1 Legislative and regulatory framework
1.1 In broad terms, which legislative and regulatory provisions govern alternative investment funds in your jurisdiction?
Alternative investment funds (AIFs) are governed by the Securities and Exchange Board of India (SEBI) under the SEBI (Alternative Investment Funds) Regulations, 2012 (‘AIF Regulations'). Prior to 2012, AIFs were governed by the SEBI (Venture Capital Funds) Regulations, 1996, which have now been repealed.
Additionally, AIFs receiving foreign investment must comply with:
- the SEBI (Foreign Portfolio Investor) Regulations, 2019 (‘FPI Regulations);
- the Foreign Exchange Management Act, 1999; and
- the rules and regulations issued thereunder, including the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (‘FEMA Regulations').
1.2 Do any special regimes or provisions apply to specific types of alternative investment funds?
Under the AIF Regulations, an AIF can seek registration in either Category I, Category II or Category III.
Category I: The stated objective is to provide certain benefits to Category I AIFs, which include AIFs that invest in:
- start-ups or early-stage ventures;
- social ventures or small and medium-sized enterprises (SMEs);
- infrastructure; or
- such other sectors as the government considers are socially and/or economically desirable.
These AIFs are perceived to have a positive effect on the economy and the government often extends concessions or incentives to them. The following types of AIFs fall under Category I:
- venture capital funds;
- SME funds;
- social venture funds;
- infrastructure funds; and
- angel funds.
Category II: Category II AIFs are residual funds that do not fall within the definitions of Category I or Category III AIFs. The largest number of AIFs are registered under this category.
Category III: Category III AIFs are typically hedge funds or funds which trade with a view to making short-term returns. They employ complex or diverse trading strategies and may engage in leverage. This category also includes all open-ended AIFs – that is, AIFs that may not have a fixed term and that permit contributors to redeem their units.
At present, certain tax and regulatory concessions have been conferred on Category I and II AIFs.
1.3 Do the legislative and regulatory provisions governing alternative investment funds have extra-territorial reach?
The AIF Regulations contain specific provisions in relation to extra-territorial reach. However, in case of breach of the AIF Regulations and/or the FEMA Regulations, both SEBI and the Reserve Bank of India (RBI) have the powers to take action against the AIF, the manager of the AIF and the sponsor of the AIF, and their respective promoters. Hence, to this extent, SEBI and the RBI can pass necessary orders against non-Indian shareholders or promoters.
1.4 Are any bilateral, multilateral or supranational instruments in effect in your jurisdiction of relevance to alternative investment funds?
India is a party to several bilateral tax treaties and investment protection treaties to address double taxation of income, which have relevance in the case of cross-border fund structures and cross-border investments. For further details see question 1.6.
1.5 Which bodies are responsible for regulating alternative investment funds in your jurisdiction? What powers do they have?
The following bodies are responsible for regulating AIFs in India.
SEBI: SEBI is the securities market regulator and was established under the SEBI Act, 1992, in order to protect investors' interests in securities and develop and regulate the securities market. SEBI is the relevant regulatory body governing AIFs. SEBI has wide powers under the SEBI Act and AIF Regulations, including the power to conduct inspections, searches and seizures, to impose penalties and to issue other orders, such as an order barring errant persons from accessing the capital markets. Additionally, SEBI issues informal guidance or non-binding opinions on various queries on the interpretation of the AIF Regulations and related circulars.
RBI: The RBI is the central bank of India and was established under the RBI Act, 1949. One of the key powers of the RBI is the power to regulate foreign exchange through the FEMA Regulations. The FEMA Regulations prescribe the framework relating to:
- foreign exchange in-flows;
- downstream investments;
- additional conditions such as sectoral caps and pricing norms;
- repatriation of income and capital out of India; and
- reporting requirements.
The RBI is also the relevant authority under money laundering laws. In this regard, the RBI has imposed obligations on certain regulated entities to report suspicious transactions to the Financial Intelligence Unit – India), which was set up in 2004 to safeguard the financial system from economic offences.
1.6 To what extent do the regulators cooperate with their counterparts in other jurisdictions?
Data provided on the SEBI website (www.sebi.gov.in) confirms that SEBI has made efforts to team up with its counterparts in other countries to strengthen cross-border cooperation in the area of securities regulation. In this regard, SEBI has signed bilateral memoranda of understanding (MoUs) with various securities regulators to:
- enhance cooperation and exchange of information for regulatory and enforcement purposes;
- facilitate mutual assistance;
- contribute to the efficient performance of supervisory functions;
- assist in imparting technical domain knowledge; and
- enable effective enforcement of the laws and regulations governing the securities markets.
Specifically in relation to AIFs, SEBI has signed bilateral MoUs with securities market regulators of 27 member states of the European Union/European Economic Area concerning consultation, cooperation and the exchange of information relating to the supervision of managers of AIFs. A total of 27 bilateral MoUs were signed on 28 July 2014 with several countries, including France, Germany, Ireland, Italy, the Netherlands, Spain and the United Kingdom.
India is a member of the Financial Action Task Force (FATF) and the RBI – through the FATF – cooperates with other member nations in implementing necessary measures, reviewing money laundering and terrorist financing techniques and counter-measures, and promoting the adoption and implementation of appropriate measures globally.
