I OVERVIEW OF RECENT ACTIVITY
Indian securities and commodities markets regulator the Securities and Exchange Board of India (SEBI) regulates investment funds set up in India, offshore funds that invest into Indian funds or Indian securities, portfolio managers, investment advisers and research analysts.
The domestic funds (Indian investment funds) are regulated as:
- a mutual funds under the SEBI (Mutual Funds) Regulations 1996 (MF Regulations). The Unit Trust of India (UTI) that was created in 1964 was the first mutual fund (MF) in India and enjoyed a complete monopoly until 1986. SBI Mutual Fund was the first non-UTI mutual fund, established in June 1987. Liberalisation of exchange controls in India in 1991 was followed by establishment of SEBI as a statutory body in 1992 and the first MF regulations were issued in 1993, which were then replaced by the MF Regulations. Total assets under management (AUM) for mutual funds have increased to around 12.3 trillion rupees as at the end of March 2016;2
- b alternative investment funds (AIFs) under the SEBI (AIF) Regulations, 2012 (AIF Regulations). The AIF Regulations superseded the SEBI (Venture Capital Funds) Regulations, 1996 and were introduced to remove regulatory arbitrage between regulated and unregulated privately pooled vehicles as well as to improve on the investor disclosure and reporting standards. As of March 2016, SEBI has registered 209 AIFs,3 which have raised commitments to the tune of around 388 billion rupees;4
- c real estate investment trusts (REITs) under the SEBI (REIT) Regulations 2014 (REIT Regulations);
- d infrastructure investment trusts (INVITs) under the SEBI (INVIT) Regulations 2014 (INVIT Regulations); or
- e collective investment schemes (CIS) under the SEBI (CIS) Regulations 1999 (CIS Regulations). Under the CIS Regulations, a CIS manager cannot launch any scheme for the purpose of investing in securities. The CIS route has been adopted by managers to manage funds of clients under plantation schemes, and a handful as art funds to invest in works of established and upcoming artists.
SEBI also regulates portfolio managers or advisory entities under the following regulations:
- a portfolio managers under the SEBI (Portfolio Managers) Regulations 1993 (PMS Regulations). As of June 2016, portfolio managers had 59,312 clients and 11 trillion rupees of assets under management across discretionary, non-discretionary and advisory services;5
- b investment advisers (IA) under the SEBI (IA) Regulations 2013 (IA Regulations). As of the time of writing, there were 462 IAs registered with SEBI;6 or
- c research analysts (RA) under the SEBI (RA) Regulations 2014 (RA Regulations). As of the time of writing, there were 299 RAs registered with SEBI.7
Offshore funds investing seeking to invest in India are regulated under the following regulations:
- a SEBI (Foreign Portfolio Investors (FPI)) Regulations 2014 (FPI Regulations). The FPI Regulations have consolidated the multiple investment routes under which foreign institutional investors (FIIs) (and their sub-accounts) and qualified foreign investors used to invest in India. There are approximately 5,279 FPIs registered and 3124 converted FPIs registered; 744 erstwhile FIIs and 2759 erstwhile sub-accounts are deemed as FPIs, and are registered with SEBI.8
- b SEBI (Foreign Venture Capital Investors (FVCI)) Regulations 2000 (FVCI Regulations). An FVCI is permitted to invest its entire corpus in AIFs (Category 1) on an automatic basis, in other words without any regulatory approval. The FVCI route is generally preferred for investments in unlisted companies, although in certain cases investments can also made in listed Indian companies. One significant advantage of FVCIs is that they can make and dispose of investments at negotiated prices; in other words, FVCIs are not subject to the pricing restrictions that are otherwise applicable for investments and divestments under the Foreign Direct Policy (FDI) route. As of the time of writing, there were 216 registered FVCIs.9
- c Offshore pooled vehicles can also invest in Indian securities under the FDI policy. Such offshore funds can also invest in any Indian fund (i.e., domestic investment vehicles regulated under applicable SEBI regulations) on an automatic basis – in other words, without any regulatory approval. If neither the sponsor nor the manager nor the investment manager of the investment vehicle is Indian ‘owned and controlled’ then downstream investment by such an investment vehicle in an eligible investee company shall have to conform to the sectoral caps and conditions or restrictions applicable to that investee company under the FDI of India. While it is difficult to ascertain the quantum of FDI received from offshore funds, FDI inflows in general have increased significantly, with an increase of 39 per cent in the financial year 2015–2016 as compared to the previous financial year.10
II GENERAL INTRODUCTION TO the REGULATORY FRAMEWORK
Asset management and investment fund activity in India is regulated generally by SEBI, constituted under the SEBI Act 1992 (SEBI Act).
The Reserve Bank of India (RBI), constituted under the RBI Act 1934, is India’s central bank and regulates foreign investment and exchange control together with the government. Until recently, the RBI regulated all forms of cross-border capital account transactions, but the RBI’s remit has now been restricted to debt, with the central government being the other relevant regulator.
While each regulator’s sphere is delineated, the activity of a regulated entity tends to be regulated at multiple levels if there is a cross-border element. In such a situation, compliance is required with the regulations of each regulator.
