Thursday, February 4, 2016

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 (AIF Regulations). 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:

1.                 Taxation

1.1.             To 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).

1.2.             Eliminate 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.

1.3.             Clarify 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.

1.4.             Make 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.

1.5.             Make 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.

1.6.             Securities 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.

2.                 Unlocking 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.

3.                 Promoting 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.

4.                 Reforming 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:

4.1.             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.

4.2.             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.

4.3.             Classification of Category III AIF: 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.

4.4.             10% Restriction of Investible Funds: 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.

Comment: 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


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