It’s the Final Countdown Achievements by and Expectations of the AIF Industry

Morning Mumbai mist, hot coffee and the 1986 song ‘The Final Countdown’ by Europe is playing in the background – life seems blissful! And it was mostly so for the Alternative Investment Funds (AIFs) industry. As we begin the run-up to Budget 2018, we look back at the milestones crossed in 2017 and the goalposts set for 2018 – and we focus on the key hits, misses and asks of the AIF industry.

2017: Key Highlights 

  • Investment by Banks in Category II AIFs: The Reserve Bank of India (RBI) amended the Reserve Bank of India (Financial Services provided by Banks) Directions, 2016 permitting banks to invest in Category II AIFs up to a maximum cap of 10% corpus of such AIF. With Category II AIFs constituting nearly 50% of the total number of AIFs registered with the Securities and Exchange Board of India (SEBI), this amendment sets the roadmap for channeling domestic savings into productive alternate assets and, at the same time, provides banks with the ability to earn a risk-adjusted return, thereby boosting the overall Return on Equity for its stakeholders.

  • Exemption from pre-IPO lock-in for Category II AIFs: The SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (ICDR Regulations) provide that in case of a company going public (through an IPO), the entire pre-issue capital held by persons other than promoters (and exempt categories) is locked-in for a period of one year. Until recently, the exempt categories included only venture capital funds (domestic and offshore) and Category I AIFs. Mid-2017, SEBI extended the exemption to Category II AIFs as well. Thus, equity shares held by a Category II AIF are exempt from the aforesaid lock-in, provided that such equity shares were held for at least one year from the date of purchase by the Category II AIF.
  • Investment by AIFs in insurance companies: The Insurance Regulatory and Development Authority of India (IRDAI) issued the IRDAI (Investment by Private Equity Fund or Alternative Investment Fund in Indian Insurance Companies) Guidelines 2017 allowing PE funds and AIFs to invest in insurance companies subject to conditions stipulated in these guidelines.
  • Characterising the earnings of AIFs as capital gains: The Central Board of Direct Taxes (CBDT) clarified that gains on sale of shares by Category I and Category II AIFs would be characterised as capital gains thereby ushering in tax clarity and certainty about tax implications for investors in AIFs. This clarification will aid in reducing tax compliance cost (spent on defending aggressive and frivolous tax litigations with the tax department).
  • Indirect transfer – cascading impact nullified: CBDT issued a circular clarifying that gains on redemption or buyback earned by a non-resident investor through tiered offshore pooling vehicles pursuant to upstreaming of gains earned from the exit of a portfolio company shall not be subject to indirect transfer tax, provided that, the exit transaction has suffered tax in India. In essence, CBDT clarified that it is not the intention to tax the same income more than once (as it passes through the layers of offshore feeder funds/investment vehicles) if the exit transaction has duly suffered tax at the first level when the AIF sells the investment.

However, 2017 wasn’t all sugar and no spice! The AIF industry faced a few tremors too, with:

  • The fiscal year started with a couple of knock-out punches in the Finance Act, 2017 (i) a new anti-abuse provision introduced as Section 56(2)(x) of the Income-tax Act, 1961 (ITA), impacting not only AIFs but other private equity investors looking at distressed / stressed investment opportunities as well as other restructuring activities that were traditionally exempt under Section 47 of the ITA, and (ii) exemption under section 10(38) of the ITA for long term capital gains on sale of listed equity shares was amended leading to the exemption being available only if the purchase transaction had suffered securities transaction tax (STT). The extent of damage under (ii) was promptly arrested by a notification from CBDT, however, (i) continues to remain unaddressed.
  • Demonetisation disrupting working capital cycles of portfolio companies, thereby derailing business plan growth targets.
  • Corporate debt quota being capped, leading to the drying up of a source of funding for portfolio companies under the foreign portfolio investment (FPI) route.
  • A Goods and Services Tax (GST) cost for investors in AIFs spiking to 18% on gross basis and the General Anti-Avoidance Rules and the Place of Effective Management Guidelines becoming operational.
  • India filing its observations pursuant to and signing the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (BEPS) notifying all its tax treaties for application of the measures to prevent BEPS. The outcome of this will determine availability of treaty benefits to investors / feeder funds of AIFs.
  • 2017 wrapping up with the SEBI order in case of SREI Multiple Asset Investment Trust in which the SEBI adjudication officer imposed steep penalties for passive breaches of the SEBI (AIF) Regulations, 2012 (AIF Regulations).

