Overseas Fund: Tax and Regulatory Aspects Material/ITF-Bhavin Shah... · Overseas Fund: Tax and...

1 19TH INTERNATIONAL TAX & FINANCE CONFERENCE, 2015

Overseas Fund: Tax and Regulatory Aspects

Overseas Fund: Tax and Regulatory Aspects CA Bhavin Shah

INTRODUCTION AND SCOPE OF THE PAPER

IntroductionA confluence of several factors such as a vibrant market economy, the impetus on infrastructure and manufacturing, relatively stable currency levels amongst emerging markets, indices touching new records, various policies and tax reforms, makes India a favourable investment destination.

As per the VCCEdge Report, the total deal value in year 2014 was approximately $ 12.54 billion. The retail sector (mainly e-commerce) accounted for approximately 27.46% and the information technology sector was second highest which accounted for approximately 17.80% of the total deal value. As compared to that, year 2015 has already accounted for $ 7.11 billion in terms of deal value. This momentum is expected to continue in second half of year 2015 as well and we may see deal value hitting the all-time high record in year 2015.

Looking at the investors’ keen interest in investing large funds to finance the growth in India and gaining the visibility on the rising macro-economic indicators, the reputed and experienced investment management teams have accelerated the fund raising activities at overseas level as well as domestic level.

The Narendra Modi Government is constantly making various policy reforms focusing on ease of doing business in India and increase in a flow of the foreign investment in India. The regulatory regime continues to be streamlined with relaxation of pricing norms for foreign investment in India, clarity in relation to put/call options, rationalization of foreign portfolio investment policy, liberalization of investments caps and conditions, proposal to allow investment in REITs under automatic route, etc.

On the domestic front, SEBI in May 2012, introduced the SEBI (AIF) Regulations to completely overhaul the regulatory framework for domestic funds in India. The AIF regulations have opened avenues for various fund investment strategies for raising onshore as well offshore pools of capital in India.

Also tax regime for the fund industry has been rationalized by introducing the key amendments such as, characterization of income as capital gains for foreign portfolio investors, deferral of implementation of GAAR till F.Y. 2017-18, safe harbour provisions for the eligible investment fund and fund manager, MAT provisions rationalized for capital



gains earned by foreign company, tax pass through status for categories I and II AIF, lower withholding tax rate in case of interest payable to FPI. These reforms have set the positive tone which will promote foreign investment in India.

We as Chartered Accountants play an important role in the fund structuring exercise. We are expected to know the implications in relation to Income-tax, FEMA, Companies Act, and relevant regulations of SEBI to carefully plan the fund structure considering the commercial need. As the offshore fund structuring involves various jurisdictions, we are also expected to have basic knowledge of tax and regulatory provisions of the prominent jurisdictions for India focused fund such as Mauritius, Singapore, Netherlands, etc.

Scope of the Paper This Paper provides an overview of India focused private equity fund structure (hereafter referred to as ‘Fund’, ‘Offshore Fund’) and key tax and regulatory considerations involved in forming a private equity fund. The gist of coverage of this Paper is as follows:

I. Overview of the variety of Funds depending on their ownership, specialization and investment objectives

II. General structure of the Fund and key entities involved

III. Key terms in Fund structuring, principal legal documents and the Fund lifecycle

IV. Key tax and regulatory considerations affecting the Offshore Fund structure

V. Key tax and regulatory considerations affecting the Domestic Fund structure

VI. Bird’s-eye view of key tax and regulatory considerations in transaction structuring

VII. Case studies for group discussion

It should be noted that with the specific nature of the fund such as hedge fund, debt fund, real estate investment trusts (REITs), infrastructure investment trusts (InvITs), etc. there may be peculiar regulatory and tax challenges with respect to such funds. It may not be possible to discuss the challenges relating to each specialized fund and therefore, this paper only focuses on the tax and regulatory considerations in setting up of the Offshore Fund which by and large remains the same for all the Funds.



SYNOPSIS

I. OVERVIEW OF TYPE OF FUNDS AND PURPOSES........................................................ 4

1.1 Various Type of Funds ......................................................................................................... 4

1.2 Typical characteristics of Private Equity Funds ................................................................ 5

II. GENERAL STRUCTURE OF THE FUND AND KEY ENTITIES INVOLVED .................. 6

2.1 Typical India Focused Offshore Fund Structure................................................................ 6

2.2 Co-investment Fund Structure ............................................................................................ 8

2.3 Unified Investment Fund Structure .................................................................................... 9

III. KEY TERMS IN FUND STRUCTURING, PRINCIPAL LEGAL DOCUMENTS AND THE FUND LIFECYCLE .......................................................................................... 10

3.1 Key Terms in Fund Structuring ........................................................................................ 10

3.2 Principal Legal Documentations ....................................................................................... 11

3.3 Lifecycle of the Fund ......................................................................................................... 12

IV. KEY TAX AND REGULATORY CONSIDERATIONS IN OFFSHORE FUND STRUCTURING .................................................................................................................. 14

4.1 Aspects to be considered and evaluated in conceptualization of the Offshore Fund structure .............................................................................................................................. 14

4.2 Rationale for Offshore Pooling .......................................................................................... 14

4.3 Jurisdictional analysis for setting up India focused offshore fund ............................... 15

4.4 Key Tax Considerations in the Fund Structuring ............................................................ 20

4.5 Regulatory Framework ....................................................................................................... 31

V. KEY REGULATORY AND TAX CONSIDERATIONS IN DOMESTIC FUND STRUCTURING .................................................................................................................. 40

5.1 Categories of AIF ................................................................................................................ 41

5.2 Investment conditions and restrictions for investment in all categories of AIFs ........ 41

5.3 The comparison between Category I, II and III AIFs ..................................................... 42

5.4 Taxation of AIF .................................................................................................................. 43

VI. KEY TAX AND REGULATORY CONSIDERATIONS IN TRANSACTION STRUCTURING .................................................................................................................. 45

CASE STUDIES .......................................................................................................................... 50

Glossary ................................................................................................................................... 55



I. OVERVIEW OF TYPE OF FUNDS AND PURPOSES

1.1 Various Type of Funds

Private Equity Fund

There is no agreed definition as to what connotes Private Equity Fund, in common parlance it is understood to mean the provision of capital from various investors with the objective of utilizing for investment in target companies. Private Equity Fund may consider investing in a target company at an early stage as a venture capital fund or may choose to invest in a company which is at matured stage. Nowadays, it is not uncommon to see Private Equity Fund investing into listed companies as well.

Venture Capital Fund (‘VC Fund’)

VC Funds are very similar to Private Equity Funds. VC Funds can be said to be a subset of Private Equity Funds and refer to investments made for launch, early development or expansion of business. VC Funds are specialized in early stage financing of start-up companies and the emphasis is on entrepreneurial undertakings rather than on matured businesses.

Buyout Fund

Buyout Fund acquires controlling interests in companies with an objective of later selling those companies or taking them public.

Hedge Fund

Hedge Fund is an investment vehicle that pools capital from a number of investors (typically open ended in nature) and invests in securities and other instruments having diverse risks or complex products including listed and unlisted derivatives.

Infrastructure Fund

Infrastructure Funds are a sector focused Private Equity Funds that primarily make investment in companies engaged in or formed for the purpose of operating, developing or holding infrastructure projects.

Infrastructure Investment Trusts (‘InvITs’)

InvIT means a trust registered under the SEBI (InvIT) Regulations, 2014 which may raise capital through units issued inter alia under private placement and/or initial/follow on offer. The InvIT shall invest in infrastructure projects, either directly or through a Special Purpose Vehicle (SPV), in accordance with stipulated conditions.



Real Estate Funds (RE Fund)

These are similar to Private Equity Funds. The only difference being that they focus on companies engaged into development of residential or commercial projects.

Real Estate Investment Trust (‘REIT’)

REIT means a trust registered under the SEBI (REIT) Regulations, 2014 which owns and manages income generating developed properties and offers its unit to public investors. REITs typically offer regular yields coupled with capital appreciation and typically caters to the retail investors.

Alternative Investment Funds (‘AIF’)

AIF in India is a privately pooled investment vehicle registered with SEBI which collects funds from investors for investing it in accordance with a defined investment policy for the benefit of its investors. AIF can be formed either in the form of trust / company / limited liability partnership / body corporate. In common parlance, we refer to them as the domestic private equity funds as their investment / return requirements are similar to private equity funds.

There are three categories of AIFs identified by SEBI:

• Category-I AIF have a positive spill over on the economy and may get concessions from the regulator or the Government. These include venture capital funds, SME funds, social venture funds, infrastructure funds and such other AIF as may be prescribed.

• Category-II AIF includes fund which does not fall in Categories I and III. Category II AIF includes private equity funds and debt funds.

• Category-III AIF employs diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. Category- III AIF includes Hedge Fund.

1.2 Typical characteristics of Private Equity Funds

Private Equity Funds may vary depending on various aspects like size of the funds, ownership, specialization etc. Various aspects are explained as follows:

Investment Size

Private Equity funds can be differentiated based on their investment size. Large fund raised by the more successful established team generally has deal size per portfolio company between $ 200 mn and $ 500 mn. Other mid-market Funds usually invest in deal worth between $ 50 mn and $ 200 mn.



Ownership

• Independent funds: Such Funds are those in which external investors are the main source of the capital contribution and in which no single investor holds substantial capital portion.

• Captive funds: Such Funds are established with strong link to a particular investor and that investor contributes almost entire capital.

• Semi-captive funds: In such Funds, although main investor contributes large part of capital, a capital is also raised from external investors as well.

Specialization

• Private Equity Funds may be differentiated based on their specialization i.e. a Private Equity Fund may be floated to target a particular or specific industry sector such as infrastructure, real estate, etc. or may invest in various companies in general (with no sector specific or business type specialization).

Purpose

• Master-Feeder Fund: A Feeder Fund is a type of a Private Equity Fund which is specifically created with a purpose of investing in a specific single Fund (Master Fund), which will invest downstream in target companies. This structure is created for various tax and regulatory reasons depending on the investor’s jurisdictions.

• Fund of Funds: These funds are created to invest in other Private Equity Funds which in turn invests in portfolio companies as per decided strategies. These Funds do not have expertise to make investment themselves in specific sectors and regions and hence, channel the investment through other Private Equity Funds who has the investment expertise.

II. GENERAL STRUCTURE OF THE FUND AND KEY ENTITIES INVOLVED

2.1 Typical India Focused Offshore Fund Structure

The offshore fund is an investment vehicle formed by the Investment Manager (‘IM’), known as sponsors/General Partner (GP), looking to raise capital on private placement basis from Limited Partner (LP) (hereafter referred to as ‘investors / LPs’) to make multiple investments in a specified industry sector or geographic region. Typically, an investment vehicle is set up either in the form of a Limited Liability Partnership or Corporate entity. The Fund is ideally set up in a tax efficient jurisdiction outside India. The Fund makes investment either directly or through one or more Special Purpose Vehicles (‘SPVs’) in Indian portfolio companies.



Typically, GP is located outside India who is responsible for all investment / divestment decisions of the Fund and is compensated with management fees. The GP is also entitled to a share in profits on the Private Equity Fund’s investment (popularly known as ‘carry’ or ‘carried interest’). LPs make capital contribution to the Fund and have passive role.

Apart from Investment Manager outside India, there would be an Investment Advisor (IA) in India for identifying investment opportunities and to carry out preliminary due-diligence work for investments in India. IA generally has a service agreement with IM to provide non-binding investment advisory services for fees.

The following diagram explains the typical offshore fund structure:

Offshore Investors

Overseas Jurisdiction

Offshore Fund

SPVTax Efficient

Jurisdiction

India

Fund management services

Non-binding investment

advisory services

Investee Co 1 Investee Co 2 Investee Co 3Investment Advisor

Investment Manager



2.2 Co-investment Fund Structure A co-investment structure is adopted where the commercial expectation is to raise

two separate pools of capital for offshore investors as well as domestic investors. To some extent certain Indian tax and regulatory reasons also drive this decision. A separate domestic fund vehicle is required for domestic investors which ought to be registered with the SEBI as an AIF. The domestic fund is managed by the India based investment manager who may also act as IA to the overseas Investment Manager for providing non-binding investment advisory services. The offshore fund and domestic fund independently makes investment in Indian portfolio companies. The following diagram explains the co-investment fund structure:

Offshore Investors


Offshore FundFund management services

Investment Manager

Tax Efficient Jurisdiction

IndiaOnshore Investors Non-binding

Investment advisory services

Onshore fund


Investment Advisor

Investee Co 1 Investee Co 2 Investee Co 3



2.3 Unified Investment Fund Structure Under this structure, investment from domestic as well as offshore investors is pooled

into a single pooling vehicle which would be registered with the SEBI as an AIF. The offshore LPs pool their money into an offshore vehicle set up in a tax efficient jurisdiction which makes the investment in the domestic fund. The domestic fund also raises money from the local investors and in turn invests in various portfolio companies in India. In this case the offshore pooling vehicle can be a self-managed fund and may not require any Investment Manager. For managing the single pool of capital of foreign and local money, the India based Investment Manager is entitled to management fees and carry.