India has also signed tax information exchange agreements with various countries, such as the Cayman Islands, enabling bilateral sharing of banking information and allowing officials of one country to undertake tax examinations in the other.
2 Form and structure
2.1 What types of alternative investment funds are typically found in your jurisdiction?
The types of AIFs typically found in India are detailed in question 1.2.
2.2 How are these alternative investment funds typically structured?
Under the AIF Regulations, an AIF can be structured in the form of a limited liability partnership, company, body corporate or trust. Typically, the trust is the preferred structure, due to ease of management and administration – in contrast to companies and limited liability partnerships (LLPs), which are subject to stringent and restrictive governance and compliance requirements under the Companies Act, 2013 and Limited Liability Partnership Act, 2008 respectively.
2.3 What are the advantages and disadvantages of these different types of structures?
Trusts: The advantages are as follows:
- They are easy to set up and wind up.
- They offer broad flexibility in relation to their commercial objectives.
- There are minimal statutory disclosure requirements, as compared to a company or LLP.
- Regulatory compliance under the Trusts Act is minimal compared to the LLP Act or the Companies Act, resulting in much lower costs of running the AIF.
The disadvantage is that they can be subject to tax at a maximum marginal rate if the trust is a discretionary trust or if the beneficial interest of the investors is indeterminate, as in the case of hedge funds.
LLPs: The advantages are as follows:
- They have a separate legal identity and perpetual succession.
- The liability of all partners is limited to the extent of their capital contribution.
- There are fewer compliance requirements compared to a company.
- There is no maximum limit on the number of partners, subject to the maximum limit of investors (1,000) under the AIF Regulations, and there is no need to engage a trustee for the AIF.
The disadvantages are as follows:
- The sponsor or manager of the AIF must be appointed as a designated partner and the designated partners have unlimited liability to ensure that the partnership complies with all applicable laws.
- In case of fraud against creditors of the LLP, the personal assets of the partners may also be attached to satisfy the claims of defrauded creditors.
- Certain onshore financial institutions cannot invest in an LLP, which limits the scope for raising capital.
- LLPs with foreign partners are subject to certain exchange control restrictions on investments in investee companies. In sectors where 100% foreign direct investment (FDI) is permitted under the automatic route and which have prescribed conditions such as minimum capitalisation, LLPs cannot bring FDI without prior governmental approval. Further, downstream investment by LLPs involves certain additional compliance requirements.
- The setting up and winding up of an LLP can take much longer compared to a trust.
Company: The advantages are as follows:
- It has a distinct legal identity and perpetual succession.
- The liability of the shareholders is limited to the extent of their investment.
- There is separation of ownership and management, as the management is vested in the board of directors of the company.
The disadvantages are as follows:
- There are more stringent compliance and reporting requirements.
- Additional compliance requirements result in higher costs.
- The company must abide by stricter accounting and auditing requirements.
- The setting up and winding up of a company can take much longer compared to a trust.
2.4 What are the most widely used alternative investment funds structures used in your jurisdiction?
In India, the most widely used AIF structure is the Category II AIF, as this provides broader flexibility for the manager to formulate the investment policy and objectives of the AIF.
2.5 Is there a preferred alternative fund structure for particular investment strategies (ie, hedge fund/private credit/private equity)?
Until the introduction of AIF Regulations in 2012, India did not have a specific regime that regulated domestic hedge funds. Since the commencement of the AIF Regulations, Category III registration has increased steadily. The preferred fund structures remain private equity and hedge funds. In recent times, due to growing interest in the lending space, the number of debt funds and funds focused on stressed/distressed opportunities has increased significantly.
2.6 Are alternative investment funds required to have a local administrator appointed?
The manager of an AIF is responsible for the day-to-day operations and management of the AIF. The manager must be an entity set up in India. Typically, managers are organised as either companies or LLPs. Also see question 4.9 on outsourcing of activities by managers.
2.7 Are alternative investment funds required to appoint a local custodian to hold assets? If yes, what legal protections are in place to protect the alternative investment fund's assets?
The AIF Regulations require the sponsor or manager of the AIF to appoint a custodian registered with the Securities and Exchange Board of India (SEBI) for safekeeping of securities if the corpus of the Category I or the Category II AIF is more than INR 5 billion. However, the sponsor or AIF manager of a Category III AIF is mandatorily required to appoint a custodian irrespective of the size of corpus of the AIF. Such custodian should keep custody of securities and, in the case of commodity derivatives, custody of the goods received in delivery against physical settlement of commodity derivatives.
2.8 Is it possible for an alternative investment fund to redomicile to your jurisdiction? If yes, what considerations are required and what are the steps involved?
No, there are no provisions for redomiciling funds into India. An AIF must be an entity set up in India (whether as a trust, company or limited liability partnership).
3.1 Must alternative investment funds be authorised or licensed in your jurisdiction?
Yes, as per the AIF Regulations, no entity or person shall act as an AIF without obtaining a certificate of registration from the Securities and Exchange Board of India (SEBI). In order to obtain this registration, the AIF must file the necessary declarations and the requisite application with SEBI.
