PremiumA lot of wealthy investors who are seeking to have their own family office, are increasingly considering to set-up their own alternative investment fund
To manage family-owned wealth, investors use various business entities such as a trust, a limited liability partnership, a Hindu Undivided Famil or HUF, a partnership firm, and a private limited company depending on the nature of income and the tax aspects.
As per the industry sources, a lot of wealthy investors who are seeking to have their own family office, are increasingly considering to set-up their own alternative investment fund (AIF).
An AIF is a privately pooled investment vehicle with a minimum investment amount requirement of ₹1 crore ( ₹25 lakh for a venture capital fund) that provides access to unconventional asset classes such as private equity, pre-IPO funds, hedge funds or simple funds claiming to have higher alpha-generating capabilities. These funds come under the purview of the SEBI’s AIF regulations.
The increased interest is, supposedly, on the back of sufficient control that the AIF legal structure offers over one’s investments. There’s also a murmur that wealth managers are encouraging their investors to set up an AIF, such that the former can circumvent some investment advisory regulations, which may not allow them to charge higher fees, as per one of the industry veterans.
In this article, we look at the differences between an AIF and a private trust, which is one of the most common structures used to manage the assets of the wealthy in India.
Rishabh Shroff, Partner & Co-head-Private Client, Cyril Amarchand Mangaldas and Vivaik Sharma, Partner, Cyril Amarchand Mangaldas share their inputs on this subject.
Who are the family members that can be part of an AIF and a private trust?
Shroff: A private trust would need to be set up for a specified category of family members to get important tax benefits, under the Income Tax Act, 1961. It is normally for a narrow category of immediate family members including spouses, father, mother, brother, sister, son, daughter, son’s wife, and daughter’s husband. If an extended group of family members wishes to invest together via a common entity, a trust will not work.
Does an AIF allow consolidation of all assets (across asset classes) just like a private trust?
Sharma: Given that AIFs are permitted to invest only in shares and securities, consolidation of other asset classes such as an immovable property through an AIF is not possible. Hence, AIFs have limited utility as asset consolidation vehicles.
What are the overseas investing limits for both AIF and a private trust?
Sharma: Overseas portfolio investments by AIFs are subject to various regulatory conditions and can be made only in unlisted venture capital undertakings overseas with prior approval from SEBI. SEBI permits AIFs to make overseas investments within an overall limit of US$ 1,500 million (for all funds). AIFs cannot make offshore investments in excess of 25% of their investable corpus.
Shroff: Private trusts which are registered and engaged in the educational sector or which have set up hospitals in India may make overseas direct investments in a foreign entity with the prior approval of the RBI, subject to further conditions prescribed under the foreign exchange regulations. For other private trusts too, prior approval from RBI would be required for any overseas investments. Given these complications, ODI from a trust is not undertaken.
What are the investment restrictions for an AIF?
Sharma: Such conditions depend on the category/sub-category of AIF. Diversification norms are prescribed for AIFs. For instance, Category I and II AIFs are not permitted to invest more than 25% of their investible corpus in a single company. For Category III AIFs, the limit is 10% of investable funds. The limit increases to 50% for Category I and II AIFs, and to 20% for Category III AIFs for large-value funds for accredited investors. While Category II and III AIFs can be sector agnostic, sub-categories of Category I AIFs require funds to focus a material part of their corpus on specific sectors or strategies.
How is the income of an AIF and a private trust taxed differently?
Sharma: Taxation of AIFs under the IT Act depends on the category of AIF. Category I and II AIFs have been accorded a pass-through status. That is, income (other than business income) earned by the said AIF is taxable in the hands of the investors, subject to applicable withholding taxes. Such income taxed at the level of the investors is exempt in the hands of the AIF. Unlike Category I and Category II, there is no specific tax regime for Category III AIFs. Income earned by these AIFs is taxable depending upon the legal structure of the AIF.