The following diagram explains the unified fund structure:

Offshore Investors



Offshore Fund

India

Onshore Investors

Onshore fund


Investment Manager

Investee Co 1 Investee Co 2 Investee Co 3



III. KEY TERMS IN FUND STRUCTURING, PRINCIPAL LEGAL DOCUMENTS AND THE FUND LIFECYCLE

3.1 Key Terms in Fund Structuring Apart from understanding the Fund structures and the roles of the various entities

related to the Fund, it is also important to understand the following terms in the Fund structuring context:

(a) Parallel Funds (known as Side Car): Parallel Funds are investment entities formed by GPs to co-invest alongside the main Fund. They are separate investment vehicles generally administered and controlled by the Investment Manager of the main Fund and do not necessarily have the same investment terms or fees as the main Fund. They are typically formed to accommodate the specific arrangement with the particular investors of the main Fund.

(b) Feeder Funds: Feeder funds are special purpose vehicles formed by the GP to accommodate investment in the main Fund by one or more investors. Generally, an investor or class of investors may prefer (primarily for tax purposes) to invest in the main Fund indirectly through an upper-tier entity.

(c) Sponsor Capital Commitment: Investors typically like to see that the GP/ Investment Manager has “skin in the game” as well by making its own commitment to the Fund (known as sponsor commitment). Investors believe this mitigates the incentives for a GP / Investment Manager, which receive a disproportionate share of profits, to take excessive (or unwarranted) risks. A specified commitment by a GP / Investment Manager and its key executives is also an attractive marketing element for promotion of the Fund.

(d) Distribution Waterfalls: The distribution waterfalls are typically contained in the constitution document of the Fund. The distribution waterfall provides that the proceeds from investments are paid in an order of specified priority. The layering of waterfall tiers, and the apportionment of distributions among them, is a matter of negotiation and has wide variety of options, although certain approaches prevail for Private Equity Funds.

(e) Carried Interest: The GP of the Fund is entitled to a profits participation (also known as carried interest, carry or success fee) that is usually a set percentage of profits (typically 20%, but can be higher or lower). The timing and calculation methodology of the carried interest is set out in the distribution waterfall, which typically provides that the carried interest is lower in priority to the return of capital contributions and the preferred return to investors.

(f) Preferred Return / Hurdle Rate: It is basically a minimum annual return that the investors are entitled to before the GP may begin receiving carried interest. The rate is typically around 8% to 10% IRR.

(g) Management Fees: Many factors affect the management fees including size and sophistication of investors, asset class, investment strategy, the amount of capital issued, the amount of work required to execute the strategy effectively etc. Most frequently, during the commitment period, fee is calculated as a percentage of the aggregate capital commitments made to the Fund. After the commitment period,



fee is calculated as a percentage of the capital contribution that has not yet been returned to the investors. Normally ‘2-20’ fee-carry model is followed where GP is entitled to 2% management fees and 20% carried interest in Private Equity Funds.

(h) Fund Set-up and Operational Cost: Set up cost of the Fund generally include the expenses incurred by the GP in forming the Fund and any related vehicles, including travel, legal, accounting, filing and other organizational expenses. Set up cost are borne by the investors out of their capital commitments, but are typically capped depending on the size and complexity of the Fund. The GP is responsible for any set up cost in excess of the cap. The recurring operating expenses of the Fund are borne by the investors out of their capital commitments. However, unlike set up cost, operating expenses are typically not capped.

(i) Clawback: A clawback is an adjustment payment that the GP / Investment Manager must make to the Fund at the end of its term when the Fund’s remaining assets must be liquidated, and in some cases, on an interim basis or at other designated times during the life of the Fund. A clawback payment is triggered if, on calculating the Funds aggregate returns, including events occurring after distributions have been made to the GP, the GP has received more than its “share” of the Fund’s economics (for example, the return to the investors is less than the hurdle rate or, even if the hurdle rate is exceeded, is less than 80% of the total Fund profits). The clawback payment is limited to the amount of carried interest distributions received by the GP, net of their associated tax liabilities.

(j) Investors Giveback: The constitution document of the Funds typically require investors to return distributions to meet their share of Fund obligations or liabilities, including indemnification and other obligations relating to liabilities in connection with the purchase or sale of investments.

Often the requirement to return distributions is subject to certain caps, which may be based on the timing of distributions (for example, no distribution may be required to be returned three years after the date of distribution). However, this may not be very successful in an Indian context given that the tax authorities are given relatively long time-frames to proceed against taxpayers.

(k) Key Person Event: Investors make investments in the Fund primarily relying on the skill and expertise of certain individuals to manage the Fund and its investments. Often the operation of the Fund is tied to the presence of these individuals who are deemed to be “key persons.” Key person events when triggered cause a suspension of the Fund’s investment period, i.e., the Fund is prevented from making new investments until a sufficient number of new key persons are appointed to the satisfaction of the investors. Often, if the suspension period continues for a long period (for example, six months), then the Fund’s constitution may require that either the investment period be permanently suspended or the Fund be liquidated.

3.2 Principal Legal Documentations Once the Fund structure is conceptualised, the same has to be incorporated in the

Fund documentations. The Fund documentation is a critical exercise and while drafting



the documents one should ensure that these documents are in compliance with both India and offshore tax and regulatory laws. The Fund documents typically include constitution document, contribution agreements, private placement memorandum, management agreement, etc. Please see below general purpose of these documents.

(a) Constitution document: A constitution is the charter document of the Fund. It is a binding contract between the company (i.e. the Fund), the directors of the company and the shareholders (i.e. the investors and the management entity) of the company. It typically sets out investment objective, manner of capital calls, distribution waterfall, provisions for transfers of interests by the investors and other standard legal terms.

(b) Private Placement Memorandum (‘PPM’): The private placement memorandum is the primary marketing document through which the GP markets its interests to prospective investors. Accordingly, the PPM outlines the investment strategy of the Fund, details of past performance of investment team, summary of the key terms on which investors could participate in the Fund, the potential risk factors, conflicts of interest that could arise to an investor considering an investment in the Fund, outline of key regulatory and tax considerations, etc.

(c) Subscription agreement: The subscription agreement is an agreement that records the terms on which an investor will subscribe to the securities / interests issued by the Fund. The subscription agreement sets out the investor’s capital commitment to the Fund and also records the representations and warranties made by the investor to the Fund. This includes the representation that the investor is qualified under law to make the investment in the Fund

(d) Management agreement: The Fund enters into management agreement with the Investment Manager. Investment management agreement records the terms under which the Investment Manager will render investment advisory services to the Fund for management fees.

(e) Sub-advisory agreement: the Investment Manager may enter into sub-advisory agreement with the Investment Advisors located in India. The sub-advisory agreement provides that Indian advisor would provide non-binding recommendatory investment advice to the Investment Manager for an advisory fee.

(f) Investor Side Letters: It is not uncommon for some investors to ask for specific arrangements with respect to their participation in the Fund. These arrangements are recorded in a separate document known as the side letter that is executed by a specific investor, the Fund and the Investment Manager. Typically, investors seek differential arrangements with respect to management fee, distribution mechanics, participation in investment committees, investor giveback, etc.

3.3 Lifecycle of the Fund Typically the life cycle of the India focused offshore fund is for 8 to 10 years.

Generally, the constitution document of the Fund provides for the extension of the life of the Fund by 2 to 3 years with prior approval from the super majority of Investors i.e., investors holding 75% of the investment. The intention of investors of the Fund is



to make the capital contribution for limited period of time and therefore, life cycle is determined based on the commercial negotiation and investment / divestment strategy of the Fund. The lifecycle of the Fund can be broken down in the following phases:

(a) Phase One: Negotiation stage and Fund raising stage – Six months to one year of the Fund life

This is the phase when the GP conceptualizes the investment strategy and offer capital raising to the potential investors on private placement basis. Generally, these private placements are effected by a number of one-on-one presentations to investors with whom GP has a pre-existing relationship. Typically, this presentation involves the distribution of marketing materials and a PPM. Investors for India focused fund typically includes pension funds, provident funds, sovereign wealth funds, financial institutions, foreign government funds, etc.

A first closing of the Fund occurs when GP identifies investors who are ready to commit sufficient capital to the Fund by entering into capital contribution agreement with the Fund.

In this phase the Fund structure is conceptualized and established in a jurisdiction which is most favourable to the Investors, offers tax neutrality and set up flexibility. Typical Fund jurisdictions for India focused Fund are Mauritius, Singapore and Netherlands.

(b) Phase Two: Investment period – First five years of the Fund life An investor’s capital commitment is typically not called all at once, but on an as-

needed basis during the investment period. The Investment Manager sources new investments for the Fund during an investment period (or commitment period) and calls capital on a deal-by-deal basis as required to fund new investments or to cover the Fund’s management fees and other Fund related expenses

The Fund makes the investment essentially in the first five years. Depending on the particular investment opportunity the investment can be made under the foreign direct investment (‘FDI’) route, foreign venture capital investment route (‘FVCI’) and the foreign portfolio investment (‘FPI’) route.

(c) Phase Three: Divestment Period and distribution to Investors – Five years to end of the Fund life

The Fund generally dispose of the investments within relative time frame of 3 to 5 years from investment. The Investment Manager looks for timely and profitable exits to redeem capital and return the investment proceeds to the investors. This helps them in establishing and maintaining the reputation which in turn enables them to raise capital again in future from the existing and new investors. The prominent mode of exits for the Funds are offer for sale in public offering, sale to strategic buyer, sale to promoter by exercising put option, buy-back, etc.

Investment proceeds are distributed to the investors on pro rata basis in accordance with the distribution waterfall as and when the divestment happens. At the end of the term of the Fund, the Fund’s remaining investments must be liquidated with the proceeds distributed to investors. This completes the one lifecycle of the Offshore Fund.



IV. KEY TAX AND REGULATORY CONSIDERATIONS IN OFFSHORE FUND STRUCTURING

4.1 Aspects to be considered and evaluated in conceptualization of the Offshore Fund structure• Evaluation of possible jurisdiction which will ensure regulatory flexibility and

tax neutrality for offshore investors.

• Evaluation of the nature of the Investment Fund such as company, limited liability partnership, trust. Similarly, nature of related Fund entities such as Investment Manager, Investment Advisor, etc.

• Determination of the shareholding patterns and capital structure for repatriation of investment proceeds to the investors in tax efficient manner.

• Substance requirement at offshore level from POEM / PE and treaty eligibility perspective.

• The roles of various entities in the Fund structure (i.e. Investment Manager, Indian Advisor, etc.) from POEM and PE perspective

• Carry Structuring for granting carry units to key persons / employees.

• Examining and evaluating the possible investment routes that may be used by the Offshore Fund depending on its commercial objectives such as FDI route, FVCI route and FPI route.

• Evaluation of various funding instruments / modes that may be generally employed by the Offshore Fund such as Equity, CCPS, CCDs and NCDs (if commercially required).

• Applicability of Transfer Pricing provisions to Investment Manager and Investment Advisor.

• Review of principal documents such as PPM, constitution document, capital contribution agreement, investment management agreement, advisory agreements and side letters from tax and regulatory perspective.

For effective and efficient advice on the above aspects it is important to understand the key tax and regulatory considerations in the Private Equity Fund context which have been explained in the following para.