3.2 If so, what criteria must be satisfied to obtain authorisation? Do any restrictions apply in this regard?
To obtain authorisation – that is, a certificate of registration – from SEBI, the applicant AIF must fulfil the eligibility criteria under the AIF Regulations. The constitutive documents (trust deed, partnership agreement or memorandum and articles of association, as per the chosen legal structure) of the applicant AIF should specifically permit it to carry on the activity of an AIF, and the applicant should be prohibited by its constitutive documents from making an invitation to the public to subscribe to its securities. Further, these constitutive documents should be duly registered under the applicable acts. For example, if the AIF is to be set up as a trust, the indenture of trust must be duly created under the Trusts Act and registered under the Registration Act, 1908.
- the applicant, its AIF manager and sponsor must fulfil the ‘fit and proper' criteria;
- either the AIF manager or the sponsor must have the necessary infrastructure and manpower to effectively discharge their obligations and duties towards the functioning of the applicant AIF; and
- the key investment team of the AIF manager of the applicant AIF should have adequate experience in advising or managing the pools of capital and possess the relevant professional qualifications as prescribed in the AIF Regulations.
3.3 What is the process for obtaining authorisation of alternative investment funds and how long does this usually take?
Once SEBI is satisfied that the applicant, AIF manager and sponsor fulfil the eligibility criteria, the applicant must make an application for grant of certificate under any of the categories specified in the AIF Regulations by filing Form A as specified in the First Schedule of the AIF Regulations. They must also simultaneously pay the non-refundable application and registration fees as specified in the Second Schedule of the AIF Regulations.
Typically, the entire registration process takes approximately two to three months at minimum. The fund documentation and AIF application usually takes two to three weeks; while vetting and approval of the application and the documentation by SEBI usually takes eight to 10 weeks.
4 Management and advisory relationships
4.1 How are alternative investment fund managers and advisers typically structured in your jurisdiction?
AIF managers and investment advisers are typically structured in one of the following forms:
- body corporate;
- private limited or public limited company (incorporated under the Companies Act, 1956 or the Companies Act 2013); or
- limited liability partnership (LLP) registered under the LLP Act.
AIF managers must seek approval from SEBI under the AIF Regulations. Further, investment advisers must seek registration under the SEBI (Investment Advisers) Regulations, 2013.
4.2 What are the advantages and disadvantages of these different types of structures?
AIF managers and investment advisers are generally structured taking into consideration tax benefits, compliance requirements and other commercial considerations. Please see question 2.3 for the advantages and disadvantages of various structures. Please see question 8.2 for tax considerations in relation to AIF managers and investment advisers.
From a compliance perspective, the LLP is the preferred structure. This is due to simplicity and flexibility in incorporation, management and governance, in comparison to a company.
4.3 Must alternative investment fund managers be authorised or licensed in your jurisdiction?
The SEBI (Investment Advisers) Regulations govern all forms of providers of investment advice; however, AIF managers are exempt from the requirement to seek registration under the regulations. This is due to the fact that SEBI has jurisdiction over AIF managers through the registration granted to an AIF under the AIF Regulations.
4.4 If so, what criteria must be satisfied to obtain authorisation? Do any restrictions apply in this regard?
In granting approval to an AIF, SEBI will consider the following factors in relation to the manager and the key investment team:
- The key investment team of the manager should have adequate experience, with at least one key member of personnel having a relevant professional qualification and not less than five years' experience in advising or managing pools of capital; in fund or asset or wealth or portfolio management; or in the business of buying, selling and dealing of securities.
- The manager should have the necessary infrastructure and manpower to effectively discharge its activities.
- The manager should make adequate disclosures in relation to any previous refusal of grant of any registration by SEBI for any entity established by the manager, or relevant details of any disciplinary history of the manager.
- The manager should comply with the ‘fit and proper' criteria as set out in the Securities and Exchange Board of India (Intermediaries) Regulations, 2008.
In order to meet the ‘fit and proper person' test, the manager and its principal officer, the director, the promoter and the key management persons must have the following characteristics:
- integrity, reputation and character;
- absence of convictions and restraint orders;
- competence, including financial solvency and net worth; and
- absence of categorisation as a wilful defaulter.
4.5 What is the process for obtaining authorisation and how long does this usually take?
As detailed in questions 4.3 and 4.4, there is no requirement for a manager to seek a separate registration/licence for managing AIFs other than approval from SEBI as part of the AIF application process. The process for obtaining authorisation typically takes approximately two to three months, as detailed in question 3.3.
4.6 What other requirements or restrictions apply to alternative investment fund managers and advisers in your jurisdiction?
The following are the key requirements set out in the AIF Regulations in relation to managers and under the SEBI (Investment Advisers) Regulations for investment advisers:
- Managers should solicit or collect funds for AIFs only by way of private placement.
- Managers should make disclosure of their investment in AIFs.
- Managers should appoint a custodian registered with SEBI for the safekeeping of securities as per the AIF Regulations.
- Managers should make disclosure of conflicts of interest to investors as and when these arise.
- Any signification change in the key investment team of the AIF manager should be intimated to all investors.
- The representatives of the investment adviser or the investment adviser providing investment advice should have the requisite qualifications as prescribed under the SEBI (Investment Advisers) Regulations.
