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Report submitted by Alternative Investment Policy Advisory Committee

1. To solicit the comments/views from public on suggestions pertaining to the report submitted by Alternative Investment Policy Advisory Committee.


2. SEBI had constituted a standing committee ‘Alternative Investment Policy Advisory Committee’ (AIPAC) under chairmanship of Shri. N. R. Narayan Murthy in March AIPAC has submitted its first report to SEBI with various recommendations stated therein.

Public Comments:

3. In order to take into consideration the views of various stakeholders, public comments are solicited on the said report as placed at Annexure. Comments may be emailed on or before February 10, 2016, to or sent by post, to:- Deputy General Manager

Division of Funds – I

Investment Management Department

Securities and Exchange Board of India

SEBI Bhavan

Plot No. C4-A, “G” Block,

Bandra Kurla Complex,

Bandra (East), Mumbai – 400 051

4. Comments/ suggestions may be provided in the format given below:

Name of entity / person / intermediary/ Organization
Sr. No. Clause No. Suggestions Rationale

Issued on: January 20, 2016

Introduction to the Report and Executive Summary

The Purpose of the Report

2.1.1. India’s economic environment is positive and is going through a period of accelerated growth and innovation. Long-term and stable risk capital is much needed for development to meet the demands of a large population in a competitive and modernizing world. Reforms to promote AIFs in these propitious conditions are well justified as they can significantly increase this steady source of long-term risk capital. With the rising demand for sizable amounts of capital to be invested in India, the AIF industry has a critical need to increase the pool of talented India-based Fund Managers with access to a better and larger deal flow i.e. a strong pipeline of investment opportunities in India.

2.1.2. Considering the developing nature of India’s AIF market, many advances in the regulatory framework are needed to promote the supply of risk capital in a prudent fashion. Accordingly, the Securities & Exchange Board of India (SEBI) established the Alternative Investment Policy Advisory Committee (AI PAC).

2.1.3. The purpose of the first AIPAC Report is to recommend wide-ranging reforms which India needs to institute in order to create a favourable climate for building a sound alternative investment eco-system in India. The Committee has worked with a solution – finding approach and has evolved recommendations that would help create: a favourable tax environment for investors; unlock domestic sources of venture capital and private equity and other funds for AIFs; enable and encourage onshore fund management in India; and reform the AIF Regulatory regime to facilitate and optimise investments by AIFs.

2.1.4. The Committee has taken cognizance of a range of stakeholders and has tried to evolve a ‘win-win’ solution. For the Government, this would result in robust direct and indirect tax collections, creation of more jobs, and acceleration of GDP growth. For SEBI, all alternative assets would come under its supervision; equity markets would be able to attract a greater supply of stable risk capital; and sound portfolio companies in a wide range of economic sectors and established and budding entrepreneurs will be able to attract equity capital to meet their start-up costs, capital expenditure and operating needs.

Fundamental Principles Underlying the Recommendations

2.1.5. The recommendations of the Committee are founded on core best practice principles as discussed below:

a. Ease of doing business is important

India needs to maintain the recent momentum to improve ease of doing business. Cumbersome regulations are hurdles on the start-up and growth of businesses in India as well as in the effective functioning of Alternative Investment Funds which provides much-needed long-term capital to enterprises. Ease of doing business creates a conducive business environment, reduces risk aversion and lowers the cost of doing business resulting in an increased inflow of capital to support new and existing businesses. Ease of doing business increases investor confidence enabling AIFs to provide stable risk capital to a larger universe of portfolio companies more effectively and in greater amounts. This leads to a robust platform, innovation in indigenous technologies, provides jobs, and generates revenue which could be ploughed back for growth and expansion. Nation-building through wealth and job creation in the economy, benefits society, being the end goal of simplifying business regulations.

b. Fund managers have the role of “Prudent Men”

Best practice for fund managers is to follow the Prudent Man rule (outlined below), and it is in the interest of the AIF industry to adhere to it. The Prudent Man Rule requires that each investment be judged on its own merit and provides the standard in accordance to which a fiduciary is expected to operate.

The Prudent Man Rule

The Prudent Man Rule first came into being in the seminal 1830 Massachusetts court formulation, Harvard College vs. Amory. The original rule stated that:

“A fiduciary must discharge his or her duties with the care, skill, prudence and diligence that a prudent person acting in a like capacity would use in the conduct of an enterprise of like character and aims.”

