[The
following guest post is contributed by Kemi Gupta, who is a 5th
year B.A., LL.B (Hons.) student at NALSAR University of Law]
following guest post is contributed by Kemi Gupta, who is a 5th
year B.A., LL.B (Hons.) student at NALSAR University of Law]
In
a matter of only a few years,[1]
India’s alternative investment industry has grown to Rs. 20,700 crore in size,[2]
and is yet claimed to be in its early stages.
Alternative investment funds (“AIFs”) constitute any privately
pooled investment vehicles, established or incorporated in India, in the form
of a trust, company, limited liability partnership or a body corporate, not
covered under any other regulations prescribed by the Securities and Exchange
Board of India (“SEBI”) or other sectoral regulations.[3]
They are divided into three categories[4]
depending on the impact they have on the economy.
a matter of only a few years,[1]
India’s alternative investment industry has grown to Rs. 20,700 crore in size,[2]
and is yet claimed to be in its early stages.
Alternative investment funds (“AIFs”) constitute any privately
pooled investment vehicles, established or incorporated in India, in the form
of a trust, company, limited liability partnership or a body corporate, not
covered under any other regulations prescribed by the Securities and Exchange
Board of India (“SEBI”) or other sectoral regulations.[3]
They are divided into three categories[4]
depending on the impact they have on the economy.
AIFs
have gained tremendous significance in the Indian market. The total number of
registered AIFs has increased from 73 in August 2013 to a total of 235 as per
the data available for June 2016.[5] Since
its introduction in 2012, the growth rate in terms of funds raised and
investments made is unparalleled. The cumulative funds raised via AIFs in 2016 show
an increase of about 38 times their value three years ago[6] whereas an increase in the
total investments made reflects a 45-fold increase.[7]
have gained tremendous significance in the Indian market. The total number of
registered AIFs has increased from 73 in August 2013 to a total of 235 as per
the data available for June 2016.[5] Since
its introduction in 2012, the growth rate in terms of funds raised and
investments made is unparalleled. The cumulative funds raised via AIFs in 2016 show
an increase of about 38 times their value three years ago[6] whereas an increase in the
total investments made reflects a 45-fold increase.[7]
The
focus of this post is limited to understanding the current law on foreign
investments in Category III AIFs. Unlike Category I funds which are known to
have a positive spillover effect on the economy,[8]
Category III AIFs have the potential of giving rise to a negative externality.
These funds undertake leverage to a great extent and trade with a view to
making short-term returns.[9]
Hedge funds are one of the major examples of Category III funds which employ
diverse or complex trading strategies to invest and trade in securities which carry
diverse risks.[10]
Considering the peculiar nature of investment, Category III AIFs are
additionally required to comply with norms pertaining to risk management,
compliance, redemption and leverage.[11]
focus of this post is limited to understanding the current law on foreign
investments in Category III AIFs. Unlike Category I funds which are known to
have a positive spillover effect on the economy,[8]
Category III AIFs have the potential of giving rise to a negative externality.
These funds undertake leverage to a great extent and trade with a view to
making short-term returns.[9]
Hedge funds are one of the major examples of Category III funds which employ
diverse or complex trading strategies to invest and trade in securities which carry
diverse risks.[10]
Considering the peculiar nature of investment, Category III AIFs are
additionally required to comply with norms pertaining to risk management,
compliance, redemption and leverage.[11]
Earlier, pooling of capital was allowed only for Indian
investors, and investment was done according to a pre-determined policy. Foreign
investment was allowed only in venture capital funds (“VCFs”), if structured as
a trust, and subject to a case-by-case approval granted by the Foreign Investment
Promotion Board (“FIPB”). This was further subject to the applicable
regulations on foreign direct investment (“FDI”): for instance, venture capital
funds could not invest directly in the e-commerce sector as it was in violation
of the FDI regulations.
investors, and investment was done according to a pre-determined policy. Foreign
investment was allowed only in venture capital funds (“VCFs”), if structured as
a trust, and subject to a case-by-case approval granted by the Foreign Investment
Promotion Board (“FIPB”). This was further subject to the applicable
regulations on foreign direct investment (“FDI”): for instance, venture capital
funds could not invest directly in the e-commerce sector as it was in violation
of the FDI regulations.