- Investment advisers which are bodies corporate should have a net worth of not less than INR 25 million.
- Investment advisers shall not receive any consideration by way of remuneration or compensation, or in any other form, from any person other than the client being advised, in respect of the underlying products or securities for which advice is provided.
- Investment advisers shall maintain an arm's-length relationship between their activities as an investment adviser and other activities.
- Investment advisers shall not enter into transactions on their own account which are contrary to the advice given to clients for a period of 15 days from the date of such advice, except in accordance with the SEBI (Investment Advisers) Regulations.
- Investment advisers shall conduct risk assessments of all their clients and intimate to them details of their risk profile.
4.7 Can an alternative investment fund manager impose restrictions on the issue, redemption or transfer of interests in the funds under management?
Yes, an AIF manager can impose restrictions on the issue, redemption or transfer of interests in relation to the AIFs it manages. Such restrictions should be clearly disclosed in the private placement memorandum, as well as in the contribution agreement which is entered into with investors.
Redemptions are allowed only in the case of open-ended AIFs (ie, Category III AIFs). Managers must clearly disclose to investors in the placement memorandum the possibility that redemptions may be suspended in exceptional circumstances. The suspension of redemptions by the manager shall be justified only in exceptional circumstances, provided that such suspension is exclusively in the best interests of investors of the AIF or is required under the AIF Regulations or by the SEBI.
4.8 Are there any requirements regarding the ownership of alternative investment fund managers? If so, please provide details.
Yes. AIF managers set up as companies or LLPs must be incorporated in India. The manager can be either Indian owned and controlled or foreign owned or controlled. Further, the AIF Regulations stipulate that a minimum continuing interest must be held by the AIF manager or sponsor in the corpus of the AIF. In case of an AIF managed by a foreign owned or controlled manager, the AIF must additionally comply with the requirements set out in the Foreign Exchange Management (Non-debt Instruments) Rules with respect to its downstream investments.
Further, a Category III AIF which has received foreign investment can invest only in those securities or investments in which a foreign portfolio investor is permitted to invest under the Foreign Portfolio Investment Regulations.
4.9 Can alternative investment fund managers delegate to third-party investment managers or investment advisers? If yes, please provide details of any specific requirements.
Yes, subject to compliance with the Guidelines on Outsourcing of Activities by Intermediaries issued by SEBI. Managers cannot outsource their core business activities and compliance functions. Managers must comply with the principles for outsourcing framed by SEBI, as follows:
- The manager must adopt a comprehensive outsourcing policy;
- The manager must conduct due diligence and adopt a risk management programme to address the outsourced activities and the relationship with the third party; and
- The manager should ensure that outsourcing arrangements neither diminish its ability to fulfil its obligations to customers and regulators nor impede effective supervision by the regulators.
Outsourcing relationships must be governed by written contracts or agreements which clearly describe all material aspects, including the rights, responsibilities and expectations of the parties, client confidentiality issues and termination procedures.
4.10 Can alternative investment fund manager provide investment management services to clients other than alternative investment funds? If yes, do any additional requirements apply?
Yes, managers can provide investment management services to funds other than AIFs. Further, the manager can also provide portfolio management services to segregate mandate accounts by seeking registration under the SEBI (Portfolio Managers) Regulations, 1993 or to retail funds under the SEBI (Mutual Funds) Regulations, 1996. A manager that advises resident Indian clients must seek registration under the SEBI (Investment Advisers) Regulations. The manager must also disclose such associated relationships as potential conflicts of interest in the private placement memorandum.
Managers must fulfil the following additional requirements prescribed by SEBI:
- capital adequacy requirements, as prescribed under the respective regulations;
- segregation between the different business activities in terms of bank accounts, key investment teams and operation teams; and
- ownership interest in funds as per the prescribed regulations.
5.1 Is the marketing of alternative investment funds subject to authorisation in your jurisdiction?
There are no specific authorisation requirements under the AIF Regulations in this regard. Under the AIF Regulations, AIFs can be marketed only though private placement by issuance of an information memorandum. However, units of an AIF can be listed on stock exchanges only after final close of the AIF or its scheme, and subject to a minimum tradeable lot of INR 10 million. At present, no AIFs have listed their units on Indian stock exchanges.
5.2 If so, what criteria must be satisfied to obtain authorisation? Do any restrictions apply in this regard?
There are no specific authorisation requirements for marketing of an AIF; however, the AIF Regulations are evolving and the Securities and Exchange Board of India (SEBI) is seeking industry feedback on regulating the fees of brokers and placement agents of AIFs, as well as imposing a standardised private placement memorandum format for new AIFs and schemes. AIFs that are seeking to raise funds from offshore investors must comply with the placement requirements of the home jurisdictions of such investors.
5.3 What is the process for obtaining authorisation and how long does this usually take?
Currently, AIF units are distributed by banks and wealth managers, which charge a fee to connect prospective investors with managers. Distribution services are not specifically or separately regulated.