The AIF Regulations replaced the SEBI (Venture Capital Funds) Regulations 1996 and overhauled the regulatory regime in India relating to formation and management of Indian funds.
All privately pooled Indian funds are required to be SEBI-registered subject to certain exceptions, including:
- a fund management activities otherwise regulated by SEBI or any other regulator;
- b family trusts;
- c employee stock ownership trusts and employee welfare or gratuity trusts; and
- d funds managed by securitisation or reconstruction companies.
The AIF Regulations have categorised different types of Indian funds, which is expected to enable the government to provide sector or activity based incentives. An AIF is required to register under one of three specified categories:
- a Category I includes social venture funds, small and medium-sized enterprises (SME) funds, infrastructure funds and venture capital funds (with a further categorisation for angel funds);
- b Category II includes those AIFs that do not fall in Category I or III – these include private equity and debt funds; and
- c Category III includes those AIFs that employ diverse or complex trading strategies and may employ leverage – these are primarily for hedge funds. However, Indian funds proposing to use fund level leverage or invest primarily in listed equity investments will also need to seek registration as Category III AIFs, as these are restricted in the other categories.
Once registered with SEBI, an AIF may launch multiple schemes of the same category (and sub-category).
AIFs can only solicit on a private placement basis up to 1,000 investors. A private placement memorandum (PPM) is filed with SEBI prior to launch and is required to be issued to potential investors. The PPM is required to contain all material information about the AIF, its sponsor and manager, including track record and disciplinary history, economics, investment strategy, risk management tools and procedures to address conflicts of interest.
SEBI has recognised that AIFs are private pools of capital whose investors tend to be sophisticated or high-net-worth individuals, but has not prescribed qualification criteria for ascertaining such sophistication. Instead, the AIF Regulations prescribe a minimum ticket size of 10 million rupees.
Certain governance rights for investors (by way of voting) have been codified, including removal of the manager, variation of the tenure and material alteration to the investment strategy. In 2014, SEBI mandated that any change in the fundamental attributes of an AIF influencing the decision of an investor to stay invested in the AIF (including a change in or change of control in the sponsor or manager, or a change to a higher fee structure (or carried interest)), would require the manager (subject to limited exceptions) to provide an exit option to the investors.
In order to promote alignment of general partner interest, the sponsor or manager must have a continuing interest in the AIF of not less than the lower of 2.5 per cent of the corpus or 50 million rupees (5 per cent and 100 million rupees for Category III AIFs).
All categories of AIFs are required to adhere to certain investment conditions, with additional conditions prescribed for each category or sub-category. Certain key conditions relate to minimum diversification, conflicted transactions, changes in investment strategy and borrowing limitations.
In its supervisory capacity, SEBI requires AIFs to file reports on a regular basis and also when there are material changes in information previously submitted to SEBI, including the PPM or the registration application. Additionally, a change in control of the AIF, sponsor or manager requires prior approval of SEBI.
SEBI has been active in evaluating measures for improving the AIF regime. To this end, it had set up a committee headed by Mr Narayana Murthy to review the existing AIF framework and its functioning (Alternative Investment Policy Advisory Committee). In January 2016, the committee submitted its report to SEBI and suggested various reforms including tax reforms and changes in existing laws to facilitate capital-raising by AIFs and boosting entrepreneurship. The Committee had also proposed creating a favourable tax environment for investors, tweaking of safe harbour norms, unlocking domestic pools of capital, enabling onshore fund management in India and reforming the AIF regulatory regime. Further, the committee has proposed recommendations to formulate appropriate regulations to govern the fund manager, as the fund manager undertakes investment decisions for the fund that could pose risks to the investors, market and economy. The deliberations between SEBI and industry participants are underway, and it is expected that SEBI will shortly issue the amendment regulations.
Recognising the representations made by the industry, in 2015 SEBI issued guidelines permitting AIFs to make overseas investments.11 As per the guidelines, AIFs are only allowed to invest in equity and equity linked instruments of ‘offshore venture capital undertakings’12 that have an India connection. All such overseas investments are capped within the overall limit of US$500 million for all AIFs (and existing venture capital funds) registered with SEBI.
iii Mutual funds
All mutual funds are required to be established as trusts. The MF Regulations set out the eligibility criteria, and also codify the rights and obligations of the sponsor, trustee (in addition to trust law), manager and custodian, including as to the contents of the trust deed and the investment management agreement. The MF Regulations also govern the economics of a mutual fund, including payment of dividends, redemptions and valuation, and mandate norms and caps on fees, expenses and commissions payable to intermediaries.
Mutual funds operate in the retail segment (with limited exceptions for private placement for specified types of schemes) by raising money from the public through the sale of the units of its schemes. Such solicitation is required to be conducted through the issue of an offer document, which is scrutinised by SEBI. As would be expected from a retail product, the offer document is required to be detailed with extensive disclosures.
The regulations provide for significant sponsor equity holding in the manager and specify eligibility criteria that appear to be aimed at ensuring sufficient solvency and a good track record.
The MF Regulations specify investment conditions, including as to borrowing. The MF Regulations also place material restrictions on the functioning and governance of the manager including in relation to other asset management or advisory activities, requiring that at least 50 per cent of its directors be unconnected to the sponsor or the trustee, and requiring prior SEBI consent for a change in control of the manager.