4.2 Rationale for Offshore Pooling Most of the time the capital from foreign investors for investment in India have been

pooled in the Fund vehicles registered outside India instead of India-domiciled Fund. The main reasons for offshore pooling are as follows:

(a) According to section 5 of the Income-tax Act, 1961 (‘the Act’), non-residents are taxed only on income that has its source in India. The scope of section 5 is expanded by the legal fiction contained in section 9, which deems certain kinds of income to be of Indian source, i.e., if capital assets is situated in India. As a result of this if the investment from foreign investors are pooled in India-domiciled Fund, then foreign investors could be liable to tax in India following the source based taxation unless the tax treaty of home jurisdiction of foreign investors provides the necessary tax exemption.



(b) The tax treaties entered into by India with countries like Mauritius, Singapore, Netherlands, etc. provide the capital gains exemption or concessional tax rates on income earned by the Fund set up in that jurisdiction. Further, in most of these jurisdictions the capital gains are exempt from tax under the domestic tax laws. Therefore, effectively, the Fund is able to pass on investment proceeds to investors without any significant incidence of tax (either in India or where the Fund is formed).

(c) India-domiciled funds are required to be registered as AIF under SEBI AIF regulations. The AIF Regulations permit an AIF to raise Funds from any investor whether Indian or foreign through the issue of units of the AIF. However, as on date, accepting investments from non-resident investors requires approval from the Foreign Investment Promotion Board (“FIPB”). In order to encourage domestic investments, the Government has recently proposed to allow foreign direct investment in AIF. However, formal notification is not yet issued in this regard.

4.3 Jurisdictional analysis for setting up India focused offshore fund The choice of the jurisdiction would ideally depend on the following key factors:

• Tax neutrality for the investors which means investors are not subject to higher taxes than if they were to invest directly

• Flexibility in raising capital, making investment in India and distribution of profit to investors

• Jurisdiction should be suitable for all investors from different countries

• Cost efficiency, i.e., lower set up cost and operational cost

Some of the popular jurisdiction for setting up India focused offshore funds are discussed in detail below.

(a) Mauritius Mauritius is well known as an excellent platform for structuring foreign direct

investments into India. It has a large network of double taxation avoidance agreements (“tax treaty”). As per the beneficial provisions of India-Mauritius tax treaty, the capital gains arising to a Mauritius company from transfer of shares of Indian portfolio companies are not subject to tax in India. For several years, India has been in talks with Mauritius to re-negotiate the India-Mauritius tax treaty. Per the information available in the public domain, Indian and Mauritian delegations are believed to have agreed on the insertion of a Limitation of Benefit (‘LOB’) clause in the tax treaty. The proposed LOB clause may require Mauritius entities to show more substance in order to claim tax treaty benefits.

India focused Investment Funds are formed as a corporate entity which holds a category 1 global business license (GBL 1) and is registered with FSC to operate as a closed end Fund under the Securities Act, 2005 and Securities (Collective Investment Scheme and Closed End Funds) Regulations 2008.

The FSC has recently revised the Guide to Global Business (“Guide”) to enhance the level of substance required to be demonstrated by Mauritius based entities for holding a GBL 1. This development is important since it is necessary for a



company to obtain a GBL 1 to be eligible to apply for a Tax Residence Certificate (“TRC”) which itself is a necessary pre-condition for a company to qualify for benefits under the India-Mauritius tax treaty.

In determining whether the conduct of business will be or is being managed and controlled from Mauritius, the FSC would take into consideration whether a corporation:

(i) has at least 2 directors, resident in Mauritius, who are appropriately qualified and of sufficient calibre to exercise independence of mind and judgment;

(ii) maintains at all times its principal bank account in Mauritius;

(iii) keeps and maintains, at all times, its accounting records at its registered office in Mauritius;

(iv) prepares, or proposes to prepare its statutory financial statements and causes or proposes to have such financial statements to be audited in Mauritius;

(v) provide for meetings of directors to include at least 2 directors from Mauritius; and

(vi) is authorized/licensed as a collective investment scheme / closed-end fund/ external pension scheme administered from Mauritius.

In addition to above, the FSC has required GBL 1 companies to satisfy at least one of the conditions listed below:

(i) have office premises in Mauritius

(ii) employ at least one person who is resident of Mauritius, on a full time basis, at an administrative / technical level

(iii) its constitution should provide for all disputes arising out of the constitution to be resolved by way of arbitration in Mauritius

(iv) hold or is expected to hold in next 12 months, assets of at least USD 100,000 in Mauritius. However, the same would exclude cash held in bank account or shares / interest in another company holding a Global Business Licence

(v) its shares are listed on a securities exchange licensed by FSC

(vi) yearly expenditure of the company in Mauritius should be of the same level as a similar corporation which is controlled and managed from Mauritius

(b) Singapore FDI inflows in India from Singapore are significantly increasing over the years.

Singapore is one of the more advanced holding company jurisdictions which possesses an established capital markets regime. Singapore has a mature and developed financial market to facilitate the raising of capital and improve stock liquidity.

India-Singapore tax treaty provides a similar capital gains tax exemption on sale of shares as available under the India-Mauritius tax treaty. Unlike India-Mauritius



tax treaty, the exemption under India-Singapore tax treaty would be available only on satisfaction of Limitation of Benefits (‘LOB’) clause. As per India-Singapore tax treaty, a Singapore resident shall be deemed to have substance (and not be considered a shell / conduit company) if it incurs annual operational expenditure of SGD 200,000 or more in Singapore in the immediately preceding period of 24 months from the date the gains arise.

(c) Netherlands Netherlands emerges as an efficient jurisdiction for making portfolio investments

(stake less than 10%) in India. The India-Netherlands tax treaty provides the capital gains exemption to Netherlands resident if shares of an Indian company are sold to non-resident buyer. In case of sale to Indian residents, such gains are taxable if the Netherlands resident holds more than 10% of the shares of the Indian company.

Due to restrictive benefits provided under India-Netherlands tax treaty, it has not emerged as prominent jurisdiction for India focused Offshore Fund. Historically, India focused Offshore Funds are set up in Mauritius and Singapore. The comparative analysis of Mauritius and Singapore as a jurisdiction for setting up India focused Offshore Fund is provided below1.

Criteria for Evaluation Mauritius Singapore

Eligibility to claim tax treaty benefits

• A person is considered as a resident of Mauritius if it is liable to tax in Mauritius by reason of domicile, residence or place of management.

• CBDT has issued a Circular No. 789 dated April 13, 2000 which provides that a valid TRC issued by the Mauritius tax authorities would constitute sufficient evidence for accepting the tax residency status of an entity in Mauritius. The Supreme Court of India in the case Azadi Bachao Andolan [(2003) 263 ITR 706 (SC)] has upheld the validity of the principles laid down by the Circular No. 789.

• Under the Singapore Income-tax Act, in order to constitute as a resident in Singapore, the control and management of the company must be exercised in Singapore.

• The companies which are resident in Singapore should be eligible to treaty benefits subject to obtaining valid Tax Residency Certificate (‘TRC’) from I n l a n d Revenue Authority of Singapore.

1 The information in relation to offshore jurisdiction is provided based on information available on online databases. The overseas experts should be consulted while advising on the offshore jurisdictions for fund structuring exercise.




Substance requirements as per the respective jurisdictions and tax treaties

• FSC has prescribed the substance requirements (discussed in detail above) which should be fulfilled in order to hold GBL 1. Holding a valid GBL 1 is a pre-requisite to obtaining a TRC from Mauritius Revenue Authority.

• Fund to be registered with the Financial Services Commission

• Registration of the Fund is relatively simpler process

• Currently, India-Mauritius tax treaty does not have LOB clause and accordingly, there are no such specific substance requirements similar to India-Singapore tax treaty to avail treaty benefits. However, based on news reports, recently, India and Mauritius have agreed on insertion of the LOB clause in the tax treaty which is likely to introduce substance test similar to India-Singapore tax treaty.

• Approval from Monetary Authority of Singapore (‘MAS’) is required for the Fund and Investment Manager to claim tax exemption/ incentive in Singapore (sections 13X & 13R, see below)

o Stringent approval process

o Requirement of certain minimum number of professional employees is must in Singapore

• India-Singapore tax treaty has prescribed the substance requirements to avail the benefits of tax treaty. The entity shall not be eligible to the benefits of tax treaty if:

o the affairs of an entity are arranged with the primary purpose to take advantage of the benefits of tax treaty; or

o it is a shell / conduit company

A shell / conduit entity is any legal entity with negligible or nil business operations or with no real and continuous business activities carried out in Singapore. A Singapore resident is deemed not to be a shell or conduit if it is listed on a recognized stock exchange or if its annual operational expenditure is at least SGD 200,000 in the immediately preceding 24 months from the date the gains arise.




Taxability of Income earned by offshore Fund in India if treaty benefits are available

• Dividend income exempt in India provided Indian company has paid dividend distribution tax (‘DDT’) in India.

• Capital gains on sale of securities are exempt in India

• Interest taxable at 21.63% (in case of FPIs and foreign currency denominated debt)/ 43.26%. As per recent newspaper reports, the tax rate on interest is likely to be reduced.

• Dividend income exempt in India provided Indian company has paid DDT in India.

• Capital gains on sale of securities exemption subject to compliance with substance requirement discussed above.

• Interest taxable at 15% in India provided Singapore entity is the beneficial owner of interest and interest amount is remitted to Singapore.

Taxability of Income earned by offshore fund in respective jurisdiction

• No tax on capital gains

• Corporate tax rate is 15%, effective tax rate after considering deemed foreign income credit is 3%. Therefore, dividends and interest income taxable at effective rate of 3%. Credit for India tax on interest income should be available.

• Capital gains are exempt in Singapore. Generally, gains on disposal of investments are considered business income in nature and taxable at 17%.

• The eligible income of the Fund, i.e., capital gains, dividend income or interest income, are exempt if the Fund is approved under section 13R and Section 13X of the Singapore Income Tax Act (Chapter 134) and the Income Tax (Exemption of Income of Approved Companies Arising from Funds Managed by Fund Manager in Singapore) Regulations 2010. As per the recent amendment, this scheme is valid until March 31, 2019.

• Dividend income is exempt from tax subject to certain conditions.

• Interest income, if not covered under the above scheme, is taxable at 17% (However, the Singapore entity will be entitled to tax credit for taxes paid in India on such interest income)




Taxation of Investment Manager in respective jurisdiction

• Management fee is taxable at effective rate of 3%

• Management fee is taxable at rate of 10%, if Fund Manager is eligible for Financial Sector Incentive (Fund Management) Award

• Otherwise, Corporate tax rate of 17%

Costs • Relatively low set up and operating costs

• High set up and operating costs

4.4 Key Tax Considerations in the Fund Structuring It may be noted that the Fund structuring is iterative and facts based exercise. Analysis

provided below is generic in nature. The applicability of each of the following tax implications in the Fund structuring context should be analysed in the light of the specific facts of the case. The following diagram explains the tax issues that may be faced by various entities involved in the offshore Fund structure:

Offshore Investors Indirect

transfer


POEM / PE

Capital gains vs. business income

Offshore Fund

GAAR


AOP: co-investment

Investment Manager


Investee Companies

Non-binding investment advisory

servicesTransfer pricing

Safe Harbour Investment Advisor



(a) Characterization of Income issue The issue of characterization of income from purchase and sale of securities

(whether taxable as business income or capital gains) has been a subject matter of litigation with the tax authorities. There have been judicial pronouncements on whether gains from transactions in securities should be taxed as “business profits” or as “capital gains”. However, these pronouncements, while laying down certain guiding principles have largely been driven by the facts and circumstances of each case. Also, the CBDT has provided guidance (vide its Instruction: No. 1827, dated 31-8-1989 and Circular No. 4/2007, dated 15-6-2007) in respect of characterization of gains as either capital gains or business income. Following are the key illustrative (not exhaustive) factors indicative of capital gains characterization (not business income):

• Intention at the time of acquisition – long term holding and capital appreciation

• Low transaction frequency

• Long period of holding

• Shown as investments in the books of account (not stock-in-trade)

• Use of owned funds (as opposed to loan) for acquisition

• Main object in constitution document is to make investments

• Higher level of control over the investee company

Characterization of Income issue in the Fund Context The amendment has been introduced by Finance (No.2) Act, 2014, to include

within the definition of capital asset, any securities held by a FPIs which has invested in such securities in accordance with the regulations made under the Securities and Exchange Board of India Act, 1992 (SEBI Act). As a consequence of this amendment, any income from purchase and sale of securities by FIIs shall be regarded as capital gains.