5.4 To whom can alternative investment funds be marketed?
AIFs can be privately placed and marketed to a limited number of sophisticated and/or private investors, including funds of funds, government institutions, corporates, public sector undertakings, private banks, insurance companies, eligible pension funds, global development financial institutions, multilateral organisations and high-net-worth individuals. Indian entities such as banks, insurance companies and pension funds are subject to the restrictions prescribed by their sectoral regulators with respect to investment in AIF units; hence their investments must comply with these regulations over and above compliance with the AIF Regulations.
5.5 What are the content criteria that marketing materials for alternative investment funds must satisfy?
The marketing materials for AIFs must satisfy the requirements as specified in the AIF Regulations. The private placement memorandum must contain all material information about the AIF and the AIF manager, including:
- the minimum commitment size;
- the background of the key investment team of the AIF manager;
- the target investors of the AIF;
- the fees and other expenses proposed to be charged by the AIF;
- the target size of the AIF;
- the tenure of the AIF (or of the specific scheme);
- conditions and limitations with respect to the redemption of AIF units;
- the investment objective and strategy;
- risk management tools and the parameters employed;
- key service providers;
- conflict of interest and procedures to identify and address the same;
- disciplinary history;
- the terms and conditions of the AIF manager;
- how the AIF or scheme will be wound up; and
- any other such information as may be required for the investor to make an informed decision on whether to invest in the AIF.
5.6 What other requirements or restrictions apply to marketing materials for alternative investment funds?
Operating an AIF is a regulated activity in India and an AIF must be registered with SEBI prior to commencing activities. Further, the AIF Regulations prescribe that the AIF cannot have more than 1,000 investors and each investor must make a minimum commitment of INR 10 million, or INR 2.5 million in the case of employees of the sponsor or AIF manager. The AIF Regulations also mandate that a disclosure must be made to the investors if there is any breach of the provisions of the private placement memorandum.
5.7 Can alternative fund managers from other jurisdictions market alternative investment funds in your jurisdiction without authorisation?
Offshore investment by resident Indians is subject to compliance with conditions stipulated under the Foreign Exchange Management (Non-debt Instruments) Rules, including compliance with the Liberalised Remittance Scheme issued by the Reserve Bank of India. The marketing of offshore funds in India must be undertaken carefully and registration of the offering document is mandatory if the offer qualifies as a public offering under Indian law.
5.8 Is the appointment of local marketing entities required in your jurisdiction?
Any person providing ‘investment advice' to resident Indians must seek registration under the Investment Adviser Regulations. Hence, appropriate advice must be sought before marketing offshore funds to Indian residents.
5.9 Is it possible to market alternative investment funds to retail investors in your jurisdiction? If so, are there specific requirements?
No, the AIF Regulations specifically bar the marketing of AIFs to the public or to retail investors. Only sophisticated investors can invest in an AIF, since each investor must make a minimum commitment of INR 10 million in an AIF.
6 Investment process
6.1 Do any investment or borrowing restrictions apply to the portfolios of alternative investment funds?
Yes, the AIF Regulations impose restrictions on both investment and borrowing of AIFs, according to their category of registration.
In terms of investment restrictions, a general diversification restriction is imposed whereby Category I and Category II AIFs can invest only the maximum of 25% of their ‘investible funds' in a single portfolio company; and Category III AIFs are further restricted investing a maximum of 10% of their investible funds in a single portfolio investment.
Further investment restrictions in terms of the constitution of the portfolio are detailed in the response to question 6.2.
In terms of borrowing restrictions, Category I and Category II AIFs are not permitted to borrow funds directly or indirectly, or to engage in any leverage except for meeting temporary funding requirements for not more than 30 days, on not more than four occasions per year and of not more than 10% of their investible funds.
6.2 Are there any specific legal or regulatory requirements regarding investments in particular assets?
Each category and sub-category of AIF under the AIF Regulations must maintain a particular composition of portfolio investments, as follows:
Category I AIFs:
- Venture capital funds:
- At least two-thirds of their investible funds must be invested in unlisted equity shares or equity-linked instruments of a venture capital undertaking or in companies listed or proposed to be listed on a small and medium-sized enterprise (SME) exchange; and
- Not more than one-third of their investible funds must be invested in:
- the initial public offering of a venture capital undertaking proposed to be listed;
- debt instruments of a venture capital undertaking;
- preferential allotment of equity or equity linked instruments of a listed company;
- equity or equity-linked instruments of a financially weak company – that is, a company whose accumulated losses had eroded more than 50% of its net worth as at the beginning of the previous financial year; or
- special purpose vehicles which are created by the fund for the purpose of facilitating investment in accordance with the AIF Regulations.
- SME funds: At least 75% of their investible funds must be invested in unlisted securities or partnership interests of venture capital undertakings or investee companies which are SMEs, or in companies listed on an SME exchange.
- Social venture funds: At least 75% of their investible funds must be invested in unlisted securities or partnership interests of social ventures.
- Infrastructure funds: At least 75% of their investible funds must be invested in unlisted securities or partnership interests of venture capital undertakings, or investee companies or special purpose vehicles which are engaged in or formed for the purpose of operating, developing or holding infrastructure projects.
Category II AIFs: At least 50% of their investible funds must be invested in unlisted investee companies.
