Sebi's new asset class proposal has made Cat 3 AIFs a worried lot

The root cause for concern is the belief that the new asset class would be taxed lower as compared to the Category 3 AIFs as the products would be launched by mutual funds, which enjoy the benefits of a pass-through status – the income is taxed in the hands of the investor and the fund does not have to pay any tax.

The Alternative Investment Fund (AIF) industry, especially the Category 3 funds community, has become a worried lot ever since the Securities and Exchange Board of India (Sebi) came out with a discussion paper, proposing a ‘New Asset Class’.

While it is believed that the proposed new asset class could be a game-changer by pulling away investors from unregistered and unauthorised investment products, there is also talk among Category 3 AIF managers that a potential tax advantage could lead to some of their investors routing a part of their money towards the new option.

The root cause for concern is the belief that the new asset class would be taxed lower as compared to the Category III AIFs as the products would be launched by mutual funds, which enjoy the benefits of a pass-through status – the income is taxed in the hands of the investor and the fund does not have to pay any tax.

Also read: MC Explainer | All you need to know about the new asset class proposed by Sebi

This assumes significance since in the case of an equity mutual fund, the investor will have to pay a tax on the capital gains, which is 12.5 percent for long-term and 20 percent for short-term, said Dipesh Jain, partner at Economic Laws Practice. Since the new asset class will be launched under the mutual fund structure, it will be taxed on the same rates as above.

In the case of a Category 3 AIF, however, the tax is paid at the fund level, which could be as high as nearly 40 percent.

“Category 3 AIFs do not have a pass-through status, unlike a mutual fund, putting investors in CAT 3 AIFs at a disadvantage. While investors pay capital gains tax on the profits earned from mutual funds, CAT 3 AIFs pay taxes at the fund level at the maximum marginal rate, of 39 percent,” said Puneet Sharma, chief executive officer at Whitespace Alpha, a Catgeory 3 AIF.

He further said that the debate has been that Category 3 AIFs do complex structures and hence tax is paid at the fund level. However, if the new asset class will also be doing a similar structure so there should be tax parity, he added.

Also read: Sebi's proposed asset class is for the discerning investor, will add to AUM, say fund houses

Further, multiple fund managers that Moneycontrol spoke to, said that the fact that Sebi has proposed pegging the minimum ticket size at Rs 10 lakh for the new asset class – it is Rs 1 crore for AIFs -- investors could opt to put a part of their investible corpus in the new option while even spreading their exposure across multiple schemes of the new asset class.

“With the advantages of a lower ticket size, lower taxes, and strategies similar to those of Category III AIFs, the new asset class - if approved in its current form - could draw capital from Category III AIFs,” said a fund manager on the condition of anonymity since the structure is still at the discussion stage.

Meanwhile, it has been proposed that the new asset class can be allowed to deal in equities and derivatives, similar to category III AIFs. The distinction, however, is on the amount of exposure to derivatives one can take.

The Sebi discussion paper caps the gross exposure for the new asset class at 100 percent, while category III AIFs are allowed up to 200 percent. This is another reason why AIF fund managers argue that clients could be drawn to this new asset class because it offers a comparable product with a lower tax.

The primary objective of the Sebi discussion paper, which was released on July 16, is to provide a higher-risk product than a mutual fund but with a lower ticket size when compared to a PMS or an AIF.

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