Fraternity’s wishlist for reforming Alternative Investment Funds

Sharda Balaji
Sharda Balaji, Founder
Posted on Mon, 28 March 2016

The SEBI (Alternative Investment Funds) Regulations, 2012, is fairly new. There has been unprecedented number of deals in 2015 and quite a heavy interest even in early stage angel investments as well. Deal-making hit an all-time high with 1,375 deals being recorded during 2015, surpassing the $21Bn milestone, the highest volume witnessed in any previous year in the history of Indian PE*. This frenzy has piqued interest of many Indian investors and angels in forming an Angel Fund / Category I fund. However, there are quite a few demands from the fraternity, of which only a point or two was addressed in the Budget 2016. Currently, AIF are required to deduct a 10% tax on all income (except business income) payable to investors, including non-residents, at the time of credit or payment, whichever is earlier. The Budget 2016 proposes that AIF shall deduct tax at the rates in force where the investor is a non-resident. Further the deduction of 10% on all income shall continue, except for business income for resident investors. It is also proposed that from 1 June 2016, that an application for nil or lower tax deduction at source be made to the assessing officer wrt income payable by an AIF, to its investors. The Budget 2016 also brought in cheer by allowing foreign investments in AIF, which will help in facilitating domestic investments. It might be noted that, clarity on characterization of income by an AIF, liberalization of conditions for the fund manager regime and many such reforms were not addressed in the Budget 2016. SEBI’s Advisory panel on this subject headed by the immensely respected Mr. Narayan Murthy, has released its report on suggestions and recommendations. Full report here. It is an exhaustive study and a delight to read the depth and multi-pronged approach to the recommendations. Summarizing the recommendations would not justify the report, but here’s our humble effort for the new fund managers and aspiring angels wanting to understand the landscape.

  1. Tax recommendations: The report delves in very great detail on the tax clarity, certainty and consistency.
    1. All the categories should have the pass-through benefit, from the current Category I and II.
    2. Investments by AIF and investee companies should be exempt from startup tax.
    3. Categorise the income from AIF as ‘capital asset’ instead of ‘business income’ and subject it to Securities Transaction Tax (STT) that which publicly listed securities enjoy.
    4. Losses at AIF should be available for set-off for the investors.
    5. The requirement to deduct tax at source should not apply vis-à-vis accrual/ distribution of income to investors exempt from tax under the Act irrespective of its nature and source.
    6. The requirement of the fund to be a “tax resident” of a foreign country shall be changed to a requirement of fund being “established” or “set-up” or “incorporated” or “registered” in such country.
    7. Investors in SEBI regulated angel funds should be provided a tax deduction of up to 50% of the investment amount. Suitable safeguards to mitigate misuse of the provision by non-financial investors / relatives of the promoter / promoter group can be considered.
    8. In the context of preference shares / debentures, where conversion is not a taxable event, the period of holding of the equity shares should be considered from the date of acquisition of such convertible securities, and not from the date of allotment of the equity shares. Conversion of preference shares into equity should be exempt from the definition of “transfer”.
    9. Taxation upon ‘sale’ and reduced taxation rates for unlisted shares acquired via ESOPs/employee incentive schemes. Ie. Tax incidence at year of sale and not year of exercise of options.
  2. The determination of fund management fees to be at arm’s length will involve a lot of subjectivity. Therefore, the condition of fund management fees to be at arm’s length should be deleted.
  3. Include the concept of ‘accredited investors’:
    1. The concept of Accredited Investors will simplify the process of determining who are eligible investors in AIFs and will be a factor in ease of doing business; and
    2. It will ensure that investors who regard themselves as capably of identifying the risks consistent with their risk tolerance and capacity, consider investing in AIFs.
  4. Offshore funds shall not be regarded as carrying on business in India merely because of the activities they perform to protect their shareholding in investee entities.
  5. Promoting FDI in AIFs:
    1. Investment by non-resident investors in AIFs on a non-repatriation basis,
    2. TDS on distribution of income to non-resident investors in AIFs to be in accordance with DTAA tax rates.
    3. Attract large amounts of foreign capital into India-focused foreign funds by providing a safe harbour to onshore managers of offshore funds.
  6. Unlock domestic capital pools such as chariatable and religious trusts to invest in AIF and other pools such as pension funds, insurance companies, banks, single family offices and the like.
  7. Reduce the investment ticket size of INR 1 crore to INR 50 lakhs.
  8. Promote On-shore Fund Management: Make Safe-harbour effective for managing funds from India.
  9. The private placement process under the Companies Act requires a minimum investment size of INR 20,000 of face value, which does not serve any purpose and should be done away with. The other recommendation of doing away with the lengthy Offer Letter has been considered in the Companies Amendment Bill of 2016.

*ET-Tech of 31st December 2015 Author: Sharda Balaji is the founder of NovoJuris.

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