India has followed an ad-hoc policy on foreign capital with periods of obsequious welcome alternating with periods of taxation turmoil. Unfortunately Indian policies have succeeded in attracting capital flows primarily from financial investors & in a manner that limits India’s ability to collect taxes. The Dr Shome committee report offers a platform to develop a comprehensive “new” policy that can attract capital flows to drive economic growth & contribute to taxation.
In the early 90s, as part of liberalizing the Indian economy, India invited foreign portfolio investors into Indian securities markets. Instead of finding acceptable ways to incorporate foreign capital into the domestic mutual fund industry, India created the FII route. Brilliantly designed & extremely attractive, the FII route provides “capital account convertibility on the Indian Rupee,” a privilege that was not offered to any other investor (resident or non-resident).
The route precluded the need for the FII to set up shop in India! In order to qualify, the FII had to be “incorporated overseas”, with 50 or more shareholders, directly or indirectly contributing capital. Resident fund managers could not set up FIIs & effectively compete with non-resident fund managers in servicing foreign investors. Once, global investors discovered the tax benefits of the India-Mauritius double tax treaty, a big part of the Indian fund management industry was quickly exported to Mauritius!
Over the last two decades, foreign mutual funds & alternative funds (primarily hedge funds) have utilised the “Most Favored Investor” status granted to FIIs to gain >66% market share, growing Indian assets under management to more than USD 225 billion compared to domestic mutual fund industry of less than USD 120 billion (actually it is >80% market share, if you compare FII equity funds with domestic equity funds).
In the mid to late 90s, India set up the domestic and foreign venture capital (FVCI &/or DVCF) routes for investments in unlisted equities. In contrast to the FII & mutual fund routes, the FVCI and DVCF routes never gained popularity due to tax policies and asset side over-regulation.
Strangely even after two decades of liberalization, the PE&VC industry that directly supports Indian entrepreneurship & is a more stable source of long-term capital has not been able to obtain the “Most Favored Investor” status & predominantly operates through the FDI route meant for strategic investors. Again, as a result of regulatory framework, the PE&VC fund management industry that has invested over USD 70 billion in India, has also gravitated to Mauritius. For similar reasons, all other alternative funds (for eg real estate funds) also operate as FDI from Mauritius.
Fund managers choose to incorporate Indian funds targeted at foreign capital in Mauritius because (a) they have to choose an “overseas” jurisdiction to pool capital in order to qualify for FII or FVCI status & (b) the largest investors in Mauritius Funds require a capital gain tax-exempt investment route. Broadly, the big investors can be classified as follows:
a) Tax Exempt Investors (TEI) such as pension funds & other social security schemes that don’t pay taxes in their home jurisdictions.
b) Global Funds (GFs) / Fund of Funds (FoF) / Hedge Funds – most are organized in a manner to focus only on markets that offer a tax-exempt investment route! Big subscribers to this category are again TEIs.
Investors in both categories above also play the role of anchor investors in fund formation worldwide and fund managers focused on India need to incorporate in Mauritius to be competitive in attracting these investors. Other subscribers, even those that are not averse to paying Indian taxes and claiming tax credits at home, due to lack of choice, still have to follow anchor investors into Mauritius funds:
c) Tax Credit Sensitive Investors (TCSI) – residents in jurisdictions (for eg Japan, India) that provide overseas tax credits only to taxes paid directly & not through a fund invested by the resident. TCSIs can only invest in jurisdictions that have a “system of taxing the investor and not the fund”.
d) Other Investors (OIs) – residents in jurisdictions that allow tax credits on taxes paid offshore by the resident or by funds invested by the resident on a “look through basis” (eg USA).
Given the composition of subscribers, the alarm around the Budget proposal to introduce GAAR should be no surprise. Industry watchers can justifiably complain of multiple doses of déjà vu – the fund industry complains & the finance ministry assures that treaty benefits would continue to be available! However, this time around, the government has chosen to set up the Dr. Shome Committee, with a roving mandate on taxation of non-resident tax payers, enabling the development of a more cogent policy to attract foreign capital & wherever possible collect taxes.
The Shome Committee has recommended the first step for a cogent policy - deferring GAAR by 3 years & keeping taxation treaties with Mauritius & Singapore outside the purview of GAAR.
The second step requires a medium term policy commitment to encourage flows of foreign capital to “Indian incorporated” mutual funds & alternative funds (AIFs).
While the mutual fund framework is fairly robust and can attract foreign capital, the landscape can be significantly altered if 100% foreign ownership is allowed in mutual funds. FIIs should be allowed to set up Indian subsidiaries to sponsor & manage domestic mutual funds that are 100% subscribed by the FII (similar to the previous regime where FVCI where allowed to setup 100% owned DVCF).
India also needs to follow through on the recently notified Alternative Investment Fund Regulations (“AIF Regulations”). AIF Regulations have been designed well & can play a significant role in re-importing the fund management industry into India. Market practice by AIFs (including hedge funds) is to seek long-term investors by offering closed-end fund products (tenor of 7-10 years) or open-end fund products that impose 1-year to 3-year lock-ins on subscribers. Here too, non-resident managers should be allowed to set up and manage AIFs that target foreign capital (similar to DVCF being 100% owned by FVCI). By its nature, a vibrant domestic AIF industry (even hedge funds with foreign capital) can add to resilience of capital flows.
In order to promote the AIF industry, the Finance Ministry would have to provide a tax framework that enables AIFs be competitive vis-à-vis Mauritius funds & domestic mutual funds. All 3 categories of AIFs need to be competitive; whether they are social funds or hedge funds, the approach should be to enable all of them, compete for capital on an equal footing. The best way would be to recognize AIFs as pooling vehicles that are similar to mutual funds & create a “system of taxing the investor and not the fund”. Similar to investors in mutual funds, investors in AIFs should be taxed depending on whether the AIF is investing in listed equities, unlisted equities, debt instruments, real estate or other funds. Also, the RBI & DIPP have to figure out steps for placing investment by foreign investors in mutual funds & AIFs on the automatic route.
Getting the New Policy in place will require coordinated action between SEBI, RBI, DIPP and the Finance Ministry. India would need to demonstrate policy stability for some time before foreign investors reduce their reliance on Mauritius. In the early days, we should expect some investors to set up feeder funds in Mauritius in order to invest in domestic funds. For example, TEIs & others while playing anchor roles in PE&VC funds, would still choose to set up feeder funds in Mauritius as long as Indian policy is to tax investments in unlisted securities. However, over a period of time, a significant number of long-term investors, especially those seeking to invest in listed securities as well as TCSI & OIs, can & will, exercise the choice of going direct into mutual funds & AIFs.
If India adopts the policy of building the domestic fund management industry, tax collections may increase & foreign capital flows (into domestic funds) should support currency stability. Over a period of time, domestic fund managers & subsidiaries of foreign fund managers will successfully persuade foreign investors to invest directly in AIFs & mutual funds, pay Indian taxes and claim tax credits at home. By drawing foreign capital away from Mauritius to domestic funds, not only can taxes be collected from foreign investors on par with domestic investors, India can also tax profits of the fund management industry!
By following the “New Policy”, India can leverage market forces to achieve its taxation objectives, instead of relying on GAAR or other measures on tax treaties. Over a period of time, India should integrate with the OECD world to enable TEIs invest directly in India leading to an uneventful sunset of the Indo- Mauritius tax treaty.
(The author is P R Srinivasan- a private equity professional. Assisted by Manu Sahni.)