2018: Key Expectations

  • MAT exemption and amendment to Section 56(2)(x): AIFs are emerging as vehicles of choice to bid for distressed / stressed assets. So, it is not a surprise that Private Equity funds and AIFs beamed with joy on the CBDT’s new year gift of proposed minimum alternate tax (MAT) exemption. It is said, however, that the devil lies in the details. Hence, the text of the Finance Bill is awaited eagerly to assess if the exemption comes with any hidden conditions. This amendment, along with the ask to reduce the rigours of Section 56(2)(x) of the ITA, would make it viable for bidders to scoop up assets at attractive prices in proceedings under the Insolvency and Bankruptcy Code and other restructuring initiatives.
  • Unit based taxation for Category III AIFs: Through a circular last year, CBDT clarified that a Category III AIF could achieve “pass through” status under regular trust taxation provisions of the ITA, if it is set up as a determinate and irrevocable trust. This clarification is only a partial reprieve for Category III AIFs as in the case of open-ended Category III AIFs, the tax inefficiencies continue. The Asset Under Management (AUM) for Category III AIFs has risen from Rs. 225 million in December 2012 to Rs. 226.565.8 million in September 2017. Hence, this industry is calling out for a little more attention. The ask is that Category III AIFs should be given similar tax treatment as mutual funds –viz. the fund is tax-exempt; the fund pays an income distribution tax on distributions to investors; and investors pay tax on sale of units based on the period of holding (long or short-term). Extending the mutual fund tax regime to Category III AIFs would be logical and lead to tax certainty for investors. Settling the dust on the tax regime for Category III AIFs will lead to the increased participation of domestic sophisticated investors, through an institutionalised platform, and create desired liquidity and depth in the stock markets.
  • Tax pass through for losses: Under the extant provisions of the ITA,  Category I and Category II AIF income is taxed in the hands of the investors as if the investment was made directly by them. However, losses incurred by such AIFs are not accorded the same treatment. In other words, income belongs to the investors but losses get trapped at the fund level. This dichotomy in treatment means that losses cannot be absorbed effectively, thereby leading to investors bearing a higher tax burden on an overall portfolio basis. The AIF industry is hopeful that this Finance Bill will remove this anomaly.
  • Capital gains tax: As of September 30, 2017, out of the total AUM of Rs. 1.16 billion across all AIFs, the AUM of Category II AIFs was Rs. 704,983.8 million, thereby making this the fastest growing and largest category under the AIF Regulations. The AIF industry has thus steadily attracted domestic savings and institutional investors by providing risk adjusted returns through portfolio diversification. Under the ITA, capital gains on sale of shares are taxed at varying rates ranging from zero percent to thirty percent depending on the period of holding and whether the shares are listed or unlisted. The expectation of Category II AIFs is that the long-term capital gains tax rate for unlisted securities be brought at par with the rate applicable to listed securities. By investing in unlisted securities, these AIFs are taking a greater risk as long-term value driven investors, which underpins the ask of not discriminating between the tax rate for listed and unlisted securities. On the other hand, the AIF industry is bracing itself for the Budget announcement due to the buzz that tax exemption for long term capital gains on sale of listed equity shares (which sale has suffered STT) may either be withdrawn or the period of holding for being characterised as long term capital gains may be increased to two years.
  • GST: Indirect tax generally follows the principle of territorial or destination-based taxation and hence most countries do not tax non-residents or offer a refund on such taxes suffered. Further, in order to encourage the fund management industry, typically the effective rate of value-added tax is kept low. The AIF industry, therefore, is seeking similar concessions. The ask from the industry is that if an AIF has pooled more than 50% of its corpus from offshore investors then, the government should either levy GST on fees charged by the manager and trustee with respect to such AIF at the rate of 5% or alternatively extend “export of services” treatment for such AIF thereby making the fees eligible for the zero rate of tax.
  • Other expectations: The Alternative Investment Policy Advisory Committee (AIPAC) formed by SEBI under the Chairmanship of Mr. Narayan Murthy released its third report on January 19, 2018. The industry is hopeful that the recommendations carried forward from the first two reports and additional recommendations from the third report find favour with the regulators and the Ministry of Finance.

All-in-all, 2018 appears to be a promising year for the AIF industry. Counting down the days to Budget 2018, the song continues in our minds:

We’re leaving together

But still it’s farewell

And maybe we’ll come back

To earth, who can tell?

I guess there is no one to blame

We’re leaving ground

Will things ever be the same again?

It’s the final countdown…