Narayan Murthy Committee’s First Report on AIF Policy: A Mixture of Immediate Fixes and Long Term Recommendations
In 2012, SEBI took steps to completely overhaul the regulatory framework for domestic funds in India and introduced the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”). The AIF Regulations were introduced by SEBI with a view to recognize such pooling vehicles as a distinct asset class and to promote investment in start-ups and early stage companies. Further, the AIF Regulations were also aimed at rationalizing investment restrictions with the concessions and incentives that were made available.
Categories of funds: Category I AIFs encompass AIFs with a defined investment strategy focusing on Venture Capital Funds, Small and Medium Enterprises Funds, Social Venture Funds and Infrastructure Funds, which in SEBI's view, lead to "... positive spillover effects on the economy". Category II AIFs encompass AIFs that may not need any focused incentives. These would include private equity funds and debt funds, among others. Category III AIFs are used to set up an onshore hedge fund structure with prescribed levels of leverage.
In 2015, the Securities and Exchange Board of India (“SEBI”) had constituted the Alternative Investment Policy Advisory Committee (“AIPAC” or the “Committee”) under the chairmanship of Mr. Narayan Murthy. AIPAC is a standing committee that has been constituted with the objective to advise SEBI on measures to further development of the alternative investment and startup ecosystem in India and to highlight any hurdles that might hinder the industry’s development.
The first report of the AIPAC was issued on January 20, 2016. Following is a brief summary of the issues highlighted by the Committee and the suggested changes.
The report outlines the following objectives that its recommendations seek to achieve:-
Summary of the Report
A. Creating a favorable tax environment:
The AIPAC is of the view that the AIF industry has a real opportunity to make a greater impact on the economy provided that AIFs as an asset class get recognition as a distinct investment class, much the same as foreign portfolio investment and foreign direct investment are recognized as carrying unique attributes. The Committee recommends the following changes to achieve the same:-
(i) Exempt income of an AIF and exempt investors in an AIF should not suffer withholding tax
Section 194 LBB of the Income Tax Act, 1961 (“Act”) deals with provisions related to withholding on income arising from an investment fund. The provision requires the investment fund to deduct tax at the rate of 10% of the net book income at the time of making distributions to the investor, or crediting the same to the account of the investor.
As a best case scenario, the Committee has recommended that Section 194LBB should be abolished. If the provision is continued, (1) exempt income must be excluded from its ambit, (2) the provision should exclude “accredited investors” which provide self-declaration, (3) provision should exclude non-resident investors as they are subject to requirements of Section 195, (4) clarify that it is applied on net income and not gross income and (4) reduce the rate to 2% of the net book income instead of 10%.
The report recommends that there should be no tax withholding on exempt income streams, entities that are exempt from income tax and distributions/credit to investors that can avail benefits under the relevant Double Taxation Avoidance Agreement (“DTAA”).This is an important reform that will go a long way in incentivizing foreign investors to invest in AIFs.
Further, the report also recommends that transactions covered under Section 194LBB should be eligible to obtain a nil withholding certificate under Section 197.
(ii) Investment gains of an AIF should be deemed to be “capital gains”.
AIPAC has recommended that the income earned by an AIF should be taxable under the head “capital gains” or “income from other sources”. This is important to remove the risk of the income being characterized as “business income”. At present, funds (especially category III AIFs) face the risk of their income being characterized as business income due to the frequency of investment and exits. Further, an earlier amendment to the Act deems all income of a foreign portfolio investor (“FPI”) to be “capital gains”. This creates a mismatch in the applicable regulations and places onshore AIFs at a disadvantage over offshore funds.
(iii) Investments by AIFs should be exempt from provisions of Section 56(2)(viia) and 56(2)(viib)
Currently, Sections 56(2)(viia) and 56(2)(viib) apply to AIFs when they purchase shares of a closely held company, or to the investee company when they subscribe to shares of such a company. These are anti-abuse provisions that have been inserted into the Act to prevent transactions above or below fair market value.
However, at present Section 56(2) of the Act provides specific exemption for companies where the consideration for issue of shares is received from “venture capital funds” due to the special nature of the transactions. AIPAC has recommended that all AIFs and their investee companies should be exempted from the rigors of Sections 56(2)(viia) and Section 56(2)(viib).
(iv) Indirect transfer provisions
AIPAC has recommended that it should be clarified that the indirect transfer provisions under Section 9 of the Act are not applicable to gains from transfer of shares or interest of the holding companies/entities above investment funds investing in India. This is important as at present, there is uncertainty surrounding the transfer of shares of an investment fund investing into India due to the fact that most India focused funds have more than 50% of their assets situated in India. This makes them subject to a Section 9 scrutiny on indirect transfers.
(v) Overhaul of safe harbor provisions for onshore managers for India-focused foreign funds
By an amendment under Finance Act, 2015, safe harbor provisions were introduced under Section 9A of the Act. These provisions were introduced to encourage onshore fund management for offshore funds as they laid down that upon fulfillment of certain conditions, activities of the fund manager would be deemed to not have a “business connection” in India.