However, this amendment applies only to securities invested by FPIs and not to securities held by private equity funds. If income from transaction in purchase and sale of securities is treated as business income then the same would be taxable in India if the Fund has permanent establishment in India. Accordingly, it would be critical for the Fund to demonstrate by considering the parameters discussed above that the income is capital gains in nature.

(b) Place of Effective Management The income tax liability as per the provisions of the Income-tax Act, 1961

(‘the Act’) is dependent upon the residential status of the taxpayer. Before the amendment introduced by Finance Act, 2015, as per section 6(3) of the Act, the foreign company was treated as tax resident in India in case either of the following condition is satisfied during the previous year:

i. It is an Indian company (i.e. a company incorporated in India); or



ii. If the control and management of its affairs is situated wholly in India.

The Finance Act, 2015 has amended the provisions of section 6(3) of the Act to provide that a company incorporated outside India, shall be said to be resident in India in any previous year if its place of effective management, in that year, is in India. Further, the explanation to section 6(3) defines the ‘place of effective management’ as a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance made. The Memorandum has stated that though POEM is a fact dependent exercise, the guiding principles for determination of POEM for the benefit of the taxpayers as well as Revenue shall be issued in due course of time.

Tie-breaker Test under Tax Treaty

Tax treaties entered into by India with Mauritius and Singapore also provide that if a person is tax resident of both the contracting states, then it shall be deemed to be a resident of the Contracting State in which its place of effective management is situated (tie-breaker scenario). Therefore, even in a tie-breaker scenario, it would need to be seen where the place of effective management of the Fund is situated in order to determine the eligibility to the Treaty.

Accordingly, if company is treated as a tax resident of India on account of POEM in India, the treaty benefits would not be available and its global income will be subject to tax in India. It has been clearly stated in the Memorandum to Finance Bill that the intent behind the proposed amendment is primarily to focus on shell companies which are incorporated in foreign jurisdiction but are being managed and controlled from India. These companies would generally hold some board meetings abroad to circumvent the Indian tax residency rules.

The Memorandum explaining the provisions of the Finance Bill, 2015 states that the principle of POEM is recognized and accepted by the Organisation of Economic Cooperation and Development (‘OECD’). The Memorandum further clarifies that while guidance may be derived from internationally available principles however, determination of POEM is a fact dependent exercise.

POEM Analysis

The tax department has not yet issued the guiding principles which could be followed for determination of POEM. In absence of guiding principles, one would need to review the aforesaid Explanation to section 6(3) in the light of international guidance available in the commentaries and judicial precedents. In this context, the OECD commentary on model convention provides definition of place of effective management to mean the place where key management and commercial decisions that are necessary for the conduct of the entity’s business as a whole, are in substance, made2 (which is similar to the Explanation to section 6(3) of the Act). The relevant extract is reproduced below:

2 India has adopted a different position to the view of OECD. It is of the view that the place where the main and substantial activity of the entity is carried on is also to be taken into account when determining the place of effective management.



“24. …The place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the enterprise’s business are in substance made. All relevant facts and circumstances must be examined to determine the place of effective management. An enterprise may have more than one place of management, but it can have only one place of effective management at any one time…

Competent authorities having to apply such a provision to determine the residence of a legal person for purposes of the Convention would be expected to take account of various factors, such as where the meetings of its board of directors or equivalent body are usually held, where the chief executive officer and other senior executives usually carry on their activities, where the senior day-to-day management of the person is carried on, where the person’s headquarters are located, which country’s laws govern the legal status of the person, where its accounting records are kept ……. “

Meaning of POEM has further been considered by the Technical Advisory Group on monitoring the application of existing treaty norms for the taxation of business profits in its Discussion Paper on “The Impact of the Communications Revolution on the application of “Place of Effective Management” as a Tie-Breaker Rule (2001)’

31. A place of effective management will generally be where key management and commercial decisions necessary for the conduct of a business are in substance made and given. This will ordinarily be where the directors meet to make decisions relating to the management of the company, but the determination of a place of effective management is a question of fact and other relevant factors taken into account by the courts have included:

• Where the centre of top level management is located.

• Where the business operations are actually conducted.

• Legal factors such as the place of incorporation, the location of the registered office, public officer, etc.

• Where controlling shareholders make key Management and commercial decisions in relation to the company; and

• Where the directors reside.

It should be noted, while the guidance from Central Management & Control and the Place of Management indicates the place of effective management will ordinarily lie with the directors, in certain circumstances these strategic decisions and powers may be exercised by others. For example, the guidance provided in paragraph 24 of the Commentary on Article 4, makes it clear that the relevant consideration is where the high level decision making occurs. If this function is performed by persons other than the Board of Directors, then the relevant consideration is the place where those other people make their decisions.

It may be noted that the Authority for Advance Ruling (‘AAR’) in case of P No 10 of 1996 [224 ITR 473 (AAR)] dealt with issue of POEM in case of a Mauritius



Manager that sought investment advisory services from an Indian advisor. In this ruling the following factors were considered to hold that the Mauritian company’s POEM was situated in Mauritius under Article 4(3) of the India-Mauritius DTAA (unless there are facts to indicate that control emanates from elsewhere)–

• The company has two resident directors of appropriate calibre to exercise independence of mind and judgment.

• The company’s secretary is resident in Mauritius.

• The registered office is Mauritius.

• Banking transactions will be channelled through an offshore bank account in Mauritius.

• Accounting records will be maintained in Mauritius in accordance with the Companies Act, 1984.

• Board meetings will be held in or chaired from Mauritius.

• All statutory records, such as minutes and members’ register, will be kept at the registered office in Mauritius

It may be noted that above decision was rendered prior to July 2008, i.e., before India added its observation to OECD commentary.

POEM in the Fund Context

As explained in previous paragraphs, a typical fund structure, involves various parties like the Fund vehicle, IM and Indian advisor. The Indian advisor performs certain activities in India such as sourcing investment / divestment opportunities in India, preliminary discussion, etc. which in turn is communicated to the overseas IM. The Board of the Fund or the investment committee (‘IC’) comprises of board members of the Fund and personnel of IM is supposed to make all the investment and divestment decisions as part of the board meetings or IC meetings. However, many times, the Indian advisor performs a lot of functions and acts as the single point of contact between various Indian parties like portfolio companies (where the fund intends to invest), third parties like lawyers, bankers, etc. and may be seen as carrying out a larger role than what a typical advisor would generally do. Therefore, the concept of POEM and tax residency becomes extremely crucial for the Offshore Fund.

While the guiding principles to be issued by the Indian tax authorities on POEM are awaited, based on the international guidance available on this matter, the POEM in the Fund context would really mean how the various activities of the Fund are conducted in terms of the people involved, their decision making abilities and powers, place where the entire investment and divestment decisions are in substance taken, communication flow, remuneration pattern, etc.

(c) Permanent Establishment As discussed above, the issue of characterization of income from purchase and

sale of securities (whether taxable as business income or capital gains) has been a subject matter of litigation with the tax authorities. If the gains are categorized



as business income in the hands of the Fund, then the same would be taxable under the Act at the rate applicable to a foreign company i.e. 43.26 per cent (on net income basis) if the Fund is construed to have a permanent establishment (‘PE’) in India.

The concept of a PE is provided in the Article 5 of the tax treaties (OECD and UN Model Conventions). The term PE is not exhaustively defined, however, per Article 5 of the tax treaties it includes fixed place PE (this includes branch, office, please of management, etc.), construction PE, service PE, Agency PE, etc.

PE in the Fund Context

In the Fund context, considering that India investment advisor is located in India and providing investment advisory services to the Investment Manager overseas, the tax authority may question the existence of PE as fixed place of business in India, place of management in India, service PE or dependent agent PE in India.

Accordingly, in the Fund context the following questions would be relevant to determine the PE exposure in India.

• Whether the Offshore Fund carried on a business activities in India?

• Which enterprise’s business was carried on through the activities of the India advisory company?

• Whether the India advisory company is providing services in India on behalf of the Investment Manager?

• Whether visit to India by personnel of the Investment Manager or the Offshore Fund would amount to service PE?

• Whether the India advisory company could claim to be an independent agent?

• Whether the India advisory company is involved in negotiation of investment / divestment transaction and taking decisions in India on behalf of the Offshore Fund and Investment Manager?

(d) Safe Harbour for fund management in India In order to encourage fund management activity from India, the Finance Act,

2015 has introduced a new section 9A in the Act, to provide a safe harbour to offshore funds which satisfy the prescribed conditions. As per the provisions of section 9A, fund management activity carried out by an eligible fund manager on behalf of an eligible investment fund, will not constitute a business connection and tax residency of the eligible investment fund in India.

Per section 9A, the conditions in order to qualify as an eligible investment fund inter alia include:

(i) Fund is not a person resident in India

(ii) Fund is resident of a country with which India has entered into a DTAA

(iii) No Indian resident, directly or indirectly, invests more than 5% of the corpus



(iv) Fund activities are subject to applicable investor protection regulation in the country of its incorporation

(v) Fund to have a minimum of 25 members who are not connected persons (directly or indirectly).

(vi) Any member along with connected person(s) not to have participation interest exceeding 10% in the Fund

(vii) Ten or less members along with their connected person(s) not to have participation interest of 50% or more in the Fund

(viii) Fund cannot invest more than 20% of its corpus in any entity

(ix) Fund cannot make investments in an associate entity

(x) Monthly average of corpus shall not be less than INR 100 crs. For establishment of new Fund, corpus of INR 100 crs to be seen at the end of the financial year

(xi) Fund to not carry on or control and manage any business in India or from India

(xii) No activities in India which can constitute business connection in India nor has any person in India acting on its behalf whose activities could constitute business connection other than the activities undertaken by the eligible fund manager on its behalf

(xiii) Fund to pay fund manager on arm’s length basis

It is provided that the conditions (v), (vi) and (vii) shall not apply in case of an investment fund set up by the Government or the Central Bank of a foreign State or a sovereign fund, or such other fund as the Central Government may subject to conditions if any, by notification in the Official Gazette, specify in this behalf.

Further, the fund manager needs to satisfy the following conditions in order to qualify as an eligible fund manager:

(i) Fund manager is not an employee of the fund or its connected person.

(ii) Fund manager is registered as a fund manager or an investment advisor in accordance with the specified regulations.

(iii) Fund manager is acting in the ordinary course of business.

(iv) Fund manager along with the connected person is not entitled to more than 20% of the profits accruing or arising to the fund from transactions carried out by the fund through the fund manager.

Safe harbour in the Fund Context

Considering the onerous nature of the conditions specified under section 9A, most of the existing Private Equity Funds and their Fund Managers may not be able to satisfy the above conditions in order to take the benefit of safe harbour rule. In this regard, lot of representations have been made to the government highlighting the challenges that could be faced by the Private Equity Funds in



complying with the provisions of section 9A. The representations have been made to notify the broad based regulated Private Equity Funds for exemptions from the most onerous conditions (v), (vi) and (vii) above.

(e) General Anti-avoidance Rule (‘GAAR’) First Inclusion of GAAR in Income-tax Act was made by Finance Act 2012.

Subsequently a new Chapter X-A was inserted by the Finance Act 2013 by the name of General Anti – Avoidance Rules. This chapter consists of sections starting from 95 to 102 having various definitions, consequences of entering the Impermissible Avoidance Arrangement and reference to the guidelines in section 101 inserted by the Income-tax (Seventeenth Amendment) Rules, 2013.

As per the amendment made by Finance Act, 2015 applicability of the GAAR provisions is deferred till the Financial Year (‘FY’) 2017-18. Further, the investments made up to 31st March 2017 would also be grandfathered from the applicability of GAAR provisions by making amendment in the Income-tax Rules.

The GAAR provisions empower the tax authorities to declare any arrangement as an “impermissible avoidance arrangement”. An impermissible avoidance arrangement means an arrangement whose main purpose is to obtain a tax benefit and that satisfies at least one of the following four tests:

• The arrangement creates rights, or obligations, which would not normally be created between persons dealing at arm’s length;

• It results, directly or indirectly, in the misuse, or abuse, of the provisions of the tax laws;

• It lacks or is deemed to lack commercial substance, in whole or in part; or

• It is entered into, or carried out, by means, or in a manner, which would not ordinarily be employed for bona fide purposes.

