Foreign Direct Investment: Trusts as Investment Vehicles

has contributed the following guest post. Vishal is a 5th
year student at the National University of Advanced Legal Studies, Kochi]
Recently, two investment vehicles have been
introduced that as per the relevant SEBI regulations are to be set up as
trusts: Real Estate Investment Trusts (‘REITs’) and Infrastructure Investment
Trusts (‘IITs’). Both are intended to be pooling vehicles for domestic and
foreign capital, and the Securities and Exchange Board of India (‘SEBI’) indicated
that further guidelines regarding foreign investment into these vehicles would
be laid down by the Reserve Bank of India (‘RBI’). This turns the spotlight
onto a rather dimly lit corner of our Foreign Direct Investment (‘FDI’) policy
that will need to be evolved to accommodate these vehicles: that of FDI into
trusts. The aim of this post is to explore the rules that currently govern
these transactions, and suggest the direction that future regulation might
Trusts have been the fund vehicle of choice for
Venture Capital Funds (‘VCFs’; these are nowadays better referred to as
Alternate Investment Funds or ‘AIFs’[1],
and are employed by private equity and venture capital investors) due to their
tax efficient nature. Much like REITs and IITs, AIFs are ‘domestic pooling
vehicles’: they are regulated by SEBI and situate in India, but will often
collect and deploy foreign capital.
An AIF set up as a trust will issue ‘units’ in
exchange for contributions from investors; the possession of a unit will make
the investor a beneficiary of the trust. Again, like REITs and IITs, an AIF’s
units come with some management rights and entitle the holder to a share of the
vehicle’s profits (making these ‘units’ similar to a company’s equity).
 AIFs set up as trusts essentially twist the trust form to mimic a closely
held private company or a limited liability partnership (‘LLP’); the closest
analogy for a REIT or IIT would be a listed company with diffused shareholding.
Thus, in the context of trusts, the FDI is made
in consideration for the issue of trust ‘units’ as opposed to equity or hybrid
securities of a company. The transfer or issue of a trust unit for
consideration could be regarded as a ‘capital account transaction’ as defined
in section 2(e) of the Foreign Exchange Management Act, 1999.
Consequently, the Department of Industrial Policy
& Promotion’s (‘DIPP’) Consolidated FDI Policy 2014, and the RBI’s 2014
Master Circular on Foreign Investment lay down that the only trusts that can
receive FDI are AIFs[2]
set up as trusts, and that such investments will always require a Foreign
Investment Promotion Board (‘FIPB’) approval. That trusts are treated with
skepticism is apparent from the Consolidated Policy’s readiness to allow AIFs
set up as companies to take in FDI through the automatic route, while denying
this benefit to AIFs set up as trusts[3].
This discriminatory treatment of trusts is seen
in each of the Consolidated FDI Policies released since 2010, and the rationale
for this can perhaps be found in the FIPB’s 2009 Review[4].
Therein, the DIPP observed that unlike a company, it was difficult to ascertain
with whom the ownership and control of a trust lay; in this connection, there
have been news reports of proposals for FDI into trusts being rejected because
the identity of the beneficiaries was unknown[5].
The DIPP acknowledged that the application of DIPP Press Notes regarding
downstream investment to trusts was difficult, and expressed the concern that
trust vehicles were largely unregulated[6].
In the 2009 Review, the DIPP had also insisted
that a foreign investment made into the defence sector through a VCF set up as
a trust adhere to the sectoral cap and other conditions, interestingly
reasoning that the units of that particular trust were nearly akin to equity in
a company, since the unit holders (i.e., the investors) were able to exercise a
high degree of control over the trust.  The DIPP suggested that the
downstream investment made by a trust into investees should itself be
regarded as an indirect FDI in terms of Press Note 2 of 2009, implying that the
investment into the trust is the ‘upstream’ FDI.
In its 2011-2013 Review[7],
the FIPB clarified that investments made by the AIF would be regarded as
FDI and would have to confirm to sectoral caps and conditions laid down in the
