A Move Towards “Pool in India”; However, Room for More Reforms Exists!

[The following post is contributed by Yashesh Ashar, who is a tax and regulatory consultant. Views
expressed are personal.]
The Finance Bill, 2016 has given in to the much
sought-after demand of the domestic private equity (PE) industry by amending
the provisions relating to the tax withholding obligations for the category I
and category II alternative investment funds (‘AIFs’) registered with the
Securities and Exchange Board of India (‘SEBI’) under the Securities and
Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (‘AIF
Under the extant provisions, with effect from
June 1, 2015, an AIF is required to withhold tax at source at the rate of 10%
on payment (or credit) of income to its investors (whether resident in India or
non-resident in India). The tax deducted at source is available as credit in
the hands of the investors.
This requirement is mainly onerous
vis-à-vis investors as it prescribes withholding of taxes on all incomes,
including those that are either exempt in their hands viz. dividend income or
long term capital gains on listed securities (in case of resident as well as
non-resident investors) as well as those that are not liable to withholding
requirements viz. capital gains income (in case of resident investors). As
regards non-resident investors, this condition also requires tax withholding
against capital gains income exempt under the relevant Double Taxation
Avoidance Agreement (‘Tax Treaty’) and would require non-resident investors to
claim refund of the tax withheld from the tax authorities, which would entail
additional lead time, cash-flow issues for the investors and consequently, impact
their return on investments in the AIF.
The Finance Bill, 2016 proposes to amend the
above provisions by prescribing that the AIF will be required to deducted tax
on income – (i) at the rate of 10%, in case of payment to resident investors;
and (2) at the rates in force, in case of payment to non-resident investors. This
amendment will allow the AIFs to consider the concessional provisions under the
relevant Tax Treaty while making payments of capital gains income to the
non-resident investors.
Historically, a substantial majority of the
capital raised from foreign investors for PE investments in India by
India-based fund-managers / by Indian investment professionals have been raised
in fund vehicles domiciled in overseas jurisdictions (predominantly in
Mauritius) due to various tax and regulatory reasons.
A move toward the “Pool in India” initiative got
impetus with, first, the AIF Regulations weeding out the asset-side
restrictions under the erstwhile SEBI (Venture Capital Funds) Regulations, 2012;
second, with the legislation providing a “partial pass-through status” to the
AIFs under the Finance Act, 2015; and third, by permitting foreign investments
in AIFs under automatic route and clarifying the regulations relating to
downstream investments by AIFs having foreign investments under the foreign
direct investment (‘FDI’) policy of the Government of India.
The new provisions relating to withholding on
capital gains income of non-resident investors bring a much needed parity in
taxation between the investors investing in funds domiciled overseas (say,
Mauritius, Singapore) and foreign investors directly investing in an AIF,
thereby providing a choice (and possibly a nudge) to foreign investors to
consider direct investments in AIFs in India. To the extent the new provisions
are favorably worded, they provide a major encouragement to pooling of funds in
However, as the title of this post suggests, the
amendments are not wholesome and much more could be done to facilitate and
encourage pooling in India:
1.         Pass-through
for losses:
 As mentioned
above, as the tax provisions stand today, the AIFs are provided only a partial
pass-through status. To be precise, the losses suffered by AIFs are not allowed
to be passed on to the investors. Thus, it would not be possible for the AIFs
to pass on the losses incurred to the investors. In order to provide a complete
pass-through for foreign investors, the AIFs should be allowed to pass on the
losses as well to the investors.
2.         Requirement
of obtaining permanent account number (‘PAN)’
: As per the provisions of the Income Tax Act, any person making
any investment in India or earning any source of income in India is required to
obtain a PAN from Indian tax authorities. Further, the provisions of the Act
also provide for a higher withholding at 20% on payment of income to
non-residents who do not have a PAN. This has proved as a deterrent for
non-resident investors from jurisdictions having favorable Tax Treaty from
making direct investments into India. The Finance Bill, 2016, proposes to
modify these provisions to provide exemption from higher withholding tax
subject to certain conditions as notified. Exempting non-resident investors
investing in AIFs from jurisdictions with favorable Tax Treaties with India,
subject to relevant KYC and certificate from chartered accountants on
taxability, would provide a much-needed relaxation to non-residents desirous of
investing directly into AIFs.
3.         Incentives
for fund managers:
order to provide a further impetus to the “pooling in India”, the taxation
regime in India should be at par with their overseas counterparts
(particularly, Singapore) even with regard to incentives for the fund managers.
For example, the fund managers in Singapore enjoy concessional tax rates on
management fees as well as remission from goods and services taxes. Such
concessions in India may go a long way in reimporting the fund management
activities exported out of India to other countries.
4.         Simplification
of the alternative investment fund’s regime
: Most of the international securities market regulators have
followed the approach of regulating the fund manager (viz. USA, Singapore,
European Union). However, SEBI seems to have adopted a dual approach by
registering and regulating the AIF as well as regulating the conduct of the
fund manager to the AIF. This approach also entails an additional process and
time in launching a new AIF. Accordingly, SEBI should consider streamlining the
AIF Regulations in the lines of internationally acceptable practice. This
recommendation has also been made by the Alternative Investment Policy Advisory
Committee (‘AIPAC’) formed by SEBI under the chairmanship of Mr. N Murthy.
5.         Pooling
for portfolio investors
Though the foreign portfolio investors are
allowed to make investment in Category III AIFs (‘Cat III AIFs’), the
Act does not provide pass-through status to them. This has impaired the
expected development of the domestic hedge fund industry post the introduction
of the Cat III AIFs under the AIF regime. This has mainly been due to the
fundamental principle of the trust taxation regime (as most of the AIFs are
set-up as trust), which does not provide pass-through for business activities.
However, considering the recent
circular of the Central Board of Direct Taxes (‘CBDT’) dated February 29, 2016
stating that income arising from transfer of listed shares and securities which
are held for more than 12 months should be treated as capital gains, if desired
by the taxpayer. Based on this, those Cat III AIFs which are proposing to make
investments in only listed shares and securities (excluding derivatives) should
be allowed pass-through status in the lines of AIFs. Needless to say that this
should be subject to reasonable obligations on the fund managers to ensure that
the individual as well as aggregate investments limits as prescribed by SEBI
for FPIs.
The above reforms may also make popular the
vastly recognized ‘unified structure’ – wherein the overseas pooling vehicle
would just act as a feeder to the AIF – for private equity investments into
India, which was either to not so popular given the tax and regulatory issues.
This may obviate the need for India based private equity firms from relocating
and incurring huge costs on relocating and maintaining offices, employees,
infrastructure for carrying out fund management activities in overseas
Apart from that, the relaxation of the
withholding provisions may make many India based private equity firms
reconsidering their strategy in favour of ‘unified structure’.
A favorable environment for pooling funds in
India could help accelerate the growth of the overall fund industry as well as
other ancillary industries such as fund administration, custodial services, and
trustee ship services thereby, creating additional employment opportunities in
the financial services sector. This may also help in stalling the export of
India’s talent pool in fund management space to other countries. A reduction in
uncertainty in tax and regulatory regime would also promote investor confidence
in directly investing in India as well as improve India’s competitive edge in
housing funds and funds management industry.
Overall, the pooling of funds in India would
have a positive effect on the Indian economy from a long-term perspective.

– Yashesh Ashar

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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