EY Tax Alert. Executive summary. CBDT notifies guidelines for onshore management of offshore funds. 17 March 2016

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1 17 March 2016 EY Tax Alert CBDT notifies guidelines for onshore management of offshore funds 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. In order to encourage fund management from India, the Finance Act, 2015 had introduced a new section 9A in the Income-tax Act, 1961 ( the Act ) to provide a safe harbour rule for onshore management of offshore funds. The said section provides that the fund management activity carried-out through an eligible fund manager in India by an eligible investment fund shall not constitute business connection in India of the fund and shall not lead to the residence of the fund in India. However, this safe harbour is subject to the fund and the fund manager satisfying various conditions. Pursuant to this, the Central Board of Direct Taxes ( CBDT ) has engaged in significant industry consultation and based on recommendations received from the various stakeholders, issued a notification on 15 March 2016 to provide guidance on the application of the conditions provided in section 9A of the Act (Safe Harbour Guidelines). Briefly, the Safe Harbour Guidelines provide (a) a mechanism for a fund to seek an pre-approval on application of the safe harbour to its specific fact pattern from the Indian Revenue Authorities (b) a look through mechanism to test the investor diversification condition (c) a framework for temporary non-compliance of some of the conditions (d) a rule to determine circumstances where a fund controls or manages a business carried out in India.

2 Background Historically, under the Indian tax laws, the presence of a fund manager in India could create a business connection or a permanent establishment for an offshore fund in India. Further, presence of a fund manager under certain circumstances may lead to the offshore fund being held to be resident in India. The constitution of business connection/ permanent establishment/ tax residence in India could result in adverse Indian tax consequences for the offshore fund. This discouraged offshore funds from shifting the fund management activity to India or appointing experienced fund managers. In order to encourage fund management from India, the Finance Act, 2015 introduced a new section 9A in the Act, to provide a safe harbour to offshore funds from the aforesaid tax consequences. The safe harbour is available subject to the fund and the fund manager satisfying various conditions provided in section 9A of the Act to qualify as an eligible investment fund and an eligible fund manager. The conditions prescribed in section 9A of the Act are onerous and require guidance for its application. As a result, several recommendations were made by various stakeholders to the Government of India and the CBDT for clarifying / relaxing several conditions in section 9A for availing the benefits. territory with which India has entered into a Double Tax Avoidance Agreement ( DTAA ) or Tax Information Exchange Agreement ( TIEA ) is relaxed to include fund established or incorporated or registered outside India in a notified country or a specified territory. The requirement that the fund shall not carry on or control and manage any business in India or from India is proposed to be applicable only to activities in India and not from India. While the aforesaid proposal of the FB 2016 addresses a couple of concerns, it was expected that the CBDT will issue a notification separately to provide guidelines on the application of section 9A of the Act. Safe Harbour Guidelines on application of section 9A The CBDT has now issued a notification dated 15 March 2016 amending the Income-tax Rules, by introducing the following: Rule 10V - Guidelines on application of various conditions of section 9A of the Act. Rule 10VA Mechanism to seek preapproval, at option of the fund. Rule 10VB Statement to be furnished by fund/ fund manager. The Government of India has also issued a press release on 16 March 2016 on the notification of the Safe Harbour Guidelines. In order to address some of the concerns of the stakeholders, the following proposals have been introduced in the Finance Bill, 2016 ( FB 2016 ) 1 The requirement that the fund should be a resident of a country or This tax alert summarises the application of the Safe Harbour Guidelines against the conditions prescribed under section 9A of the Act to qualify as an eligible investment fund and an eligible fund manager. 1 Released on 29 February The proposals will be effective subject to being approved by both houses of the Parliament and accorded assent by the President of India. 2 Income-tax (5 th Amendment) Rules, 2016.

3 Relevant clause of section 9A Safe Harbour Guidelines Conditions to qualify as an eligible investment fund a) The fund is not resident in India b) The fund is a resident of a country or a specified territory with whom India has entered into DTAA or a TIEA c) Participation/ investment by persons resident in India (directly or indirectly) in the fund, should not exceed 5% of the corpus of the fund However, the FB 2016 proposes to relax this condition by including a fund established or incorporated or registered outside India in a notified country or a specified territory. The guidelines provide that where the direct investor in the fund is a person other than a natural person, the fund shall undertake due diligence to ascertain the extent of indirect participation, if any, of a person resident in India. Further, where the direct investor in the fund is the Government or the Central Bank or a Sovereign Fund or a Multilateral Agency or an appropriately regulated investor 4 (in the form of pension fund or university fund or bank or collective investment vehicles such as mutual funds), the fund shall obtain a written declaration from the direct investor regarding participation by resident Indians. An extended time period has been given to a new fund as well a fund which is being wound up to comply with this condition (refer note below the table). d) The fund and its activities are subject to investor protection regulations in the home country e) The fund has a minimum of 25 members who are, directly or indirectly, not connected persons f) No member of the fund along with connected persons should have participation interest, directly or indirectly, of more than 10% in the fund g) Aggregate participation interest of 10 or less members (directly or indirectly), An extended time period has been given to a new fund as well fund which is being wound up to comply with this condition (refer note below the table). The guidelines provide that where the investor in the fund is an institutional entity, for the purpose of testing the condition relating to number of members (in clause e) and the participation interest (in clause f and g) a look through approach shall be adopted, provided that the institutional entity: - Independently satisfies the conditions in clauses c, e, f, and g of section 9A; 4 If it is regulated or supervised by the securities market regulator or the banking regulator of the country outside India of which it is a resident, in the same capacity in which it has made investment in the fund.