Consolidated FDI Policy. The FIPB also seemed to suggest that an AIF
could only raise funds (investment into the trust) from investors
registered with SEBI as Foreign Venture Capital Investors (‘FVCIs’;
importantly, FVCIs are not subject to pricing restrictions when they buy, sell
or redeem trust units). Another condition imposed by the FIPB was that an AIF’s
investors must be resident in a country that is a member of the Financial
Action Task Force and is a signatory to IOSCO’s Multilateral MoU.
From the above paragraphs, two conclusions may be
drawn: Firstly, the FIPB Reviews and the news reports cited above point to the
conclusion that the concerns that the DIPP/FIPB have with trust vehicles has
engendered an attitude of suspicion; resultantly, they only feel comfortable
with trust vehicles if the investors into the trust are themselves regulated
(like FVCIs are by SEBI), if the investments are subject to their approval, and
if certain safeguards against money laundering, securities fraud and terrorist
financing exist. For REITs and IITs, the implications of this may be that
investors will be required to go through a lengthy and cumbersome approval
process before multiple regulators and/or subjected to heavy regulation.
Secondly, an FDI employing a trust, when
permitted, is potentially comprised of two ‘legs’. The ‘first leg’ is the issue
of trust units to an investor. In the context of AIFs, this is the ‘pooling’ or
‘fund raising’, which requires an FIPB approval. The ‘second leg’ is the downstream
investment by the trust: this is regarded as a direct FDI. Whether the
‘first leg’ is also characterized as a direct FDI, and must comply with FDI
rules such as pricing guidelines on purchase and sale/redemption of trust units,
is unclear. The Consolidated FDI Policy is silent on this aspect, and it seems
strange to suggest that both the ‘first leg’ and the ‘second leg’ should be
regarded as direct FDIs.
From a conceptual point of view, an argument
might be made that the ‘first leg’ should stand outside the FDI regime, since
it is a pooling of capital and not a deployment of it. This would mean that the
foreign investment into the trust would be free from FDI conditions such as
seeking approvals and pricing guidelines on purchase and sale/redemption of
trust units. In the context of REITs and IITs however, the DIPP/FIPB will most
likely try to regulate the ‘first leg’ by making it subject to their approval
due to the nature of the investment and the vehicle. It would be desirable if
REIT and IIT investors were not subject to pricing guidelines.
The law as it currently stands lacks clarity with
regard to the rules that govern the ‘first leg’, and is marked by a cautious
approach to trusts as vehicles for FDI. The status of the ‘second leg’ also
needs to be clarified, given that REITs and IITs may employ special purpose
vehicles (‘SPVs’), and that these SPVs may be organized as LLPs. Unless
addressed promptly in the correct manner, these might prove detrimental to the
success of REITs and IITs. It might be productive to begin from the ground up
when laying down rules for investment into REITs and IITs, rather than trying
to integrate these rules into the current FDI framework. In conclusion, it is
worth noting that the only thing that might dissuade investors as much as an
adverse regulatory climate is regulatory uncertainty.

Vishal Achanta                                                                                 

In 2012, SEBI replaced the Venture Capital Fund
Regulations, 1996 with the Alternative Investment Fund Regulations. The latter
delineates three categories of AIFs, of which VCFs are one sub-category.
See also, Paragraph of the 2014 Consolidated FDI Policy, which
requires FIPB approval to be obtained for FDI into every Indian company that is
engaged only in the activity of investing in other Indian companies.
At the time the DIPP made these observations, VCFs
set up as trusts could choose to remain unregulated by SEBI. This is no longer
the position; VCFs, as a sub-category of AIFs, must register with, and be
regulated by SEBI.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

1 comment

  • "The ‘second leg’ is the downstream investment by the trust: this is regarded as a direct FDI."

    How is downstream investment direct FDI? 3.10.2 of the FDI Policy states that downstream investment is indirect.

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