Implications of US Investor on Indian AIF

The presence of US investors in Indian Alternative Investment Funds (AIFs) brings about significant implications, spanning registration requirements, exemptions, taxation considerations, and regulatory obligations. This article delves into the detailed analysis of these aspects, shedding light on the intricacies of accommodating US investors within the framework of Indian AIFs.

Registration of Foreign Advisers/Funds in USA

Non-U.S. Advisers: There is no exemption for non-U.S. advisers. Non-U.S. persons advising U.S. persons are subject to the Act and must register under the Act³⁶ unless eligible for one of the exemptions discussed below (e.g., the “foreign private adviser” registration exemption)³⁷. The SEC does not accept “home state registration” of non-U.S. advisers in lieu of SEC.

³⁶ In the Matter of Banco Espirito Santo S.A., Investment Advisers Act Release No. 3304 (Oct. 24, 2011) (The SEC brought an enforcement action against a commercial bank headquartered in Portugal for violating section 203(a) by marketing its portfolio of financial services, including offering securities and providing advice regarding those securities, to U.S. residents who were primarily Portuguese immigrants without registering with the Commission.)

Certain Exemptions from Registration for Foreign Advisers/Funds in USA

³⁷ Exemption to Foreign Private Advisers. Available to an adviser that

(i) has no place of business in the United States;

(ii) has, in total, fewer than 15 clients in the United States and investors in the United States in private funds advised by the adviser;

(iii) has aggregate assets under management attributable to these clients and investors of less than $25 million; and

(iv) does not hold itself out generally to the public in the United States as an investment adviser.⁶⁴

a. Counting Clients

(i) Multiple Persons as a Single Client. Rule 202(a)(30)-1 provides that the following can be considered a single client:

(A) a natural person and (i) any minor child of the natural person; (ii) any relative, spouse, spousal equivalent, or relative of the spouse or of the spousal equivalent of the natural person with the same principal residence; and (iii) all accounts or trusts of which the persons described above are the only primary beneficiaries; or

(B) a corporation, general or limited partnership, limited liability company, trusts or other legal organization that receives investment advice based on its investment objectives (rather than the individual investment objectives of its owners), and two or more of these entities that have identical owners

(ii) “Look through” private funds. An adviser must count both its direct clients and each investor in any “private fund” it advises.

No Double Counting. An adviser may treat as a single investor any person who is an investor in two or more of the adviser’s private funds.

Nominal Holders. An adviser may be required to also “look through” persons who are nominal holders of a security issued by a private fund to count the investors in the nominal holder when determining if the adviser qualifies for the exemption. For example, holders of the securities of any feeder fund in a master-feeder arrangement may be deemed to be the investors of the master fund

⁶⁴ Section 203(b)(3) (exempting “any investment adviser that is a foreign private adviser”); Section 202(a)(30) (defining a “foreign private adviser”). Rule 202(a)(30)-1 defines the term “in the United States” by reference to the definitions of a “U.S. person” and the “United States” in Regulation S under the Securities Act, except that the rule treats as “in the United States” any discretionary account owned by a U.S. person and managed by a non-U.S. affiliate of the adviser. An adviser must assess whether a person is “in the United States” at the time the person becomes a client or, in the case of an investor in a private fund, each time the investor acquires securities issued by the fund. See rule 202(a)(30)-1, at note to paragraph (c)(3)(i).

b. Holding Out.

The SEC staff views a person as holding himself out as an adviser if he advertises as an investment adviser or financial planner, uses letterhead indicating activity as an investment adviser, or maintains a telephone listing or otherwise lets it be known that he will accept new advisory clients, or hires a person to solicit clients on his behalf.

(i) Participation in Non-Public Offerings. Foreign private advisers will not be deemed to be holding themselves out generally to the public in the United States as an investment adviser solely because they participate in a non-public offering in the United States of securities issued by a private fund pursuant to an exemption from registration under the Securities Act of 1933.71

(ii) Use of the Internet. An adviser using the Internet to provide information about itself ordinarily would be “holding itself out” as an adviser. However, the SEC has stated that it will not consider a non-U.S. adviser, including foreign private advisers, to be holding itself out as an adviser if it gives Prominent Disclaimer & uses Appropriate Procedures

Participating Non-U.S. Affiliates. The SEC staff takes the view that, under certain conditions, a non-U.S. adviser (a “participating affiliate”) does not have to register under the Act if it provides advice to U.S. persons through a registered affiliate. The conditions that must be satisfied include the following:

a. an unregistered adviser and its registered affiliate must be separately organized;

b. the registered affiliate must be staffed with personnel (located in the U.S. or abroad) who are capable of providing investment advice;

c. all personnel of the participating affiliate involved in U.S. advisory activities must be deemed “associated persons” of the registered affiliate; and

d. the SEC must have adequate access to trading and other records of the unregistered adviser and to its personnel to the extent necessary to enable the SEC to monitor and police conduct that may harm U.S. clients or markets. The Commission affirmed these staff positions in the context of the private adviser exemptions.