As an investor protection mechanism, in certain instances, including a change in control of the manager or a change in the fundamental attributes of a scheme, an exit option is required to be given to the investors.
Real estate mutual fund schemes and infrastructure debt fund schemes have a specific set of conditions that they need to comply with, which are in addition to the general conditions (to the extent that there is a conflict, the specific conditions apply).
Recently, norms for mutual fund exposure to riskier corporate bonds have been tightened. In a move to safeguard the interest of the investors, the investment limit in bonds of a single company has been capped at 10 per cent. Additionally, SEBI has also revised prudential limits for debt-oriented mutual fund schemes and as such the exposure limit for a mutual fund scheme across a single sector has been reduced to 25 per cent.
iv REITs and INVITs
REITs and INVITs, regulated by the REIT Regulations and the INVIT Regulations respectively, are established as trusts, and both regulations were notified on 26 September 2014. Given the overarching commonality of the intent behind the introduction of INVITs and REITs (as discussed in Section I, supra) and concurrent effective dates, it is to be expected that the two regimes are quite similar.
A public offer is required to be made for the units of the trust by way of an offer document, which is scrutinised by SEBI. This document is required to include extensive disclosures, and the respective regulations require the manager and the lead merchant banker to issue an accompanying due diligence certificate. REITs and INVITs are not permitted to have multiple classes of units or schemes. SEBI has been evaluating measures for improving the REITs regime in India. It has recently issued a consultation paper proposing certain changes to the REIT Regulations such as raising the number of sponsors, permitting investments by REITs in special purpose vehicles (SPVs) that have investments in other SPVs subject to certain prescribed conditions, clarifying the definitions of ‘associates’ and ‘real estate property’, minimum public shareholding, permitting investment of up to 20 per cent of value of the REIT assets in under construction assets, securities of companies or body corporate in real estate sector, government securities, money market instruments, etc.
INVITs also have the flexibility to privately place their units through a PPM scrutinised by SEBI, when it proposes to invest more than 10 per cent of the value of its assets in under-construction projects. Such private placement is required to be aimed at qualified institutional buyers and bodies corporate only.
The units of the trust (including where privately placed) mandatorily need to be listed on a stock exchange in India, with a minimum trading lot of 100,000 rupees for REITs; for INVITs, the minimum trading lot for privately placed units is 10 million rupees; and otherwise, the minimum trading lot is 500,000 rupees. The regulations also specify the minimum offer size, the minimum public shareholding and the minimum number of investors.
Prior to the allotment of units, the sponsors are required to transfer (or so undertake) the underlying assets or their shareholding in the entity owning such assets, and the value of the assets should not be less than 5 billion rupees.
Both regulations specify minimum standards of net worth, qualifications and experience for, and rights and responsibilities of, sponsors, the manager and the trustee, and also the rights and responsibilities of the trust’s valuers and auditors. Additionally, the INVIT Regulations require a project manager to be appointed, and also codify the responsibilities of such project managers who will undertake operations and management of the INVIT assets.
As with mutual funds, not less than 50 per cent of the board of the managers of REITs or INVITs are required to be independent and cannot be on the governing board of any other REIT or INVIT, as applicable. The regulations also have extensive provisions for ensuring arm’s-length dealings with the sponsor, manager and their associates and on valuation of assets of the trust, particularly in a related party context.
The rights of unitholders have been codified in the regulations, including stipulating high standards of affirmative voting, such as 1.5x or 3x of the dissenting votes (depending on the subject matter). In certain specified situations, an exit option is also required to be given to the unitholders.
Detailed investment conditions and restrictions have been enshrined in the regulations for ensuring appropriate allocation of corpus and preventing concentration of investments.
Like, REITs, the INVITS regime has not yet taken off in India on account of several rigidities in the regulations. For example:
- a an INVIT can have only a maximum of three sponsors;
- b the sponsor is required to hold, on a collective basis, not less than 25 per cent of the total units of the INVIT on a post-issue basis for a period of not less than three years from the date of listing of such units;
- c INVITS are not permitted to hold infrastructure projects through a multi-tier structure (i.e., 90 per cent of the assets have to be held through single-tier SPV);
- d units proposed to be offered to the public cannot be less than 25 per cent of the total outstanding units and minimum public holding post-listing should be 25 per cent; and
- e the investment manager of an INVIT should have not less than five years of experience in fund management, advisory services or development in the infrastructure sector.
In June 2016, SEBI issued a consultation paper for public comments recommending several amendments to the INVIT regulations to iron out the rigidities and thus pave the path for INVITs listing in India.
Recently, the Finance Minister of India, Mr Arun Jaitely, emphasised that India would require over US$1.5 trillion to fill up the funding requirement in the infrastructure sector. Thus, the infrastructure sector continues to provide a huge opportunity for investors to invest in India.
A CIS includes any scheme or arrangement under which investor contributions are pooled with a view to earning profits and in which the assets are managed on behalf of the investors. CISs are regulated by SEBI under the CIS Regulations, which, together with the SEBI Act, provides certain exceptions to pooled investment vehicles governed by other regulations or regulators.