The rule was formally set forth in the Employee Retirement Income Security Act of 1974 (ERISA) in the US. Section 404 of the Act. The fiduciary standard is comprised of 5 separate standards, including

a) Duty of Loyalty: A fiduciary must discharge his duties solely in the interest of plan participants. Thus, the fiduciary must avoid conflicts of interest when managing plan assets

b) Exclusive Purpose Rule: A fiduciary must discharge his duties for the exclusive purpose of providing benefits or defraying reasonable expenses only. The plan must not pay excessive compensation to its investment and service providers.

c) Duty of Care: A fiduciary must discharge his duties with the “care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like chapter with like aims.” This standard of care is also known as the “prudent expert” standard

d) Duty to Diversify: A fiduciary must diversify the plan’s investments so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so

e) Duty of Obedience: A fiduciary must discharge his duties in accordance with the documents and instruments governing the plan insofar as they are consistent with governing laws.

Fund managers for AIFs in India are required to follow the guidelines set in the Prudent Man Rule, giving them an empowering framework; with the assumption that there will be serious consequences for non-compliance.

c. Adopt global best practices, and where necessary, innovate the “next” (best) practice

Alternative investment funds are still an evolving sector in the Indian financial services landscape. The recommendations in this report are based on the core principle of adopting global best practices and where required, innovating the ‘next’ best practice. These recommendations are framed with the view that every next practice created is not just a global gold standard, but is also innovative and based on careful thought and consideration. A few examples of ‘Next Practices’ from this report are:

  • Securities Transaction Tax (STT)- based taxation for listed equities,
  • tax pass-through for retail investors in mutual funds
  • the concept of accredited investors,
  • simplified investment manager framework,
  • tax efficient Employee Stock Option Plans (ESOPs), yet tax neutral,
  • recognition of new market participants such as Family Offices, amongst

India must attempt to develop the next best practice for the AIF industry.

d. Clarity, consistency, and certainty in tax policies

In countries where alternative investments have been immensely successful, a clear and consistent policy framework has been a significant enabler, and this includes a stable tax regime. These criteria clarity, certainty and consistency in policy impact the growth of the venture capital and private equity eco- system, and the funds’ ability to attract capital and provide efficient, tax- adjusted returns. For example, funds are pooling vehicles for their investors, and the universally applicable principle is of a single-level of taxation in the hands of investors, also known as limited partners (LPs). In a globalized world, where countries compete for capital, the success of alternative investments in the medium to long-term depends on India’s tax policy for alternative investments being globally competitive.

e. Harmonisation and consistency across different regulators

It is vital that the recommendations of the Committee are coherently co- ordinated and harmonized across different regulators such as the Reserve Bank of India (RBI), the Central Board of Direct Taxes (CBDT), the Ministry of Finance, the Ministry of Corporate Affairs and others. For AIFs to work seamlessly, they need to be treated equally and on par by all stakeholders and regulators.

f. AIFs should at least have parity with public market funds in tax policies

Investments in venture capital and private equity funds are risky, commonly illiquid, and relatively longer term in nature. Accordingly, venture capital and private equity funds should, at the very least, have a tax regime that is on par with that applicable to investors in public markets.

Summary of Recommendations

2.1.6. The four chapters that follow focus on the four forces that will drive the progress and contribution of the AIF industry.

I. Creating a Favourable Tax Environment

2.2.1. The tax recommendations are aimed at bringing about ease of doing business ensuring neutrality, clarity, consistency and certainty in the tax policy; helping increase the confidence of investors, fund managers and entrepreneurs; and establishing parity in tax policies between alternative investments and public market investments.

2.2.2. Once implemented, the recommendations will help attract significantly more capital from offshore and Indian investors into Indian private equity and venture capital, including SEBI-regulated Alternative Investment Funds.

i. Make Tax Pass-Through Work Effectively: The tax pass through system of taxation of AIFs ensures that investors do not pay more tax than they would, had they made the investments directly themselves. AIFs are simply vehicles that pool the savings of investors for professional fund management over a long-term period. Accordingly the pass-through method should be made to work flawlessly with simplicity. This requires the immediate implementation of the following:

a) The exempt income of AIFs should not suffer tax withholding of 10%.

b) Exempt investors should not suffer withholding tax of 10%.

c) nvestment gains of AIFs should be deemed to be ‘capital gains’ in

d) The tax rules applicable to ‘investment funds’ in Chapter XII-B of the Act should be extended to all categories of AIFs.

e) Losses incurred by AIFs should be available for set-off to their

f) Non-resident investors should be subject to rates in force in the respective Double Tax Avoidance Agreements.

ii. Eliminate Deemed Income: It is important to recognize the basic principle that investments made in portfolio companies are capital contributions and not the income of the portfolio company. Similarly, the income of an AIF arises only when it receives dividend or interest income during the holding period, or realises capital gains at the time of exit. In order to be consistent with these principles, AIFs and portfolio companies should be exempted from section 56(2)(viia) and 56(2) (viib), respectively, of the Income-tax Act, 1961 (the Act).

iii. Clarify Indirect Transfers: Overseas investors in India-centric fund vehicles should not be subject to the indirect transfer provisions of the IT Act when they transfer their investments in an India-centric vehicle to another investor. This provision creates a perverse incentive for investors to prefer investments in multi-country regional funds whose exposure to India is less than 50% rather than funds which invest the majority of their capital in India.

