Proceeds from investment in category III AIFs are tax free in the hand of investors. Since category III AIFs do not have pass through status, they pay tax at fund level. Hence, investors receiving proceeds from redemption are exempted from paying any tax.
Category III AIFs employ diverse or complex trading strategies by investing in listed and unlisted derivatives. They are also allowed to employ leverage strategies i.e. borrowing to invest. Currently, they can borrow 200% of the fund size.
In practice, there are two kinds of strategies in Category III AIFs. First, there are long-only funds where AIF fund managers run thematic long-only ideas like an equity mutual fund but with lighter restrictions. Second, there are hedge funds, which use strategies far more complex than a typical mutual fund. These funds use strategies such as long-short derivatives and leverage to give returns which are uncorrelated with markets risk.
The taxation of AIFs largely depends on strategy they deploy. A single scheme can have two different tax structures. For instance, ABC Fund has allocated 65% of its corpus in long only strategy and the rest in long short position. For long only part, the scheme has to pay respective capital gains tax norms applicable on equity funds i.e. ABC Fund has to pay 15% on short term gains or 10% on long term gains above Rs.1 lakh on equity component.
Similarly, for long short component, the fund has to pay highest tax slab of 42.7% on gains. AIFs having LLP structure can reduce this tax to 33% and enhance the overall returns of investors.
Category III AIF has witnessed massive growth of 36% in commitments. The commitment raised in this category has increased to Rs.63,699 crore in December 2021 from Rs.46,824 crore in December 2020.