Investment advisers that rely on the “private fund adviser” exemption are called “exempt reporting advisers” under SEC rules, and are required to submit to the SEC, and update at least annually, certain reports on Part 1 of Form ADV. These advisers are subject to a limited subset of rules and regulations under the Advisers Act.

Taxation for Investors in USA

The PFIC rules were introduced in the United States in 1986 to discourage US taxpayers from investing in passive foreign investments that could potentially defer or reduce their US tax liabilities. A PFIC is a foreign corporation that meets one of the following criteria:

1) At least 75% of its gross income is passive income (interest, dividends, capital gains, etc.)

2) At least 50% of its assets produce passive income or are held for the production of passive income.

You need to file form 8621 if you have any PFIC investments in the year, with a separate page for every single investment made (if investments were made in chunks, then for each day of investment, a new Part V of form 8621 needs to be filled)

A PFIC owned by a U.S. Citizen or Green Card Holder is subject to the following rules of United States taxation, which can easily add up to a tax rate of over 50%:

• All distributions are taxed as regular income at the highest possible federal tax rate.
• Capital gains are not eligible to be taxed at preferential long-term capital gains rates; they are viewed as regular income and are subject to the highest current federal tax rate – despite the marginal tax rate for which your income level qualifies.
• Even unrealised gains are taxed, meaning you are liable to pay taxes even before you withdraw from your investment and realise your gains.
• If you elect to have deferred gains in your PFIC, you will be assessed with a non-deductible penalty interest charge that is compounded regularly for the duration of your deferral period; so by the time you finally realize gains, you will have accumulated an obscene amount of interest.

Now, let’s see the three ways your overseas investments are taxed and understand if it makes sense for you to continue investing in an India-based mutual fund.

1. Section 1291 Fund (Excessive distribution)

You are obligated to fill up Form 8621 to declare your PFIC investments. If you forget to do so, you are automatically slotted under this category. And the bad news is that this is the most regressive of the three options.

Even though you are only taxed when you exit your investment, the gains are allocated to each year you have held the investment or become a US person, whichever is later, and then taxed at the maximum rate for each of those years.

Section 1291 fund are subject to special rules when they receive an excess distribution (defined below) from, or recognize gain on the sale or disposition of the stock of, a section 1291 fund. A distribution may be partly or wholly an excess distribution. The entire amount of gain from the disposition of a section 1291 fund is treated as an excess distribution.

An excess distribution is the part of the distribution received from a section 1291 fund in the current tax year that is greater than 125% of the average distributions received in respect of such units held by the shareholder during the 3 preceding tax years. The excess distribution is determined on a per unit basis and is allocated to each day in the holding period of the units.

The following table sets forth the highest rate of tax in effect under section 1 (applicable to individuals) for calendar years 1987 through 2021.

Tax year(s) (based on calendar year taxpayer)	Highest rate of tax in effect under IRC section 1
2018–2021	37%
2013–2017	39.6%
2003–2012	35%
2002	38.6%
2001	39.1%
1993–2000	39.6%
1991–1992	31%
1988–1990	28%
1987	38.5%

To exacerbate matters, you are also charged interest and penalty for non-payment of tax in the years you held the investment.

For example, let’s say you bought some units of mutual funds at the start of 2013 and sold them at the end of 2022 for a $10,000 gain. In this case, the gains would be allocated to each of the 10 years you held the investment (i.e., $1,000 to each of the 10 years). Then, each of the $1,000 will be taxed at the maximum rate for each of the years and a penalty of 0.5 per cent for each month of delay, subject to a maximum of 25 per cent. You also need to pay an interest based on the federal short term rate plus 3 per cent. And guess what, the interest compounds daily.

2. QEF (Qualifying Election Fund)

This is a relatively better option, as its taxation system is closest to how Washington taxes its US-based mutual fund investors.

It is the only option that recognises your gains as capital gains. That’s good news because capital gains tax maxes out at 20 per cent, whereas ordinary income tax rate can go well above 30 per cent.