The CIS Regulations were notified in order to curb the growth of a number of unregulated private schemes in the 1990s.13 In the ensuing years, SEBI initiated proceedings against a number of such entities. Given the stringent norms under the CIS Regulations and its history, there have not been many takers for the CIS route – from 1999 to date, there has only been one registration.14
vi Portfolio managers
Individualised asset management, whether discretionary or not, is regulated by the PMS Regulations.
The PMS Regulations prescribe qualification, experience and capital adequacy conditions for registration as a portfolio manager. They also provide for a code of conduct, including in respect of avoidance of conflicts and disclosures, general responsibilities, reporting and compliance items. To protect small retail investors, the PMS Regulations mandate that the minimum investment amount for an investor be 2.5 million rupees. The PMS Regulations also prescribe provisions that need to be incorporated in the management contract.
The portfolio manager is also required to furnish the client (and also SEBI) with a disclosure document in a prescribed format, which is required to be certified by an independent chartered accountant.
The IA Regulations seek to regulate entities providing investment advice to specific clients, and to protect investors from biased and inaccurate advice.
Registration with SEBI is not mandatory for other regulated entities or those who provide advice incidental to their main activity. Notably, there is also an exemption to IAs solely advising foreign clients.
Being a regulation driven by the need to protect retail investors, the IA Regulations stipulate capital adequacy norms and other eligibility criteria, including qualification and certification requirements that require designated persons to pass examinations of the National Institute of Securities Market (NISM).
IAs are required to assess the suitability of advice being provided and, to this end, are required to undertake risk profiling of each client. As with investor protection regulations in India, the IA Regulations also have extensive provisions on activity segregation, disclosure and management of conflicts of interest.
To regulate dissemination of research analysis and reports (and recommendations) relating to listed or to-be-listed securities, SEBI introduced regulations for governing RAs in September 2014, thus closing the loop on all forms of investment management and advisory activities in India. Notably, the obligations under the RA Regulations are applicable to proxy advisers as well.
As with the IA Regulations, SEBI has provided for exemptions to certain SEBI intermediaries. However, to the extent that such persons issue research reports to the public, they have to adhere to some obligations under the RA Regulations including on conflicts of interest, disclosures and limitations on personal trading. Disclosure requirements are applicable to the RA and also its ‘associates’ – a term that is very wide in scope and has created some level of ambiguity in compliance. Banks that wish to undertake RA services can do so through a separate subsidiary and after ensuring that there is an arm’s length relationship between the bank and the subsidiary.
The RA Regulations also stipulate eligibility criteria, including qualification and certification requirements such as NISM certification.
ix Offshore funds
Foreign investment in India is required to comply with the Foreign Exchange Management Act, 1999, its subordinate regulations (FEMA Regulations) and circulars issued by the government (consolidated in the FDI Policy). These regulations govern various aspects of foreign investment including entry routes (some recipients or sectors may require prior approval of the Foreign Investment Promotion Board (FIPB)), pricing, instruments and other conditions such as minimum capitalisation. Notably, pursuant to recent regulatory changes, FDI in AIFs is allowed under the automatic route.
As discussed in Section I, supra, an offshore fund seeking to make listed portfolio investments requires an FPI registration for which it must satisfy the prescribed eligibility criteria, including being a resident of certain countries (Financial Action Task Force-compliant jurisdictions and jurisdictions whose securities regulators are signatories to the International Organization of Securities Commission’s multilateral memorandum of understanding). The application for registration is to be made before any Designated Depository Participant (DDP) that has been delegated the authority by SEBI under the FPI Regulations. There are three categories under which registration can be obtained by FPIs, ranging from sovereign funds to unregulated entities.
An FPI’s or an FPI group’s listed equity holding is required to be less than 10 per cent of the total equity. Additional permissible investments include:
- a mutual funds and CISs;
- b dated government securities (but not treasury bills);
- c security receipts;
- d unlisted non-convertible debentures and bonds of a company in the infrastructure sector or an ‘infrastructure finance company’; and
- e rupee-denominated bonds or units issued by infrastructure debt funds.
Offshore funds seeking to primarily invest in the unlisted space may choose to seek registration as an FVCI under the FVCI Regulations due to certain benefits accorded to FVCIs that are not available to FDI investors, which include:
- a the ability to invest in venture capital funds;
- b free entry and exit pricing;
- c exemptions from certain lock-in and public offer requirements; and
- d a broad range of permissible instruments, including debt.
FVCIs are, however, subject to certain investment conditions, including investing at least 66.67 per cent of their funds in unlisted equity or equity-linked instruments.
An FVCI application is to be made before SEBI, which acts as single-window clearance for approval from SEBI as well as the RBI. FVCIs need to abide by any additional conditions that may be imposed by the RBI when granting approval.
III COMMON ASSET MANAGEMENT STRUCTURES
Indian funds are generally set up as trusts (in some cases mandated by law). The AIF Regulations provide flexibility for AIFs to be established as trusts, companies, Limited Liability Partnerships (LLPs) or bodies corporate. However, most AIFs are formed as trusts15 due to legal, regulatory and tax reasons. Under the AIF Regulations, Category I and II AIFs must be closed-ended with a minimum tenure of three years, and Category III AIFs may be either open or closed-ended.
