Contributed By Trilegal
Over the last few years, alternative investment has grown to be an attractive source of funding for Indian businesses. The increasing flow of alternative funds feeds start-ups, private companies, entrepreneurs and others, who may not always qualify for traditional capital sourcing. Whereas traditional sources of finance, such as banks, have a limited risk appetite, alternative investment provides enterprises with stable long-term "patient" capital.
While India previously regulated venture capital funds (VCFs), it has recently cast a much broader net seeking to cover other types of alternative funds, including private equity, infrastructure, debt, social venture and hedge funds. Alternative investment funds (AIFs) in India are governed by the Indian securities regulator, Securities and Exchange Board of India (SEBI), under the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations).
In brief, the AIF Regulations define an AIF as a privately pooled investment vehicle set up in India, which raises funds from investors and invests in accordance with a defined investment policy for the benefit of its investors. The AIF Regulations mandate that an AIF should have a sponsor and a manager, although the manager of an AIF may also act as the sponsor. The AIF Regulations also mandate that the manager or sponsor of the AIF should make a sponsor investment, ie, have "skin in the game" (which cannot be set-off against the management fee).
The AIF Regulations exclude funds regulated under the SEBI (Collective Investment Schemes) Regulations, 1999; the SEBI (Mutual Funds) Regulations, 1996; and any other regulations issued by Indian regulators that regulate activities to do with pooling of capital or fund management.
The scope of AIFs, under the AIF Regulations, excludes:
While investors in an AIF could be domestic or foreign, each investor is required to commit (ie, undertake to contribute to the fund by way of legally binding document) a minimum amount of capital, and an AIF is required to raise a minimum amount of commitment from its investors prior to commencing operations (for further details, see 2.3 Regulatory Regime).
As per data available from SEBI on 30 June 2019, in the seven years since the promulgation of the AIF Regulations, AIFs in India have raised funds worth USD21 billion, out of which USD17 billion have been invested. With the growing appetite of sophisticated investors in India, these numbers are only expected to rise.
AIFs have been classified under three categories with the intention of distinguishing the investment criteria and providing a framework for regulatory concessions under other laws, depending on the category.
A change in category is only permitted if an AIF has not made any investments and if the AIF has accepted commitments it will permit investors to withdraw with a fee refund if applicable.
The following are the three categories of AIFs:
Category I AIFs
This category includes funds which invest in start-ups, early-stage ventures, social ventures, small and medium enterprises (SMEs), infrastructure or other sectors which the government or regulators consider socially or economically desirable. VCFs (including angel funds), SME funds, social venture funds, and infrastructure funds have been categorised as sub-categories of Category I AIFs. These AIFs face stricter regulation, but also, arguably, enjoy certain benefits. These AIFs are closed-ended and must have a minimum tenure of three years.
Category II AIFs
This category includes funds which do not specifically fall under Category I or Category III and do not undertake leverage or borrowing other than to meet their day-to-day operational requirements. Hence, Category II is the residual category of AIFs (see Category III AIFs, below).
Private equity funds (ie, funds investing primarily in equity or equity-linked instruments or partnership interests) and debt funds (ie, funds investing primarily in debt or debt securities) for which, typically, no specific incentives or concessions are given by the government/any regulator, typically fall under this category. Similar to Category I AIFs, Category II AIFs are also closed-ended and must have a minimum tenure of three years.
Category III AIFs
This category includes funds which employ diverse or complex trading strategies and may employ leverage. Hedge funds, funds which trade with a view to making short-term returns, and other funds which are open-ended and for which no specific incentives or concessions are given by the government or any other regulator, fall under this category. This category is perceived to be for high-risk, high-reward investments. AIFs seeking to invest primarily in listed markets are also bundled in this category, even if their strategy is long hold. Category III AIFs can be open-ended or closed-ended and have no minimum tenure.
The AIF Regulations permit an AIF to be formed as a trust, company, or a limited liability partnership (LLP), in India. Out of these three structures, there is stark preference among Indian managers to structure AIFs as trusts. As of 14 November 2019, 620 AIFs were registered with SEBI. Of these, 604 are registered as trusts, 13 as LLPs, and three as companies.
