Download Alternative Investment Funds

Meeting with Shri Jayant Sinha, the Minister of State
for Finance
Areas on which tax clarity is sought by private equity /
venture capital funds
2nd September, 2015
Road Map
 Executive Summary
 Alternative Investment Funds
 Safe Harbour Rules
2
Budget 2015 – A path breaking initiative for PE/VC
Several announcements made by the Government in the Union Budget 2015-16 provide an
enormous fillip to offshore and domestic PE/ VC funds
GAAR deferral by two years. Grandfathering of investments made till 31 March 2017.
Clarifications on indirect transfer related tax provisions
Tax ‘pass through’ to Category-I and Category-II Alternative Investment Funds
Safe harbour rules for offshore funds – a ‘Make in India’ initiative for the fund management
industry
►
With suitable enhancements, the initiatives taken in Budget 2015 will provide a compelling vision that will
encourage (i) the flow of domestic savings and overseas capital into private equity and venture capital (PE/
VC) assets and (ii) strengthen the onshore fund management industry
►
The enhancements to the tax provisions, which can be introduced by way of notifications/ clarifications have
been summarised in the next slide and detailed in this presentation
Executive Summary
Alternative Investment Funds (AIFs)
1.
2.
3.
The exempt income of AIF (dividend and exempt long-term capital gains) should not be subject to tax
withholding of 10%
Clarification on characterisation of AIFs investment gains as capital gains
Investments by AIFs should be exempt from the provisions of section 56(2)(viib) of the Income-tax Act, 1961
(the Act)
Overseas VC/PE funds - safe harbour rules for business connection and tax residence in India
1.
2.
3.
4.
5.
Investor diversification conditions should incorporate a look-through approach
SEBI registered Foreign Venture Capital Investors and Foreign Portfolio Investors should automatically qualify
as an eligible investment fund
Determination of fund corpus should be tested 24 months from the date of its launch
Approval mechanism for specific funds on case to case basis
Prescribe that offshore funds to not be regarded as carrying on business in India merely because of the
activities they perform to protect their shareholding in investee entities
Taxation of AIFs – Clarifications sought
1.
The exempt income of AIF should not suffer tax withholding of 10%
► This subjects investors to needless compliance burden of making tax refund claims for taxes deducted on
exempt income streams or on entities exempt from tax
► Section 190 of the Act provides for deduction of tax at source on any income of the assessee in accordance with
the provisions of Chapter XVII – Collection and Recovery of Tax. However, the withholding on such income shall
be subject to the condition that such income is chargeable to tax under section 4 of the Act.
Proposed notification
It is clarified that no withholding shall apply in respect of
► credit/ distribution of any income exempt under section 10 of the Act or
► any other income credited/ distributed by an investment fund to any person in whose case income, irrespective
of its nature and source is not chargeable to tax under the Act
Taxation of AIFs - Clarifications sought
Clarification on characterisation of AIFs investment gains as capital gains
2.
►
The characterisation of gains from an investment activity of AIF as ‘capital gains’ or ‘business profits’ is a vexed issue.
►
AIFs are privately pooled investment vehicles which collect funds from investors, whether Indian or foreign, for investing
in accordance with a defined investment policy for the benefit of their investors. Further, Category I and II AIFs
predominantly invest in unlisted investee entities with a medium to long-term investment horizon (typical holding
periods would range from 2-5 years).
►
Historically, Category I and II AIFs have characterised their gains from investment activity as ‘capital gains’ relying on the
principles emanating from the CBDT instruction/ circular and judicial precedents. In the course of scrutiny audits,
however, the Indian Revenue authorities have in the past re-characterised the gains/income of the AIFs as ‘business
profits’ thus leading to litigation.
Proposed clarification
►
The fact that an AIF is by definition an entity to make investments should not by itself be determinative of the
characterisation of income earned by an AIF.
►
Investments made by a Category I / II AIF for a period of more than 12 months should be a strong indicator that the
investment is held as a ‘capital asset’ and therefore gains, if any, derived from transfer/ sale of such investments should
be regarded as capital gains.
Taxation of AIFs - Clarifications
sought(contd)
►
Investment of temporary cash surpluses by AIFs in liquid mutual funds, treasury bills, Commercial Papers, Certificates of
Deposits and other similar instruments. should not impact the characterisation of income of the investment gains made
by AIFs.
►
Investments made by AIFs with the objective of earning interest income (i.e. debentures) over the holding period should
ordinarily be indicative of the investment being a ‘capital asset’ and therefore gains, if any, derived from transfer/ sale of
such investments should be regarded as capital gains
Taxation of AIFs - Clarifications sought
3.