Since the objective is to attract more offshore investors in dedicated India-centric private equity and venture capital fund vehicles which invest all their investible capital in India, it is recommended that CBDT should clarify that investors in the holding companies or entities above Eligible Investment Funds (EIFs) investing in India, are not subject to the indirect transfer provisions.

iv. Make Safe-harbour Effective for Managing Funds from India: Currently most fund managers of offshore funds manage their investments from offshore locations rather than from India. This is a disadvantage to both them and India. The fund managers lose the benefit of being close to the Indian private equity and venture capital deal flow i.e. the pipeline of investible ventures. India loses the employment and tax revenue benefits of a large India-based fund management industry and larger related volumes of long-term and stable private equity and venture capital inflows.

In order to attract significant amounts of foreign capital by having fund managers based in India, it is important that their operations in India are not treated as permanent establishments under DTAAs. In order to provide them a safe-harbour, the Government has enacted section 9A of the Income Tax Act.

The feedback is that the provisions of s.9A are not sufficiently effective in providing a fool-proof safe harbour to onshore India-based managers of offshore private equity and venture capital funds. This report recommends changes in conditions in s.9A relating to: investor diversification, control or management of portfolio companies, tax residence, arm’s length remuneration of fund managers and annual reporting requirements.

v. Make Foreign Direct Investment in AIFs Work Efficiently: The Government’s policy to permit foreign direct investment in SEBI- registered AIFs is a welcome measure. To make this policy work effectively it is recommended that the Government clarify the rules for investment by non-resident Indian investors in AIFs on a non- repatriation basis; eliminate ambiguity to enable non-resident Indians (NRIs) to invest in AIFs using funds in their rupee NRO accounts; provide for Tax Deduction at Source on distribution of income to non- resident investors in AIFs in accordance with DTAA tax rates in force; grant permission to LLPs to act as sponsors and/or managers of AIFs; and the relaxation of Indian tax compliance obligations for non- resident investors in AIFs.

vi. Securities Transaction Tax (STT): This report recommends the introduction of STT for private equity and venture capital investments, including SEB I-registered AIFs and has parity with the taxation of investments in listed securities. Given the high risk and relatively illiquid and stable nature of private equity and venture capital, it needs to at least be treated at par with volatile, short-term public market investments for taxation.

We recommend the government adopt a roadmap for AIF taxation based on the STT framework. In the interim, the CBDT should immediately clarify that exempt income flowing through AIFs does not suffer any withholding tax and make the necessary amendments to make pass-through work effectively.

It is recommended that the Government Introduce STT at an appropriate rate on all distributions (gross) of AIFs, investment, short- term gains and other income and eliminate any withholding of tax. After STT, income from AIFs should be tax free to investors.

2.2.3. While all recommendations need to be implemented, the two critical reforms that would greatly advance and simplify the tax framework are: a) tweaking ‘Safe Harbour’ norms; and b) implementing the Securities Transaction Tax (STT) approach to taxation of investments and distributions by Indian AIFs.Next Practices: India should at least be the global best practice and advance further by introducing “NEXT PRACTICES”. Recommendations in this category are:

i. Deduction for investments in angel funds/ social venture funds;

ii. Allow management expenses for venture capital and private equity investments to be capitalized as ‘cost of improvement’;

iii. Taxation upon ‘sale’ and reduced taxation rates for unlisted shares acquired via ESOPs!employee incentive schemes;

iv. Clarify tax rate of 10% on long term capital gains to be applicable on transfer of shares of private limited companies ;

v. Taxation of convertible preference shares! debentures based on the holding period reckoned from the date of investment rather than the date of conversion;

vi. AIFs to be permissible investments of charitable and religious trusts ;

vii. Taxation on conversion! transfer of Global Depository Receipts issued against permitted securities (other than listed shares) ; and

viii. Service tax in respect of capital raised by an AIF from overseas investors. A clarification should be provided that investors in funds are the service recipients of the services provided by a fund manager! service provider.

The proposed amendments to the Income Tax Act have been included in this report wherever possible.

II. Unlocking Domestic Capital Pools

2.3.1. India has an urgent need to unlock domestic capital pools for investment as private equity and venture capital. This is due to factors such as:

i. Large Capital Needs: Given that India is large economy, it needs to invest sizeable volumes of long-term capital every year to help create jobs across the nation, build new infrastructure, and become innovative in addressing challenges while being globally competitive.

ii. Risk Aversion of Traditional Forms of Finance: In a rapidly growing economy that is encouraging entrepreneurship, and where start-ups, and medium and large enterprises have a rising need for risk capital across various stages – start up, growth, listing and recovery – traditional funding sources have a limited ability and are constrained by risk aversion.

iii. Public Capital Markets have limited funds and are volatile: A dynamic entrepreneurial eco-system requires strong and stable capital flows and substantial equity infusion. The public capital markets can only cater to a small part of this need and are subject to market volatility.