Offshore funds may invest in an Indian fund (subject to the FEMA Regulations) or directly in the Indian portfolio companies. In some cases where the investment team is based in India and manages a domestic pool, the offshore fund may co-invest in the Indian portfolio companies alongside the Indian fund.
IV MAIN SOURCES OF INVESTMENT
As of 31 March 2016, AIFs had raised commitments of about 388 billion. Category II AIFs (typically private equity) alone accounted for about 62 per cent of this amount.16 Foreign capital in the private equity industry in India,17 especially in venture capital,18 constitutes a substantial majority of commitments.
As of 31 March 2016, the AUM of mutual funds was about 12.3 trillion rupees,19 of which individual investors accounted for about 45.6 per cent, while the balance was invested by institutional investors (corporate investors accounting for over 85 per cent).
As of July 2016, the net investment by FPIs (including deemed FPIs) for the calendar year 2016 stood at a positive figure of 226.01 billion rupees, with about 46.52 billion rupees in debt.20
V KEY TRENDS
The AIF Regulations laid down the basic framework for unlocking the value of the private fund market. Recent changes in the regulatory framework have further infused foreign capital into the Indian market. Foreign investment in investment vehicles without the requirement of regulatory or governmental approval is now permitted.21 Prior to the amendment, such foreign investments were subject to approval from FIPB, which led to some amount of approval uncertainty and delay in timelines. Downstream investment by an investment vehicle is regarded as foreign investment if either the sponsor or the manager or the investment manager is not Indian ‘owned and controlled’, and such downstream foreign investment would have to conform with sectoral caps and conditions and restrictions as per the FDI Policy.
The Indian private funds industry has also been seeking greater certainty on the tax treatment of AIFs on account of amendments introduced by the Finance Act 2016.
For foreign investment into India on a cumulative basis for the period 2000 to 2016, Mauritius continued to be the highest investor country, contributing 33 per cent of total FDI received followed by Singapore at 16 per cent.22 In May 2016, India renegotiated the India–Mauritius double taxation avoidance agreement (DTAA), clearly signalling India’s strong inclination to shift to a source-based taxation policy. One of the beneficial outcomes of the renegotiation is that interest withholding tax would be 7.5 per cent, among the lowest rates across DTAAs signed by India. However, the phasing out of capital tax exemption has raised many concerns on tax implications for global depositary receipts, bonus shares, mergers, etc. A panel comprising SEBI, the Central Board of Direct Taxes (CBDT), HSBC and Franklin Templeton is examining issues stemming from the protocol to the India–Mauritius DTAA.23 For debt investments, Cyprus was a preferred route until it was declared a non-cooperative jurisdiction and added to the ‘Notified Jurisdictional Area’ list from 1 November 2013, leading to higher withholding tax of 30 per cent. In June 2016, the Indian and Cypriot governments reached an agreement on amendments to the India–Cyprus DTAA whereby Cyprus will be removed from the negative list with retrospective effect, and the right to tax capital gains (on alienation of shares) will stand amended to the source country from 1 April 2017 onwards. Given that the capital gains exemption article under the India–Singapore DTAA is linked to exemptions that continue under the India–Mauritius DTAA, tax treaty renegotiations have commenced between India and Singapore as well. In recent years, fund managers have shifted base to Singapore to create a fund management presence. With the new developments on tax treaty renegotiations, the fund managers are certainly concerned and are hopeful that their existing structures and investments will not be adversely impacted.
To attract investments in production and marketing and enhance the competitiveness of Indian enterprises through access to global designs, technologies and management practices, 100 per cent FDI in single brand product retailing is permitted, subject to local sourcing norms and certain conditions in relation to branding. The government of India recently relaxed the local sourcing norms for foreign brands up to three years, and relaxed the local sourcing regime for another five years for entities with ‘state-of-art’ and ‘cutting edge’ technology, and further liberalised this sector by announcing in June 2016 a relaxed sourcing regime for another five years for such entities. This has been a positive step, especially for companies like Apple Inc, to enable them to set up Apple stores in India.
The Startup India Initiative has also been initiated, which intends to build a strong eco-system for nurturing innovation and startups in the country that will drive sustainable economic growth and generate large-scale employment opportunities. The Start Up Action plan proposes to reduce the regulatory burden on start-ups, including granting certain tax exemptions, fast-tracking patent examination at lower costs and relaxed norms for public procurement.
Further, 100 per cent FDI is permitted in business-to-business e-commerce, and guidelines have been prescribed for the same. The guidelines have, to a large extent, reiterated and consolidated the existing FDI policy on e-commerce. A significant condition prescribed in the guidelines is the restriction of not effecting more than 25 per cent of the sales from any single vendor and its group companies, and the obligation to maintain a level playing field with regard to pricing of goods and services, on the current business model adopted by the e-commerce. These guidelines have brought clarity where there was none as the marketplace model, while prevalent, had remained undefined and therefore ambiguous and open to speculative interpretations.
Pricing guidelines for FDI instruments with optionality clauses have also been prescribed, permitting put and call options at pre-agreed prices in favour of the investors, subject to satisfactory conditions.