By way of a Notification[12]
issued by the Reserve Bank of India, foreign investments in AIFs have now been
allowed under the automatic route. Persons resident outside India, including a registered
foreign portfolio investor (“RFPI”) and a non-resident Indian (“NRI”), have
been allowed to invest in units of AIFs. Furthermore, the extent of foreign investment
in the corpus of the AIF will no longer be a factor in determining whether
downstream investment of the AIF will constitute foreign investment or not.
issued by the Reserve Bank of India, foreign investments in AIFs have now been
allowed under the automatic route. Persons resident outside India, including a registered
foreign portfolio investor (“RFPI”) and a non-resident Indian (“NRI”), have
been allowed to invest in units of AIFs. Furthermore, the extent of foreign investment
in the corpus of the AIF will no longer be a factor in determining whether
downstream investment of the AIF will constitute foreign investment or not.
Therefore, with this new change, the implication would be
that a pooled investment vehicle in India could have majority or even almost
the entire investment from offshore investors and still buy into businesses
where foreign ownership is restricted. Funds are considered as ‘domestic’ in
nature so long as their sponsors and managers are Indian. In other words, what matters is that sponsors and managers
ought to be Indian “owned and controlled”, but the investment in the AIF itself
could be made by foreign investors. This is because in such a fund structure,
the control is said to be with the sponsors and managers, rather than
investors. AIFs so sponsored or managed are free to invest in all sectors,
without being bound by any of the sectoral restrictions and caps imposed under
the FDI rules. For instance, downstream investments by AIFs in sectors such as
e-commerce, insurance, retail, defence etc. which were previously restricted, can
now be bypassed.
that a pooled investment vehicle in India could have majority or even almost
the entire investment from offshore investors and still buy into businesses
where foreign ownership is restricted. Funds are considered as ‘domestic’ in
nature so long as their sponsors and managers are Indian. In other words, what matters is that sponsors and managers
ought to be Indian “owned and controlled”, but the investment in the AIF itself
could be made by foreign investors. This is because in such a fund structure,
the control is said to be with the sponsors and managers, rather than
investors. AIFs so sponsored or managed are free to invest in all sectors,
without being bound by any of the sectoral restrictions and caps imposed under
the FDI rules. For instance, downstream investments by AIFs in sectors such as
e-commerce, insurance, retail, defence etc. which were previously restricted, can
now be bypassed.
After
the announcement, the total amount of funds raised and investments made by AIFs
have shown a tremendous growth rate collectively.[13] However,
individually, Category III reflects a growth rate only 14.58 per cent[14]
as opposed to a 115 per cent[15]
growth in Category II and 18.49 per cent[16]
in Category I. Categories I and II have displayed better progress in the 9
month period since the allowance of foreign investments in AIFs as compared to
the investments made by Category III AIFs in the same period. The introduction
of foreign investments is a relatively new affair for AIFs, and a proper
analysis of growth is only possible with the passage of time.
the announcement, the total amount of funds raised and investments made by AIFs
have shown a tremendous growth rate collectively.[13] However,
individually, Category III reflects a growth rate only 14.58 per cent[14]
as opposed to a 115 per cent[15]
growth in Category II and 18.49 per cent[16]
in Category I. Categories I and II have displayed better progress in the 9
month period since the allowance of foreign investments in AIFs as compared to
the investments made by Category III AIFs in the same period. The introduction
of foreign investments is a relatively new affair for AIFs, and a proper
analysis of growth is only possible with the passage of time.
