The Rubik’s Cube is a popular puzzle to solve. One of the strategies involved in the solution is to work on it, one section at a time. The evolution of the ‘safe harbour’ regime for fund managers in India, in a way, reflects a step-by-step progress to solve the proverbial Rubik’s Cube in the context of bringing the fund management industry into India, and extending the Make-in-India principle to this important service sector. While significant progress has been made in this respect, there are still some ‘pieces’ or ‘cubelets’ that require alignment.
The genesis
India has been the beneficiary of significant foreign inflows since economic liberalisation. According to DIPP statistics, India is estimated to have FDI of $288 billion and FPI of $187 billion as on March 31, 2016.
A substantial part of foreign inflows, especially FPI, would typically be managed by fund managers—who are domiciled either in jurisdictions where investors are located or where the investments are sought to be made. For investments into India, for a variety of reasons, offshore fund managers have shied away from domiciling themselves in India. It has been common for Indian investments to be managed by offshore fund managers from overseas.
Recently, offshore fund managers have expressed willingness to locate themselves “closer to the action on the ground” and in India. A back-of-the-envelope calculation suggests that even if fund managers managing only 25% of the current AUM relocate to India, and assuming a 1% management fee, this could translate into a potential asset management fee of about $467 million ($187 billion x 25% x 1%) being earned in India on an annual basis on the FPI piece alone. Apart from the positive impact from a forex perspective, this could broadly result in generation of annual income taxes of $140 million. The larger impact of having fund managers on the ground is the potential greater level of investments into India it could generate, and the consequential multi-fold positive impact on investee companies and the economy in general.
The pieces of the Rubik’s Cube to be addressed in locating fund managers in India are tabulated in a 2×2 ‘cube’.
The government has indicated its intent to facilitate such relocation and extend Make-in-India to the fund management community. The tax ‘safe harbour’ provisions for fund managers incorporated in the Indian income-tax code in 2015 was one of the actions in this direction. Sebi has also taken measures to facilitate such movement.
Tax aspects
Broadly, the safe harbour regime seeks to provide that locating the fund manager in India would not lead to any incremental income-tax risks for the offshore fund managed by such manager. This safe harbour is subject to compliance with a set of conditions by the offshore fund (13 in all, including around investor and investment diversification) and some other conditions by the onshore fund manager (four in all, including around regulatory oversight and compensation to the manager). Some of these conditions have been adapted from similar regimes in global asset management hubs.
After the safe harbour regime was introduced, various forums have highlighted the challenges with the regime. While revenue authorities have notified safe harbour rules clarifying and, in some cases, diluting the rigour of some more stringent conditions, there are yet conditions which could pose a challenge in taking the intent forward.
- Investment diversification rule, i.e. requiring the fund to acquire not more than 26% stake in an Indian investee company.
This may prove to be a show-stopper, particularly for private equity and venture capital funds that look at acquiring a significant minority interest in Indian investee companies. The way this condition operates is that the holding of interest beyond 26% deems the fund manager as “controlling and managing a business in India,” and such “control/management” results not being eligible for safe harbour. Logically, there is a difference in shareholding and management, which is followed with even more rigour in the investing world, and the former should not be used as a determinant of the latter. This condition was not present in the initial version of safe harbour provisions, and is one that may be done away with keeping in mind the above logic and the larger objective sought to be achieved.
- Investor diversification rules in terms of minimum of 25 “unconnected” investors with no investor holding more than 10% stake and the holding of top 10 investors not exceeding 50%.
The above conditions pose challenges for offshore funds that are privately distributed to select investors only, and to those who have what is referred to as “anchor” investors—marquee investors who typically land up having an interest beyond the above 10% limit. Given this industry norm, this condition may also be done away with. If there is reason to suspect that a private investor is seeking to misuse these provisions, this can always be sought to be countered through a mandatory pre-approval process.
- Monitoring participation of Indian residents in the fund, which should not exceed 5% of the total corpus of the fund.
Offshore funds are generally not available for subscription by Indian residents. This restriction is usually incorporated in the “offer document”. However, especially for FPIs that have a retail investor profile, given the ever-changing profile of investors, funds are finding it difficult to comply with ongoing monitoring of this condition. Since FPIs are, in any case, subject to investor disclosure requirements in their home jurisdiction and even by Sebi, this condition may be relaxed.
A positive developments has been the constitution of a pre-approval committee comprising senior tax officers, which can be approached for a pre-clearance of the structure/arrangement. This is a step in the right direction for providing certainty, which has been both a key ask of investors and a key intent of the government. Offshore funds may want to avail this opportunity to proactively discuss their challenges and seek a resolution thereof.
Regulatory aspects
There are Indian regulatory challenges as tabulated in the top-right corner of the ‘cube’.
Under Indian foreign exchange regulations, an offshore fund manager seeking to establish a wholly-owned subsidiary needs to capitalise the subsidiary with $50 million. This merits a review, especially since the relevant Sebi regime regulating such activities does not prescribe such a high capitalisation norm. A potential approach would be to align this norm with the one adopted by the industry regulator.
On its part, Sebi has released a draft of proposing certain amendments to the Sebi Portfolio Managers Regulations around compliance and other requirements on local managers undertaking fund management activity under the safe harbour regime, which is a facilitative step.
The last piece in the ‘cube’ that needs to be solved is an offshore regulatory issue. This may represent a limited challenge only for certain jurisdictions that have regulatory restrictions around who could be appointed as a fund manager to manage funds domiciled in those jurisdictions. There are jurisdictions which recognise and allow offshore fund managers that are regulated by certain overseas regulators to manage funds located in their jurisdictions. In specific jurisdictions where this does come up as an obstacle, one solution could be a dialogue between the regulators with a view to permitting Indian fund managers to be appointed as fund managers to funds domiciled in their jurisdiction.
Various policy-level initiatives are being undertaken to encourage setting-up of International Financial Services Centres (IFSC) in India. The alignment of interests between these two initiatives is apparent, and it would help the IFSC cause if the final creases in the safe harbour provisions are ironed out.
Given the government’s intent, it is quite likely a question of ‘when’ and not ‘if’ before Indian fund managers start managing offshore funds from India, and the economy starts reaping benefits of this progressive change. The Rubik’s Cube vis-a-vis ‘safe harbour’ regime for fund managers shall, hopefully, be solved sooner than later.
Gautam Mehra is leader, Nehal Sampat is executive director, Tax & Regulatory Services, PwC India. Views are personal.