Investments by AIFs should be exempt from provisions of section 56(2)(viib) of the Act
►
Since the VCF Regulations have been superseded by the SEBI (AIF) Regulations, the exemption from
section 56(2)(viib) of the Act to Venture Capital Funds (VCFs)/ AIFs should be extended to all AIFs
►
AIFs, being institutional investors regulated by SEBI, hold a fiduciary responsibility to invest in
transactions on an arm’s length basis
►
Proviso to section 56(2)(viib) of the Act provides for exclusion of certain class or classes of persons
notified by the Central Government from applicability of the said section
Proposed notification
SEBI registered Alternative Investment Funds are included in the class or classes of persons notified by the
Central Government for non-applicability of the provisions of section 56(2)(viib) of the Act.
H
Safe Harbour rules - Clarifications sought
Investor diversification conditions should incorporate a look-through approach
1.
►
PE/ VC funds usually have a sponsor or anchor investor, who invests 25-49% of the fund. Also, most India focussed
PE/ VC funds are set up with subscriptions from less than 10 investors.
►
In absence of a clear provision to consider direct members as well as underlying members for ascertaining the
number of members in a fund, the funds which invest in India through intermediate holding entities, may not
satisfy the aforesaid condition even when the total of number of direct members and underlying members is
more than 25.
►
Government and government related investors such as central banks, Government agencies, and sovereign wealth
funds may not satisfy this condition as they do not have named members or beneficiaries.
Proposed notification
In the guidelines for the purpose of section 9A of the Act, the following should be clarified:
In determining the number of members, look through approach be permitted. The term ‘member’ should be interpreted
in a manner to include investors and beneficiaries. Where an investor does not have an identifiable set of beneficiaries,
for eg, university endowments, central banks, Government agencies, and sovereign wealth funds, due consideration
should be given to the treatment of such investors under the Securities and Exchange Board of India (FPI) Regulations,
2014 and clarifications issued there under.
Safe harbour rules - Clarifications sought
2.
SEBI registered Foreign Venture Capital Investors and Foreign Portfolio Investors should
automatically qualify as an eligible investment fund
►
The existing regulatory framework to allow foreign investments either under the FPI Regulations or
FVCI Regulations is comprehensive and there are detailed monitoring mechanisms to track the quality
of investors and the sectors in which the investment flows. Hence the funds that are eligible to be
registered as a foreign portfolio investors or foreign venture capital investors should be excluded from
the applicability of diversification rules
Proposed notification
In the guidelines for the purpose of section 9A of the Act, the following should be clarified:
The conditions should not be applicable to entities that meet the criteria to be registered as a Category I or
a Category II Foreign Portfolio Investor (FPI) in accordance with the Securities and Exchange Board of India
(FPI) Regulations, 2014 or a Foreign Venture Capital Investor (FVCI) under the Securities and Exchange
Board of India (FVCI) Regulations, 2000.
Safe harbour rules - Clarifications sought
3.
Determination of fund corpus should be tested 24 months from the date of its launch
►
Where the offshore fund is a newly set up fund, (particularly, if the fund is set up closer to March 31) it may be difficult
for such fund to have a monthly average corpus of more than Rs 100 crores in year 1. Typically, for the fund to build a
track record and reach a target corpus of Rs 100 crores, it would take such fund a period of 2 to 3 years
►
Further, the term ‘corpus’ has been defined in clause (b) of sub-section 8 of section 9A to mean the total amount of
funds ‘raised’ for the purpose of investment. In this connection, it is important to note that in case of PEVC funds, the
entire corpus is not immediately raised at the fund launch stage. The investors only commit capital to the fund which is
provided to the fund in stages over a number of years as and when the fund manager identifies investment
opportunities
Proposed notification
In the Guidelines for the purpose of Section 9A of the Act, it should be clarified that if the fund has been established or
incorporated in the previous year, the corpus of fund shall not be less than one hundred crore rupees at the end of such
previous year or 24 months from the date of launch of the fund. Similarly, when the fund is winding down this condition
should be relaxed in the last year.
Further, in a limited life close ended fund, the reduction in the corpus of the fund in its winding down phase should not per se
disentitle the fund from the benefits of the safe harbour provisions.
Safe harbour rules - Clarifications sought
Approval mechanism for specific funds on case to case basis
4.
►
It is quite possible that the PE/ VC fund may not be able to satisfy all the conditions laid down in
section 9A to qualify as an eligible investment fund. Further, there are onerous conditions laid down
for the fund manger to qualify as an eligible fund manager
Proposed notification

Time bound pre-approval mechanism be provided in the Guidelines to make an application to an appropriate tax
authority, explaining the manner in which a fund qualifies as an EIF and a fund manager qualifies as an eligible
fund manager. The approval granted by the tax authority should be valid for the life of the fund, subject to there
being no change in the facts based on which the approval is granted.