The safe harbor provisions under the Act have not been utilized by the fund management industry as they have been found to be too onerous. In order to improve the safe harbor provisions, the Committee has recommended various changes such as rationalization of the diversification requirements, allowing indirect investors to be counted while calculating the number of investors and removal of caps on the percentage of corpus that can be invested into a single investment. Most importantly, the Committee has sought clarity on the fact that a fund would not be regarded as carrying out business activities in India merely by the virtue of holding shares in various entities and subsequent measures taken to protect their interest therein.
(vi) Extension of “pass-through” status to all categories of AIFs and grant of pass-through status to net losses at AIF level
At present, “pass-through” status has been granted only to category I and category II AIFs. The Committee has recommended that “pass-through” status should be granted to category III AIFs as well. Globally, investment funds rely on a 'tax pass-through status' wherein the income of the investment fund is taxed directly in the hands of its investors, and not at the level of the fund itself. This provides fiscal neutrality to funds as it eliminates tax at the pool level while maintaining taxation at the investor level.
Further, AIPAC has recommended that net losses incurred at the end of a fund’s lifecycle or has unabsorbed losses, which cannot be utilized by the AIF should be allowed to be passed on to investors. The investors should then be allowed to offset other capital gains against such losses.
(vii) Long term roadmap for a Securities Transaction Tax based approach for AIFs
One of the major long term recommendations from the AIPAC is to introduce a Securities Transfer Tax (“STT”) at an appropriate rate on all distributions (gross) of AIFs, investments, short-term gains and other income and eliminate any withholding of tax. The AIPAC was of the opinion that having regard to the level of risk taken by investors into an AIF, the investment should be treated at par with investment into listed securities. STT based taxation is already applied in case of transactions involving listed securities. After STT has been imposed at an appropriate rate, income from AIFs should not be subject to tax at the hands of investors. However, it must be noted that the imposition of STT would take away from the “pass-through” nature of taxation in category-I and category-II AIFs as it would lead to an additional and mandatory tax being imposed at the level of the AIF.
(viii) Proposed “next practices”
In addition to the immediate changes, AIPAC has recommended the following measures as “next practices” which have been positioned as measures that go beyond the existing “best practices” that are prevalent globally. Some important suggestions are as follows:-
B. Unlocking capital pools:
The Committee identified that at present there are constraints on banks and NBFCs to supply risk capital as they are subject to risk management requirements. Hence, other domestic pools need to be identified as potential pools of domestic capital into AIFs. The AIPAC is of the view that more domestic capital would enable India to attract more global capital and the policy should incentivize institutions looking to make equity investments in India should consider the AIF route as a sound alternative and domestic capital is likely to take higher early-stage risk and can spur the start-up system in India.
The following potential domestic sources of capital have been identified by AIPAC:
C. Promoting Onshore Fund Management:
The AIPAC identified that the current regulatory and tax regime is a key factor in driving VC/PE fund managers overseas and causes most India focused VC/PE funds to be domiciled overseas. The report suggests that (a) tax clarity on issues such as rationalization of withholding requirements under Section 194LBB (as discussed in the section titled “creation of a favorable tax environment” above); and (b) operational freedom of fund managers have a key role to play in promoting onshore fund management.
Operational freedom for domestic AIFs: AIPAC has recommended that the following measures must be taken to increase operational freedom for AIFs and to have a more robust system of investor protection:-
Overseas investments by AIFs – The AIF Regulations should allow for either 25% of the total corpus of the AIF (under an automatic route as opposed to the current policy of prior permission) or 50% of the offshore component of the corpus of the AIF to invest in overseas portfolio companies. The understanding of ‘Indian connection’ should be liberalized i.e. investment from an AIF in itself should be regarded as satisfying this criteria.
D. Reforming the AIF regulatory regime:
AIPAC has recommended a greater thrust on regulating the fund managers as opposed to the funds. The Committee has recommended that the existing SEBI (Portfolio Management) Regulations, 1993 (“PMS Regulations”), SEBI (Investment Advisers) Regulations, 2013 and AIF Regulations should be consolidated to a single Alternative Investment Fund Managers regulations (“AIFM Regulations”). As an alternative, the Committee has recommended that the following changes must be made to the AIF Regulations:-
The AIPAC report marks a welcome start for necessary dialogue that is required between the industry and the regulator. While the Report outlines emphasizes on specific changes required in the current regulatory framework for certain immediate changes, it is far sighted in its recommendations and contains various structural suggestions that would go a long way in enabling a thriving AIF platform in India.
A critical positive feature of the AIPAC is that it is constituted as a standing committee which will continue its work in other areas that affect the AIF industry. We hope that the Committee shall also monitor the implementation of its recommendations and consistently engage with the government and the industry to create a stable, secure and progressive regime for pooled investment structures in India.