In other words, a mutual fund investor should choose this option in the first year of investment or get covered by these rules when you become a US person, whichever is later. If not, things can get more complicated.

That said, not all PFIC investments are eligible. The mutual fund you have invested in must comply with the IRS regulations.

A PFIC is a QEF if a U.S. person who is a direct or indirect shareholder of the PFIC elects (under section 1295(b)) to treat the PFIC as a QEF and complies with the requirements described in section 1295(a)(2)

3. Mark-to-Market (MTM) election

Here, the unrealised gains/losses are treated as ordinary income, not capital gains/losses. Say you made $1,000 on your Indian investment, this money would be added to your regular income and then get taxed. If you make a loss, you can adjust it with the gains you may have made in previous years.

Additionally, an Indo-US bilateral agreement provides further relief. There is no double taxation on the same gain. However, you will end up paying tax at a rate that is higher between the two countries.

Let’s understand with an example. The current long-term capital gains tax in India is 10 per cent, but if you fall in the 15 per cent bracket for long-term capital gains in the US, you will need to pay the 10 per cent tax in India and the remaining 5 per cent in the US.

Other Regulatory Requirements

Overview of Applicable Securities Laws: The most significant US federal securities laws covering the sale of shares/units of a fund in the United States are: (i) the US Securities Act of 1933, as amended (“Securities Act”); (ii) the US Investment Company Act of 1940, as amended (“Investment Company Act”); (iii) the US Investment Adviser Act of 1940, as amended (“Advisers Act”); (iv) the US Securities Exchange Act of 1934, as amended (“Exchange Act”); and (v) the US Commodity Exchange Act (“CEA”).

1) Securities Act: The Securities Act governs the offer and sale of securities (for example, shares/units of a UCITS or AIF) and generally requires the registration of securities with the SEC. Securities sold in an exempt or private offering, however, need not be registered with the SEC under the Securities Act. For example, Regulation S promulgated under the Securities Act provides a territorial exception to registration commonly used by funds to offer and sell units/shares through US professional fiduciaries.

Exceptions from the Securities Act: Section 5 of the Securities Act makes it illegal to offer or sell unregistered securities throughout the United States through any means of US interstate or international commerce unless the security or the transaction is exempt from registration with the SEC. Funds can typically rely upon Regulation S, Section 4(a)(2) and Regulation D of the Securities Act for transactions in their shares in order to avoid the registration provisions under the Securities Act.

Regulation S:

The SEC historically has taken the position that the registration requirements of the Securities Act do not apply to offers and sales of securities made abroad when the offers and sales are made with only incidental US contacts and are made in such a way as to reasonably preclude redistribution of the securities in the US. Regulation S represents an attempt by the SEC to clarify the extraterritorial application of the Securities Act. When offers and sales of securities are deemed to occur outside the US for purposes of the Securities Act, the shares/units of a fund will not be subject to registration under Section 5 of the Securities Act.

To clarify when offers and sales will occur outside of the United States for purposes of the Securities Act, Regulation S provides two non-exclusive “safe harbor” provisions in Rule 903 (issuer safe harbor) and Rule 904 (safe harbor for resales). If the offer and sale satisfy the conditions of either of the safe harbor provisions, such transaction will be deemed to have occurred outside of the US and outside the reach of Section 5.

[Rule 903 – the transaction is executed in, on or through a physical trading floor of an established foreign securities exchange that is located outside the United States & Rule 904 – the transaction is executed in, on or through the facilities of a designated offshore securities market described in paragraph (b) of this section, and neither the seller nor any person acting on its behalf knows that the transaction has been pre-arranged with a buyer in the United States.]

The Regulation S safe harbor is generally not available for direct sales to US persons

To comply with the Securities Act of 1933, the AIF must submit Form D to the SEC. As per the offering of Indian Rules and Regulations, Form D is an SEC filing form, which has been used to fill the notice of an exempt provision of securities under the Regulations D of the Securities and Exchange Commission of the US. Information on the fund and its securities offerings is provided using Form D.