Safe harbour rules - Clarifications sought
5.
►
Prescribe that offshore funds to not be regarded as carrying on business in India merely because of
the activities they perform to protect their shareholding in investee entities
At times, offshore private equity funds (especially buyout funds) acquire a controlling stake in the investee
companies. Further, in other cases also, where the fund has acquired a minority stake, the fund may have
minority interest protection rights which could be viewed as resulting in ‘control’ over the business of the
investee company in India
Proposed notification
►
The condition that the eligible investment fund should not carry on or control and manage any business in
India or from India should be clarified to not impact a fund that make majority stake financial investment
in a portfolio company and as a consequence control and manage the business to preserve and enhance its
value.
Safe harbour rules - Clarifications sought
6.
Prescribe production of certificate of incorporation or tax residency certificate or charter/formation
document to suffice as being evidence of the fund being established or set-up or incorporated or
registered in a country
►
There are many instances where a fund may not qualify as a tax resident of a country on account of domestic tax
laws and hence do not avail tax treaty benefits
►
Whether the fund is a resident or not should not impact India’s eligibility to collect required information under the
applicable Double Taxation Avoidance Agreement (DTAA) or Tax Information Exchange Agreement (TIEA). The
relevant Article on Exchange of information in India’s DTAAs typically provides that “the exchange of information is
not restricted by Article 1”; Article 1 provides that the DTAA shall apply to persons who are residents of one or both
of the Contracting States.
Proposed notification
►
In the Guidelines for the purpose of Section 9A of the Act, it be clarified that production of a certificate of incorporation
or tax residency certificate or charter/formation document should suffice as being evidence of the fund being established
or set-up or incorporated or registered in a country with which India has a Double tax Avoidance Agreement or Tax
Information Exchange Agreement
►
Further, on a going forward basis, funds established in countries that have signed the OECDs Common Reporting
Standard for automatic exchange of tax information should also be included for purpose of this clause
Safe harbour rules - Clarifications sought
7.
Prescribe exclusions from applicability of cap of 20% of profits on the fund management fees
►
Fund management contracts could involve a fixed fee and a performance fee component for the
performance of the eligible fund managers. In cases where the eligible fund managers are entitled to
receive a fixed fee component, irrespective of the performance of the investments being managed by
them, one may not be able to fulfil the condition of the fees not being more than 20 per cent of the
profits. In any case, given the condition that the fees should be at arm’s length, the same should not be
relevant. Further, even where higher fees are received by the eligible investment manager, it is good from
a tax collection stand point as such higher amount would be subject to income-tax in India.
►
Also, the cap of maximum 20% of profits will result in fund managers not being able to satisfy this
condition where the fund has incurred losses.
Proposed notification
►
In the guidelines for the purpose of Section 9A of the Act, it be clarified that the annual management fees
received by the eligible investment manager as a fixed percentage of the capital commitments/ assets
under management and any applicable taxes thereon (such as service tax), should not be considered for the
purpose of the condition in clause (d) to Section 9A(4).
Safe harbour rules - Clarifications sought
8.
Prescribe on remuneration to investment managers
►
Determination of fees to be at arm’s length will involve a lot of subjectivity
►
Any challenge by the tax authority could result in an uncertainty on the tax liability of eligible
investment funds on account of risk of them being regarded as resident in India or carrying on
operations in India
Proposed notification
►
In the guidelines for the purpose of section 9A of the Act, it should be clarified that the condition does not
apply to cases whether the eligible fund manager and the eligible investment fund are unrelated parties as
well as to situations where provisions relating to transfer pricing under the Act are applicable.
►
Further, if eligible fund manager and the eligible investment fund get the transactions approved by way of
undertaking transfer pricing study or by way of filing an Accountants Report, the same should be sufficient.
Alternatively, a provision for safe harbour to determine the arm’s length price should be provided, and such
norms should be made public for industry comments before the same are finalised
Future agenda for PE/ VC Funds
►
Recently, the Securities and Exchange Board of India has formed an ‘Alternative Investment Policy
Advisory Committee’ (AIPAC) to advise SEBI on issues related to the further development of the alternative
investment and startup ecosystem in India.
►
Extensive recommendations have been made by the sub-committees of AIPAC to the AIPAC on various
issues affecting the AIFs/ PE/ VC funds (including tax and regulatory issues discussed).
►
As a next step, the tax recommendations proposed to the AIPAC will be shared with the Central Board of
Direct taxes(CBDT) during the course of workshop to be attended by CBDT and SEBI.
Thank You