Update: Proposed Amendments to the AIF Regulations

[The following post is contributed by Bhushan Shah and Labdhi Shah from Mansukhlal Hiralal & Company]
Alternative Investment Funds (AIF(s)) play a vital role in Indian economy
as they drive economic growth and contribute significantly to nation building. To
regulate AIFs under one single regime, the Securities and Exchange Board of
India (SEBI) in 2012 notified SEBI (Alternative
Investment Funds) Regulations, 2012
). In 2013, SEBI further notified amendments
to AIF Regulations.
In 2015, SEBI established the Alternative
Investment Policy Advisory Committee (AIPAC),
which was headed by Mr Narayana Murthy for further development of alternative investments
by removing hurdles. AIPAC very recently submitted its Report
and SEBI has invited comments on this Report by 10 February 2016.
In this update, we have briefly summarised
recommendations made by AIPAC in the Report:
Make Tax Pass-Through Work Effectively
: Given
that AIFs are simply vehicles that pool the savings of investors for
professional fund management over a long-term period, it is imperative that the
tax pass-through system is made simple and effective. In this regard, the
Report recommends the following: (a) the exempt income of AIFs should not
suffer tax deducted at source (TDS) of
10%; (b) exempt investors should not suffer tax withholding of 10%; (c) investment
gains of AIFs should be deemed to be ‘capital gains’ in nature; (d) the tax
rules applicable to ‘investment funds’ in Chapter XII-B of the Income Act, 1961
(IT Act) should be extended to all
categories of AIFs; (e) losses incurred by AIFs should be available for set-off
to their investors; (f) non-resident investors should be subject to tax rates
in force in the respective Double Tax Avoidance Agreements (DTAA).
Deemed Income
: Given that the income of an
AIF arises only when it receives dividend or interest income during the holding
period in a portfolio company, or realises capital gains at the time of exit
from the portfolio company, it is important to understand that investments made
in portfolio companies are capital contributions and not the income of the
portfolio company. Thus, in light of these principles, it is recommended that AIFs
as well as portfolio companies are exempted from Section 56(2)(viia)and
56(2)(viib), respectively, of the IT Act.
Indirect Transfers
: The Report recommends seeking
clarification from CBDT that investors in the holding companies or entities
above eligible investment funds investing in India are not subject to the
indirect transfer provisions.
Safe-Harbour Effective for Managing Funds from India
Given that the safe harbour rules enacted by the Government under Section 9A of
the IT Act have not been effective so far, the Report recommends changes inthe
conditions provided thereunder, namely: (a) investor diversification; (b) control
or management of portfolio companies; (c) tax residence; (d) arm’s length
remuneration of fund managers; and (e) annual reporting requirements. These
changes will help fund managers to manage their investments from India.
Foreign Direct Investment (FDI) in AIFs Work Efficiently
While the Government’s move to allow FDI in SEBI-registered AIF is a welcome
measure, in order to make the same effective, the Report recommends that the
Government should: (a) clarify the rules for investment by non-resident Indian
investors in AIFs on a non-repatriation basis; (b) eliminate ambiguity to
enable NRIs to invest in AIFs using funds in their rupee NRO accounts; (c)
provide for TDS on distribution of income to non-resident investors in AIFs in
accordance with DTAA tax rates in force; (d) grant permission to LLPs to act as
sponsors and/or managers of AIFs; and (e) relax Indian tax compliance
obligations for non-resident investors in AIFs.
Transaction Tax (STT)
: The Report recommends that
Government should introduce STT at an appropriate rate on all gross distributions
of AIFs and investments, short-term gains and other income and eliminate any
withholding of tax. Post the levy of STT, income from AIFs should also be tax
free to investors.
Domestic Capital Pools:
The Report observes that merely
10-15% of the equity capital required by start-ups, medium enterprises and
large companies is funded from domestic sources, and the remaining is funded
from overseas, owing to constraints on the traditional sources of funding to
supply risk capital. Given this scenario, the Report inter alia recommends that: (a) regulators such as RBI and IRDA
must be convinced to encourage institutions regulated by them to invest in AIF
asset class; (b) all banks, pensions, provident funds, insurance companies and
charitable endowments which invest in equities mustutilize a minimum of 2-5% of
the corpus or annual contribution of that amount in SEBI approved Category 1
AIF; (c) investment limits for banks and insurance companies in AIF must be
increased from 10% to 20%; (d) For banks, investments in AIF should be treated
as priority sector investments and it should not impact the banks’ capital
market exposure; and (e) charitable or religious funds should be permitted to