4 Relevant clause of section 9A along with their connected persons in the fund, should be less than 50% Safe Harbour Guidelines - Has been set up solely for pooling funds and investment thereof; and - Is a resident of a country with which India has a DTAA or TIEA. An extended time period has been given to a new fund as well a fund which is being wound up to comply with condition prescribed in clause (e) (refer note below the table). h) Investment by the fund in an entity should not exceed 20% of the corpus of the fund i) The fund shall not make any investment in its associate entity j) The monthly average of the corpus of the fund shall not be less than INR 1 billion k) The fund shall not carry on or control and manage, (directly or indirectly), any business in India or from India The Act already provides relaxation for a newly set-up fund. The FB 2016 proposes the deletion of the words from India in this clause that would permit funds that otherwise control and manager or carry on business outside India. The guidelines provide that a fund shall be said to be controlling or managing a business carried out by any entity, if the fund directly or indirectly holds 26% of voting rights. l) the fund is neither engaged in any activity which constitutes a business connection in India nor has any person acting on its behalf whose activities constitute a business connection in India other than the activities undertaken by the eligible fund manager on its behalf; m) The remuneration paid by the fund to an eligible fund manager in respect of fund management activity should not be less than the arm's length price The guidelines provide that for determining the arm s length price of the remuneration, the provisions of the Act shall apply as if the transaction between the fund and the fund manager is an international transaction and the fund and the fund manager are Associated Enterprises. Additionally, the fund manager shall be required to maintain transfer pricing documentation and also file a report in Form 3CEJ (newly prescribed). Where the remuneration paid or payable by a fund to the fund manager is not at arm s length, then the benefits of section 9A of the Act shall not be denied, unless the remuneration has been determined to be not

5 Relevant clause of section 9A Safe Harbour Guidelines at arm s length for a period of 3 successive years or any 3 out of 4 previous years. a) The fund manager should not be an employee of the eligible investment fund or a connected person of the fund b) The person should be registered as a fund manager or investment advisor in accordance with specified regulations c) The person should act in the ordinary course of his business as a fund manager d) The person along with its connected persons should not be entitled to more than 20% of the profits accruing or arising to the eligible investment fund from the transactions carried out by the fund through such fund manager Conditions for eligible fund manager Reporting requirement for eligible investment fund Every eligible investment fund shall furnish a statement containing information in connection with fulfilment of the conditions in a prescribed manner within 90 days from the end of the financial year, The guidelines provide that the fund shall furnish the statement in a newly prescribed form i.e. Form No. 3CEK. The benefits of section 9A of the Act shall not be denied to a fund provided the delay in furnishing the statement in Form No. 3CEK does not exceed a period of 90 days from the prescribed due date. Note A fund shall not be denied the benefit of being an eligible investment fund on non-fulfilment of any of the conditions specified in clauses (c), (d) and (e), if the non-fulfilment - (i) (ii) is for the reasons beyond the control of the fund and does not exceed 90 days. does not exceed 18 months beginning from the date of setup of the fund or is not beyond the final closing of the fund, whichever is earlier, and bona fide efforts are made to satisfy the conditions. (iii) is for the reason that the fund is in the process of being wound up which does not exceed a year beginning from the date on which the process of winding has begun. Pre-approval Mechanism In order to provide certainty on eligibility of a fund to claim the benefit of section 9A of the Act, for term of the fund, the guidelines provides a mechanism wherein a fund at its option can seek an approval of the CBDT. The salient features of the preapproval mechanism have been summarised below: The fund seeking approval may make an application in writing (enclosing the relevant details) to Member (Income-tax), Department of Revenue, Ministry of Finance. The application has to be made 3 months before the beginning of the previous year for which the fund seeks the approval.

6 A committee (to be headed by a Principal Chief Commissioner or Chief Commissioner and consisting of two other income-tax authorities not below the rank of Commissioner) as notified by the CBDT shall examine the application. The committee may, before giving its recommendation, call for such documents or information from the fund as it may consider necessary. Pursuant to this, the Committee shall submit its recommendations regarding grant of approval or otherwise and the conditions subject to which an approval is to be granted. Based on the recommendations of the committee, the CBDT shall within 60 days from the end of the month in which the application is made, either grant an approval to the fund or reject the application (after providing an opportunity of being heard). The approval granted by the CBDT shall be applicable for the relevant previous year and subsequent years unless withdrawn. Further, it has been provided that CBDT may withdraw the approval granted (after giving an opportunity of being heard) to any fund on being satisfied that: the approval has been obtained by misrepresenting the facts or fraud; or the conditions mentioned in section 9A are not fulfilled; or any condition subject to which approval was granted, has been violated. Comments The Safe Harbour Guidelines are a welcome move and will help in addressing the concerns raised by the fund industry, especially, relating to investor diversification and certainty in eligibility of the fund to avail benefits of section 9A of the Act for the entire term of the fund by seeking a pre-approval. By providing that temporary noncompliance in certain cases shall not impact the fund s eligibility to avail benefits of section 9A of the Act, the Government has demonstrated its willingness to provide some relaxation on the conditions so as to make this initiative work effectively. However, the requirement for the fund manager to maintain transfer pricing documentation and file a report in Form 3CEJ, even when the fund manager and the fund are not Associated Enterprises as defined under the Act, results in additional compliance for the fund to avail this benefit. While the guidelines provide clarity on some of the onerous conditions of section 9A of the Act, aspects such as the investment diversification condition, investment in associated entity and not including asset managers of mutual fund as eligible fund managers, may continue to pose challenges for fund managers to consider relocating their fund management activity to India.

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