Category III AIFs: No portfolio allocation restrictions apply, apart from the general diversification requirement captured above. This category of AIF is permitted to invest in listed or unlisted investee companies or derivatives or complex or structured products; and to deal in goods received in delivery against physical settlement of commodity derivatives.
Funds of funds: An AIF which invests in the units of other AIFs may be created under the AIF Regulations and categorised as a Category I, Category II or Category III AIF. Category I funds of funds are permitted to invest only in the units of Category I AIFs. Category II funds of funds are permitted to invest in the units of Category I and Category II AIFs. Category III funds of funds are permitted to invest in the units of Category I and Category II AIFs. No fund of funds AIFs are permitted to invest in other fund of funds AIFs.
7 Reporting, governance and risk management
7.1 What key disclosure requirements apply to alternative investment funds in your jurisdiction?
AIFs must ensure transparency and disclose the following information to investors:
- financial, risk management, operational, portfolio and transactional information regarding fund investments;
- any fees ascribed to the AIF manager or sponsor, and any fees charged to the AIF or any investee company by an associate of the AIF manager or sponsor;
- any inquiries/legal actions by legal or regulatory bodies in any jurisdiction, as and when they occur;
- any material liability arising during the AIF's tenure, as and when it arises;
- any breach of a provision of the placement memorandum or agreement made with the investor or any other fund documents, as and when it occurs; and
- any change in control of the sponsor, manager or investee company.
Any significant change in the key investment team must be intimated to all investors.
7.2 What key reporting requirements apply to alternative investment funds in your jurisdiction?
Category I and Category II AIFs must provide reports to investors at least on an annual basis, within 180 days of the year-end. Category III AIFs must provide quarterly reports to investors within 60 days of the end of the quarter. These reports must include the following information, as may be applicable to the specific AIF:
- financial information of investee companies; and
- details of material risks and how they are managed, which may include:
- concentration risk at fund level;
- foreign exchange risk at fund level;
- leverage risk at fund and investee company levels;
- realisation risk (ie, change in exit environment) at fund and investee company levels;
- strategy risk (ie, change in or divergence from business strategy) at investee company level;
- reputation risk at investee company level; and
- extra-financial risks, including environmental, social and corporate governance risks, at fund and investee company level.
7.3 What key governance requirements apply to alternative investment funds in your jurisdiction?
In terms of governance, the AIF Regulations impose a fiduciary duty on the manager and sponsor to act in the interests of the AIF's investors. All conflicts of interest must be mandatorily disclosed to all investors; and the AIF manager is mandated to establish and implement policies and procedures to identify, monitor and mitigate all conflicts of interest.
The AIF Regulations also oblige the manager to:
- address all investor complaints;
- provide any information sought by the Securities and Exchange Board of India (SEBI);
- maintain all records as specified by SEBI;
- take all steps to mitigate conflicts of interest; and
- ensure transparency and disclosure requirements as specified in the AIF Regulations.
The AIF Regulations are silent with regard to the establishment of investment committees and advisory boards. Hence, by market practice, this is left to the discretion of the manager.
7.4 What key risk management requirements apply to alternative investment funds in your jurisdiction?
As per the AIF Regulations, AIFs shall provide, when required by SEBI, information for systemic risk purposes (including the identification, analysis and mitigation of systemic risks).
There are also risk management requirements for Category III AIFs which employ leverage. These include:
- having a comprehensive risk management framework supported by an independent risk management function appropriate to the size, complexity and risk profile of the fund;
- having a strong and independent compliance function appropriate to the size, complexity and risk profile of the fund, supported by sound and controlled operations and infrastructure, adequate resources and checks and balances in operations;
- maintaining appropriate records of trades/transactions performed, which must be made available to SEBI on request; and
- ensuring full disclosure and transparency as regards conflicts of interests to investors (and to SEBI, on request), both in the placement memorandum and through correspondence as and when such conflicts arise.
8.1 How are alternative investment funds treated for tax purposes in your jurisdiction?
Category I and II AIFs: The Indian Income Tax Act, 1961 has accorded tax pass-through status to Category I and II AIFs incorporated in India as a trust, limited liability partnership, body corporate or company. With respect to its income (other than business income), this is taxed directly in the hands of the investors of the AIF, as if the investments had been made directly by such investors. Similarly, losses (other than business losses) are regarded as losses of the investors and may be carried forward and offset in future years. With respect to business income and business losses, there is no pass-through. Hence, business income is taxed at the AIF level at the maximum marginal rate. With regard to business losses, the AIF is allowed to carry forward and offset such losses in future years.
Category III AIFs: While Category I and II AIFs have been conferred with tax pass-through status, Category III AIFs are not afforded such tax relief under the Income Tax Act. Most Category III AIFs are organised as trusts under the Indian Trusts Act, 1882. Under the Income Tax Act, where the beneficiaries are identifiable with their shares being determinate (specific trusts), the trustee of the trust is taxed, as a ‘representative assessee', such taxes as would be recoverable only from the investors it represents, as if the income arose out of investments made directly by the investors. A determinate trust is where the names of the investors and their respective beneficial interests are known from the trust deed. In AIFs where the beneficiaries are indeterminate (eg, in case of open-ended funds), the income will be subject to tax at the maximum marginal rate.