invest in SEBI – registered Social Venture Funds.
Onshore Fund Management:
The Report observes that
currently, approximately 95% of venture capital (VC) and private equity capital (PE) is contributed by overseas investors and the majority of
overseas investors (i.e. 98% of total foreign VC/PE capital) and their managers
prefer to domicile their funds offshore, i.e. in countries with stable and
favourable tax and regulatory regimes on fund management, since their FDI and Foreign
Portfolio Investment (FPI) regimes
are considered to be far more consistent in contrast to the changing tax and
regulatory regimes specific to VC/PE Funds in India. Two major factors which
have led to this situation are (a) the lack of clarity in taxation; and (b)
severe restrictions on the operational freedom of fund managers domiciled in India.
In order to overcome this, the Report recommends: (a) creating parity between
Indian and offshore regulations and with their respective DTAA; (b) allowing foreign
investment from international limited partners directly into domestic AIFs by
bringing changes to the FDI policy/FEMA and the policy on TDS; (c) creating level
playing field between the fund managers domiciled in India and those located
offshore, which is not the case in India currently; (d) enablingmore foreign
funds to be domiciled in India and brought under the purview of SEBI by
ensuring clear policies and their consistent application over the entire life
of fund vehicles; (e) an immediate clarification from CBDT that exemptsthe income
flowing through AIFs from suffering any withholding tax; (f) amending the
safe-harbour norms for ease of doing business.
the AIF Regulatory Regime:
The Report observes that most
regulatory efforts have rightly focused on protecting minority shareholder
interests and improving compliances, however, there has been a limited direct
regulatory effort focused on PE and VC industry itself. Thus, the Report
recommends the following:
Regulation ofthe Fund Manager
and not the Fund
:  The
Report recommends the repeal of (i) SEBI (Portfolio Manager) Regulations, 1993,
(ii) SEBI (Alternative Investment Funds) Regulations, 2012; and (iii) SEBI
(Investment Adviser) Regulations, 2013 and the introduction of a regulatory
framework / policy to govern the fund manager such that the fund manager is
responsible for all the investment activities of the client. The Report further
recommends that new SEBI (Alternative Investment Fund Managers) Regulations (AIFM Regulations) shouldreplace all the
above-mentioned Regulations. A registered Investment manager under the AIFM
Regulations willprovide discretionary or non-discretionary investment advisory/
management services to investors who could be individuals/ a group of individuals
or open-ended/ close-endedfunds or clients seeking customized products. Investment
manager will have specific capitalization requirements, which could provide for
sub-categories based on the nature of the AIFM’s business (i.e. discretionary,
non-discretionary, customized or collective investments). The funds raised by
registered investment manager will follow the SEBI guidelines and notify SEBI
under an appropriate reporting framework.
Amendments in AIF Regulations:It
is recommended that the definition of “venture capital fund” in Category I AIF
is amended to include funds that invest in “growth” stage ventures.
Classification of Category III
: The Report recommends creating sub-categories,
namely under Category III AIF:  (a)
Category III Sub-category A for an AIF which will primarily invest in public
markets and will not employ leverage including through investment in listed or
unlisted derivatives (except for the purpose of hedging the investments). The
said new category will invest on a long-term basis with a minimum life of 3
years; and (b) Category III Sub-category B for ‘Complex Trading Fund’, i.e.
funds which employ diverse or complex trading strategies and may employ
leverage including through investment in listed or unlisted derivatives. This
classification will segregate a diverse range of strategies under the Category
III umbrella into 2 distinct buckets based on investment horizon, underlying
securities and investment objectives. This will further aid in matching
investors with appropriate strategies.
10% Restriction of Investible
Clause 15(d) of the AIF Regulations state that
Category III AIF shall invest not more than 10% of the investible funds in a
singleInvestee Company. It is recommended that 10% restriction of ‘investible
funds’ in a single Investee Company should be replaced with the reference to the
‘market value’ of such securities at the time of investment.
In a global scenario, where countries compete for capital, the success of
alternative investments in India in long-term will depends on its tax policy which
require to be globally competitive. AIFs can make a significant contribution to
India’s GDP and the implementation of AIPAC’s can help India attract large
capital flows.
Bhushan Shah & Labdhi Shah

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.

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