The clear preference for trusts as a viable AIF structure stems primarily from two distinct reasons:
Such contribution agreement and investment management agreement are not required to be made public.
It is important to note that under Indian law, a trust does not have a separate legal personality. The legal ownership of the trust lies with the trustee(s), and the investors are beneficiaries who have a beneficial interest in the trust.
An AIF formed as a trust will require a trustee. Typically, third-party professional trusteeship service providers are appointed as the trustees of AIFs. An AIF formed as a trust will require a "settlor" to settle the trust. This can be the investment manager/sponsor or any Indian-resident individual. Generally, there are no ongoing liabilities for a settlor.
AIFs in India require the following documents:
A trust deed is required for the settlement of the AIF as a trust (and for related matters such as appointment of the trustee and granting the trust requisite powers). In the case of an LLP, the constitutional document is an LLP agreement, and in the case of a company it is the memorandum of association, articles of association and any shareholders’ agreement. Constitutional documents are required to be filed with SEBI.
SEBI requires an AIF to raise funds through a private placement memorandum/offering memorandum (privately placed) or PPM. This is required to be filed with SEBI.
An AIF can raise funds only by way of issuing a PPM to the investors on a private placement basis, ie, units of an AIF cannot be issued to the public at large. A PPM must disclose to the investor all material information necessary for the investor to take an informed decision on their investment in the AIF. This would include information such as:
It is expected that SEBI will imminently declare a standard form for a PPM specifying the heads that must be covered therein.
An investment management agreement between the trustee/LLP/company and the investment manager, governs delegation terms by the former to the investment manager for the management and administration of the AIF.
In the case of an AIF formed as a trust, a contribution/subscription agreement between each investor, the trustee (on behalf of the AIF) and the investment manager, usually provides the substantive terms of the AIF. In the case of an LLP, this is drafted as an LLP agreement, and in the case of a company, as a shareholders’ agreement (and a subscription agreement).
See 2.1 Types of Alternative Funds.
The AIF Regulations permit domestic and foreign investors to invest in AIFs by way of subscription to units of the AIF. An AIF cannot have more than 1,000 investors, and in the case of an angel fund, no more than 200 investors. Notably, no regulatory or government approvals are required for foreign investors to invest in AIFs.
The total commitments of all the investors in an AIF is termed as its “corpus”. The AIF's “investible funds”, ie, funds which it could invest into portfolio entities, are arrived at after subtracting the estimated fund expenses for administration and management from the corpus. Each scheme of an AIF must have a minimum corpus of INR200 million (with angel funds being allowed to have a minimum corpus of INR50 million).
An investor must commit a minimum of INR10 million to an AIF, as per the AIF Regulations. This limit has been reduced to INR2.5 million for employees/directors of the AIF or the investment manager, and for investors investing in angel funds.
The manager/sponsor are mandated to invest to provide some "skin in the game". For Category I and II AIFs, this is set at the lesser of INR50 million or 2.5% of the corpus of the AIF, and for Category III AIFs this is set at the lesser of INR100 million or 5% of the corpus of the AIF. This is a continuing interest in the AIF and cannot be set off against management fees.
Key Diversification/Investment Limits
Category I and II AIFs cannot invest more than 25%, and Category III AIFs cannot invest more than 10%, of their investible funds in a single portfolio entity. Importantly, AIFs are required to adhere to the aforesaid investment diversification limit at all times, ie, at the time of each investment.
Category I and II AIFs are required to invest primarily in unlisted portfolio entities. "Primarily", in this context, is meant to indicate that the majority of the investments of a Category I or II AIF must be in unlisted securities. Sub-categories of Category I AIFs also have to comply with certain further investment restrictions.
Category I AIFs registered as VCFs must invest at least two thirds of their investible funds in unlisted equity shares/equity-linked instruments of a venture capital undertaking; or companies listed/proposed to be listed on an SME exchange/SME segment of an exchange. For this purpose, a venture capital undertaking is defined as a domestic company, which is not listed on a recognised Indian stock exchange and which is engaged by the business for providing services, production or manufacture of articles/things, and which does not include non-banking financial companies, gold financing, or any activities not permitted under the industrial policy of the Indian government.