8.2 How are alternative investment fund managers and advisers treated for tax purposes in your jurisdiction?
Managers and advisers are not governed by any separate tax regime and are taxed under the same provisions as apply to other resident entities. Generally, Indian fund managers and advisers are incorporated as companies or limited liability partnerships (LLPs).
Companies are taxed at a rate between 22% and 25%, subject to the satisfaction of certain conditions; a dividend distribution tax (DDT) of 15% also applies to dividends distributed to shareholders (both rates exclusive of surcharge and cess). The recipient shareholder is exempt from tax on such dividends received, subject to a certain cap.
An LLP must pay tax at the rate of 30% (plus applicable surcharge and cess), as against the lower corporate tax rate applicable to companies. However, the profits distributed by an LLP to its partners are taxed only in the hands of the LLP, as part of its income, and the partners of the LLP need not pay any additional tax on receipt of such profits. LLPs are also not subject to DDT or equivalent tax on profits upstreamed to their partners.
In certain cases where the tax liability of the company or the LLP is less than a prescribed limit, the company or LLP will be required to pay a minimum alternate tax at a rate of 18.5% (plus applicable surcharge and cess) of the book profit (to be computed in a specified manner).
8.3 How are alternative investment fund investors treated for tax purposes in your jurisdiction?
Please see question 8.1.
8.4 What effect do international laws such as the US Foreign Account Tax Compliance Act and international standards such as the Common Reporting Standard have in your jurisdiction?
India has incorporated into law, in its entirety, the internationally accepted reporting standard under the Common Reporting Standard (CRS), and has also signed an inter-governmental agreement with the United States for the implementation of Foreign Account Tax Compliance Act (FATCA) rules. To this end, an insertion was made in the Income Tax Rules, 1962, under which Indian tax officials must obtain specific account information from US ‘reportable accounts', as required under FATCA, as well as from banks and other financial institutions, as required under the CRS. India, being one of the early signatories to the CRS, committed to exchange information automatically by 2017. The government has also ratified the Multilateral Competent Authority Agreement for exchanging ‘country-by-country' reports on an international platform as per the stipulated timelines.
AIFs, which constitute registered financial institutions, must register with the US Internal Revenue Service and obtain a global intermediary identification number, and also register with the Indian income tax authorities for reporting. Whether an AIF is a reporting financial institution or a non-reporting financial institution, several factors come into play, including the status of investors (eg, resident or non-resident), the status of its manager and so on.
8.5 What preferred tax strategies are typically adopted in the alternative investment fund context?
With respect to cross-border funds, the typical strategy adopted is to set up the offshore pooling vehicle in a tax favourable jurisdiction which has better tax implications for capital gains (eg, the India-Netherlands tax treaty exempts certain kinds of capital gains from tax) or lower withholding tax (eg, on interest income – for example, the rate is 7.5% under the India-Mauritius tax treaty).
9 Trends and predictions
9.1 How would you describe the alternative investment fund landscape and prevailing trends in your
The past half-decade has seen an unprecedented rise in the number of registrations of AIFs in India. While the number of registered AIFs at the beginning of 2018 stood at a modest 366, registrations had soared to 637 as of January 2020. AIFs witnessed a 60% rise in capital growth in the past year alone. As of September 2019, AIFs had raised in total $21.7 billion – more than 11 times the $1.95 billion raised as of September 2015.
Another significant juncture in the funds landscape this decade was the setting up of India's first strategic investment fund: National Infrastructure and Investment Fund (NIIF), anchored 49% by the Indian government with over $3 billion of capital commitments, modelled on the AIF framework. In the short span of three years, NIIF has grown across three distinct strategies:
- strategic investments in infrastructure through platform joint ventures;
- the fund-of-funds vertical with a diverse footprint across management strategies; and
- opportunistic and structured investment through the third vertical.
Encouraged by the success of NIIF, the Indian government has also established two new funds:
- a fund providing last-mile funding to stalled affordable and middle-income housing projects, expected to start with assets under management (AUM) of INR 250 billion and the government funding 40% of the AUM; and
- a fund forming part of the government's five-prong strategy to resolve non-performing loans.
The Indian AIF industry has already attracted several large institutional investors across jurisdictions and sectors, such as Temasek, GIC, ADIA, QIA, KIA, KIC, CPPIB, AustralianSuper, CDPQ, CDC, IFC and ADB. It is expected to continue growing over the coming years.
9.2 Are any new legal or regulatory developments anticipated which will impact on alternative investment funds or alternative investment fund managers in your jurisdiction?
Given the rapid growth of the Indian AIF industry and the need to boost foreign investment through such structures, the Securities and Exchange Board of India (SEBI) has established an Alternative Investment Policy Advisory Committee (AIPAC) to make recommendations in this regard. With a focus on promoting the development of AIFs and the start-up ecosystem in India, and removing any hurdles that are hindering the progress of the AIF industry, AIPAC submitted its recommendations in three reports, the last of which was issued on 19 January 2018. The third report sets out AIPAC's recommendations on key issues, including:
- removing withholding tax for exempt investors and exempt streams of income;
- introducing an investor-level tax regime for AIFs while completely eliminating the AIF as a taxable entity;
- clarifying the indirect transfer taxes applicable at the time of transfer of foreign shares which derive substantial value from Indian assets;
- introducing the concept of an ‘accredited investor' in India; and
- dividing Category III AIFs into two sub-categories, to distinguish trading funds from non-trading funds.
