Globally, financial centres are locations with an agglomeration of participants in banking, asset management, insurance and financial markets with venues and supporting services for these activities. The world has witnessed the transformation of New York, London, Singapore, Hong Kong and Tokyo as 'Global Financial Centres'. Recently, there has been a spurt of newer financial centres in Dubai, Malaysia, Kazakhstan and few other countries.

The Government of India (‘GoI’) operationalized India’s first International Financial Services Centre (IFSC) in Gujarat at GIFT City in April 2015. With the launch of the IFSC at GIFT City, the GoI had taken the first step to bring financial services transactions which are relatable to India, back to India. Approved by Government of India as an IFSC at GIFT City, the IFSC reinforces India’s strategic position as a global hub for financial services. IFSC at GIFT provides an unprecedented opportunity to global investors to set up businesses in the areas of banking, investments, insurance and reinsurance, capital market and asset management. 

While enough has been said about the benefits of setting up units in IFSC, this article talks about the benefits of setting up an Alternative Investment Fund (AIF) in particular and how IFSC AIF would differ from a non-IFSC AIF from a regulatory standpoint.

Background of AIFs

In 2012, SEBI took steps to completely overhaul the regulatory framework for domestic funds in India and introduced the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”). Among the main reasons cited by SEBI to highlight its rationale behind introducing the AIF regulations was to recognize AIFs as a distinct asset class; promote startups and early-stage companies; to permit investment strategies in the secondary markets; and to tie concessions and incentives to investment restrictions. SEBI has defined 3 categories of AIFs along with investment conditions and restrictions for each of them.

Before the emergence of the Venture Capital – Private Equity (“VCPE”) industry in India, entrepreneurs primarily depended on private placements, public offerings and lending by financial institutions for raising capital. However, given the considerations involved, these were not always the optimal means of raising funds.

Currently, there are more than 600 AIFs registered with the SEBI. As on 31 December 2019, as per the data published by SEBI, the total capital commitment of these AIFs is US$ 49.69 billion out of which the fund raised from investors is US$ 24.53 billion and the amount of investments made is US$ 20.30 billion. These facts clearly demonstrate the potential of AIFs as a pooling vehicle in India.

Considering the success of the AIF regime in domestic market and a with a view to encourage fund regime in IFSC, in 2015, the SEBI had issued detailed guidelines to facilitate and regulate the securities market in India’s first IFSC at GIFT City.

Key differences in IFSC AIFs vs AIF regulations in India

1.    Single Window Clearance 

The Regulatory powers of 4 regulators (RBI, SEBI, IRDA and PFRDAI) are vested in IFSCA which ensure a smooth and single window approval for setting up in IFSC.

2.    Leverage

The SEBI AIF regulations restrict category I and Category II AIFs from borrowing or engaging in any leverage. The only excepting is to meet temporary funding requirements upto 30 days, on not more than 4 occasions in a year and subject to a maximum of 10% of investible funds. Category II AIFs are permitted to engage in leverage subject to consent from investors of the fund, upto a maximum limit not exceeding 2 times of the Net Asset Value.

However, these restrictions do not apply to IFSC AIFs. They are permitted to take leverage subject to-

•  The maximum leverage by the IFSC AIF, along with the methodology for calculation of leverage, shall be disclosed in the placement memorandum
• The leverage shall be exercised subject to consent of the investors
• The IFSC AIF employing leverage shall have a comprehensive risk management framework appropriate to the size, complexity and risk profile of the fund.

3.    Co-investments

The regulatory framework for AIFs is such that monies from all investors is pooled in the AIF and all the investors generally participate in deals on basis of their pro-rata share in the AIF. The AIF is not permitted to allow investors to increase their allocation to a particular deal on a standalone basis.

However, IFSC AIFs are permitted to co-invest in portfolio company through a segregated portfolio by issuing a separate class of units and such that the investments by such segregated portfolios shall, in no circumstance, be on terms more favourable than those offered to the common portfolio of the AIF; and appropriate disclosures have been made in the placement memorandum regarding creation of such segregated portfolio. This will simplify deal structuring and provide flexibility to AIFs and investors to allocate more capital to lucrative opportunities.

4.    Diversification Norms

As per SEBI Regulations, category I and II AIFs cannot invest more than 25% on the investable funds in any one investee company. For Category III AIFs, this is capped at 10%. However, for IFSC AIFs, these limits do not apply provided appropriate disclosures have been made in the placement memorandum and the investments by AIFs are in line with the risk appetite of the investors.