There is one specific restriction
imposed with regard to Category III under the notification. A Category III AIF with
foreign investment is allowed to make portfolio investment in only those
securities or instruments in which an RFPI is permitted to invest. Therefore, in
order to fully understand the investment opportunities available to Category
III foreign investments, it would be necessary to look at the investment options
available to an RFPI.
imposed with regard to Category III under the notification. A Category III AIF with
foreign investment is allowed to make portfolio investment in only those
securities or instruments in which an RFPI is permitted to invest. Therefore, in
order to fully understand the investment opportunities available to Category
III foreign investments, it would be necessary to look at the investment options
available to an RFPI.
Regulation 21 of the SEBI (Foreign
Portfolio Investors) Regulations, 2014 (“FPI Regulations”) provides for the
type of instruments in which RFPIs can invest. Some of these include securities
in the primary and secondary markets including shares, debentures and warrants
of companies, listed or to be listed on a recognized stock exchange in India;
units of schemes floated by domestic mutual funds and schemes floated by
collective investment schemes, derivatives, treasury bills and dated government
securities, commercial papers issued by an Indian company, rupee denominated
credit enhanced bonds; security receipts issued by asset reconstruction
companies etc. Investment in unlisted debt securities is permitted only in the
infrastructure sector.
Portfolio Investors) Regulations, 2014 (“FPI Regulations”) provides for the
type of instruments in which RFPIs can invest. Some of these include securities
in the primary and secondary markets including shares, debentures and warrants
of companies, listed or to be listed on a recognized stock exchange in India;
units of schemes floated by domestic mutual funds and schemes floated by
collective investment schemes, derivatives, treasury bills and dated government
securities, commercial papers issued by an Indian company, rupee denominated
credit enhanced bonds; security receipts issued by asset reconstruction
companies etc. Investment in unlisted debt securities is permitted only in the
infrastructure sector.
Keeping in mind the aim of
developing the corporate bond market, the Reserve Bank of India in a potential
move to encourage further foreign investment into the debt markets, released a
draft circular on 16 May 2016 which proposes to expand the basket of
permissible instruments for RFPI to include unlisted debt securities as well.[17]. As per the proposal, RFPIs
shall be permitted to invest in the primary issuances by public companies of
unlisted non-convertible debentures, thereby expanding the scope of investment
opportunities available to Category III AIFs with foreign investments.
developing the corporate bond market, the Reserve Bank of India in a potential
move to encourage further foreign investment into the debt markets, released a
draft circular on 16 May 2016 which proposes to expand the basket of
permissible instruments for RFPI to include unlisted debt securities as well.[17]. As per the proposal, RFPIs
shall be permitted to invest in the primary issuances by public companies of
unlisted non-convertible debentures, thereby expanding the scope of investment
opportunities available to Category III AIFs with foreign investments.
As
far as the tax liability is concerned, while Categories I and II have been
extended a pass through status,[18]
Category III is yet to be extended the same privilege. Under the pass-through
system, income of an investment fund is exempted from tax and such income is
chargeable to income-tax in the hands of the unit-holder in the same manner as
if the investment was directly made by the unit holder. Despite the
recommendations made by the Narayana Murthy Committee,[19]
pass through status has not been conferred on Category III AIFs. It is subject
to tax as a representative assessee instead of being taxed at the investor
level. This has impaired the expected development of the domestic hedge fund
industry[20]
and might run counter to the Reserve Bank of India’s aim for which it permitted
foreign investments in Category III AIFs.
far as the tax liability is concerned, while Categories I and II have been
extended a pass through status,[18]
Category III is yet to be extended the same privilege. Under the pass-through
system, income of an investment fund is exempted from tax and such income is
chargeable to income-tax in the hands of the unit-holder in the same manner as
if the investment was directly made by the unit holder. Despite the
recommendations made by the Narayana Murthy Committee,[19]
pass through status has not been conferred on Category III AIFs. It is subject
to tax as a representative assessee instead of being taxed at the investor
level. This has impaired the expected development of the domestic hedge fund
industry[20]
and might run counter to the Reserve Bank of India’s aim for which it permitted
foreign investments in Category III AIFs.