The burden of proving that the main objective of an arrangement is to obtain a tax benefit is imposed on the Indian tax authorities rather than on the taxpayer. Upon successfully invoking GAAR, the tax authorities would determine the tax consequences such as reallocating the income or re-characterizing the arrangement, looking through the arrangement by disregarding any corporate structure, re-characterising equity into debt, etc.

GAAR in the Fund Context

The Expert Committee on GAAR headed by Dr. Parthasarathi Shome which had submitted its report on 1 September 2012 recommended that where Circular No. 789 of 2000 with respect to Mauritius is applicable, GAAR provisions shall not apply to examine the genuineness of the residency of an entity set up in Mauritius.

Further, the Expert Committee report also provides various illustrative cases for the applicability of GAAR provisions. One of these illustrations is categorically with respect to pooling of the funds and the committee recommends that the GAAR provisions in such cases should not be invoked. However, the above recommendations have not been incorporated in the Act.



(f) Tax Treaty Benefits Section 90(4) of the Act requires an assessee, not being a resident of India, to

obtain a Tax Residency Certificate (‘TRC’), of his being a tax resident in a country outside India in order to claim relief under the tax treaty. Rule 21AB of the Income-tax Rules, 1962 (‘the Rules’) prescribes the details that should be included in TRC. If such details do not form a part of TRC, then per section 90(5) of the Act, the assessee should provide the further information as mentioned in Form 10F. As per the said rule, the assessee should keep and maintain the documents which are necessary to substantiate the information provided.

CBDT has issued a Circular No. 789 dated April 13, 2000 in the context of Mauritius companies claiming Treaty benefits which provides that a valid TRC issued by the Mauritius tax authorities would constitute sufficient evidence for accepting the tax residency status of an entity in Mauritius. The Supreme Court of India in the case of Union of India vs. Azadi Bachao Andolan [(2003) 263 ITR 706 (SC)] has upheld the validity of the principles laid down by Circular No. 789 (supra). The validity of TRC as a proof for availing treaty benefit was also upheld in the following cases:

• E Trade Mauritius Ltd., In Re [(2010) 324 ITR 1 (AAR)];

• D. B. Zwirn Mauritius Trading [(2011) 333 ITR 32 (AAR)];

• Ardex Investments Mauritius Ltd., In re [(2012) 340 ITR 272 (AAR)]

• Dynamic India Fund I, In re [(2012) 251 CTR 206 (AAR)];

• SmithKline Beecham Port Louis Ltd., In re [(2012) 24 Taxmann.com 153 (AAR)];

• Castleton Investment Ltd., In re [(2012) 348 ITR 537 (AAR)]

However, it may be noted that the tax authorities have become vigilant in granting the treaty benefits merely on the basis of a TRC and have sought to examine whether or not such entities are conduits formed merely to claim Treaty benefits. The Supreme Court in case of Vodafone International Holdings B.V. vs. Union of India (17 taxman.com 202) (SC) has stated that in a case where the Revenue finds that in a holding structure, an entity, which has no commercial / business substance has been interposed only to avoid tax then in such cases it would be open to the Revenue to discard inter-positioning of such entity. The Supreme Court also adverted to its earlier decision in the case of Mcdowell and Co. Ltd. vs. CTO (3 SCC 230) holding that legitimate tax planning within the framework of the law is permissible, all tax planning is not illegal and only tax evasion through the use of colourable devices or dubious methods is not permissible.

It may also be noted that the Bombay High Court in the case of Aditya Birla Nuvo Ltd. (12 taxmann.com 141) has denied the benefit of capital gains tax exemption to the Mauritius based seller (subsidiary of US Parent Co.) upon sale of shares of an Indian company available under the India-Mauritius tax treaty holding that the transaction under the sale and purchase agreements was basically to transfer the entire rights, title and interest in the Indian Company by the US Parent Co. (and not the Mauritius-based entity).



Tax Treaty eligibility in the Fund Context

The Offshore Fund is usually formed as pooling vehicle in jurisdiction which apart from other strategic reasons offers the tax neutrality for investors from various countries. Accordingly, it would be critical for the Offshore Fund to adhere to the substance requirement to enable it to be eligible for tax treaty benefits. Also considering the pooling of the capital from investors located in various countries and existence of the Fund Manager in the similar jurisdiction as the of the Fund, it should be able justify that it is not a conduit holding company formed merely to claim Treaty benefits.

(g) Taxation of Indirect Transfers As per explanation 5 of section 9 the Act, any share or interest in a company

or entity registered / incorporated outside India shall be deemed to have been situated in India if the share or interest derives, “directly or indirectly”, its value substantially from assets located in India.

Earlier, the term ‘substantially’ was not defined under the provisions of the Act. Therefore, there was no clarity on the circumstances when shares of an offshore company substantially derive their value from assets located in India. However, the Finance Act, 2015 has amended the provisions of the Act to provide that the shares of a foreign company shall be deemed to derive its value substantially from the assets located in India if on the specified date, the value of such assets exceeds the amount of INR 100 million and represents at least 50% of the fair market value of all assets owned by the foreign company. The amended provisions has provided the exemption to small shareholders, i.e., the shareholders who hold less than 5% voting power / share capital and not having, directly and indirectly, management or control rights. Further, as per the amended provisions, Indian company whose ownership or control gets transferred directly or indirectly would be required to report such transaction to tax authorities. Failure of reporting will entail penalty of 2% of transaction value in case the transfer has the effect of transferring the right of management or control and in other cases INR 500,000.

The CBDT, vide Circular No. 4/2015 dated 26 March, 2015 has clarified that dividends declared and paid by a foreign company outside India in respect of shares which derive their value substantially from assets situated in India would not fall within the ambit of provisions relating to taxability of indirect transfer.

Indirect transfer provisions in the Funds context

In light of the aforesaid provisions, if an investor sells the shares held in the Fund then the gains made by the selling investor are likely to be subject to tax in India on the basis that such sale indirectly results in the transfer of a capital asset situated in India as the Fund would be deriving its value substantially from Indian assets. However, this would be subject to availability of the relevant Treaty benefits applicable to the investors based on their respective country of residence.

The Fund may also invest in Indian portfolio company through special purpose vehicle. The indirect transfer tax would get triggered for the Fund on transfer



of shares of special purpose vehicle which derives value from assets located in India. However, this would be subject to availability of the relevant tax treaty benefits applicable to the Fund.

Also, for repatriation of investment proceeds to the investors, the Fund may undertake buy back / redemption of shares. The Circular No. 4/2015 has provided that indirect transfer would not be triggered only in case of declaration of dividends by the foreign company. It does not provide any clarity in case of buy back / redemption of shares. Therefore, the question remains, whether the indirect transfer tax would apply to cases where the Fund undertakes any buy back / redemption of shares held by the investors?

In light of the above it would be critical to structure the capital of the Fund such that it is tax neutral for the offshore investors.

(h) Association of Persons (‘AOP’) risk The definition of person under section 2(31) of the Act recognized the AOP as a

separate taxable entity. The term AOP has not been defined under the Act and therefore has to be understood in its plain and ordinary meaning and in the light of the principles laid down by various judicial rulings. The Supreme Court of India in the case of CIT v. Indira Balkrishna [39 ITR 546 (SC)] held that in order to constitute an AOP, persons must join in a common purpose or common action and the object of the association must be to produce income. It is not enough for the persons to receive income jointly.

Recently, the Bangalore Tribunal in the case of DCIT vs. M/s. India Advantage Fund – VII (ITA No. 178/Bang/2012) held that there was no AOP in case of a domestic fund registered as a Domestic Venture Capital Fund (“DVCF”). The Tribunal held that it cannot be said that the beneficiaries have come together with the object of carrying on investment in mezzanine funds which is the object of the trust. The beneficiaries are mere recipients of the income earned by the trust. They cannot therefore be regarded as an AOP.

AOP in the Fund Context

There are no judicial precedents available in relation to the Offshore Fund Structures which lay down the principles on what constitute an AOP where there are co-investments. i.e., the offshore Fund invest in India alongside one or more Domestic Fund in the co-investment fund structures. If the Offshore Fund and Domestic Fund are regarded as acting jointly with respect to their co-investments in India, it could result into creation of a potential Association of Person (‘AOP’), being a separate taxable entity and benefits of tax treaty could be denied to the Offshore Fund.

(i) Transfer Pricing As per Section 92 of the Act, any income arising from an international

transactions shall be computed having regard to the arm’s length price. If the Investment manager and Indian advisory company are Associated Enterprise (‘AE’), they will have to comply with the transfer pricing provisions. There have been litigations under the transfer pricing provisions on mark-up charged by



Indian advisory companies to Investment Manager. Following are the few cases where the issue relating to mark-up charged by Indian advisory companies has been discussed and it was held in favour of assessee (based on facts of the case):

• Carlyle India Advisors (P.) Ltd. [2012] 24 taxmann.com 176

• General Atlantic (P.) Ltd. [2013] 32 taxmann.com 178

• New Silk Route Advisors Private Limited (ITA No.1327/Mum/2014)

If the fees charged by the Indian advisory companies are not considered to be at arm’s length, then there could be adverse implications under the transfer pricing provisions for India Advisory Company.

4.5 Regulatory Framework The Offshore Fund structure would depend on the availability of the investment routes

under the Foreign Exchange Management Act (‘FEMA’) and rules and regulations framed therein. Foreign investment in India is regulated under the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 (“the Inbound Regulations”). Under the Inbound Regulations, the prominent investment routes for the Offshore Fund are as follows:

• Foreign Direct Investments (FDI); (Regulation 5(1) and Schedule 1 of the Inbound regulations)

• Foreign Venture Capital Investment route for SEBI registered Foreign Venture Capital Investors (FVCI); (Regulation 5(5) and Schedule 6 of the Inbound regulations)

• Foreign Portfolio Investment route for SEBI registered Foreign Portfolio Investors (FPI); (Regulation 5(2A) and Schedule 2A of the Inbound regulations)

The Inbound Regulations are framed and regulated by the Reserve Bank of India (‘RBI’) and the Department of Industrial Policy and Promotion (“DIPP”). In addition this it is also important to keep in mind the regulations framed by the SEBI for FVCI and FPI. We have listed below key aspects of the Inbound Regulations and the SEBI Regulations under each of the above investment routes.

The Budget 2015 made the following important announcements in relation to the foreign investment in India. It may be noted that the following are still on the proposed stage and yet to see the light of the day.

• It is proposed to give power to the Central Government to frame the capital account regulations. The RBI would continue to have power to specify the regulations for debt instruments. However, all existing capital account regulations would continue and regulated by the RBI until modified or rescinded by the Government.

• It is also proposed that distinction between different types of foreign investments, especially between FPI and FDI to be done away with and would be replaced with composite caps.



• Foreign investments would be allowed in Alternative Investment Funds (‘AIF’). It was not clarified whether it would be under the automatic route.

(a) Foreign Direct Investment route Any person resident outside India (subject to a few limitations) can invest

in India under the FDI route. Depending on business sector of the portfolio company, the FDI can be made under the following routes:

i. Automatic route: This route does not require the prior approval of the RBI or FIPB. Most of the sectors in India fall under the ‘automatic route’ where 100% FDI is allowed.

• Sectors under automatic route with thresholds: In few sectors, which are under the automatic route, foreign investment cannot exceed specified limits. For example, 26% in Commodity Exchanges, 74% in Credit Information Companies, etc.

• Sectors under automatic route with conditionalities: Real estate sector (development of residential and commercial properties), NBFC sector, etc.

ii. Approval Route

Under the approval route, FDI is allowed only with the permission of the Government (FIPB). Some of these sectors includes Defence, Print Media, etc.

iii. Prohibited sectors

Foreign investment in the some sector is specifically prohibited. Some of these sectors includes Lottery business, Chit funds, Real Estate Business, etc.

Eligible Instruments

The FDI can be made in Indian companies by using the following instruments:

• Equity shares

• Compulsorily Convertible Preference Shares (‘CCPS’)

• Compulsorily Convertible Debentures (‘CCD’)

• Depository Receipts (‘DRs’)

• Warrants and partly paid shares (subject to conditions)

Pricing guideline

Pricing guidelines for investment under the FDI route / transfer of capital (Schedule 1 of the Inbound Regulations).



