SEBI releases the report submitted by the Alternative Investment Policy Advisory Committee

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1 27 January 2016 EY Tax Alert SEBI releases the report submitted by the Alternative Investment Policy Advisory Committee Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. The Securities and Exchange Board of India (SEBI) constituted the Alternative Investment Policy Advisory Committee (Committee) as a standing committee under the chairmanship of Shri N.R. Narayana Murthy. The Committee has submitted its first report with various reform recommendations around four central areas viz taxation, development of domestic capital pools, attracting fund management onshore and the SEBI regulatory regime for Alternative Investment Funds (AIF). The thrust of the Committee s recommendations are furthering the development of the alternative investment and startup ecosystem in India, removing hurdles that hinder the development of the alternative investment industry and pointing out issues that need inter-regulator coordination to harness the industry s potential. SEBI has invited public comments on the report on or before 10 February This alert summarizes the key recommendations of the Committee s report.

2 Background In March 2015, the Securities and Exchange Board of India (SEBI) constituted the Alternative Investment Policy Advisory Committee' (Committee) as a standing committee under the chairmanship of Shri. N. R. Narayana Murthy 2 to advise SEBI in the following areas: a) further development of the alternative investment and start up eco-system in India; b) removal of hurdles that might hinder the development of the alternative investment industry; c) issues which need to be taken up with other regulators for the development of the alternative investment industry; and d) any other issue relevant to the alternative investment industry and development of the start-up eco-system in India. On 20 January 2016, the SEBI released the Committee s first report for public comments on or before 10 February Core best practice principles d) Clarity, consistency, and certainty in tax policies. e) Harmonisation and consistency across different regulators. f) AIFs should at least have parity with public market funds in tax policies. Recommendations The Committee s report focuses on four central areas. These include reforms in the fields of taxation, development of domestic capital pools in India, attracting overseas managers onshore in India and the categorization of AlFs in SEBI s regulatory regime. The principal recommendations made in each of the above areas is summarised below. 1 Creating a Favourable Tax Environment The tax recommendations aim at bringing about ease of doing business ensuring neutrality, clarity, consistency and certainty in the tax policy. These are as follows: a) Make tax pass-through work effectively The recommendations of the Committee are founded on the following core best practice principles: a) Ease of doing business. b) Fund managers have the role of Prudent Men. c) Adopt global best practices, and where necessary, innovate the next (best) practice. The tax pass through system for taxation of AIFs ensures that investors do not pay more tax than they would, had they made the investments directly themselves. The Committee recommends the immediate implementation of the following changes to the present tax rules that apply to AIFs: The exempt income of AIFs (eg dividend, long-term capital gains on transactions in equity shares chargeable to securities 2 Subramaniam Krishnan, Partner, Ernst & Young LLP is a co-opted member of two of sub-committees formed by the Committee (that dealt with taxation and reform of the SEBI s regulatory regime for AIFs.

3 transaction tax) should not suffer tax withholding of 10%. There is currently a requirement on AIFs to withhold tax at 10% on all income accruals/ distributions. Exempt investors in AIFs should not suffer withholding tax of 10%. Presently, there is no general exemption from withholding tax provisions available to investors who are otherwise tax exempt under the domestic tax law. Investment gains of AIFs should be deemed to be capital gains in nature. The determination of characterisation of gains realised by AIFs is subject to principles emanating from case law and historical instructions that may lead to litigation. The pass-through tax provisions should be extended to Category III AIFs. Pass-through tax provisions presently only apply to Category I and II AIFs. Category III AIFs do not have a specific tax code and hence are subject to domestic tax law based on the AIFs legal status (ie company, trust, etc). any financial year. Such losses are to be carried forward for set-off against future gains of the AIF in subsequent years, which in some scenarios could lead to the losses not being available to either the AIF or the investors. Non-resident investors should be subject to tax withholding at the final tax rate applicable to the type of income earned, based on domestic tax law or applicable Double Tax Avoidance Agreement (DTAA). There is currently a requirement on AIFs to withhold tax at 10% on all income accruals/ distributions to non-residents irrespective of the nonresidents final tax liability on such income. b) Eliminate tax on deemed income The Committee recognises that AIFs, being institutional investors, hold a fiduciary responsibility to invest in transactions on an arm s length basis and are subject to ongoing SEBI oversight and investor reporting obligations. Considering the above, the Committee recommends an exemption under sections Losses incurred by AIFs should be available for set-off to their investors. The tax law currently do not permit an AIF to allocate to their investors net losses incurred in

