Background

In March, 2015, SEBI had issued guidelines for facilitating and regulating financial services relating to securities market in an International Financial Service Centre (“IFSC”) set up under section 18(1) of Special Economic Zones Act, 2005 at GIFT City, Gujarat. While these guidelines provided a broad framework for setting up of Alternative Investment Funds (“AIFs”) in IFSC, the operating guidelines were yet to be notified. SEBI, on November 26, 2018, has issued a  Circular [1] which sets out the Operating Guidelines for AIFs in IFSC. As a background to the Circular, the SEBI and the RBI had vide various circulars put in place a regulatory regime for setting up of AIFs as ‘financial institutions’ in the IFSC, which would be treated as ‘persons resident outside India’ for the purposes of Indian foreign exchange regulations.

Key Highlights

•        Registration process: a fund set up in IFSC in the form of a trust or a company or a limited liability partnership or a body corporate, can seek registration under the provisions of SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations) under the categories mentioned in the AIF Regulations. This would mean that funds set up in IFSC could benefit from the AIF regulatory framework which is conducive to funds having varied philosophies (including VC, PE and hedge funds).

•        Eligibility to invest in the IFSC AIF: following investors are permitted to invest in an AIF in IFSC: (i) a person resident outside India; (ii) a non-resident Indian; (iii) institutional investor resident in India who is eligible under FEMA to invest funds offshore, to the extent of outward investment permitted; (iv) person resident in India having a net worth of at least USD 1 million during the preceding financial year who is eligible under FEMA to invest funds offshore, to the extent allowed in the Liberalized Remittance Scheme of the RBI[2].  Further, an investor is required to make a minimum investment of USD 150,000. If the investor is an employee or director of the AIF/manager, minimum investment amount is USD 40,000.

•       Investment conditions: AIFs in IFSC shall be permitted to invest in the following: (i) securities which are listed in IFSC; (ii) securities issued by companies incorporated in IFSC; (iii) securities issued by companies incorporated in India or companies belonging to foreign jurisdiction. Thus, such AIFs would be eligible to make investments in a wider range of securities, particularly securities of offshore companies for which non-IFSC AIFs registered with SEBI require specific regulatory approval which is granted on a case-by-case basis.

For making investments in India, AIFs in IFSC can make such investments under the Foreign Portfolio Investor or Foreign Venture Capital Investor or Foreign Direct Investment (FDI) route.

•        De minimus requirements:

•        Sponsor/Manager of the AIF: Sponsor/Manager of an existing AIF may act as a Sponsor / Manager of an AIF set up in the IFSC by either setting up a branch in the IFSC, or incorporating a company or limited liability partnership in the IFSC. New Sponsor/Manager are required to incorporate a company/LLP in the IFSC.

•       The Operating Guidelines also address the requirement to appoint custodians for AIFs and the manner in which Angel Funds (a category of AIFs) can be established in the IFSC.

Key Takeaways

•        Setting up AIFs in IFSC effectively permits fund managers based in India to manage foreign capital without having to set up presence offshore and incur significant costs. IFSC also offers a regulatory platform for fund managers looking to set up funds seeking to make investments in India as well as other jurisdictions.

•        These guidelines eliminate the tax risks associated with General Anti Avoidance Rules (“GAAR”), permanent establishment, and Place of Effective Management (“POEM”) that surround any offshore structures put into place by Indian fund managers managing/advising on offshore pool of capital. Such tax related considerations have lead to an increase in costs and efforts for demonstrating genuine commercial substance and activity in offshore fund structures. Having said that, an AIF in IFSC would be treated as an Indian resident taxpayer and would not have access to any benefit under any double tax avoidance agreement. However, the beneficial tax regime available to Category I and II Alternative Investment Funds which accords them a tax-pass through status should also be applicable to AIFs set up in the IFSC.

•        Indian fund managers either set up in IFSC or having a branch in IFSC should be able to benefit from the exemption on Goods and Services Tax (which is otherwise applicable at a rate of 18%) on the management fees that the manager charges the AIF for managing the AIF’s pool of capital. Further, such managers should also be eligible for income tax holidays on their fee income i.e. 100% exemption of such income for first 5 years after commencement of business followed by an exemption of 50% of the income for an additional period of 5 years.

•        Funds which are focused on making investments in derivatives, including commodity derivatives, listed on stock exchanges within IFSC could enjoy the benefit of being insulated from any currency risk considering that their investments in the AIF as well as downline investments in derivatives listed on such stock exchanges would be denominated in foreign currencies.

•        Given that the Operating Guidelines indicate that all provisions of the AIF Regulations and the guidelines and circulars issued thereunder, shall apply to AIFs setting up/ operating in IFSC, then the investment conditions/restrictions applicable to different categories of AIFs will also apply to AIFs in the IFSC. For example:

•        An AIF is not permitted to invest more than 25% of its investible funds in a single investee entity. While this condition will apply to AIFs in IFSC, this would not be applicable to an offshore fund investing in India under the extant foreign investment laws.

•        A Category I or II AIF may not borrow funds directly or indirectly and shall not engage in leverage except for meeting temporary funding requirements for not more than 30 days, not more than 4 occasions in a year and not more than 10% of the investable funds. While this is a restriction that the AIF in the IFSC will face, a fund set up in offshore can seek leverage without being subject to these conditions.

•        The Operating Guidelines indicate that an AIF in IFSC can invest in another AIF (in IFSC and outside) subject to AIF Regulations. This will be useful for structuring ‘master-feeder’ structures for the following reasons: (i) fund managers need not incur significant costs of setting up pooling vehicles offshore; (ii) the management fees and carry can be taken in India by the Manager; (iii) the non-IFSC AIF receiving investment from the IFSC AIF will be permitted to invest in debt instruments which a IFSC AIF will not be able to do under the FDI route without taking FVCI registration and/or FPI registration (both of which have restrictions around investment in debt instruments); and (iv) provides operational flexibility. The points to note however are: (i) unlike an offshore vehicle which can invest part of its capital in a non-IFSC AIF and part directly into portfolio companies, an IFSC AIF (Fund of Funds) will be required to invest its entire capital in the non-IFSC AIF; and (ii) all other restrictions that apply to AIFs under the AIF Regulations, will apply to the non-IFSC AIF which would not be the case if the feeder vehicle is established in an offshore jurisdiction which has ease of doing business.

[1] SEBI Circular No. SEBI/HO/IMD/DF1/CIR/P/143/2018
[2] Currently, Indian resident individuals are permitted to remit monies outside India for permissible capital and current account transactions within a limit of US$ 250,000 per financial year per individual

Authors:

Pallabi Ghosal, Partner