In India a significant portion of registered Alternative Investment Funds (AIFs), (around 80% of 1600+ AIFs), fall under Category I and II. Given that Category II includes a broad range of private equity funds, debt funds, and real estate funds, it's consistently the most popular category.

Alternative Investment Funds (AIFs) are typically closed or shut down at the end of their predetermined tenure, but there are also provisions for early termination and a structured process for dealing with unliquidated assets. Before AIF framework was introduced in 2012, Venture Capital Funds (VCFs) used to operate under a different framework. A consultation paper from SEBI in 2024 states that a considerable number of VCFs with expired tenures had not been wound up and continued to hold unliquidated investments. Some of them were allowed to settle the violations relating to winding up and/or migrate to AIF regime.

Most AIFs, particularly Category I and II, are closed-ended, meaning they have a fixed tenure as specified in their Private Placement Memorandum (PPM). This tenure is the most common and standard reason for an AIF to wind up. At the end of the specified tenure, the AIF enters a "liquidation period," which typically lasts for one year. During this time, the fund's primary activity is to liquidate all its investments, pay off any liabilities, and distribute the proceeds to its investors on a pro-rata basis. The fund is prohibited from making any new investments.

An AIF can also be shut down before its fixed tenure for a number of reasons. It could be investor driven. This can happen if investors believe the fund's performance does not meet expectations or if a significant event has occurred and at least 75% of the investors (by the value of investment) pass a resolution to wind up the AIF. The trustees too have the authority to wind up the fund if they are of the opinion that it is in the best interest of the investors. SEBI can of course direct the winding up of an AIF if it is deemed to be in the interest of investors, such as in cases of non-compliance, fraud, or other regulatory violations. Lastly, if an investment manager is removed and investors are unable to find a replacement with a 75% vote, the AIF manager may move to wind up the fund.

A common challenge for AIFs is the inability to liquidate all their assets within the one-year liquidation period. To address this, SEBI has introduced a framework for a "dissolution period." If a fund has unliquidated investments after its liquidation period, it can enter a dissolution period with the consent of at least 75% of the investors (by value of investment). During the dissolution period, the fund is still prohibited from making new investments. An important requirement is that the AIF manager is not allowed to charge management fees. If at the end of the dissolution period, there are still unliquidated investments (this has happened in many instances of investments in real estate companies, low rated debt paper and early stages / start-up companies), they must be compulsorily distributed "in-specie." This means the actual assets (e.g., shares and other securities in unlisted companies, rather than cash) are distributed to investors in proportion to their investment. Certain compliances and reporting are mandated under the regulations during this process.

It is possible for AIF to have unpaid liabilities after its assets have been liquidated. This is a critical issue in the winding-up process, and the SEBI regulations and fund documents have specific mechanisms to address it. During the winding-up and liquidation process of an AIF, the proceeds from the sale of assets are distributed in a specific order of priority. The first claim on the fund's assets is for all its outstanding liabilities and winding-up expenses. This includes fees for liquidators, legal and audit fees, and any other debts owed by the fund. After all liabilities are paid, the remaining proceeds are distributed to investors to return their contributed capital. Money remaining after the return of capital is then distributed according to the fund's waterfall or distribution mechanism, which typically includes "carried interest" (a share of profits) for the fund manager and the remaining profits for the investors.

The problem arises when the fund's assets are not enough to cover its liabilities due to losses or there is not enough cash after in-specie distribution of assets to the investors. In cases the fund is insolvent, and the remaining assets are used to pay off the liabilities on a pro-rata basis. The key principle here is that AIFs are generally structured as a "limited liability" vehicle for the investors. The investors in the AIF (also known as Limited Partners or LPs) have a liability that is limited to the extent of their committed capital. This means that if the fund becomes insolvent and has outstanding liabilities, the investors are not required to contribute additional capital to cover those liabilities. The fund's unpaid debts are essentially a loss for the creditors/vendors who may have supplied goods or provided services to the fund.

