in multiple portfolio companies comprising different classes of securities. For fair valuation, there is no single methodology available in good faith because the FMV is determined on a case-by-case basis. Under regulation 23 of the AIF Regulations, AIF can decide the methodology of the valuation at liberty and only at once. The valuation of investments is also determined by the geopolitical and economic situation of the country. The law has acknowledged the complexity in calculating the valuation of the AIF and, therefore, has been flexible. The law now encourages a one-size approach as a straight-jacket formula, and is a huge step back for the development of the AIF industry.

Additionally, under regulation 23(2) of the AIF Regulations, for Categories I and II AIFs, the valuation shall be carried out at least once every six months or once a year on approval of at least 75 percent of the investors. Usually, there is a time gap between the commitment for investment by the unitholder and the drawdown of the investment, possibly leading to a change in the valuation of the portfolio companies, and in effect altering the valuation of the AIF. It is at the drawdowns that the AIF units are allotted to the investors. After the amendment, there is an indirect burden for undertaking the valuation before each closing of the investment round for issuance of AIF units at the FMV, consistent with the value of the portfolio company.  Also, if the AIF units are transferred inter se, they need to be sold at the FMV, requiring the valuation to be made again. This increases the frequency of valuation of AIF and contradicts the AIF regulations. Because of high threshold for the frequency of valuation of the AIF, there could be delays in the closing along with making the investment expensive, impeding genuine businesses from raising capital.


Section 56(2)(x)(c) is applicable after 1April 2017. The amendment does not grandfather the AIF investments made before the amendment came into effect. The vagueness in its implementation creates uncertainty while ex post facto bringing past AIF investments within its ambit. It can tax the transaction for issuance or transfer when made below the FMV, leading to litigation. The ambiguity regarding the retrospectivity increases the fear and insecurity in the minds of the unitholders and the fund managers.

The amendment has introduced uncertainty in the valuation, taxation, and its implementation for AIFs. Earlier, the regulations relating to AIFs provided fund managers with the requisite freedom and had a clear demarcation regarding taxation under section 115UB of the ITA. However, currently, the amendment has done more damage than good. With the objective of standardisation of stamp duty in sight, it failed to foresee its ripple effect on the taxation of AIF units. The focus on increasing ease in business ended up being a huge stumbling block for the domestic AIF industry and hampering the development of early businesses.

Priya Maharishi and Vansh Singla

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