Some recommendations made by AIPAC in its reports found favour with SEBI, other regulators and the Ministry of Finance, leading to amendments to the AIF Regulations and the IT Act.
SEBI has consistently followed its mandate to improve investor protection through:
- increased disclosure of information to unit holders;
- tight control over expenses and commissions chargeable to investors; and
- enhanced transparency in the activities of managers, to avoid conflicts of interest.
In line with its commitment to these objectives, SEBI has been overhauling several regulatory regimes. For instance, the new regulations governing portfolio managers preclude managers from charging their clients upfront fees and have doubled the minimum investment amount from clients to INR 5 million. SEBI has also introduced similar changes to the Mutual Fund Regulations in recent months, such as elimination of upfront commission. Further, SEBI has, through public consultation papers, indicated proposals that it wishes to introduce to the AIF regime and for investment advisers. If the proposals are effected, there could be a standard format for the AIF's placement memorandum, which would simplify AIF registration and make available a host of information that would otherwise be unavailable to prospective investors before committing to investing in an AIF. Further, it is proposed that the performance history of AIFs should be benchmarked, allowing investors to compare AIF performance against other AIFs. The proposals relating to investment advisers include:
- providing for client-level segregation of advisory and other services (eg, distribution) at a group level; and
- making mandatory the communication of standard terms and conditions of investment advisory services to the client prior to engagement.
All of these proposed amendments would have a wide-reaching impact on the AIF industry and lead to stronger oversight and supervision.
9.3 Do you envisage any particular industry strategy of attracting particular interest in the next 12 months?
Some industry strategies worth exploring include investing in the relatively new investment regimes such as infrastructure investment trusts (InvITs) and real estate investment trusts (REITs). The popularity of InvITs and REITs lies in their ability to provide stable yield and liquidity through fractional ownership of infrastructure and real estate assets. These vehicles have transformed the real estate and infrastructure market model from asset heavy to asset light, and have made the sectors conducive to easy entry and exit by not only institutional investors, but also retail investors. For tax purposes, InvITs and REITs are classified as ‘business trusts' and have been accorded a separate concessional tax regime, under which they are tax transparent –that is, they have pass-through status and income is chargeable to tax directly in the hands of unit holders, and not at the trust level. The concessional tax regime also exempts InvIT/REIT investee companies from dividend distribution tax which is otherwise payable by Indian companies at the time of distribution of dividends. InvIT and REIT investors are also subject to beneficial capital gains tax rates.
India has also operationalised its first international financial services centre, Gujarat International Finance Tec-City (GIFT), which has been ranked third in the latest edition of the Global Financial Centres Index. AIFs/pooling vehicles can now be set up in GIFT City and dependence on offshore holding jurisdictions – such as Singapore, Mauritius and the Cayman Islands – can be reduced. Various tax and regulatory concessions have been conferred on entities operating in GIFT City; only time will tell whether the funds industry will embrace GIFT City as the new normal for fund-raising jurisdictions.
Post the promulgation of the Insolvency and Bankruptcy Code, 2016 funds are devising new investment and structural strategies for acquiring stressed or distressed assets. Several strategic investors and global and local funds have bid for and acquired such assets through bilateral arrangements, public auctions and court processes (before the National Company Law Tribunal). The government's new fund to provide last-mile funding to stalled housing projects (see question 9.1) will be accorded priority over other creditors at the insolvency resolution proceedings.
10 Tips and traps
10.1 What are your top tips for the smooth establishment and management of an alternative investment fund in your jurisdiction, and what specific challenges would you note?
The key to smooth establishment of an AIF in India is to get the investment structure right from the start. Investment managers must engage in careful consideration of the target investors, their jurisdiction of residence, the target sectors and the instruments for deciding on the right structure and combination of vehicles. The structure must meet both the spirit and the letter of the regulations – although, as many of the regulations are fairly nascent, there is little direct jurisprudence or regulatory opinion on the matter.
Paying adequate attention to compliance, governance and reporting (to regulators and to investors) is another habit that investment managers must cultivate. Care must be taken not to switch between convenient or aggressive positions.
Attention must be paid to the contractual arrangements between the general partner and the limited partners, as well as between the AIF and investee companies, such that the scope of rights and obligations of each party is clearly delineated. This should mitigate, if not eliminate, the risk of disputes arising at the time of exit or winding up, and in turn should avoid value destruction at the portfolio level.
Flexibility must be retained in the documentation and structure so as to accommodate any future changes in the regulatory and tax regimes. Given that the regimes for pooling vehicles in India are at a fairly nascent stage, changes in law during the life of the fund may adversely affect the AIF.
Lastly, thus far, inadequate attention is being paid to the management team and the alignment of its interests with those of the fund and its investors. Limited partners have increasingly become wary of significant team churn, and hence diligence on the key investment team and contractual arrangements to tie the interests of the team with those of the AIF has become a crucial dialogue with general partners.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.