Furthermore, VCFs cannot invest more than one third of their investible funds into subscriptions to initial public offers of a venture capital undertaking, or debt/debt instrument of venture capital undertakings, in which such VCF has already made investment; preferential allotment of equity/equity-linked instruments of a listed company, subject to a one-year lock-in period; or equity/equity-linked instruments of a listed financially weak/sick company.
Category I AIFs registered as SME funds must invest at least three quarters of their investible funds in unlisted securities/partnership interests of venture capital undertakings or investee companies, that are SMEs/companies listed or proposed to be listed on an SME exchange or the SME segment of an exchange.
Category I AIFs registered as social venture funds must invest at least three quarters of their investible funds in unlisted securities/partnership interests of social ventures and may accept grants for the same.
Category I AIFs registered as SME funds must invest at least three quarters of their investible funds in unlisted securities/partnership interests of venture capital undertakings or investee companies, or SPVs, that are engaged in/formed for the purpose of operating, developing or holding infrastructure projects.
Category III AIFs may invest in securities of listed or unlisted investee companies or derivatives or complex/structured products.
Category I AIFs are permitted to invest in the units of Category I AIFs; Category II AIFs are permitted to invest in Category I and Category II AIFs; and Category III AIFs are permitted to invest in the units of Category I or Category II AIFs. However, in each case, an AIF cannot invest in the units of a fund of funds.
There are restrictions on AIFs making overseas investments. In addition to prior approval from SEBI, the aggregate overseas investments of an AIF are limited to 25% of its investible funds. An AIF applying to SEBI is required to demonstrate that its overseas investment is unlisted and has an "Indian connection".
AIFs also serve as an attractive mode of investment because there are no restrictions on the repatriation of cash to its investors (including offshore investors).
AIFs cannot grant loans simpliciter; however, they can subscribe to debt instruments such as non-convertible debentures and/or optionally convertible debentures.
Furthermore, Category I and II AIFs are also limited in their power to raise loans. Category I and II AIFs cannot leverage or borrow, except to meet day-to-day needs for a period no longer than 30 days, for not more than 10% of their investible funds (see 2.3 Regulatory Regime) and not more than four times a year.
Category III AIFs, however, can leverage and borrow. Such leverage and borrowing can be undertaken with the consent of the investors and is also subject to a maximum cap as may be prescribed by SEBI, provided that such AIFs shall disclose information regarding:
The current leverage limit on Category III AIFs, as prescribed by SEBI, is twice the net asset value of the AIF.
AIFs can make investments only by way of subscribing to securities. Cryptocurrencies are currently not considered as securities under Indian law and therefore AIFs cannot invest in cryptocurrencies. It is also not possible for an AIF to hold hard assets and therefore, necessarily, investments are typically made in securities of companies or in LLPs.
AIFs are required to register with SEBI by way of filing an application form in a prescribed format. The SEBI application form should be accompanied by:
Certain undertakings and declarations, including on disciplinary history, are also required to be submitted to SEBI.
Applications are submitted to SEBI online. As per the AIF Regulations, SEBI is required to approve or reject the application within 30 days. However, SEBI has the power to request additional information. While each case is different, most applications are processed by SEBI within two months.
All AIFs are required to have a manager entity and a sponsor entity.
An investment manager provides investment management services to the AIF. The AIF Regulations require that the manager should be an entity incorporated in India. An AIF is also required to have at least one sponsor (which needs to be named as such to SEBI). The sponsor may be an Indian entity or an offshore entity. The sponsor could also be any person(s) that sets up the AIF. In the case of an AIF organised as a company, this includes a promoter, and for an LLP, it includes a designated partner.
If the manager and sponsor of an AIF are ultimately owned and controlled by resident Indian citizens and such persons are in control of the AIF to the general exclusion of others(an “IOCC AIF”), then investments by the AIF are treated as domestic investments, ie, no restrictions or conditionalities related to foreign direct investment (FDI) will apply, such as sectoral restrictions, impermissibility of certain instruments and pricing guidelines.
Furthermore, the members of the key investment team of an investment manager must have adequate experience and also meet certain qualifications. At least one member of the key investment team must have not less than five years' experience in advising and managing pools of capital, or in fund/asset/wealth/portfolio management, or in the business of buying, selling and dealing with securities, or other financial assets, and has the relevant professional qualification for the same.