Section 4(a)(2):

Section 4(a)(2) exempts from registration offers and sales by the issuer that do not involve a public offering or distribution.  These smaller, private offerings are often referred to as private placements.  The exemption of Section 4(a)(2) only applies to that particular offering and does not exempt the private placement securities from potential registration in the future, including in the event of resale.  An issuer is defined as any person who issues, or proposes to issue, a security.  The Securities Act does not define the term public offering but relevant case law and SEC rulings have introduced a number of factors that help determine if an offering should be considered public. To qualify for this exemption, which is sometimes referred to as the “private placement” exemption, the purchasers of the securities must:

• either have enough knowledge and experience in finance and business matters to be “sophisticated investors” (able to evaluate the risks and merits of the investment), or be able to bear the investment’s economic risk
• have access to the type of information normally provided in a prospectus for a registered securities offering and
• agree not to resell or distribute the securities to the public

In general, public advertising of the offering, and general solicitation of investors, is incompatible with the private placement exemption.

Regulation D: (https://www.sec.gov/oiea/investor-alerts-and-bulletins/private-placements-under-regulation-d-investor-bulletin)

Regulation D includes two SEC rules—Rules 504 and 506—that issuers often rely on to sell securities in unregistered offerings.  Most private placements are conducted pursuant to Rule 506. Each of these rules comes with its own different qualification requirements and restrictions with respect to the offer and sale by the issuer.

Accredited investor: Companies conducting an offering under Rule 506(b) can raise an unlimited amount of money and can sell securities to an unlimited number of accredited investors. An offering under Rule 506(b), however, is subject to the following requirements:

• no general solicitation or advertising to market the securities
• securities may not be sold to more than 35 non-accredited investors (all non-accredited investors, either alone or with a purchaser representative, must meet the legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment)

Non-accredited investors: If non-accredited investors are participating in the offering, the company conducting the offering:

• must give any non-accredited investors disclosure documents that generally contain the same type of information as provided in Regulation A offerings (the company is not required to provide specified disclosure documents to accredited investors, but, if it does provide information to accredited investors, it must also make this information available to the non-accredited investors as well)
• must give any non-accredited investors financial statement information specified in Rule 506 and
• should be available to answer questions from prospective purchasers who are non-accredited investors

Purchasers in a Rule 506(b) offering receive “restricted securities.” A company is required to file a notice with the Commission on Form D within 15 days after the first sale of securities in the offering. Although the Securities Act provides a federal preemption from state registration and qualification under Rule 506(b), the states still have authority to require notice filings and collect state fees.

Rule 506(b) offerings are subject to “bad actor” disqualification provisions.

Rule 504 permits certain issuers to offer and sell up to $10 million of securities in any 12-month period.  These securities may be sold to any number and type of investor, and the issuer is not subject to specific disclosure requirements.  Generally, securities issued under Rule 504 will be restricted securities (as further explained below), unless the offering meets certain additional requirements.  As a prospective investor, you should confirm with the issuer whether the securities being offered under this rule will be restricted, which will affect your ability to resell the securities.

2) Investment Company Act: The Investment Company Act generally requires the registration with the SEC of “investment companies” (generally any type of collective investment scheme, including a UCITS or AIF) that “publicly offers” shares in the US and regulates the activities of registered investment companies. Sections 3(c)(1) and 3(c)(7) of the Investment Company Act provide exemptions from the definition of “investment company” (and thus almost all of the requirements of the Investment Company Act).

3) Advisers Act: The Advisers Act generally provides that it is unlawful for any “investment adviser” to engage in the business of advising others without registering with the SEC, including advising funds with any US resident investors. Section 202(a) (11) of the Advisers Act defines the term investment adviser to mean: “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.” It is important to note the broadness of the definition, which covers both US and non-US investment advisers and applies to both discretionary and non-discretionary activities. The term investment adviser does not make a distinction between the commonly used terms “adviser”, “investment manager” or “management company” as is the case in many foreign jurisdictions.

4) Exchange Act: The Exchange Act (which also governs both the registration and the reporting of US “public” companies) regulates “brokerage activity” in the United States as well as reporting for certain funds that offer and sell shares to US residents.

5) Commodity Exchange Act (CEA): If a fund offers or sells its interests to US persons and it is permitted to invest in certain derivatives, the laws of the CEA are implicated and the rules and regulations of the CFTC may apply to the fund, its operator and its investment manager.

6) Other Laws: The sale of shares of a fund in the United States also raises potential issues relating to the ERISA and state securities law issues in the US states in which the beneficial owner of shares/units may be resident.

Conclusion: Navigating the implications of US investors on Indian AIFs requires a nuanced understanding of registration, exemptions, taxation, and regulatory requirements. Compliance with US laws, coupled with effective tax planning, is imperative for AIFs seeking to attract and retain US investors while ensuring regulatory adherence and minimizing tax liabilities. A comprehensive approach to addressing these implications is essential for fostering successful investment partnerships between Indian AIFs and US investors.