Are you seeking unique asset exposure, sophisticated portfolio diversification, tax efficiency, and the flexibility to invest in Indian assets using foreign currencies? Alternative Investment Funds (AIFs) in India offer exactly what you require. Unlike listed stocks and mutual funds, AIFs are popular as sophisticated investment tools for high-net-worth and ultra-high-net-worth NRIs. 

This article provides a comprehensive understanding of how you can tap into AIFs in India beyond mutual fund investments. 

Understanding AIFs and their appeal to NRIs

At the core, AIFs are privately pooled funds registered, managed, and governed under the SEBI AIF Regulations 2012. Compared to mutual funds, AIFs are more focused in terms of asset classes. They are popular among NRI investors for several reasons. 

• Unique opportunities to invest in private asset classes in India - AIFs are focused on private asset classes that are inaccessible to general investors. These are high-growth stories offering unique opportunities for capital appreciation. 

• Accurate risk management and portfolio risk diversification - Focussed asset classes help AIFs cater to customised risk profiles, and allow sophisticated investors to manage portfolio risk more accurately. 

• Generating high alpha in a well-managed investment portfolio - The Majority of AIFs are market-neutral or show minimal correlation with market movements in publicly listed assets. Their focus on illiquid high-growth assets helps portfolios secure higher alpha. 

• Tax efficient and fully-repatriable - Investing in AIFs from NRE and FCNR accounts makes the funds fully-repatriable. NRIs residing in low-tax countries having tax treaties (DTAAs) with India find AIFs highly attractive from taxation perspective. In addition, AIFs managed in the GIFT City, India's first International Financial Services Centre (IFSC), offer unique advantages in terms of relaxations on information disclosure to the Indian tax authority. 

The regulatory framework and the eligibility

The Securities and Exchange Board of India (SEBI) regulates alternative investment funds under its AIF Regulations, 2012. This regulatory guideline has been amended recently in 2023. 

It requires sponsors or managers of AIFs to show significant "continuous" monetary interests in their funds. It ensures regulatory alignment and mature financial behavior through the so-called 'skin in the game' strategy. 

As per the recent amendments in the SEBI (AIF) Regulations, 2012, AIFs are categorised into three broad segments. 

NRIs willing to invest in AIFs must also be careful about the Foreign Exchange Management Act (FEMA) guidelines, maintained by the RBI. 

Investment routes: NRE/NRO accounts and GIFT City options

According to FEMA guidelines, NRIs, Persons of Indian Origin, and foreign nationals can invest in AIFs using funds from their NRE, NRO, and FCNR accounts. India's only IFSC, the Gujarat International Finance Tech-City (GIFT City)-based banks and financial institutions also offer opportunities of investing in AIFs directly using foreign currencies with minimal Indian regulatory oversight.  

Investment through, 

• NRE and FCNR accounts are fully-repatriable and exempt from paying tax on profits/gains in India. 

• NRO accounts are repatriable up to a maximum of USD 1 million every financial year.  

NRIs willing to invest a large corpus in AIF should choose NRE accounts. Investing above INR 1 crore will require several years to fully repatriate. 

Investing through GIFT City accounts offers unique advantages like, 

• Currency neutrality, as NRIs may choose to invest in any major currencies. 

• Regulatory frameworks are similar to international standards.  

• Accepting investment in foreign currency denominations.  

Overall guidelines related to repatriation and funding sources at a glance:

Taxation and compliance requirements

Regarding tax implications, AIFs can be categorised into two broad types. 

• Pass-through structure - Category I and II AIFs belong to this category. Except for business income from AIF portfolio assets, all other incomes are passed on to investors and are taxable in the hands of investors. It helps NRI investors to claim DTAA benefits. Business incomes such as interests, rental, and dividend earnings are taxed at the fund level. 

• Taxed at fund level - Category III AIFs belong to this category. All income from such AIFs is taxed at the fund level before distribution to investors. Effective tax rate depends on the organizational structure of an AIF. Trusts suffer from the maximum marginal tax rate, which can be as high as 42.74% including cess and surcharge. 

NRI investors planning to invest in AIFs should also be careful about proper ITR filing and tax documentation. 

• PAN is mandatory (except for investment in GIFT City-based IFSC AIFs)

• It is mandatory for AIFs to deduct TDS for investments through NRO accounts. 

• NRI investors can claim a tax refund if TDS is more than their actual tax liability in India. 

• NRIs are eligible to claim benefits under DTAA after furnishing necessary documents (e.g., tax residency proof, address proof in their country of residence, etc.) 

Despite a strong regulatory framework around AIFs in India, these pooled investment funds are not free from risks and challenges.  

Risks, challenges, and minimum investment size

• Liquidity risk - AIFs require investors to use only patient capital as these funds are highly illiquid in the short and medium terms. It can create liquidity crunch in investment portfolios. Liquidity risks may also arise due to FEMA restriction on repatriation of funds related to investments from NRO accounts.  

• Absence of standard due diligence protocol - AIFs are not standardised investment tools. Their investment strategies vary widely. It can be difficult even for sophisticated HNI and ultra-HNI investors to perform thorough due diligence. 

• Operational and managerial risk - Despite explicit continuing interests in funds, there is no concrete mechanism to control operational and managerial risks in AIFs. Lack of proper due diligence by investors and distributors are critical for managing such risk. 

Alternative Investment Funds are sophisticated investment avenues to diversify portfolio risks and leverage unique growth opportunities of private asset classes in India. NRIs willing to invest in AIFs must diligently go through fund documents to understand risks and return potential of individual funds and their respective tax implications.

Frequently Asked Questions:

1. What is the minimum investment amount required for AIFs in India?
   The minimum investment for most AIFs in India is ₹1 crore; this threshold is reduced to ₹25 lakh for employees or directors of the AIF or its manager.

   
   

2. What is the typical lock-in period or tenure for AIF investments?
   Most AIFs have a closed-ended tenure ranging from 3 to 10 years, during which capital withdrawal is restricted.

   
   

3. What operational and regulatory challenges might NRIs face during ongoing AIF investment management?
   NRIs need to monitor SEBI and FEMA updates, maintain proper documentation for tax filings, comply with KYC norms, and stay aware of repatriation regulations throughout the investment lifecycle.

   
   

4. What are the key due diligence steps NRIs should take before investing in an AIF?
   Investors should assess the fund manager’s track record, underlying asset quality, governance, fee structure, and alignment with their risk appetite because AIFs vary widely in strategy and transparency.