From the Finance Minister’s speech to present the budget proposals on 28 February 2015 (“Budget 2015”), it was evident that after years of lobbying by the private equity industry in terms of making its voice heard and its importance recognised by the policy makers, it was a time of reckoning for them.
The Finance Minister in his budget speech clearly recognized the crucial role that the private equity funds could play in terms of achieving the larger macroeconomic goals of job creation through growth, investment and fulfilment of the aspirational ‘Make in India’ through domestic manufacturing. Measures such as extending ‘tax pass through’ for Category I and Category II alternative investment funds, granting such funds access to foreign capital appears to be all aimed at encouraging setting up of domestic funds to mobilise higher resources and make higher investments and provide the much required private equity capital to Indian businesses including new ventures and start-ups. Further, structural reforms such as merging of Forward Markets Commission with the Securities and Exchange Board of India (“SEBI”) and merging of the foreign investment composite limits also signal a more robust, stable and forward looking regulatory regime for development of the Indian markets. Lastly, but not the least changes to remove tax hurdles for sponsors in setting up of REITs/InVITs, encouraging fund managers to freely organise their business in India by providing carve outs from ‘business connection’ for offshore funds which are managed from India, etc. signal a very positive approach by the government for this asset class. In this article we discuss some of the key changes and announcements announced in the Budget 2015 which affect the Funds’ industry in India.
1. Pass through status for Alternative Investment Funds (“AIF”)
Proposal: The AIF Regulations issued by SEBI classify AIFs under three broad categories. Under the extant tax regime, a tax pass through is available only to the sub-category of a venture capital fund (“VCF”) within Category I AIFs. Budget 2015 proposes to extend the benefit of a tax pass through to all Category I and Category II AIFs.
Effect: Any income earned by an investor in a Category I or II AIF shall be charged to tax directly in the hands of the investor, as if such investor had directly made an investment in the underlying portfolio company. However, unlike the currently existing pass-through for VCFs, at the time of distribution of such income by the AIF to the investor, a withholding tax of 10% shall apply for which credit can be claimed by the investor. Thus, no tax shall be payable at the fund level on such income. The exception to this rule is in case of income earned by the Category I or II AIF which is categorized as business or professional income/gain, in which case the tax shall be payable at the fund level at the applicable rates. However, there will be no withholding at the time of distribution and no further tax should be payable by the investor upon receipt of such income from the AIF. Budget 2015 also proposes to allow Category I and II AIFs to carry forward 1 By- Siddharth Shah (Partner, Khaitan & Co) and Divaspati Singh (Senior Associate, Khaitan & Co) unutilized losses incurred at the fund level and setoff such losses against future income.
However, such losses cannot be passed on to the investors.
Further, in order to place the corporate and non-corporate AIFs at par, the Bill proposes that no dividend distribution tax or tax on buy back of shares shall be payable by Category I and II AIFs organized as companies when distributing income to the investors. Another important relief that has been promised is that in the coming days, the Income Tax Rules shall be amended such that no tax need be deducted at source by the portfolio company when making a payment to an AIF. Given the challenges faced by investors in the past in claiming a tax credit for taxes withheld at the portfolio company level, this move is most welcome, since it eliminates a major irritant for investors. One hopes that this relief is extended to all categories of AIFs.
Illustrations (broad indications for example purposes only)
* The Investor pays tax on the entire income i.e. capital gains of INR 50 crores as if he had
directly invested in the portfolio company but will get credit for the taxes of INR 5 crore withheld
by the Fund
* The distribution of INR 10 crore in the hands of the investor will be treated as exempt income on account of the set-off of prior losses by the Fund
Misses: Firstly, Budget 2015 has not tried to address the ambiguity around characterisation of income in the hands of the Category I or II AIFs in terms of investment income vs. business income. This leaves a door of uncertainty open for the assessing officers to exercise their discretion to allege the income of such funds to be treated as business income. Secondly, by allowing the set off of losses only in the hands of the funds and not the investor, the investor will lose the benefit of accrued losses for set off against any other income and at the end of the life of the fund, any accrued carried forward losses would be lost. Finally, the proposed tax pass-through has not been extended to Category III AIFs and thus Category III AIFs will still have to offer their income to tax under the provisions of Section 161-164.