Issue or transfer of capital listed on a recognised stock exchange

Price is worked out as per the SEBI guidelines

Issue or transfer of capital not listed on recognised stock exchange in India

The fair valuation of shares as done by a SEBI registered Merchant Banker or a Chartered Accountant as per any internationally accepted pricing methodology on arm’s length basis

The price of shares issued / transferred to person resident outside India shall not be less than price calculated as per the above guidelines. The transfer of shares of an Indian company by person resident outside India to person resident in India shall not be higher than the price calculated as per the above guidelines. Pricing guidelines do not apply to the transfer of shares of an Indian company between two non-residents. In case of issue of CCPS and CCDs, the price / conversion formula should be determined upfront at the time of the issue of instruments. The price at the time of conversion should not in any case be lower than the fair value worked out, at the time of issuance of such instruments, in accordance with the extant FEMA regulations

Issues of warrants and partly paid shares As per the Circular No. 3 dated July 14, 2014 issued by RBI, in case of issue of

warrants and partly paid shares, price / conversion formula should be determined upfront, however, the price at the time of conversion warrants should not in any case be lower than the fair value worked out, at the time of issuance of such warrants, in accordance with the extant FEMA regulations. In case of issue of partly paid shares, 25% of the total consideration amount shall be received upfront and balance shall be received within 12 months. If issue size exceeds INR 500 crore, then balance consideration can be received after 12 months. In case of issue of warrants, 25% of the consideration shall be received upfront and balance shall be received within 18 months.

Depository Receipts ‘Depository Receipts Scheme, 2014’ for investments under DRs has been notified

by the Central Government. Under this Scheme, any Indian company, listed or unlisted, private or public or any other issuer or person holding permissible securities is eligible to issue or transfer permissible securities to a foreign depository for the purpose of issuance of depository receipts. The aggregate of eligible securities which may be issued or transferred to foreign depositories, along with eligible securities already held by persons resident outside India, shall not exceed the limit on foreign holding of such eligible securities under the FEMA regulations. Further, permissible Securities shall not be issued to a foreign depository at a price less than the price applicable to a corresponding mode of issue of such securities to domestic investors. In case of listed companies, the minimum pricing norms as applicable under the SEBI Guidelines shall be complied with.



Optionality Clause The RBI has vide Circular No. 86 dated January 9, 2014 permitted the shares/

debentures with an optionality clause subject to minimum lock-in period of 1 year. In case of unlisted companies, exit price should not exceed the price arrived at as per any internationally accepted pricing methodology on arm’s length basis duly certified by a SEBI registered Merchant Banker or a Chartered Accountant. It is also clarified that such call/put option shall not offer exit with the assured return to the investors.

Downstream Investments As per regulation 14 of the Inbound Regulations, FDI into Indian companies may

be direct or indirect. Indirect FDI is referred to as the downstream investment made by an Indian company, which is owned or controlled by non-residents, into another Indian company. As per the FDI policy, such downstream investment is also required to comply with the same norms as applicable to direct FDI in respect of relevant sectoral conditions on entry route, conditionalities and caps with regard to the sectors in which the downstream entity is operating. Companies are considered ‘owned’ by foreign investors if they hold more than 50% of capital of the company and are deemed to be foreign ‘controlled’ if the foreign investors have a right to appoint a majority of the directors or to control the management or policy decisions including by virtue of their shareholdings or management agreements.

Key considerations in relation to Offshore Fund Structure The following are the few specific aspects which should be noted for the Fund

Structuring.

• Most of the domestic pooling structures (AIF) is evolved in the form of Trust due to the operational flexibility. Under the FDI regime, foreign investment into trust is subject to the FIPB approval. In the past, FIPB has granted approval for such investment that qualify with the condition of compliance with downstream conditions as applicable under FDI regime, irrespective of whether AIF being owned and controlled by Indian resident. Further, the repatriation of investment proceeds from AIF to the Offshore Fund / investor may also require the RBI approval.

• Foreign investment into LLP is also subject to FIPB approval. Currently, LLP with foreign investment is not allowed to make downstream investment. Therefore, foreign investment into domestic fund which is formed as LLP may not be workable option.

• Foreign investment into an Indian company, engaged only in the activity of investing in the capital of other Indian companies also require prior FIPB approval.

• There is an ambiguity whether the investment management activities undertaken by an AIF manager are the asset management activities (which are subject to higher minimum capitalization norms) or it should qualify as Investment Advisory Services which is non-fund based activity and



accordingly, should require the minimum capitalization of USD 0.5 mn only.

• Round-tripping: Although there is no express provision either in the FEMA or the regulations therein, it refers to Indian money going abroad as Outbound Investment and then being rerouted into India as FDI. This is prohibited and in the past, the RBI / ED have launched proceedings against several companies for round-tripping.

• The Union Cabinet, chaired by the Prime Minister, has given its approval to allow the Real Estate Investment Trusts (REITs) as an eligible financial instrument / structure under the Foreign Exchange Management Act, 1999. As a result of this decision, entities registered and regulated under the SEBI (REITs) Regulations 2014 will be able to access foreign investments which as of now are prohibited under the FEMA Regulations. The notification in this regard is not yet been issued.

• Assured return and creation of securities is not permissible under FDI route.

o In case of Tata Docomo, the RBI rejected Docomo exit at pre-agreed price which was higher than the fair market value as on date.

o In case of Hubtown Ltd. the Bombay High court has made an observation that the transaction of routing the FDI through a newly interposed company was a colourable device and was structured to secure repayment of FDI amount and return thereon.

(b) Foreign Venture Capital Investment (‘FVCI’) route SEBI introduced the SEBI (Foreign Venture Capital Investors) Regulations,

2000 (“FVCI Regulations”) to encourage foreign investment into venture capital undertakings. The FVCI Regulations make it mandatory for an offshore fund to register itself with the SEBI. The SEBI in turn seeks the RBI approval for granting the FVCI registration.

In practice, the RBI has been prescribing in its approval letter for FVCI entities that investment will be restricted to select sectors being infrastructure, biotechnology, IT related to hardware and software development, nanotechnology, seed research and development, research and development of new chemical entities in pharma sector, dairy industry, poultry industry, production of bio-fuels and hotel-cum-convention centres with seating capacity of more than 3,000. It may be noted that the recent report issued by the Dr. Arvind Mayaram Committee constituted by the Ministry of Finance has made suggestions to the Government to remove the sectors restrictions for the FVCI.

The investment conditions and restrictions as laid down under the FVCI Regulations are summarized hereinbelow:

i. An FVCI is required to designate its investible funds for investment into India at the time of seeking registration. Accordingly, the investment



conditions and restrictions would be applicable with respect to such investible funds.

ii. The investment restrictions on FVCI are required to be achieved by the end of its life cycle.

iii. An FVCI is required to invest at least 66.67% of its investible funds in unlisted equity shares or equity linked instruments (i.e. instruments convertible into equity shares or share warrants, preference shares, debentures compulsorily or optionally convertible into equity) of a VCU.

iv. An FVCI may invest up to 33.33% of its investible funds

• by way of subscription to an initial public offering (“IPO”) of a VCU whose shares are proposed to be listed on a recognized stock exchange;

• in debt/debt instruments of a VCU in which the FVCI has already made an investment by way of equity;

• preferential allotment of equity shares of a listed company subject to lock in period of one year;

• the equity shares or equity linked instruments of a financially weak company (i.e. a company which has at the end of the previous financial year accumulated losses, which has resulted in erosion of more than 50% but less than 100% of its net worth as at the beginning of the previous financial year) or a sick industrial company whose shares are listed; and

• special purpose vehicles which are created by a FVCI for the purposes of facilitating or promoting investment in accordance with the FVCI Regulations.

FVCIs enjoy certain regulatory advantage over FDI route as mentioned below:

• The pricing norms applicable to FDI route do not apply to FVCIs. Accordingly, FVCI can subscribe, purchase or sell securities at any price subject to other applicable law. However, it should be noted that the recent report issued by the Dr. Arvind Mayaram Committee has suggested that exemption from pricing guidelines currently available to FVCI should be removed.

Apart from investment into Equity, CCPS and CCD, FVCI can also invest into optionally convertible redeemable preference shares (OCRPS) and optionally convertible debentures (OCDs).

• Possible to invest in debt securities such as non-convertible debentures. ECB norms should not apply for investment in debt / optionally convertible instruments

• As per RBI Circular No. 93 dated March 19, 2012, FVCI can invest in securities listed on recognized stock exchange subject to provisions of the SEBI FVCI Regulations.



• One year lock-in applicable to shares (under the SEBI ICDS Regulations) do not apply to shares held by FVCI if shares are held for at least one year before IPO. This enables FVCI to exit immediately post listing.

• The transfer of listed shares from FVCIs to promoters is exempt from public offer provisions under the SEBI takeover regulations.

• FVCIs are granted the status of a Qualified Institutional Buyer (‘QIB’).

(c) Foreign Portfolio Investor (‘FPI’) route On January 7, 2014, SEBI introduced the SEBI (Foreign Portfolio Investment)

Regulation 2014 (“FPI Regulations”). Under the FPI regime, SEBI has merged foreign institutional investors (“FIIs”), sub-accounts and qualified foreign investors (“QFIs”) regimes into a single investor class – foreign portfolio investors (“FPIs”). SEBI approved Designated Depository Participants (‘DDPs’) shall register Foreign Portfolio Investor (‘FPI’) on behalf of SEBI subject to compliance with know your client (‘KYC’) requirements.

FPIs have been classified under three categories as below:

• “Category I FPI” which shall include Government and Government related foreign investors etc.;

• “Category II FPI” which shall include appropriately regulated broad based funds, appropriately regulated entities, broad-based funds whose investment manager is appropriately regulated, university funds, university related endowments, pension funds etc.; and

• “Category III FPI” which shall include all others not eligible under Categories I and II FPI.

The FPI regulations provide that investment in the issued capital of a single company by a single FPI or an investor group shall be below 10% of the total issued capital and of the company. As per investment conditions under the SEBI FPI regulations, FPI can make investment in shares, debentures and warrants of companies, listed or to be listed on a recognized stock exchange in India.

Key considerations in the Fund Context

• Depending on the facts of the case, the Offshore Fund qualifies for registration as Category II or III FPI. As per the SEBI FPI Regulations and the FAQs issued by SEBI, FPI can invest only in listed or to be listed shares or debentures of the companies. Accordingly, investment in unlisted shares and debenture (other than debenture issued by Infrastructure Company) would not be permissible.

• The Offshore Fund may choose to invest under the FPI route where the investment is in listed company for stake up to 10% and there are regulatory hurdles for investment under the FDI route such as sectorial restriction. Further, any income earned by FPIs from purchase and sale of securities is considered as capital gains. So there is no risk of characterisation of income earned by FPIs as business income.



• The FDI route does not permit investment in Indian companies by way of listed NCDs. The offshore fund may use the FPI route to make investment in Indian company by way of listed NCDs where there are regulatory hurdles for investment under FDI route such as sectorial restriction, pricing norms, etc.

• Recently, SEBI (CIR/IMD/FIIC/1/2015 dated February 3, 2015) and RBI (Circular No. 71 dated February 3, 2015) have issued circulars to provide that FPIs shall not be allowed to invest in corporate bonds that have a minimum residual maturity of less than 3 years. Further, RBI has issued a Circular No. 73 dated February 6, 2015 to clarify that FPIs shall not be allowed to make any investments in debt instruments having minimum initial / residual maturity of three years with optionality clause exercisable within three years. However, FPIs shall be free to sell the securities with no lock-in period (including those that are presently held with less than three years residual maturity) to domestic investors.

• Recently, SEBI vide Circular No. CIR/IMD/FIIC/05/2015 dated June 12, 2015 has clarified that a DDP may consider an applicant holding FVCI registration, for grant of registration as an FPI provided the fund raised, allocated and invested are clearly segregated for both the registrations and separate accounts are maintained with the custodian for execution of trade. The applicant FVCI shall be required to comply with the conditions of FPI regulations.

