Taxation provisions of off-shore funds managed by indian managers
Many of the overseas India focused funds typically have a structure where the investment manager is based outside India and is supported by an investment adviser based in India. These overseas funds generally invest in India under one of the three routes, i.e. foreign portfolio investment (FPI), foreign direct investment (FDI) or the foreign venture capital investor (FVCI).
Though these funds may be managed overseas, in some cases, the activities of the investment adviser may be construed by the Indian revenue authorities as constituting a business connection or a permanent establishment of such fund or the investment manager in India.
The overseas fund may also be treated as a resident of India on account of the place of effective management being in India based on the activities of the investment adviser. This may result in a situation wherein the offshore fund’s income from investments made in countries outside India (if any) could be subject to tax in India.
Further, it may also lead to denial of applicable tax treaty benefits to the overseas fund or investment manager based outside India.
In order to encourage the fund management activities of the offshore funds from India, a safe harbour regime for onshore management of offshore funds was introduced vide the Finance Act, 2015. The safe harbour regime, introduced by way of insertion of section 9A in the Income-tax Act, 1961 (the Act), provided that the presence of a fund manager/an investment adviser in India would not constitute business connection, permanent establishment or a tax residence for the offshore funds in India, subject to fulfilment of the prescribed conditions.
Among others, the key conditions to be satisfied by the fund, referred as eligible investment fund (EIF), includes that the fund should be from a country with which India has a tax treaty or from a specified territory, that the fund should have certain minimum number of investors, maintain an average corpus of `100 crore, should not carry or control and manage, directly or indirectly any business in India, etc. Additionally, the law requires the Indian investment manager (referred as eligible fund manager) to be either a portfolio manager or an investment advisor or mutual fund advisor registered under the Securities and Exchange Board of India regulations.
Further, the Indian investment manager should not be a ‘connected person’ with the eligible investment fund. For the effective implementation of the said provisions, suitable guidelines and compliance procedures have been prescribed under Income Tax rules, 1962 (Rules).
While these provisions are well intentioned, there are various conditions in the fine print which are quite onerous to comply with for the overseas funds. One such condition is the requirement that the aggregate participation of 10 or less number of members in a fund should be less than 50% of the aggregate corpus of the fund, thereby restricting the ability of the fund sponsor/ anchor investor to have a greater participation.
Also, the minimum investor requirement of 25 members in the fund restricts the benefit primarily to managers of open ended funds. Accordingly, private equity (PE) funds and venture capital funds are unlikely to benefit from such provisions. Further, the requirement to not invest more than 20% of corpus in one entity and the restriction on ‘controlling’ businesses in India, makes it difficult for buy-out/growth funds to benefit from these beneficial provisions under the Act since such funds typically take a controlling stake and management rights in the portfolio companies.
Additionally, it is not customary in the industry to engage a third party/professional fund managers on a consultancy / independent basis, for reasons of risk and confidentiality, particularly in a private equity/venture capital fund context. Accordingly, the requirement of the eligible fund manager to be independent to the eligible investment fund, while desirable, may be difficult to fulfill.
With regards to payment of minimum remuneration to be paid by eligible investment fund to eligible fund manager, the Central Board of Direct Taxes (CBDT) has recently issued a draft notification inviting comments on the manner for calculation of such a remuneration. The draft notification provides that in case of certain regulated funds registered as Category I FPI, the remuneration is to be calculated basis a fixed percentage of the assets under management.
In case of other funds, the draft guidelines propose providing three options which includes a fixed percentage either of the assets under management, or profit derived by the Eligible Investment Fund in excess of the hurdle rate, or the management fee (fixed or linked to the profits derived the Eligible Investment Fund). Once this is implemented, it is expected to take away the ambiguity surrounding the method to be used for determining the arm’s length remuneration to be paid by the eligible investment fund to the eligible fund manager.
In relation to the other concerns as discussed above, there are expectations that the government in the coming years may consider liberating or granting more flexibility in order to attract fund management activities of offshore funds from India.
Considering the above, it is imperative that offshore investors should evaluate their options and take an informed decision on this subject as stakes involved are high and their focus should be on growing the business and not worry about tax and regulatory issues and ensuing litigation, which can best be avoided with thorough and careful planning.
Amit Kedia and Mitesh Mehta contributed to this article.
Vikas Vasal is national leader tax at Grant Thornton India LLP.
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