While not specific to AIFs, it is relevant to note that:
AIFs and the manager are permitted to appoint third-party service providers for certain functions. These typically include auditing, custody, valuation and compliance functions. SEBI does not permit delegation of core functions.
Category I and Category II AIFs are required to appoint a SEBI-registered custodian if the corpus of such AIF is more than INR5 billion. A Category III AIF must appoint a SEBI-registered custodian irrespective of its size. An AIF is required to provide its investors with a valuation of its assets conducted by an independent valuer on a six-monthly basis (or annually, if 75% of the investors by value of their investment in the AIF agree to such annual valuation). Regulations also impose a mandatory audit requirement.
Non-local service providers to AIFs are not subject to incremental requirements.
Indian income tax laws accord “tax pass-through” status to SEBI-regulated Category I and II AIFs established or incorporated in India. Category III AIFs are not accorded such benefits; however, Category III AIFs set up as trusts may potentially follow general principles of trust taxation and other provisions of Indian tax laws to achieve tax transparency.
The statutory “tax pass-through” status (for Category I and II AIFs) has been granted in respect of all income (other than income chargeable under the heading "Profits and gains of business or profession" earned by such AIF). If income earned by an AIF is not characterised as “business income”, it is taxable in the hands of the investors of that AIF, in the same manner as if it were the income accruing to, or received by, such investors had they invested the money themselves. The income received by such AIFs is deemed to be of the same type and in the same proportion as if it had been received by investors.
If the income of the AIF is characterised as “business income” received or accruing or arising to the AIF, such income is taxable at the maximum marginal rate applicable to the AIF.
The taxation of offshore investors is governed by the provisions of the Indian Income Tax Act, 1961 (IT Act), read with the provisions of the double taxation avoidance agreements (DTAAs) between India and the country of residence of such offshore investor. The provisions of the IT Act would apply to the extent that they are more beneficial than the provisions of the DTAAs.
Investors in AIFs generally qualify for benefits under the DTAAs, subject to customary substance and other requirements.
The use of subsidiaries for investment purposes is not usual, primarily due to potential tax leakage in cash extraction from the subsidiary. Therefore, AIFs using a subsidiary structure tend to have specific commercial considerations that override or offset such issues, for example, infrastructure AIFs may use a subsidiary structure for value creation in a platform.
While the sponsor of an AIF may be an Indian or offshore entity, Indian entities generally act as sponsors in AIFs. This is also partly because the manager of an AIF has to be an Indian entity, and the manager and sponsor are often the same entity.
Under Indian law, AIFs are permitted to raise capital from domestic and foreign investors. Notably, no regulatory or government approvals are required to raise capital from foreign investors. AIFs are permitted to make distributions freely to foreign investors, ie, there are no foreign exchange investment and exchange control restrictions applicable to repatriation of money to foreign investors by means of AIFs, such as pricing guidelines. While a number of development finance and multilateral institutions participate directly in AIFs, it is fairly usual for a fund structure to offer a feeder vehicle offshore such as in Mauritius, Singapore, the Cayman Islands or Luxembourg, and a large number of AIFs seem to have raised capital from North America and Europe.
Investors in AIFs are also required to satisfy the customary "know your client" (KYC) checks.
Investments by AIFs are usually targeted at Indian entities. Offshore investments by AIFs are subject to restrictions under the AIF Regulations and Indian exchange control regulations. The key conditions are:
There has been a recent policy push towards onshore fund management. The Indian government has also established an International Finance Services Centre (IFSC) called Gujarat International Finance Tec-City (GIFT City). GIFT City serves as a special economic zone, which is deemed to be an offshore jurisdiction. GIFT City aims to incentivise feeders, traditionally set up outside India, to set up their feeders within the geographical boundaries of India.
Furthermore, there have been a slew of funds set up for stressed-asset investing, along with a preference for club-style platforms and managed accounts.
There have also been a number of end-of-fund life transactions, such as structured secondaries and fund life extensions.
In light of the liberalised investment and tax regime for AIFs, and predictability over the past few years, a number of offshore investors have started considering direct participation in the onshore pool, rather than investing via an offshore feeder.