What it means for the industry: Barring the uncertainty around characterisation of income as stated above, the Budget 2015 proposals should bring certainty around taxability of income for the funds as well as for the investors in such funds. For e.g. based on the last circular issued by the CBDT, some professional trustees were insisting on creating tax reserves as high as 30% of the distributions at the trust level to deal with potential tax liabilities on account of the uncertainty of taxation of such AIF as indeterminate trusts under Section 161-164. Now since these provisions specifically cater to all categories of AIF, reliance on the provisions of Section 161-164 would not be necessary. Further, clear mechanism for tax credit to the investors should also help in cutting down of frivolous tax litigations which they were subjected to on account of wide discretion available to assessing officers under Section 161-164. This would surely encourage institutional investors who were frustrated with the uncertainty around the taxability of AIFs to give them a fresh look thereby enhancing the domestic institutional pool of capital for AIFs.
2. REITs and InVITs
While the first budget session of the NDA government in 2014 (“Budget 2014”) introduced the taxation regime for REITs and InVITs, the regime failed to take off on account differential and not very favourable treatment accorded to the sponsors at the time of sale of their units in the REIT/InVIT vis-à-vis other unitholders. To recap, the current provisions of the Act as applicable to REITs/InVITs are as follows:
(a) Business Trusts: REITs/InVITs have been envisaged in the nature of ‘business trusts’ which would raise money from investors through issue of units which may be invested in income
bearing assets held by the trust through a controlling interest in an SPV. Asset will brought in by the sponsor through transfer of SPV shares into the REIT.
(b) Transfer of the SPV from the Sponsor to the trust: Capital gains arising at the time of transfer of the SPV to the REIT are deferred till the time of disposal of the REIT units by the Sponsor, provided the Sponsor is not entitled to preferential capital gains treatment on transfer of REIT units as applicable to other unit holders of REITs, except in respect of cost and holding period of the shares of the SPV.
(c) Taxation of income:
Proposal: Primarily to recognise the crucial role of the sponsors in the success of the REIT/InVIT regimes and to also bring the regime at par with a more conventional IPO of project SPVs by the Sponsors, the proposals introduced in Budget 2015 are as follows:
(a) Tax Treatment on disposal of Sponsor Units: The Budget 2014 proposal placed the sponsors of such business trusts in a disadvantageous position when compared to other investors in the business trust when it came to exits by way of IPOs of the business trust units. Under the extant law, capital gains earned by investors on sale of units of the business trusts on the stock exchange are taxed under the same preferential tax regime that applies to sale of listed equity shares on the exchange. Thus, gains earned on the sale of units (on a stock exchange) held for more than 36 months are exempt from tax, and gains on the sale of units (on a stock exchange) held for 36 months or less are taxed at the rate of 15%. However, such a concessional tax regime was hitherto not extended to the sponsors. Budget 2015 proposes to remedy this situation, by extending this preferential tax regime to sponsors of business trusts as well.
(b) Taxation of Rental Income: The current regime was silent in respect of taxability of REITs/InVITs which own the assets directly and not through SPVs. Budget 2015 proposes to accord a tax pass through to a REIT with respect to rental income from real estate property directly held by it. Such income shall going forward, be deemed to be income of the unit holder and shall be charged to tax in his hands and no tax shall be payable at the REIT level. A withholding tax of 10% in case of resident unit holders and at the rates applicable as per the relevant tax treaty or the IT Act as the case maybe in case of non-resident unit holders shall apply.
What it means for the industry: With these changes, the last crucial hurdle for the successful implementation of these regimes seems to have been addressed well by the Finance Minister and the path is almost cleared for the roll out of this much awaited product in the Indian markets. For the policy makers, it’s now essentially over to the industry to really make the most out of these regimes which could really be the change agents for the industries that they target viz. real estate and infrastructure, and also for the Indian capital markets.
3. Offshore Funds managed from IndiaOffshore funds have to be typically managed and controlled from outside India to avoid creation of a ‘business connection’ or ‘permanent establishment’ in India which could potentially expose their income attributable to such ‘business connection’ or ‘permanent establishment’ to be taxed in India. This had effectively lead to a situation where several Indian fund managers had migrated to jurisdictions outside of India to avoid creating such ‘business connection’ or ‘permanent establishment’ in India essentially leading to brain drain from the country of this intellectual class. To address this issue of relocation of fund managers outside India, even the earlier government had attempted to suitably amend the domestic tax regime which may enable domestic fund managers to manage offshore funds, without being treated as a ‘permanent establishment’/‘business connection’ of such fund in India.