These are provisions that allow the fund to reclaim a portion of the distributions previously made to investors or the manager (such as carried interest) if the fund subsequently incurs liabilities that it cannot cover. This is a mechanism to ensure that the liabilities of the fund are settled before the capital is returned to the investors.

The liabilities could include fees payable to the investment manager. During liquidation process, while the AIF manager still needs to perform certain administrative tasks, SEBI regulations implicitly discourage the charging of regular management fees as the fund is no longer engaged in its primary activity of making new investments and managing a growing portfolio. The terms regarding fees during this period are usually specified in the fund's Private Placement Memorandum (PPM).

A vexed tax issue arises when the unpaid liabilities are written off or waived by the creditors/vendors who supplied something or provided some service to the fund. Provisions created for such liabilities may have to be written back. Further, a key condition for operating within this dissolution period is that the investment manager cannot charge any management fees, hence any fees wrongly provided for in accounts earlier may have to be written back. The investment manager could also waive the fees due to dissolution or may not be entitled to fees as per dissolution framework. The fund in such a case writes back such liability in its accounts which get recorded as its income. The tax treatment of a "written-back" liability by an AIF is not straightforward and depends on several factors, primarily the AIF's category and the nature of the original liability.

As it often happens in taxation law that cannot envisage all possible situations, there is nothing specific in the AIF taxation rules to address this situation. So one has to draw a parallel from general principles of taxation. In case of other entities engaged in business, under Indian income tax law, a "written-back" liability, meaning a liability that is no longer required to be paid and is credited to the profit and loss account, is generally treated as income. The key question is whether this income is classified as "business income" or something else. The law provides that if a person has claimed an allowance or deduction in a previous year in respect of a liability relating to business and subsequently receives a benefit from the remission or cessation of that liability, the value of that benefit is treated as income from "profits and gains of business”.  Another provision also treats the value of any "benefit or perquisite" arising from a business as business income. Historically, there was a debate on whether this applies to monetary benefits, but amendments in 2023 have clarified that it can.

Therefore, the general principle is that if a liability (like an operational expense or a short-term trading debt) was originally claimed as a deduction by the fund and is subsequently written back, it is likely to be taxed as business income.

In case of AIFs, the tax treatment of this written-back income is dependent on the AIF's category, due to the concept of "pass-through" status. Category I and II AIFs generally enjoy a "pass-through" status. This means that most of their income, such as capital gains, dividends, and interest, is not taxed at the fund level. Instead, it is passed through to the investors and taxed in their hands as if they had earned the income directly. A critical exception to this rule is "business income." Any income that is characterized as "profits and gains of business or profession" is taxed at the AIF level, not passed through to the investors.

A prima facie view is that a written-back liability, which is almost always a form of business income as per the principles mentioned above, could therefore be taxed at the fund level and taxed at the Maximum Marginal Rate (MMR), which is the highest rate applicable to individuals (currently around 43% including surcharge and cess). If the concerned AIF is a company or LLP, it could be taxed at the corporate or LLP tax rates, as applicable.

However, in author’s view the above-mentioned prima facie view is flawed. The most crucial factor is the nature of the original unpaid liability. If it was a trading liability (e.g., operational expenses, brokerage fees, investment manager’s fees or other costs incurred in the ordinary course of business), the writeback will most certainly be treated as business income for any other entity engaged in business. But in the case of AIFs, the income is generally in the nature of capital gains or passive income like dividend and interest which is passed on to and taxed in the hands of investors on gross basis. Thus, the expenses that gave rise to the written back liability are never claimed as a deduction by the fund from any income from business. Hence the write back should not be treated as taxable income. The investors could have adopted a different position or given specific treatment in respect of such expenses, especially the costs relating to earning capital gains, dividends and interest. But that should not alter the legal position for taxation of the fund. In any case, the concerned AIF has neither any control over such treatment by the investors nor it has any information relating to that.

The author is therefore of the view that such write back of liabilities is not taxable in the case of an AIF that is in the process of closure or dissolution.

It is crucial that those in charge of administration of any AIF nearing its tenor must keep the aforesaid regulatory, accounting and tax issues in mind while initiating the liquidation or dissolution process