Several sectoral caps were relaxed in June 2016. Amendments to FDI policy include:
- a food products: 100 per cent FDI under government approval route has now been permitted for trading, including through e-commerce, in respect of food products manufactured or produced in India;
- b defence sector: foreign investment beyond 49 per cent has now been permitted through the government approval route in the defence sector in cases resulting in access to modern technology in the country, or for other reasons to be recorded;
- c broadcasting carriage services: 100 per cent FDI under the automatic route is now permitted in teleports, direct to home, cable networks, mobile TV, headend in the sky broadcasting service and cable networks. However, FIPB approval would be required for FDI beyond 49 per cent in a company not seeking licence or permission from a sectoral ministry, resulting in change in the ownership pattern or a transfer of stake by an existing investor to a new foreign investor;
- d pharmaceuticals: FDI up to 74 per cent is now permitted under the automatic route in brownfield pharmaceuticals; and
- e civil aviation:
• with a view to aiding modernisation of the existing airports to establish a high standard and help to ease the pressure on the existing airports, 100 per cent FDI is now permitted under the automatic route in Brownfield Airport projects; and
• foreign investment up to 49 per cent is allowed under the automatic route in scheduled air transport service, domestic scheduled passenger airline and regional air transport service, and now FDI beyond 49 per cent is permitted through government approval.
VI SECTORAL REGULATION
Under the Insurance Act 1938 and The Insurance Regulatory and Development Authority (IRDA) Act 1999, the IRDA governs insurance companies. The Insurance Regulatory and Development Authority (Investment) Regulations, 2000, govern their investment allocation. Insurance companies are permitted to invest in Category I and II AIFs, subject to a maximum of the lower of overall exposure to AIFs of 3 and 5 per cent (for life insurance and general insurance respectively) or 10 per cent of an AIF (20 per cent for an infrastructure fund).24 However, for Category II AIFs, investment is permitted only if at least 51 per cent of such AIF has been invested in infrastructure facilities, SME entities, venture capital undertakings or social venture entities.
Pension funds are governed by the Pension Fund Regulatory and Development Authority (PFRDA). Pension funds are permitted to invest in Category I and II AIFs, subject to a ceiling of 2 per cent of the corpus of the pension fund.25 For Category II AIFs, investment is permitted only if at least 51 per cent if such AIF has been invested in infrastructure facilities, SME entities, venture capital undertakings or social venture entities.
iii Real property
Indian funds proposing to invest in real estate are governed through the AIF Regulations, REIT Regulations, MF Regulations (as real estate mutual funds) or the CIS Regulations, as discussed in Section II, supra.
The Real Estate (Regulation and Development) Act 2016 (Real Estate Act) came into effect this year and seeks to establish a regulatory oversight mechanism to enforce disclosure, fair practice and accountability norms in the real estate sector, and to provide adjudication machinery for speedy dispute redressal. It further contemplates the setting up of one or more Real Estate Regulatory Authority in each state or appointment of one Real Estate Regulatory Authority for two or more states, and a Real Estate Appellate Tribunal for, inter alia, regulation and promotion of the real estate sector, and to ensure sale of plot, apartment or building, as the case may be or sale of a real estate project. On coming into effect, the Real Estate Act would have a substantial effect on the real estate sector in India.
iv Hedge funds
As discussed in Section II, supra, Indian hedge funds require registration as Category III AIFs. Offshore hedge funds require registration as an FPI to make a play in the listed or derivatives segment in India.
v Private equity
As discussed in Section II, supra, private equity funds in India require registration as AIFs and are generally registered as Category II AIFs. Long-only funds seek registration as Category III under the AIF Regulations.
vi Other sectors
Banks are regulated by the RBI. The RBI’s prudential norms permit banks to invest in venture capital funds (Category I AIF) up to 10 per cent of the corpus unless approved otherwise by the RBI.
The RBI also regulates certain types of ‘financial institutions’ known as non-banking financial companies (NBFCs). Due to various structural considerations, NBFCs are also used by asset managers for making investments. Offshore funds investing through NBFCs would need to comply with the FEMA Regulations, including minimum capitalisation.
In India, a special regime is available for banks and some financial institutions for speedier recovery of debt. Under the regime, governed by the RBI, securitisation and reconstruction companies are permitted, subject to certain conditions, to pool capital from investors (who are ‘qualified institutional buyers’) with a view to purchasing certain types of debt, and to pay any recoveries to the investors. Such pooling vehicles are required to be established as trusts. Funds focused on the corporate bonds market and distressed debt market have raised large pools of capital both from domestic and offshore investors. NBFCs and asset reconstruction companies (ARCs) are becoming popular routes for tapping into these opportunities. A hundred per cent FDI is permitted in ARCs under the automatic route. FPIs can invest up to 85 per cent of the securities receipts in each scheme floated by an ARC. Lastly, the ‘masala bond’ regime introduced by RBI in September 2015 (i.e., the issuance of rupee-denominated bonds overseas under the overall external currency borrowing route)26 has also opened up an additional avenue for chief financial officers of Indian portfolio companies to raise debt from foreign entities without taking the exchange rate risk. This risk, however, gets factored into the coupon to be paid. However, masala bonds issuances have other conditions – for example, investors should be from Financial Action Task Force on Money Laundering-compliant countries and the instrument can only be a plain vanilla bond with a minimum maturity period of five years and a limited negative list for end-use restrictions.