Proposal: To extend the ‘Make in India’ picture to the fund industry, the Finance Minister proposed in the Budget 2015 that an ‘eligible investment fund’ managed from India by an ‘eligible investment manager’ will not constitute business connection of the said fund in India and such eligible investment fund will also not be regarded as being resident in India. Key criteria for an offshore fund to qualify as an ‘eligible investment fund’: (a) fund is resident of a country with which India has a Double Taxation Avoidance Agreement; (b) the aggregate participation or investment in the fund, directly or indirectly, by persons resident in India must not exceed 5% of the corpus of the fund; (c) the fund and its activities are subject to applicable investor protection regulations in the country where it is established; (d) fund has minimum 25 members who are not connected; (e) any member along with connected person does not have more than 10% interest in the fund; (f) aggregate participation interest of ten or less members along with their connected persons, shall be less than 50%; (g) investment by fund in an entity shall not exceed 20%; (h) fund shall not invest in associated entity; (i) monthly average corpus of the fund should not be less than INR 100 crores; (j) the fund shall not carry on or control or manage any business from India; (k) the fund does not have any other business connection other than the manager; and (l) remuneration of the manager is at arm’s length.Key criteria for an ‘eligible investment manager’: (a) the person is not an employee of the fund or a connected person of the fund; (b) registered as a fund manager or an investment advisor in accordance with the specified regulations (SEBI Portfolio Manager Regulations or the SEBI Investment Advisor Regulations); (c) person should be acting in the ordinary course of his business as a fund manager; and (d) the person along with his connected persons should not be entitled, directly or indirectly, to more than 20% of the profits accruing or arising to the eligible investment fund from the transactions carried out by the fund through the fund manager.
What it means for the industry: While it may be a welcome start to give impetus to the domestic fund management industry, however, the fine print of the proposed changes including the definitions of ‘eligible funds’ and ‘eligible managers’ leave very little flexibility to actually structure an investment fund under these exemptions. It appears the proposals seem to be more targeted to benefit large institutional fund investors such as endowments, pension funds, mutual funds, etc. and may be less relevant for typical private equity funds who may find these conditions difficult to fulfil. Having said that, the concept of ‘place of effective management’ (“POEM”) has also been introduced in Budget 2015 and it is currently not clear whether the concept of POEM will apply to ‘eligible investment funds’.
4. Commodity Exchanges
Proposal: To strengthen the regulation of commodity forward markets and to reduce wild speculation, the Finance Minister proposed the merger of the Forwards Markets Commission (“FMC”) with SEBI. Budget 2015 has proposed to amend the Securities Contracts (Regulation) Act, 1956 (“SCRA”) to include ‘commodity derivatives’. The proposed amendments inter alia repeal the Forward Contracts (Regulation) Act, 1952 and provide that all recognized associations under the Forward Contracts Regulation Act, shall be deemed to be recognized stock exchanges under the SCRA.
What it means for the industry: While this appears on one hand as structural reform measure to streamline the regulatory framework for investment products and to rationalise the multiplicity of regulators existing currently, the immediate fall out of this could also potentially result in opening up of commodity futures as an investment product in a more formal manner. For example, currently there are no specific regulations from FMC governing a pooled investment scheme proposing to invest in commodity derivatives since the definition of ‘securities’ under SCRA did not explicitly cover commodity derivatives and hence it fell outside SEBI’s power to regulate. However, with this consolidation and expansion of the definition of ‘securities’ under the SCRA, it should provide a framework for SEBI to formulate a policy around these investment products in line with other investment products regulated by it. For e.g., this could on one hand mean that SEBI could allow AIFs to invest in these products or on the other hand this could pave way for participation by FPIs in commodity derivatives thereby deepening the market significantly. Needless to say, SEBI will need to look at this asset class entirely independently keeping in mind the relatively higher sensitivity of commodities market to the general economy.
5. Foreign investments in AIFs
Proposal: The Finance Minister has proposed to allow other categories of foreign investors to invest in AIFs. While the fine print of the changes to this effect needs yet to be seen but this essentially means that while currently only NRIs were permitted to invest in AIFs (organised as trusts) subject to prior approval from the Foreign Investment Promotion Board, this may now be opened up for all categories of foreign investors.
