[Vishal Achanta 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 take.
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’, 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 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.
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. 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. 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.
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, 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 126.96.36.199 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.