Overall,
despite the risk-intensive nature of Category III AIFs, extending the
availability of foreign investment benefits in this category is surely a welcome
step. However, in order to enhance the availability of this investment
mechanism, suitable reforms need to be made to tax laws.
despite the risk-intensive nature of Category III AIFs, extending the
availability of foreign investment benefits in this category is surely a welcome
step. However, in order to enhance the availability of this investment
mechanism, suitable reforms need to be made to tax laws.
–
Kemi Gupta
Kemi Gupta
[1] The SEBI (Alternative
Investment Funds) Regulations, 2012 (the “AIF Regulations”) were notified on
May 21, 2012.
Investment Funds) Regulations, 2012 (the “AIF Regulations”) were notified on
May 21, 2012.
[2] Net figure of the total
‘Investment made’ as at the end of 30th June, 2016, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
‘Investment made’ as at the end of 30th June, 2016, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
[3] Regulation 2(1)(b) of the AIF
Regulations.
Regulations.
[4]
Namely Category I, Category II and Category III. The investment conditions and
restrictions for each for these categories of funds are prescribed under the
AIF Regulations.
Namely Category I, Category II and Category III. The investment conditions and
restrictions for each for these categories of funds are prescribed under the
AIF Regulations.
[5] List of Registered Alternative
Investment Funds as on June 30, 2016, available at:
http://www.sebi.gov.in/cms/sebi_data/attachdocs/1469684217867.pdf.
Investment Funds as on June 30, 2016, available at:
http://www.sebi.gov.in/cms/sebi_data/attachdocs/1469684217867.pdf.
[6] The
cumulative funds raised via AIFs stood at Rs. 26,003.48 crore as on 30 June
2016 from a total of Rs. 687.97 crore as on June 2013: Cumulative Net Figures of
‘Commitments raised’,’ Funds raised’ and ‘Investments made’ as compiled by SEBI
from time-to-time, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
cumulative funds raised via AIFs stood at Rs. 26,003.48 crore as on 30 June
2016 from a total of Rs. 687.97 crore as on June 2013: Cumulative Net Figures of
‘Commitments raised’,’ Funds raised’ and ‘Investments made’ as compiled by SEBI
from time-to-time, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
[7] An
increase from Rs. 451.71 crores to 20667.2 crores from June, 2013 to June,
2016, Available at:
http://www.sebi.gov.in/cms/sebi_data/attachdocs/1470648818515.html
increase from Rs. 451.71 crores to 20667.2 crores from June, 2013 to June,
2016, Available at:
http://www.sebi.gov.in/cms/sebi_data/attachdocs/1470648818515.html
[8]
Regulation 3(4)(a) of the AIF Regulations.
Regulation 3(4)(a) of the AIF Regulations.
[9]
Regulation 3(4)(c) of the AIF Regulations.
Regulation 3(4)(c) of the AIF Regulations.
[10] Ibid.
[11] Regulation 18 of the AIF
Regulations.
Regulations.
[12] Amendment to the Foreign
Exchange Management (Transfer or Issue of Security by a Person Resident Outside
India), 2015 and Foreign Exchange Management (Permissible Capital Account
Transactions) (Fourth Amendment) Regulations, 2015, which have been notified vide Notification No. FEMA 345/2015-RB dated
November 16, 2015, vide G.S.R. No.859 (E) dated November 16, 2015 and Notification No. FEMA 355/2015-RB dated
November 16, 2015, vide G.S.R. No.858 (E) dated November 16, 2015
respectively.