What it means for the industry: Another change to augment the ‘Make in India’ campaign, it would be a significant impetus for domestic fund managers. If the proposal were to put the raising of foreign contribution in the AIFs under the automatic route, this could significantly ease the process for domestic funds to raise foreign capital. Besides the fact that the FIPB approvals are discretionary, such approvals have been taking anywhere between 3-4 months or even much longer in many cases which has been a cause of frustration for investors and fund managers. Any liberalization in the current approval regime may reduce the fund raising time period and also pave way for domestic fund managers who have been receiving significant interest from NRIs and other foreign investors for participating in this alternate asset class.
6. Merger of foreign investment limits
Proposal: The Finance Minister in his budget speech proposed that in order to simplify the foreign investment norms, the distinction between various foreign investment regimes, especially Foreign Direct Investment and Foreign Portfolio Investment, may be removed and replaced with composite caps.
What it means for the industry: This move could further ease the process for foreign investors who are at times caught in situations where limits under FDI may have been fully utilized but headroom under FPI/FII limits may be available or vice versa. The market had seen this arbitrage in case of stock exchanges and commodity exchanges or banking sector which have such segregated caps between FDI and FPI/FII. This would potentially avoid unnecessary hassle of seeking registrations etc. and the associated hardships.
7. General Anti-Avoidance Rules (“GAAR”)
Proposal: GAAR in its current form was sought to be effective from FY 2015 – 16 and onwards. Budget 2015 proposes to defer the implementation of GAAR by two years (i.e., FY 2017-18) as also the effect of GAAR will only be prospective post 1 April 2017.
What it means for the industry: GAAR was seen as a major roadblock by domestic and offshore fund managers while considering the jurisdiction of choice for setting up of the fund. Further, the retrospective applicability of GAAR to structures organised after 2010 also created uncertainty for foreign investors and lack of suitable planning opportunity resulted in being tangled in the unforeseen tax risk which did not exist at the time of organising the structures. By deferring the implementation of GAAR with the promise of revisiting open issues and providing for a comprehensive regime, and to make it effective only prospective, we believe the fund management community would welcome any and all efforts in the interim two year period that clarify the scope and implementation of GAAR.
8. Extension Of Concessional Tax Rate for Interest Payable to FPIs on their Investment in Government Securities and Rupee Denominated Corporate Bonds
Proposal: Budget 2015 proposes to extend the benefit of lower tax withholding rate of 5% on interest payment made to FPIs in respect of investments made by them in: (a) INR denominated corporate bonds and (b) Government securities, for interest payable up to 30 June 2017.
9. Abolition of Minimum Alternate Tax (“MAT”) for FIIs
Proposal: Budget 2015 proposes that no MAT shall be chargeable on capital gains earned by FPIs on their transactions in securities (except in respect of short term capital gains earned on transactions on which no STT is payable).
What it means for the industry: This would surely come as a relief to several FIIs/FPIs who have been slapped with the MAT notices in the recent times by the tax authorities which had also vitiated a stable tax regime for foreign portfolio investors. On the flip side, restricting the benefits to only FIIs/FPIs would leave the ambiguity open for other categories of foreign investors viz. NRIs, FDI or FVCIs. Further, the proposal appears to suggest that MAT is intended to apply to foreign companies, which itself has been an issue of contention amongst the foreign investors.
To conclude, Budget 2015 appears to have made an honest attempt at trying to address some of the fundamental issues faced by the funds industry. It appears that the intent of the government is to indeed provide more certainty and clarity for the funds, investors and the managers thereby improving the ease of doing business in India. Clearly, the moto of ‘Make in India’ seems to have been weaved well into the proposals for this sector to encourage the growth of alternative investment asset class in the country. The fact that the industry has finally found its voice and recognition with the Finance Minister is itself something for the industry to cheer about. However, there are still issues that need to be appropriately addressed and matters which require clarity. While the first step has been taken by the Finance Minister in the Budget 2015 to address these issues, the industry needs to respond with more vigour to grow the importance and relevance of this asset class and seek even more clearer and beneficial regime from the policy makers. With the projected double digit growth rate for the economy, the fund industry has a lot to look ahead in terms of riding this wave.
(Siddharth Shah is a partner at Khaitan & Co. and Divaspati Singh, senior associate at the firm.)
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