VII TAX LAW
The key legislation governing the taxation of income in India is contained in the Income Tax Act, 1961 (IT Act). For offshore funds, the additional overlay is the DTAA between the country of their residence and India, if any.
Category I and II AIFs have been accorded tax pass-through treatment under the IT Act, subject to a withholding tax of 10 per cent for distributions made to the investors by a Category I or Category II AIF. In case of offshore investors investing from a DTAA country:
- a the withholding tax rate can be reduced to applicable rate under the DTAA; and
- b any income earned that is otherwise not chargeable to tax will not be subject to the aforesaid withholding tax.
However, it would be pertinent to note that business income earned by Category I and II AIFs will not enjoy the pass-through treatment, and would therefore be subject to regular tax rate under the IT Act.
Category III AIFs do not have the benefit of tax pass-through and would accordingly need to structure for pass-through under the general trust taxation provisions of the IT Act. Such structuring would not be possible if the AIF is not set up as a trust under the Indian Trusts Act.
For offshore funds, the tax treatment under the DTAA is a significant factor in determination of the tax payable (or tax exemption). Under the IT Act, FPIs have the benefit of a concessional tax regime for both interest income and capital gains. To the extent the FPI is located in a favourable DTAA jurisdiction, the rate of tax under DTAA or the IT Act, whichever is more beneficial, would apply.
Pursuant to the representation by industry and the recommendations of the Justice AP Shah Committee, amendments were made to the IT Act to remove the applicability of Minimum Alternate Tax (MAT) to FPIs. MAT is applicable when the income tax payable by a company on its total income is less than 18.5 per cent of its book profit – in brief, MAT is not applicable to a foreign company if the foreign company is a resident of a country having DTAA with India and such foreign company does not have a permanent establishment (PE) in India.
Offshore funds could potentially be brought to tax in India if they have a business connection (BC)27 or PE in India. Traditionally, managers have sought to maintain an offshore set-up to mitigate such a risk. To encourage onshore fund management, the IT Act was amended in 2015 to provide specific exceptions to the application of BC and PE effective management (i.e., the safe harbour regime). Thus, as per the safe harbour regime under Section 9A of the IT Act (read with applicable rules) whereby an eligible investment fund (EIF) would not be subject to tax in India merely on account of having an eligible fund manager (EFM) in India, subject to satisfaction of several conditions, such as:
- a the EIF shall be a resident of a country notified by the central government;
- b the aggregate participation or investment in an EIF, directly or indirectly, by persons resident in India shall not exceed 5 per cent of the corpus of the EIF;
- c the EIF shall have a minimum of 25 members who are, directly or indirectly, not connected persons (look-through permitted only for the direct investor);
- d the aggregate participation interest, directly or indirectly, of 10 or less members along with their connected persons in EIF, shall be less than 50 per cent;
- e the EIF shall not invest more than 25 per cent of its corpus in any entity; and
- f the EIF shall not carry on or control and manage, directly or indirectly, any business in India, in other words, the EIF cannot hold more than 26 per cent of the share capital of the investee company.
This is a positive step for offshore funds to have access to the Indian markets and utilise the pool of talent in India. However, the conditions for determining eligibility under the safe harbour norms appear to be onerous and, in their current form, have not had any significant impact on the growth of the Indian fund management industry.
In June 2016, SEBI issued a consultation paper for public comments that sets out the proposed regulatory regime for EFMs by proposing to introduce a new chapter under the SEBI (Portfolio Managers) Regulations 1993. The proposed amendments include net worth condition for EFMs, appointment of a principal officer and a minimum of two employees having requisite qualification and experience, as well as other obligations and responsibilities of EFMs.
In their current form, General Anti Avoidance Rules (GAARs) give extensive rights to tax authorities in India to tax offshore funds, including by unwinding transactions and recharacterisation of income. In June 2016, the CBDT, the apex body for tax administration under the IT Act, issued a circular amending the relevant Rules to provide that GAARs will not apply to income earned or received by any person from transfer of investments made before 1 April 2017 (this date was previously 30 August 2010) and that GAARs will apply to any arrangement, irrespective of the date it has been entered into, if the tax benefit is obtained on or after 1 April 2017 (this date was previously 1 April 2015).
Taxation of carried interest in India is untested. For Indian funds, fund managers tend to structure their carried interest as a payout on investment holdings in the fund, much the same manner as the holdings of the investors, albeit by issuing different classes of units in an AIF structured as a trust. In case of offshore funds, a direct payout of carried interest by such offshore fund to an Indian resident may risk the offshore fund being taxed in India. However, structuring through alternative mechanisms are adopted to avoid multiple levels of taxation.
Lastly, since 2012, when a retrospective amendment was inserted in the IT Act, there has been ambiguity on taxation in India on account of offshore transfers where the value of the transferred interests derives value from underlying assets in India. The CBDT recently notified rules relating to indirect transfer of assets. The rules specify the manner in which the fair market value of assets of a foreign company with underlying Indian assets is computed. The fair market value is critical as it forms the basis of the trigger of ‘indirect transfer’ in the income tax law. Thus, foreign investors should bear in mind the indirect tax transfer rules regarding liability, reporting and paying Indian taxes on offshore transactions with an Indian connection.