It is common for offshore funds to be set up for investment in a few targeted companies or sectors. Therefore, ensuring that these limits do not apply to IFSC AIFs would go a long way in establishing IFSC among the global financial centers like Singapore and Mauritius.

5.    Deployment of Funds

IFSC AIFs have 5 investment avenues to deploy funds-

• Securities listed in IFSC; 
• Securities issued by companies incorporated in IFSC; 
• Securities issued by companies incorporated in India or foreign jurisdiction 
• Units of an AIF 
• Securities which a domestic AIF is permitted to invest in. 

For investments in India, FPI/ FDI/ FVCI limits would apply. However, existing conditions on outbound investments by AIFs do not apply to IFSC AIFs i.e., no SEBI approval required for investments outside India.

Tax Framework

Category I & II AIFs

Category I and Category II AIFs have tax pass-through status for Indian income-tax purposes (except for business income, which is taxable in the hands of the AIF for which 100% tax holiday can be claimed for a period of 10 consecutive years out of a block of first 15 years). Investors are taxed on income arising from investments made by the AIF as if the investments were made directly by them.

Income accruing or arising or received by non-resident investors from offshore investments through a Category I and II AIF is not taxable in India.

Investors can claim losses (other than business loss) of AIF on pass through basis, provided the units of such AIF are held for a period of 12 months or more. However, any business loss can be carried forward only at the AIF level. Exemption has been provided to non-resident investors from filing return of income, provided they earn income only from investments made in a Category I or Category II AIFs in IFSC and tax has been deducted on the distribution made by such AIFs to non-resident investors. Further, such non-resident investors are also exempted from obtaining PAN in India.

Category III AIFs

1.  Category III AIFs are subject to fund level taxation.

2. The following income earned by the Category III AIF, which are attributable to non-resident investors in the AIF, is exempt from tax:

• Income on transfer of any securities (other than shares in a company resident in India), including derivatives, debt securities and offshore securities.
• Income from securities issued by a non-resident (not being a permanent establishment) and where such income otherwise does not accrue or arise in India
• Income from a securitisation trust chargeable under the head “profits and gains of business or profession
• Income on transfer of specified securities listed on a recognised stock exchange located in IFSC where consideration for such transaction is in convertible foreign exchange

3. Income on transfer of shares in an Indian company is taxable as follows to the Category III AIF:

• Short-term Capital Gains -15% if Securities Transaction Tax paid, else 30%;
• Long-term Capital Gains -10%

4. Income in respect of securities (such as interest, dividend) is taxable to the Category III AIF at the rate of 10% (5% in case of interest income on certain rupee denominated bonds, government securities or municipal debt securities referred to in section 194LD)

5. Any income accruing or arising to or received from the Category III AIF or on transfer of its units is exempt from tax in the hands of investors.

6. Surcharge on certain Long-term Capital Gains, Short-term Capital Gains and dividends earned by the Category III AIF is capped at 15%. Further, the provisions of Alternate Minimum Tax are not applicable to the Category III AIF.

7. Exemption from stamp duty, Securities Transaction Tax and Commodities Transaction Tax for transactions carried out on IFSC exchanges.

For Manager/ Sponsor

• 100% corporate tax exemption for 10 consecutive years out of block of 15 years (from date of approval from regulator) in respect of income from business carried on in IFSC.
• The Minimum Alternate Tax (‘MAT’)/ Alternate Minimum Tax (‘AMT’) rate has been reduced to 9% (as against 18.5%). However, companies in IFSC choosing to opt for new tax regime under domestic tax law shall be exempt from MAT provisions.
• The dividend distributed by Manager may be taxable in the hands of its shareholders under the domestic tax law.
• Supply of services by Manager to AIFs in IFSC is exempt from Goods and Services Tax.
• Interest payable to a non-resident in respect of monies borrowed exempt from income tax. 

IFSC in GIFT City is emerging rapidly as a global fund destination on the back of all these regulatory reforms from all regulators and Government of India. The exemption from diversification norms, leverage limits and co-investment norms makes IFSC GIFT city even more favourable when compared to popular fund jurisdictions such as Dubai, Singapore, Mauritius and Cayman Islands. The regime for AIFs in IFSC would enable AIFs to explore wider avenues of funding and provide the needed fillip to distressed asset platforms and debt- oriented invest structures to set up their bases in India. All these advantages along with other tax incentives, world class infrastructure and robust business environment make a strong case of IFSC GIFT as one of the leading financial hubs of the world in years to come.