4 56(2)(viia) 3 and 56(2)(viib) 4 of the tax law where the investor is a SEBI registered AIF. c) Clarify indirect transfer provisions for offshore funds The provisions in the tax law dealing with indirect transfer of a capital asset situated in India as presently drafted attract Indian tax on offshore transfer of interest in India-centric funds between offshore investors. The Committee recognises that this provision creates a perverse incentive for investors to prefer investments in multicountry regional funds or global funds whose exposure to India is less than 50% rather than funds which invest the majority of their capital in India. In order to further the objective to attract offshore investors in dedicated India-centric private equity and venture capital fund vehicles which invest all their investible capital in India, the Committee recommends that the domestic tax law should clarify that investors in holding companies or entities above funds investing in India are not subject to the indirect transfer tax provisions. d) Make safe harbour provisions effective for managing funds from India The Committee recognises that in order to attract significant 3 Under this provision, a firm or closely held company could be taxed on the difference between the fair market value of shares received and the consideration paid. 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 India s DTAA. In this regard, the Committee points out that the provisions of section 9A introduced in the tax law in the Union Budget for the financial year are not sufficiently effective. The Committee recommends a number of changes and seeks clarifications in the various conditions in section 9A relating to investor diversification, control or management of portfolio companies, tax residence, arm s length remuneration of fund managers and annual reporting requirements. e) Make Foreign Direct Investment (FDI) in AIFs work efficiently The Government of India recently introduced a policy permitting FDI in SEBI registered AIFs. To make this policy work effectively, the Committee recommends that the Government: Clarify the rules for investment by nonresident Indian (NRIs) 4 Under this provision, a closely held company could be taxed on the difference between the consideration received for issue of shares and the fair market value of such shares.

5 investors in AIFs on a nonrepatriation basis. Eliminate ambiguity to enable NRIs to invest in AIFs using funds in their Indian Rupee NRO accounts. the investor level (ie investor in AIFs should be made tax free). g) Adopt global best practices and innovate global next practices The Committee makes the following recommendations in this section. Provide for tax withholding for non-residents at the final tax rate applicable to the type of income earned, based on domestic tax law or applicable DTAA. Grant permission to Limited Liability Partnerships to act as sponsors and/or managers of AIFs. Relax Indian tax compliance obligations for non-resident investors in AIFs, in cases where the necessary tax has already been withheld at source. f) Securities Transaction Tax (STT) Given the high risk and relatively illiquid and stable nature of private equity and venture capital, the Committee recommends that such investments need to at least be treated at par with volatile, shortterm public market investments for taxation. Consequently, the Committee recommends that the Government adopt a roadmap for the introduction of a STT based AIF taxation regime wherein STT at an appropriate rate is charged on all distributions (gross), investment, short term gains and other income with a consequential elimination of taxation (and withholding tax) at Deduction upto 50% for investments in SEBI registered angel/ venture capital funds with suitable safeguards. Introduction of the concept of accredited investor based on income criteria to define sophisticated investors under various regulations. Permit tax deduction for management expenses for venture capital and private equity investments. Taxation of unlisted shares acquired under stock option/ incentive schemes upon sale (as against at the point of exercising the option) and at capital gains tax rates. Clarify the tax rate of 10% on long term capital gains to be applicable on transfer of shares of private limited companies. Taxation of convertible preference shares/ debentures based on the holding period reckoned from the date of investment rather than the date of conversion. Further, provide an express exemption from taxation on conversion of preference shares into equity shares of a company.

6 Permit charitable and religious trusts to invest in AIFs. Introduce taxation provisions for conversion/ transfer of Global Depository Receipts (GDRs) issued against permitted securities (other than listed shares) along the lines of the existing tax provisions for GDRs issued by Indian listed companies. 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. 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. Provide a service tax exemption to service providers to AIFs by clarifying that investors in funds are service recipients of the services provided by a fund manager/ service providers to AIFs. 2 Unlocking domestic capital pool The Committee recognises that an insignificant percentage of equity capital required by start-ups, medium and large companies is funded from domestic sources in contrast to other economies. The Committee recommends wideranging reforms to help unlock diverse domestic sources, such as domestic pension funds, insurance companies, charitable and religious trusts, banks, LLPs, single family offices, NRIs, Foreign Venture Capital Investor, initial public offerings, angel investments, accredited investors and others which have the capacity to provide significant amounts of long-term risk capital. 3 Promoting onshore fund management The Committee observes that an ideal tax and regulatory framework for AIFs should aim for India-focused funds pooled or domiciled in India and fund The Committee recommends several reforms in this regard: Tweaking safe harbour tax provisions discussed in para 1d. STT approach discussed in para 1f. Providing operational freedom to domestic AIFs and AIF managers to provide them parity with offshore funds and fund managers. Abolition of withholding tax on AIF distributions or a substantial reduction in the rate of tax withholding. 4 Reforming the AIF regulatory regime In order to sustain the continued growth of the AIF industry, the Committee proposes significant reforms in the enabling regulatory framework for alternative investments. The Committee s recommendations are summarised below: a) Regulation of fund manager and not the fund. Consequently, introduce a new SEBI (Alternative Investment Fund Managers) Regulations and simultaneously repeal the

7 existing SEBI regulations for Portfolio Managers, Alternative Investment Funds, and Investment Advisers. A registered investment manager under the proposed AIFM Regulations can provide discretionary or nondiscretionary investment advisory/management services to investors who could be an individual/ a group of individuals or to funds whether open-ended/ close-ended or clients seeking customized products. Several consequential recommendations for the new regulatory framework have also been made. b) Minor amendments to existing AIF regulations have been proposed to include growth stage investments in the definition of venture capital funds under Category I AIFs. Comments The publication of the Committee s report inviting public comments represents the continuation of a commendable consultative approach adopted by SEBI. This provides an opportunity all stakeholders to provide their comments on any of the Committee s recommendations. The report clearly indicates the road ahead through specific recommendations supported by underlying principles, best practices, and the much larger vision of economic growth and sustainable development of the Indian economy. 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. Further, a separate classification Category III AIFs between levered and unlevered public marketsfocused funds has been proposed.

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