Tuesday, April 19, 2016

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 Regulations’).

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 India.

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: In 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 jurisdictions.

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

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