2.3.2. Fund Managers need access to capital both from domestic and foreign pools. Several important capital pools pensions, insurance, DFIs and banks, as well as pools of charitable institutions need appropriate risk-adjusted returns. AIFs provide their corpuses with significant returns when prudently managed in a favourable economic environment.

2.3.3. There is, therefore, a critical need to unlock other domestic pools of capital as identified in this report because such pools currently constitute only approximately 10 % of the total private equity and venture capital invested in India annually.

2.3.4. This chapter recommends wide-ranging reforms to help unlock diverse domestic sources, such as domestic pension funds, insurance companies, charitable endowments, banks, the concept of accredited investors and others which have the capacity to provide significant amounts of long-term risk capital.

III. Promoting Onshore Fund Management

2.4.1. An ideal tax and regulatory framework for AIFs should aim for India-focused funds pooled or domiciled in India and fund managers, who manage these funds to operate locally. This model of localizing funds and their management is followed by developed economies resulting in a thriving AIF industry.

2.4.2. Proactive measures need to be taken to attract fund managers to India due to the beneficial impact on the Indian economy and the creation of a robust eco-system to boost entrepreneurship, job creation and GDP growth.

2.4.3. This scenario is only possible if there is a level playing field between fund managers domiciled in India and those located offshore, which is clearly not the case in India currently. The policy framework needs to change, and the operational freedom of domestic AIFs needs to be enhanced.

2.4.4. The Committee has evolved a set of recommendations that would enable and encourage onshore fund management, and has taken cognizance of all stakeholders. The two vital reforms that would greatly help the cause are a) tweaking ‘Safe Harbour’ norms and b) implementing a Securities Transactions Tax (STT) approach to taxation on investments and distributions by Indian AIFs which has worked effectively for several years in the case of Foreign Portfolio Investors. In the interim it is recommended that the authorities should clarify, on an immediate basis, that exempt income flowing through AIFs should not suffer any withholding tax.

2.4.5. The modification of safe-harbour rules proposed in this report is a result of feedback that India has not reaped the benefits of the current safe-harbour rules. Accordingly, the industry has not gone down this route primarily on account of the existing tax law not being conducive.

2.4.6. These suggestions are transformative and would be hugely beneficial and should be implemented on a priority basis.

2.4.7. The chapter titled ‘Promoting Onshore Fund Management’ provides numerical examples of the tax impact of the withholding tax approach and the STT approach to illustrate the benefits of the latter. It shows that the withholding tax regime creates undue hardships and is inconsistent with the need for ease of business. On the other hand, the suggested STT regime will simplify taxation of AIFs.

2.4.8. Greater operational freedom for India-domiciled AIFs will attract more offshore capital into them. Such freedom requires a disclosure-based approach to regulation. In addition, there needs to be greater flexibility in the regulations such as for investing in offshore companies.

2.4.9. The chapter also shows that venture capital and private equity portfolio companies are major sustainable tax generators, not the venture capital and private equity funds in themselves.

IV. Reforming the AIF Regulatory Regime

2.5.1. In order to sustain the continued growth of the AIF industry, the path ahead requires reforms in the enabling regulatory framework for AIFs. While most regulatory efforts have rightly focused on protecting minority shareholder interests and improving compliance, there has been limited direct regulatory effort focused on the private equity and venture capital industry itself.

There have been considerable developments recently, for example the pass- through approach introduced in the Union Budget 2015 and the Reserve Bank of India’s AIF investment policy liberalising investments in AIFs. Sustained reforms in a few areas could further grow the industry. These include a current and rationalised approach, an awareness of merging boundaries of different pools, a consistent and simple framework harmonized across regulators, and a sharply defined clarity on investment boundaries.

The Committee’s recommendations cover:

i. Regulation of fund manager and not the fund

ii. Minor amendments to existing AIF regulations to include ‘growth’ in the definition of venture capital funds under Category I AIFs

iii. Classification of Category III AIFs

2.5.2. The report clearly indicates the road ahead through specific recommendations supported by underlying principles, best practices, and the much larger vision of economic growth which shapes and sustains the quality of human lives.

The Way Forward

Alternative Investment Funds bring significant benefits to the economy. If the regulatory issues are streamlined, AIFs can attract large capital flows to potentially reach a size of as much 2% of the GDP. The Committee believes that, as the way forward, it is vital for this report to be widely disseminated to key regulatory agencies for consideration and implementation, garnering support for the framework laid down by the Standing Committee.


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