AIFs are required to provide SEBI with regular reports. Category I and II AIFs are required to submit such reports on a quarterly basis, while Category III AIFs that undertake leverage are required to submit reports on a monthly basis.
Category I and Category II AIFs are required to provide annual reports to investors containing financial information about their investee companies and material risks to their investors within 180 days from the end of the relevant year. Category III AIFs are required to provide these reports to investors on a quarterly basis within 60 days of the end of the quarter. Additionally, AIFs, irrespective of category, are required to disclose certain information to their investors from a corporate governance and transparency standpoint including conflicts of interest, risk management, disciplinary history, valuations, and any significant change in the key investment team.
Notably, the manager of an AIF is required to prepare a compliance test report (on compliance with the AIF Regulations) in a prescribed format and submit it to the trustee/sponsor of the AIF within 30 days of the end of every financial year. Any violation observed is to be reported to SEBI as soon as possible, by the trustee/sponsor.
A major change expected is a standard format for PPMs that will be prescribed by SEBI. A draft version of this format is already under discussion with various stakeholders. A standard form PPM is expected to reduce regulatory timelines by facilitating quicker review by SEBI of AIF registration applications (as the PPM forms part of such application).
Over the past few years, a special committee set up to advise on matters relating to alternative investment, the Alternative Investment Policy Advisory Committee (AIPAC), has submitted reports on various policy reforms required to strengthen the alternative investment framework in the country.
The latest AIPAC report, issued in July 2018, made certain key recommendations, including the following:
AIF Regulations do not impose any restrictions as to the legal structure of managers. Fund managers are usually set up as companies or as LLPs, with the latter gaining more traction in the last few years, as LLPs are potentially more tax-efficient in certain cases. Each structure comes with its attendant considerations, for example, establishing and running a company in India has higher compliance requirements than establishing and running an LLP, but LLP law provides greater government investigative powers.
Accordingly, managers may choose either structure, and the reasons for doing so tend generally to be driven by commercial considerations, rather than legal or regulatory considerations.
A fund manager is not required to be registered with SEBI to carry out its activities as the investment manager of an AIF. However, it could be argued that fund managers are regulated by SEBI under the AIF Regulations to the extent that they act as investment managers to an AIF, particularly given their participation in the regulatory approval process, ongoing regulatory compliance requirements and duties under the regulations.
As part of the regulations, SEBI has prescribed some minimum standards of compliance and transparency, and also retains inspection rights over investment managers/sponsors (with attendant disciplinary powers). SEBI has also specifically imposed a fiduciary obligation on managers.
Other than direct taxes applicable to the management fee received by the managers of AIFs for providing investment and management services, GST at a rate of 18% is applicable on the management fee. There are no specific taxation principles, under direct or indirect tax laws, that apply to managers.
The IT Act provides that a foreign company is treated as tax resident in India if its place of effective management (POEM) is in India that year. POEM is defined to mean a place where key management and commercial decisions, necessary for conducting the business of an entity as a whole, are made.
POEM focuses on “substance over form” and provides that the place where the management decisions are taken is more important than the place where the implementation of the decisions takes place. However, an exception to the POEM concept is carved out for companies having turnover or gross receipts equal to or less than INR500 million in a financial year.
While typical permanent establishment rules also apply, POEM is greater in scope and relevance.
In addition to the management fee paid to the manager for providing investment management services, "carried interest" is typically paid for the profit share. Under Indian tax laws, carried interest, if received as a performance fee, is taxable in a similar way to the management fee. However, there are certain tax-efficient structures that managers/sponsors may adopt that seek classification of carried interest as a return on investment.
While there are no regulatory restrictions on managers outsourcing their functions or business operations, managers are not permitted to outsource their core business activities or functions such as investment-related activities. However, it is important to note that the ultimate responsibility for compliance with the AIF Regulations and the fund documents lies with the manager.
There are no minimum capitalisation norms applicable to managers. However, it is mandatory that the key investment team of the manager has adequate experience, with at least one key personnel having not less than five years’ experience advising or managing pools of capital.
