CBDT Provides Relief To FPIs From Investor Diversification Conditions

Background

The presence of a fund manager in India could entail business connection / permanent establishment / tax residence risks for offshore funds in India. In order to encourage fund management of offshore funds from India, the Finance Act, 2015 had introduced a new Section 9A in the Income Tax Act, 1961 to provide a safe harbor regime for onshore management of offshore funds thereby neutralising the impact of constitution of business connection / permanent establishment / tax residence for the offshore funds in India.

However, in order to qualify as an ‘eligible investment fund' and an ‘eligible fund manager' (EFM) for the purposes of availing the safe harbor, the fund, and the fund manager are required to comply with the conditions laid down under Section 9A of the Act and the rules made thereunder - 13 in aggregate for an EIF and four in aggregate for an EFM.

The conditions prescribed in Section 9A of the Act are onerous and required guidance for their application.

Accordingly, the Finance Act, 2016 amended certain conditions for a fund to qualify as an EIF. The Central Board of Direct Taxes (CBDT) also issued Notification No 14/ 2016 dated March 15, 2016, inter alia, outlining the guidelines for application of various conditions of Section 9A of the Act and the process to be followed by a fund to seek pre-approval, at its option, for application of the safe harbor regime to its specific fact pattern.

Our earlier tax alerts discussed the changes introduced in Finance Act 2016 to the provisions of Section 9A of the Act as well as the contents of the Notification No 14/2016 dated March 15, 2016.

To further rationalize and incentivise this regime, the CBDT vide Notification No 77/2017 dated August 3, 2017, has provided that an investment fund set up by a Category-I or Category-II foreign portfolio investor (FPI) registered with the Securities and Exchange Board of India (SEBI) need not satisfy certain conditions specified in Section 9A of the Act to qualify as an EIF.

Additionally, the CBDT has issued Notification No 78/ 2017 dated August 3, 2017, specifying the list of countries in which the investment fund should be established/incorporated/registered to be eligible to avail of the safe harbor regime.

Amendment Provided In Notification 77

As indicated earlier, to qualify as an EIF, 13 conditions need to be satisfied by a fund which, inter alia, include the following:

• The fund has a minimum of 25 members who are, directly or indirectly, not connected persons;
• Any member of the fund along with connected persons shall not have any participation interest, directly or indirectly, in the fund exceeding 10 percent; and
• The aggregate participation interest, directly or indirectly, of 10 or less members along with their connected persons in the fund shall be less than 50 percent.

The CBDT has now, vide Notification 77, provided that the aforesaid three conditions shall also not apply to an investment fund set up by a Category-I or Category-II FPI registered with the SEBI.

As a result, a Category-I or Category-II FPI registered with SEBI needs to only comply with the investor diversification conditions laid down by SEBI (FPI) Regulations, 2014.

Thus, Notification 77 removes one of the significant hurdles for offshore funds (particularly newly launched funds) to maintain (and track) a diversified investor base based on two separate set of regulations – one for the purpose of SEBI (FPI) Regulations, 2014 and the other for the purposes of Section 9A of the Act. This will also help to eliminate the onerous requirement of testing whether the investors in the fund are ‘connected persons' or not, as mandated under the Act.

Amendment Provided In Notification 78

To be eligible to qualify as an EIF, the investment fund is required to be:

• a resident of a country or specified territory with which India has entered into a Double Taxation Avoidance Agreement or Tax Information Exchange Agreement; or
• is established/incorporated/registered in a notified country or specified territory.

In this regard, the CBDT has now prescribed a list of 121 countries wherein the investment fund would need to be established/incorporated/registered to avail of the safe harbor regime. The list of 121 countries include jurisdictions like Mauritius, Singapore, Cyprus, Cayman Islands, Ireland, Luxembourg, the Netherlands but does not include Hong Kong.

Comments

The issuance of the notification reflects yet another effort by the government to attract offshore funds to the safe harbor regime. Eliminating the requirements relating to investor diversification for Category-I and Category-II FPIs, who are in any case well regulated by SEBI, is a logical step and will go a long way in encouraging FPIs to embrace this regime.

Incrementally, in this context, the government should notify mutual fund asset managers as EFM. For private equity funds, however, the condition that the offshore fund should not own more than 26 percent of a portfolio company in order to avail of this regime, continues to act as a barrier.

This article was first published on the EY Tax Alert Bulletin.

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