The regulatory and tax framework governing investment funds has undergone myriad changes in the past year. The much-talked-about relaxation for foreign investments in AIFs has been notified through an amendment to the applicable foreign exchange regulations. The Alternative Investment Policy Advisory Committee submitted its report to SEBI, making various significant recommendations that could lead to the overhauling of the AIF framework. Given the enormous funding gap in the infrastructure sector, SEBI and RBI have made several amendments to ease fundraising for this sector. Further, the constructive approach adopted by SEBI is evident from its consultation papers on amendments to the REIT and INVIT Regulations, which is a positive development. Also, amendment regulations are expected in the near future that will encourage sponsors to monetise their land banks and infrastructure projects and channel the liquidity towards new investments.
As is evident from the above, the regulatory developments have not only been in the sphere of liberalisation of the FDI caps and limits across various sectors, but have also simplified the process-based requirements that act as hurdles towards fundraising, particularly in start-ups and growth sectors. The Indian government has, in the past two years, taken progressive measures to promote India as the destination of choice not only for doing business with India but also for doing business in India, namely, pioneering the ‘Make in India’28 initiative to encourage multinational corporations and domestic companies to manufacture their products in India. The ‘Start up India’ initiative encourages entrepreneurship in India, and the ‘Skill India’ initiative enables sustainable employment among the youth in India. The above initiatives, coupled with RBI’s renewed focus on addressing the non-performing loan problems plaguing the banking industry and Finance Ministry’s resolve to bring back black money into India, are indications of strong structural changes being made to address key concerns in the Indian economy.
To summarise, an improved macroeconomic situation, resilience in the face of Brexit tremors, and several favourable legal, regulatory and tax amendments will lead to an improved fundraising and deployment scenario for Indian fund managers and portfolio companies. India achieved a 7.6 per cent growth rate in 2015–2016, and could thus be viewed as a ‘sweet spot’ in an otherwise sluggish global economy.29
1 Cyril Shroff is a managing partner and Shagoofa Rashid Khan is a partner at Cyril Amarchand Mangaldas.
3 Number of registered intermediaries available on SEBI website at: www.sebi.gov.in/sebiweb/intermediaries/.
4 AIF AUM data available at: www.sebi.gov.in/cms/sebi_data/attachdocs/1464847826344.html.
6 See footnote 2.
7 See footnote 2.
9 See footnote 2.
10 Fact Sheet on Foreign Direct Investment available at http://dipp.nic.in/English/Publications/FDI_Statistics/2016/FDI_FactSheet_JanuaryFebruaryMarch2016.pdf'>http://dipp.nic.in/English/Publications/FDI_Statistics/2016/FDI_FactSheet_JanuaryFebruaryMarch2016.pdf.
11 SEBI Circular No. CIR/IMD/DF/7/2015 available at www.sebi.gov.in/cms/sebi_data/attachdocs/1443691973267.pdf.
12 Means a foreign company whose shares are not listed on any recognised stock exchange in India or abroad.
13 Dr Dave Committee Report on CISs, available at www.sebi.gov.in/cms/sebi_data/attachdocs/1347599548466.pdf.
14 List of registered collective investment management company issued by SEBI, available at www.sebi.gov.in/sebiweb/home/detail/23271/no/Registered-Collective-Investment-Management-Company.
15 As of 31 March 2016, out of the 209 AIFs registered with SEBI, only five were formed as LLPs and one as a company, with the remaining being registered as trusts. See footnote 3.
16 See footnote 3.
17 McKinsey & Company’s Indian Private Equity: Road to Resurgence, June 2015.
18 Speech of the Hon’ble Minister of State for Finance Shri Jayant Sinha delivered at IVCA Event: Private Equity Reforms: Path the Future at New Delhi on 1 July 2015.
19 See footnote 1.
21 Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) (Eleventh Amendment) Regulations 2015 available at https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT35545E09E76D76D41CB9C096814B9C87E6A.PDF.
24 IRDA Circular IRDA/F&I/CIR/INV/172/08/2013, available at www.irda.gov.in/ADMINCMS/cms/whatsNew_Layout.aspx?page=PageNo2047&flag=1.
25 PFRDA Circular PFRDA/2016/8/PFM/02, available at www.pfrda.org.in/WriteReadData/Circulars/AIF8e56d8df-6719-4d49-8e3e-09ee444ad220.pdf.
26 RBI Circular is available at: https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=10049&Mode=0.
27 A concept similar to ‘permanent establishment’, and is set out in Section 9 of the IT Act. The same is applicable in case of a non-DTAA scenario.
28 After the launch of Make in India initiative, during October 2014 to May 2016, FDI equity inflow increased by 46 per cent (i.e., from US$42.31 billion to US$61.58 billion) in comparison to the previous 20 months (February 2013 to September 2014), as informed by Commerce and Industry Minister Nirmala Sitharaman in a written reply to the Rajya Sabha (Upper House of the Indian Parliament).