The comparison between FDI, FVCI and FPI routes of investment is given in table below–

Parameters FDI FVCI FPI

Investment in unlisted shares & debentures

• Permissible • Permissible • Not Permissible (except debenture of infrastructure company)

Investment in listed securities

• Can be acquired on private placement basis

• S e c o n d a r y acquisition can be only through an off-market deal

• Permissible to acquire on market

• Permissible to acquire on market

Investment in debt instruments

• Possible to invest in CCDs

• Can invest in debt instruments such as OCDs and NCDs

• Can invest in debt instruments with minimum residual maturity of three years



Parameters FDI FVCI FPI

Foreign investment limits

• Possible to acquire up to 100% stake in an investee company, subject to sectoral caps, if any

• Possible to acquire up to 100% stake in an investee company, subject to sector r e s t r i c t i o n for FVCI and a p p l i c a b l e i n v e s t m e n t guidelines

• Investment in the issued capital of a single company by a single FPI or an investor group shall be below 10% of the total issued capital of the company

Pricing • Pricing guidelines need to be adhered, while making investment and also on transfer of shares of investee companies

• Pricing guidelines do not apply

• Pricing guidelines do not apply

Pre-IPO lock-in exemption under SEBI ICDS regulation

• Not available • Pre-IPO shares not subject to 1 year lock-in if shares held by FVCI for at least 1 year before IPO

• Not available

QIB status • No QIB status • FVCI entity enjoys QIB status

• Category I and II FPIs enjoy QIB status

(d) Outbound Investment regulations As per FEMA (Transfer or issue of any foreign security) Regulations, 2004

(‘Outbound Regulations’), an Indian party engaged in financial services sector in India can make investment outside India subject to compliance with the following conditions:

i. It should be registered with the regulatory authority in India for conducting the financial sector activities;

ii. It has earned net profit during the preceding three financial years from the financial services activities;

iii. It has obtained approval from the regulatory authorities concerned both in India and abroad for venturing into such financial sector activity; and

iv. It has fulfilled the prudential norms relating to capital adequacy as prescribed by the concerned regulatory authority in India.



As per the regulation 20A of the Outbound Regulations, a resident Individual can set up Joint Ventures (‘JV’) / Wholly Owned Subsidiaries (‘WOS’) abroad outside India for bona fide business activities within the limit of USD 250,000. Further, as per the Outbound regulations, resident individual is prohibited from making direct investment in a JV or WOS abroad which is engaged in the business of financial services activity.

(e) Liberalised Remittance Scheme (‘LRS’) Under LRS Scheme, a resident individual can acquire and hold shares of a

foreign company subject to maximum remittance of USD 250,000 per financial year.

As per the RBI guidelines on Liberalised Remittance Scheme for Resident Individuals dated February 4, 2004, the facility under LRS scheme is not available for making remittances directly or indirectly to Mauritius. However, the latest guideline dated June 1, 2015 and Master Circular on Miscellaneous Remittances from India – Facilities for Residents dated July 1, 2015, do not provide for such restriction.

Key considerations in the Fund Context

• In case of India sponsored fund, what are the possible ways for GP based in India to set up Investment Manager Entity outside India?

• In case of India sponsored fund, whether it is permissible for GP based in India to make sponsor investment into the offshore fund?

V. KEY REGULATORY AND TAX CONSIDERATIONS IN DOMESTIC FUND STRUCTURING

SEBI has notified the Alternative Investment Funds Regulations in May 2012. The AIF Regulations aim to recognise the needs of every type of private pooling vehicle so that such funds are channelled in the desired space in a regulated manner without posing a systemic risk. AIF Regulations replaced the VCF Regulations. Funds registered under the VCF Regulations shall continue to be regulated by the said regulations till the existing fund or scheme is wound up.

AIF means any fund established in India in the form of a trust, company, limited liability partnership or a body corporate which:

(i) is a privately pooled investment vehicle that collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors; and

(ii) is not covered under the SEBI (Mutual Funds) Regulations, 1996, SEBI (Collective Investment Schemes) Regulations, 1999 or any other regulations of SEBI, which aims to regulate fund management activities.



5.1 Categories of AIF SEBI has classified AIF into the following broad categories:

Category I AIF: Funds which invest in start-ups, early stage ventures, social ventures, infrastructure or other sectors which the government or regulators consider as socially or economically desirable will qualify as Category I AIFs. These funds are generally perceived to have positive spillover effects on the economy and for which the SEBI or the Government might consider providing incentives or concessions. This category includes Venture capital funds, SME funds, social venture funds, infrastructure funds and such other AIFs as may be prescribed.

Category II AIF: Funds that do not fall in Category I and III AIF and those that do not undertake leverage or borrowing other than to meet the permitted day to day operational requirement including Private Equity Funds or Debt Funds.

Category III AIF: Funds that employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives, for e.g. Hedge Funds.

5.2 Investment conditions and restrictions for investment in all categories of AIFs Investment approach

AIF can raise funds through private placement by the issue of placement Memorandum. AIF will be required to state its investment purpose, investment strategy and its investment methodology in its placement Memorandum to the investors. Any material change in the fund strategy shall require consent of at least two-thirds of unit holders by value.

We have summarized below relevant applicable conditions for investment in AIF as well as investment by AIF (refer regulation 10, 15, 16, 17 and 18 of AIF regulations)

General conditions and restrictions for investment in all categories of AIF:

• The AIF may raise funds from any investor whether Indian, foreign or non-resident Indians by way of issue of units;

• Each scheme of the Alternative Investment Fund shall have corpus of at least twenty crore rupees;

• The minimum investment by each investor shall be one crore rupees.

• In case of investors who are employees or directors of the Alternative Investment Fund or employees or directors of the Manager, the minimum value of investment shall be twenty five lakh rupees. SEBI vide Circular no CIR/IMD/DF/14/2014 dated June 19, 2014 has clarified that, in case of units of AIF which are issued to employees of the manager of the AIF for profit sharing without any contribution or investment from them, minimum investment limit of twenty five lakh rupees shall not be applicable.

• The Manager or Sponsor shall have a continuing interest in the Alternative Investment Fund of not less than two and half percent of the corpus or five crore rupees, whichever is lower, in the form of investment in the Alternative Investment Fund and such interest shall not be through the waiver of



management fees. For Category III Alternative Investment Fund, the continuing interest shall be not less than five percent of the corpus or ten crore rupees, whichever is lower.

• Any scheme of AIF shall not have more than 1,000 investors.

5.3 The comparison between Categories I, II and III AIFs is given in table below:

Particulars Category I AIF Category II AIF Category III AIF

Concept Funds which invest in start-ups, early stage ventures, Social Ventures, SMEs, infrastructure or other sectors which the government or regulators consider as socially or economically desirable sectors

Funds that do not fall in Categories I and III AIF

Funds that employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives

Types of funds Venture capital funds, SME funds, social venture funds, infrastructure funds and such other AIFs as may be prescribed

Private Equity Funds, Debt funds

Hedge Funds or Funds which trade with a view to make short-term returns

Tenure Close ended fund with a minimum tenure of 3 years. Extension of tenure permitted up to 2 years subject to approval of 2/3rd of the unit holders of value

Same as Category I Can be open ended or close ended

Leverage Cannot borrow or leverage directly or indirectly except for meeting temporary funding requirements for:• Maximum 30

days• Maximum 4

occasions in a year

• Maximum 10% of investible funds

Cannot borrow or leverage directly or indirectly except for meeting temporary funding requirements for:

• Maximum 30 days

• Maximum 4 occasions in a year

• Maximum 10% of investible funds

(Hedging permitted subject to SEBI guidelines which is yet to be issued)

Can borrow or leverage subject to consent from investors and limit specified by SEBI



Particulars Category I AIF Category II AIF Category III AIF

Key investment restrictions

Cannot invest more than 25% of the investible funds in one investee company

Same as Category I Cannot invest more than 10% of the investible funds in one investee company

Investment in other AIFs

• May invest in units of Category I AIF of same sub-category

• Investment in Fund of funds not permitted

• May invest in units of Category I or II AIF

• Investment in Fund of Funds not permitted

• May invest in units of Category I or II AIF

• Investment in Fund of funds not permitted

5.4 Taxation of AIF The Finance Act, 2015 has incorporated Chapter XII-FB “Special provisions relating to

tax on income of investment funds and income received from such funds”, i.e., section 115UB and sections 10(23FBA) / 10(23FBB) in the Act which will govern the taxation of Category I and Category II Alternative Investment Funds in India (‘Investment Fund’).

The salient features of the special regime are:

• As per section 10(23FBA), income of the Investment Fund, other than income from profits and gains of business, shall be exempt from tax in the hands of the Investment Fund. Per section 115UB such would be taxable in the hands of the investors on a pass through basis. Such income will be taxable in the same manner as if it were the income accruing or arising to, or received by, such investor had the investments, made by the Investment Fund, been made directly by such investor.

Further, income taxable in investors’ hands shall be deemed to be of the same nature and proportion as in the hands of the Investment Fund.

• Income in the nature of profits and gains of business or profession shall be taxable in the hands of Investment Fund at the maximum marginal rate. Per section 10(23FBB), the investors shall be exempt from tax on such income.

• Where any income other than income from profits and gains of business, is credited or paid to an Investor by the Investment Fund, the Investment Fund shall deduct income-tax at the rate of ten per cent. Income of the AIF shall be deemed to have been credited to the investors on the last day of the previous year in the same proportion in which investors would have been entitled to receive the income had it been paid during the year.

• If in any year there is a loss at the Investment Fund level either current loss or the loss which remained to be set off, the loss shall not be allowed to be passed through to the investors but would be carried over at the Investment Fund level to be set off against income of the next year in accordance with the provisions of the Act.



• Further, the provisions related to Dividend Distribution Tax or Tax on distributed income shall not apply to the income paid by the Investment Fund to the investors.

• As per Notification No. 51 dated 24th June, 2015, the income (other than business income) received by the Investment Fund would be exempt from TDS requirement.

• It shall be mandatory for the Investment Fund to file its return of income. The Investment Fund shall also provide to the prescribed income-tax authority and the investors, the details of various components of income, etc. for the purposes of the scheme.

It may be noted that tax pass through status has not been accorded to Category III AIFs. Accordingly, the taxability of Category III AIFs will be governed by the general principal of taxation (depending on the form in which Category III AIF is set up i.e Trust or LLP or company)

Key Considerations

Section 194LBB provides that the investment fund will have to deduct tax at 10 per cent on non- business income distributable to the investors.

• Whether distribution to the foreign investors from Mauritius and Singapore would be subject to 10 per cent withholding tax in spite of treaty benefits being available to them?

• Whether even exempt income such as dividends and long term capital gains on listed shares would be subject to withholding tax on distribution to the Investors?

5.5 The comparison between AIF set up as a Trust and LLP is given in table below–

Particulars AIF set up as a Trust AIF set up as a LLP

R e g i s t r a t i o n as investment entity

• Possible • Possible (However, ROC requires no objection certificate from SEBI)

Participation • There are no restrictions as to who can participate in a trust

• Only individuals and body corporate can participate

• As per NBFC directions, it cannot become a partner in a LLP

Liquidity and Transfer

• Contribution agreement allows for exit situations, flexibility and modus for liquidity actions/ events

• Partnership interest transferable by way of retirement and/or resignation. Conditions may be provided in the LLP agreement.



Particulars AIF set up as a Trust AIF set up as a LLP

• Further, the Trust Act does not provide any significant hindrance in achieving the same.

• To conform with requirements under the LLP Act

Liability • Unlimited liability on Trustee, being legal owner – indemnified out of Trust property.

• Generally, Trustee being a company, liability can be limited to its capital.

• LLP separate legal entity – partner’s liability limited to their contributions

• In case of fraud – unlimited liability on Partners

Level of c o m p l i a n c e and reporting obligations

• Other than as mandated by the AIF Regulations, a trust does not have any reporting obligations otherwise to the regulators. Accordingly, Trust is subject to relatively less compliance requirements

• LLP is subject to more compliance requirements such as filing of forms, financial statements, return etc. with the ROC under the LLP Act.

Availability of documents on public domain

• No documents available on public domain

• Various documents available on public domain such as Incorporation documents, Statement of Account and Statement of Income and Expenditure including audited financial statements etc.

Tax Pass through status (for Category I and Category II AIF)

• Available • Available

Market Practice Due to operational flexibility, most of the domestic funds in India are set up in the form of Trust.

Very few domestic funds are set up in the form of LLP.