Additionally, the manager and the sponsor of the fund are required to have the necessary infrastructure and manpower to undertake their activities. The manager and sponsor must also qualify as “fit and proper persons” under SEBI (Intermediaries) Regulations, 2008. The criteria for such qualification include evaluation of:
The sponsor of an AIF has to invest a minimum amount as sponsor commitment (see 2.3 Regulatory Regime). Furthermore, the minimum corpus of an AIF must be INR200 million.
The scheme of the AIF Regulations suggests that foreign entities cannot act as managers to AIFs. Foreign entities may, however, provide non-binding investment advice to AIFs/managers by way of establishing a subsidiary in India and registering with SEBI as an investment adviser under SEBI regulations governing investment advisers.
Both domestic and foreign investors may invest in AIFs and investors typically include HNIs, family offices, pension and insurance funds, institutional investors and banks. The flow of capital from development finance and multilateral institutions seems to have been steady over the past few years. Sovereign or quasi-sovereign wealth funds have also been active investors.
Certain domestic investors, such as banks, insurance companies and pension companies, are governed by their respective regulations and the relevant regulator has prescribed certain limitations on investments by these domestic investors. For example, banks cannot invest more than 10% of the unit capital of a Category I or II AIF and cannot invest in a Category III AIF. Similarly, while pension companies and insurance companies may invest in Category I and II AIFs, there are certain prudential norms prescribed by the relevant pension and insurance regulators on investments by these companies.
AIFs can be marketed by way of private placement through issuance of a PPM, to any person/entity in or outside India, subject to a limit that they cannot have more than 1,000 investors. At present, there are no specific rules defining the scope of private placement. Managers must seek legal advice in this regard.
Under the (Indian) Companies Act, 2013, any offer or invitation to subscribe to shares made by an Indian company to more than 200 persons in the aggregate financial year is considered as a public offer. This applies to AIFs set up as companies.
Furthermore, as mentioned above, no scheme of an AIF can have more than 1,000 investors.
See 4.2 Marketing of Alternative Funds.
See 4.1 Types of Investor in Alternative Funds.
AIFs that receive foreign investments from persons resident outside India are required by the RBI to file a form (Form InVi) to disclose foreign investment.
Such AIFs and/or AIFs that have made overseas investments, are required to submit a report on their foreign liabilities and assets (FLA Reporting) by 15 July of every year. This has been streamlined by the RBI and can be done on a web-based online reporting portal.
AIF Regulations do not require any disclosures to be made by the investors. However, all investors investing in an AIF must comply with KYC norms.
Investors in India are taxed based on their legal structures and different tax rates are applicable to corporations, partnerships and individuals.
AIFs in India have been accorded a statutory tax pass-through status for all streams of income other than business income, ie, investors in an AIF are taxed as if they have invested directly in portfolio companies. See 2.11 Tax Regime. The only requirement is that AIFs must withhold tax from the distributions to its investors, applicable at the rate of 10% on all income (other than business income) payable to resident investors and at rates in force (ie, the rates specified in the income tax law for the relevant year or rates specified in the applicableDTAA entered into between India and the country of residence of such non-resident) as applicable on all income (other than business income) payable to non-resident investors.
As part of various ongoing tax and regulatory developments around the globe, eg, information exchange laws such as the Foreign Account Tax Compliance Act (FATCA) and the Common Reporting Standard (CRS), there are now additional investor and counterparty account-related due diligence requirements for financial institutions. With the intention of increasing tax transparency and the automatic exchange of financial account information for tax purposes, the government of India recently signed the following agreements:
To give effect to these agreements, the Indian tax authorities have instituted rules which require Indian financial institutions to seek additional personal, tax and beneficial owner information and certain certifications and documentation from all investors. In relevant cases, information will have to be reported to the tax authorities/appointed agencies.
AIFs are considered to be financial institutions for these purposes and, therefore, investors in AIFs are required to comply with the request of the AIFs to furnish such information, documentation and declarations as and when deemed necessary by the AIFs. FATCA and CRS provisions are relevant not only at the on-boarding stage of investors but also throughout the life cycle of investment with AIFs. Investors are therefore required to intimate to the AIFs/managers, any change in their status with respect to any FATCA or CRS-related information/documentation provided by them previously, including any declarations provided in respect of the residency of the investors for tax purposes.