Shroff: Taxation of a private trust is also contingent upon various factors and how the trust is set up. Questions such as whether the trust is determinate or discretionary (share of beneficiaries is not fixed), revocable or irrevocable etc. are relevant. The income of a revocable trust (that can be ended anytime) is directly taxed in the hands of the contributors/settlors. In the case of an irrevocable determinate trust, income may either be taxed in the hands of the beneficiaries or the trustees as a representative of the beneficiaries.
In the case of an irrevocable discretionary trust, trustees would be liable to tax, as a representative of the beneficiaries, at the maximum marginal rate i.e. 42.74%. This is the most commonly used option by families/individuals looking to settle trusts for their wealth. Whilst the trust tax rate is very high, the flexibility a discretionary trust provides for distributing family wealth over time weights heavily in the minds of promoters whilst settling such trusts. If done properly and early in the game, such trusts provide asset protection advantages as well.
What are the basic compliance requirements of an AIF and a private trust?
Sharma: In the case of a private trust structure, the trustees of such trust are required to file/ report tax returns.
On the other hand, AIFs are required to file periodic reports to SEBI and to their investors. AIFs are also compulsorily required to file an income-tax return in India. Further, AIFs would also be required to file a withholding tax return and undertake related compliances with respect to the taxes withheld by it on the distribution to its investors.
Additionally, AIFs are also required to furnish a statement to the investors and the tax authorities, giving the details on the nature of income credited or paid to the investors each year.
How does an AIF compare to a private trust when it comes to basic set-up and recurring costs?
Sharma: Typically for AIFs, set up cost ranges between 1% to 2% of the overall fund size. Recurring or operating expenses are typically around 1.5% to 2% per annum excluding management fees
Shroff: The basic cost of setting up a private trust is nominal in relation to statutory costs and expenses. Lawyer / legal fees vary by the quality (or lack thereof) of the lawyer used. The recurring cost would depend upon the assets held and managed by the trust as well as the nature of the trustees. If the obligation of managing investments and the corpus of the fund is outsourced to a professional trustee, then the same would entail an annual asset management fee.
With tenure limitations for AIFs, are these structures appropriate for succession planning?
Sharma: AIFs are required to have a specific tenure (except Cat III open-ended AIFs) and are typically used for third-party investments. The fund managers are required to liquidate assets and wind up the fund in accordance with the tenure of the AIF. Unlike a private trust structure, AIFs are not suitable for succession planning.
Shroff - A private trust has numerous advantages. They help with the consolidation of wealth and corporate control in a family business, including the prevention of fragmentation of shareholding over time (as shareholding may get dispersed across multiple heirs across generations). It also facilitates succession planning and inter-generational transfer of assets without the need for probate (if applicable). A trust structure also provides asset protection benefits from third-party claims, including creditors and matrimonial claims. However, each circumstance is different and each family’s trust needs to be carefully calibrated.
Who is it suitable for to set up an AIF/private trust?
Sharma - An AIF structure would work for making investments as per a defined investment philosophy. Many promoters and families use AIFs as their preferred route for a formal family office (as opposed to a generic company or LLP).
Shroff- A private trust structure works best for individuals/families looking to achieve objectives like ring-fencing of assets, smooth intra-generational transfer of assets, potential estate duty protection, consolidation of wealth, etc. more often than not, trusts are used by multi-generational business owners for such objectives.
Can a family use an AIF structure for wealth creation and a private trust for succession planning?
Sharma- Setting up an AIF requires fulfillment of certain requirements like having a key person with at least 5 years of fund management, portfolio management, dealing in securities, or similar experience and necessary infrastructure for fund management for which confirmations are required to be provided to SEBI.
Both an AIF and a trust can function in parallel, and such structures need not be considered under an either/or approach. Many families use both routes for different objectives.
What is the equation between a family office and an AIF/private trust?
Shroff - Both an AIF and a private trust can function parallelly and can both be a part of a family office. In fact, in the recent past, an AIF is emerging as a popular choice for family offices as it offers sufficient control over investments and helps in the diversification of the portfolio of family offices.
(with inputs from Maulik M, Senior Correspondent at Mint)