VI. KEY TAX AND REGULATORY CONSIDERATIONS IN TRANSACTION STRUCTURING It may be noted that Transaction Structuring, i.e., investment and divestment by

Private Equity Funds is discussion topic in itself. Any investment / divestment structuring requires understanding of various laws such as Income-tax, Companies Act, FEMA, SEBI Regulations, Stamp Duty, Indirect Taxes, Competition Act, etc. It may not be possible to discuss all aspects of transaction structuring, however, many of the tax and regulatory considerations discussed above would also be relevant for transaction structuring. Focusing on private equity transactions we have discussed



below the evolving withholding tax issue for the benefit of the participants. We have also provided below the bird’s-eye view of the some of the relevant provisions in the transaction structuring:

Withholding tax obligations Under section 195(1) of the Act, any person responsible for paying to a non-resident

any sum chargeable under the provisions of the Act shall be required to deduct tax thereon at the rates in force. As per Explanation 2 to section 195(1) of the Act, the requirement to withhold tax is applicable in case of non-resident payer as well.

The Supreme Court in case of G. E. India Technology Centre P. Ltd. vs. CIT (327 ITR 456), held that a person making payment to a non-resident is not obliged to withhold tax if such sum is not chargeable to tax. The CBDT Instruction No. 2 dated February 26, 2014, also supports this view.

Section 195 casts the withholding tax obligation on the buyer while making payment to non-resident seller. Failure to withhold tax could lead to tax, interest and penal implications for buyer. Therefore, buyer is always cautious of tax implications of the non-resident seller and may look for some safeguarding options even if the non-resident seller is eligible for beneficial provisions of Mauritius or Singapore tax treaties. Accordingly, investment / divestment transactions by offshore Private Equity Funds are structured cautiously and is always subject matter of negotiations. The following are the buyer safeguarding preferences in order of its priority:

Nil withholding certificate: Most of the buyers in case of private equity deals seek nil withholding certificate to avoid any adverse implications for non-withholding of tax. This is time consuming and uncertain process and it may not be possible to hold on deal completion till the issue of certificate by the tax authorities.

Holding back amount in an escrow account: Buyer to hold back amount in an Escrow account equivalent to the capital gains tax liability arising as per the provisions of the Act. The escrow can be released in different phases depending upon whether there is any tax litigation arising with respect to the sale transaction.

Tax insurance: A number of insurers offer coverage against tax liabilities arising from private equity deals. This would involve additional insurance premium cost.

Tax indemnity: The seller provides the tax indemnity to the purchaser from any tax claim or notice that may be issued in relation to non-withholding of tax or as a representative assessee. The period and amount of tax indemnity is always subject matter of commercial negotiation.

Further, the tax indemnity is always backed by strong representations and warranties from seller regarding facts which may be relevant for potential tax claim. Many a times buyer also insists tax opinion confirming the tax liabilities of seller for particular transaction.

It may be noted that in practice, the most of the private equity deals are done based on the seller providing the tax indemnity along with the appropriate tax representations and warranties to the buyer for non-withholding of tax.



Bird’s eye view of the relevant provisions:

Issue Remarks

Capital gains tax on Sale of Shares by the Offshore Fund

• Long Term Capital Gains

Listed shares / unlisted shares as part of IPO – Exempt (if STT paid)

Listed shares / debentures – 10.82 % if no STT (based on favourable rulings)

Unlisted shares / debentures – 10.82% in INR terms (could be 21.63% in foreign currency terms for private companies)

• Short Term Capital Gains

Listed shares / unlisted shares as part of IPO – 16.22% (if STT paid)

Others – 43.26% (32.445% for FPIs)

• Treaty rates (if beneficial) to override above rates

Income characterization • Business Income vs. Capital Gain on sale of shares

o Capital gains certainty in case seller is FPI

Residential Status of a Company

• A foreign company is a resident of India, if in that year, its Place of Effective Management is in India.

• Guidelines for determination of POEM to be issued by the tax authorities – yet awaited

• POEM is a concept recognized by the OECD and most tax treaties

• See detailed discussion above under the head tax considerations – POEM.

Income deemed to accrue or arise in India

• Section 9 relating to capital asset situated in India and indirect transfers

S.56(2)(viia) and Rule 11U/11UA

• Applies when any foreign company acquires any shares in an unlisted Indian company for less than its FMV computed as per Rule 11UA (book value for equity shares, market value for preference shares)

Section 195 • Buyer required to withhold taxes on acquisition from a non-resident seller if such sale results in taxable income

Capital Gains on Buyback

• In case of listed companies, consideration received (-) cost of shares is taxable in the hands of the shareholders

• In case of unlisted companies, s.115QA triggered - buyback tax on companies @ 23.072% on the difference of buyback price and issue price of shares



Issue Remarks

o Exempt for the shareholder; no credit of taxes available

o Loss of treaty benefit for shareholder

Capital Gains on Reduction

• Consideration received (-) cost of shares (-) Amount taxed as Deemed Dividend is taxable in the hands of the shareholders

Conversion of instruments

• Conversion of CCDs is exempt

• Conversion of CCPS – not free from doubt - Not taxable as per Instruction dated 12th May, 1964 (F. No. 12/1/64-IT (AI) issued by the Ministry of Finance to all Commissioners of Income-tax

Carry Forward of losses • In case of a closely-held company no carry forward / set off of losses is allowed if more than 49% of the beneficial voting power changes hands.

• Does not apply to carry forward of unabsorbed depreciation

DTAA / Limitation of Benefit

• LOB restricts Treaty benefits to genuine residents. Substance over Form Test

Transfer Pricing • Transaction with an Associated Enterprise to trigger transfer pricing provisions

Tax on Foreign Dividends

Dividends received from certain foreign investee companies (26%+ stake) are taxed at a concessional rate of 15% on gross basis

Dividends paid by domestic companies

• Exempt from tax in the hands of the shareholder

• DDT payable by the domestic company – effective rate of 20.358%

The Key Indian regulatory provisions

Law/Regulation Remarks

Companies Law • Kind of share capital – Sec. 43

• Shareholders Rights – Sec.58

• Preferential allotment of securities exchangeable / convertible with shares subject to valuation – Sec. 62

• Buyback of shares subject to conditions – Sec. 68

• Acceptance of public deposits – Sec.73 to 76

• Dividend – Sec. 123 to 127

• Loan to directors or to any other person in which director is interested not permissible in most cases – Sec. 185

• Inter corporate Investments subject to limits – Sec. 186



Law/Regulation Remarks

FEMA: FDI & ODI regulations

• Please see the detailed discussion under regulatory framework above

Stamp Duty • Stamp Duty on Transfer of Shares in physical form

• Stamp Duty on Share Purchase Agreement / Shareholders’ Agreement

SEBI (Issue of Capital & Disclosure Requirement) Regulations, 2008

• In case of IPO, pre-issue capital to be locked in for 1 year. Lock in not applicable for FVCI if such shares are held by FVCI for 1 year pre-IPO

Other Laws • NBFC and CIC Directions and RBI Act

• Other SEBI Regulations such as Takeover Regulations, Delisting Guidelines, etc.

• Competition Act



CASE STUDIES

7.1 Case Study 1: Offshore Fund Structuring

Facts• ABC Advisors is a team of highly qualified investment professionals located in

US. ABC have had track record of many successful fund raising.

• Considering the lucrative investment opportunities in India, ABC now proposes to form India focused Private Equity Fund in the jurisdiction which offers tax neutrality for the potential investors. The potential investors are located in various countries such as USA, Canada, Netherlands, Singapore, Hong Kong, Middle East, European countries etc.

• All the final investment and divestment will be taken by ABC team. ABC also proposes to set up an advisory entity in India which will have qualified investment team for sourcing investment and divestment opportunities. The role of the India advisory entity will be of providing non-binding investment advisory services to ABC.

Queries ABC has approached you to advise them on conceptualization of the Fund Structure.

What would be the key advisory area from the India tax and regulatory perspective in the Fund structuring?

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7.2 Case Study 2: India Sponsored Fund

Facts• PQR Advisors is a team of highly qualified investment professionals located in

India. PQR Advisors proposes to set up India focused fund which will pool the investment from potential investors located in India as well as overseas.

• The commercial expectation is that the overseas investors will be pooled in the overseas fund vehicle. The overseas fund will have approximately 8 to 10 investors. It may be possible that 2 to 3 investors may hold more than 50% of the total capital of the Fund.

• PQR has sought your advice on conceptualization of the Fund Structure.

Queries• Can PQR manage the offshore fund from India?

• What are the distinctive factors in co-investment fund structure and unified fund structure from India tax and regulatory perspective?

• PQR proposes to set up the entity in the overseas jurisdiction which will advise and manage the overseas fund. The commercial expectation is that PQR will make sponsor commitment in the overseas fund. Please advice on these aspects.

• Whether the investors located in India can participate in India focused offshore fund? What should be the fund structure for investors located in India?

• Whether overseas investors from various countries can directly participate in domestic fund?

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7.3 Case Study 3: Investment / divestment by the Fund

Facts• Ace, a Mauritius based private equity fund, proposes to acquire certain stake in

JS Infra Ltd. by way of primary investment as well as secondary acquisition from SG, a private equity fund located in Singapore.

• SG is managed by the IM located in Singapore. The Indian investment advisor provides investment / divestment advisory services to IM. The Indian advisor undertake the activities such as sourcing investment / divestment opportunities in India, negotiation with the promoter / seller, co-ordination with the legal advisors, etc. None of the board members of the Fund and IM is located in India. All the key decisions (investment / divestment) are taken by investment committee comprising of the board members of SG and personnel of IM.

• The Share Subscription Agreement provided that JS Infra would give an exit to Ace at the end of five years by one or more modes. The promoters of JS Infra have also given an undertaking to buy out Ace if all modes fail. The Agreement provided that Ace would be given an exit at such a price as would give it an IRR of 20%.

Queries• Advise Ace for its primary as well as secondary acquisitions? What are the key

tax and regulatory implications Ace should be aware of?

• What are the possible investment routes for Ace?

• Ace would like to know the possible exit modes and the tax and regulatory issues under each of the options?

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GLOSSARY

Term Long Form

VC Funds Venture Capital Funds

IM Investment Manager

GP General Partner

LP Limited Partner

IAC Investment Advisor Company

REIT Real Estate Investment Trust

CBDT Central Board of Direct Taxes

SEBI Securities and Exchange Board of India

AIF Alternative Investment Fund

MAT Minimum Alternate Tax

FEMA Foreign Exchange Management Act

InvITs Infrastructure Investment Trust

SME Small and Medium Enterprise

SPVs Special Purpose Vehicles

PPM Private Placement Memorandum

DDT Dividend Distribution Tax

FDI Foreign Direct Investment

FII Foreign Institutional Investor

FPI Foreign Portfolio Investor

FIPB Foreign Investment Promotion Board

FSC Financial Services Commission

MAS Monetary Authority of Singapore

FVCI Foreign Venture Capital Investor

GAAR General Anti-Avoidance Rules

GBL-1 Global Business License – Category I

TRC Tax Residency Certificate

DTAA Double Taxation Avoidance Agreement

LOB Limitation of Benefit

AMC Asses Management Company

POEM Place of Effective Management

PE Permanent Establishment

OECD Organisation of Economic Commerce and Development

PE Permanent Establishment

BC Business Connection

AAR Authority for Advance Ruling



Term Long Form

STT Securities Transaction Tax

the Act Income-tax Act, 1961

the Rules Income-tax Rules, 1962

CCDs Compulsorily Convertible Debentures

OCDs Optionally Convertible Debentures

CCPS Compulsorily Convertible Preference Shares

AOP Association of Persons

DVCF Domestic Venture Capital Fund

AE Associated Enterprise

DIPP Department of Industrial Policy and Promotion

RBI Reserve Bank of India

ADR American Depository Receipts

GDR Global Depository Receipts

SBI State Bank of India

PLR Prime Lending Rate

PAT Profit After Tax

LLP Limited Liability Partnership

NBFC Non-Banking Financial Company

IPO Initial Public Offer

VCU Venture Capital Undertaking

OCPS Optionally Convertible Redeemable Preference Shares

ECB External Commercial Borrowing

QIB Qualified Institutional Buyer

QFI Qualified Foreign Investors

DDP Designated Depository Participant

KYC Know Your Customer

ICDR Issue of Capital and Disclosure Requirement

ROC Registrar of Companies

LRS Liberalised Remittance Scheme

JV Joint Ventures

WOS Wholly Owned Subsidiaries

DisclaimerThe views expressed in this document are those of the authors and do not necessarily reflect views of any organization. The contents of this document are for general information. This document is not a substitute for any professional advice or services, nor should it be used as a basis for any decision or action that may affect your finances or your business. It is advisable that before making any decision or taking any action that may affect your finances or business, you should consult a qualified professional advisor.

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