Exchange Management (Transfer or Issue of Security by a Person Resident Outside
India), 2015 and Foreign Exchange Management (Permissible Capital Account
Transactions) (Fourth Amendment) Regulations, 2015, which have been notified vide Notification No. FEMA 345/2015-RB dated
November 16, 2015, vide G.S.R. No.859 (E) dated November 16, 2015 and Notification No. FEMA 355/2015-RB dated
November 16, 2015, vide G.S.R. No.858 (E) dated November 16, 2015
respectively.
[13]
The total amount of funds raised has increased from Rs. 17,241.07 crore as on
31 December 2015 to Rs. 26,003.48 crore as on 30 June 2016 and the increase in
investments made for the same period has shown an increase from Rs. 14,031.39
crore to Rs. 20,667.2 crore. Cumulative
Net Figures of ‘Commitments raised’,’ Funds raised’ and ‘Investments made’ as
compiled by SEBI from time-to-time, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
The total amount of funds raised has increased from Rs. 17,241.07 crore as on
31 December 2015 to Rs. 26,003.48 crore as on 30 June 2016 and the increase in
investments made for the same period has shown an increase from Rs. 14,031.39
crore to Rs. 20,667.2 crore. Cumulative
Net Figures of ‘Commitments raised’,’ Funds raised’ and ‘Investments made’ as
compiled by SEBI from time-to-time, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
[14]
An increase in the total amount of funds raised from Rs. 4,375.94 crore in
December 2015 to Rs. 4,854.48 crore in June 2016. The growth rate is calculated
for a period of 9 months. Raw
data available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
An increase in the total amount of funds raised from Rs. 4,375.94 crore in
December 2015 to Rs. 4,854.48 crore in June 2016. The growth rate is calculated
for a period of 9 months. Raw
data available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
[15] An increase in the total amount
of funds raised from Rs. 8,988 crore in December 2015 to 16,734.99 crore in
June 2016. The growth rate is calculated for a period of 9 months. Raw data
available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
of funds raised from Rs. 8,988 crore in December 2015 to 16,734.99 crore in
June 2016. The growth rate is calculated for a period of 9 months. Raw data
available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
[16] An increase from Rs. 3,876.52
crore to Rs. 4,414.01 crore in the same period. The growth rate is calculated
for a period of 9 months. Raw data available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
crore to Rs. 4,414.01 crore in the same period. The growth rate is calculated
for a period of 9 months. Raw data available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
[17] ‘RBI invites comments on
allowing FPIs in Unlisted Debt Securities and Securitized Debt Instruments’, Press Release: 2015-2016/2673, Available at: https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=36990
(May 16, 2016)
allowing FPIs in Unlisted Debt Securities and Securitized Debt Instruments’, Press Release: 2015-2016/2673, Available at: https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=36990
(May 16, 2016)
[18] However, the AIFs are provided
only a partial pass-through status. The losses suffered by AIFs are not allowed
to be passed on to the investors.
only a partial pass-through status. The losses suffered by AIFs are not allowed
to be passed on to the investors.
[19] Report submitted by Alternative
Investment Policy Advisory Committee, available at:
http://www.sebi.gov.in/cms/sebi_data/attachdocs/1453278327759.pdf.
Investment Policy Advisory Committee, available at:
http://www.sebi.gov.in/cms/sebi_data/attachdocs/1453278327759.pdf.
[20] Ibid.
With respect to the condition " A Category III AIF with foreign investment is allowed to make portfolio investment in only those securities or instruments in which an RFPI is permitted to invest", the Notification dated November 16 2015 (as amended in Feb 15 2016) clearly states that
"An Alternative Investment Fund Category III with foreign investment shall make portfolio investment in only those securities or instruments in which a Registered Foreign Portfolio Investor is allowed to invest under the principal Regulations."
Accordingly, the Principal Regulations i.e. specifically, Paragraph 1C of Schedule 5 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations have to looked at, not Regulation 21 of the SEBI (Foreign Portfolio Investors) Regulations, 2014 mentioned in the article.