Sebi panel suggests reforms to grow alternative funds industry

New Delhi: An advisory panel set up by the capital markets regulator has suggested a slew of tax reforms and changes in existing laws to facilitate capital-raising by alternative investment funds (AIFs) and boost entrepreneurship.

The committee formed by the Securities and Exchange Board of India (Sebi) and headed by Infosys founder N.R. Narayana Murthy put out a report on Wednesday suggesting ways to create a favourable tax environment for investors.

It also addressed how to unlock domestic sources of venture capital and private equity and other funds for AIFs; enable and encourage onshore fund management in India; and reform the AIF regulatory regime to facilitate and optimize investments by AIFs.

AIFs, or money collected from high net-worth investors to invest primarily in unlisted securities and start-ups to promote entrepreneurship, more than doubled during the past year—outpacing traditional investment vehicles such as mutual funds and market-linked insurance products.

AIF managers raised capital commitments worth Rs.20,457.45 crore from affluent Indian investors till the end of December, compared to Rs.11,186.36 crore in the previous year.

Local alternative fund managers, including private equity (PE) and venture capital (VC) funds, have followed their overseas counterparts in pouring money into Indian technology and e-commerce start-ups, triggering a boom in early-stage investments.

The 21-member panel recommended that the government introduce a securities transaction tax (STT) on all distributions (gross) of AIFs, investment, short-term gains and other income and eliminate any withholding of tax.

After STT, income from AIFs should be tax-free to investors, the panel suggested in its report.

The introduction of STT for private equity and venture capital investments, including Sebi-registered AIFs, should have parity with the taxation of investments in listed securities, the panel said.

“Given the high risk and relatively illiquid and stable nature of private equity and venture capital, it needs to at least be treated at par with volatile, short-term public market investments for taxation,” the report said.

According to the committee, the exempt income of AIFs should not be subject to withholding tax of 10%; the exempt investors too should not be subjected to the tax.

Also, the panel said the investment gains of AIFs should be deemed to be capital gains in nature and losses incurred by AIFs should be available to their investors for set-off.

If STT is implemented and withholding taxes are removed, tax authorities can directly collect a significant amount of taxes on the investments made by AIFs, the panel said. “STT approach will reduce tax disputes and enable smooth collection of taxes.”

To promote investments into AIFs, the panel suggested that AIFs and portfolio companies be exempted from certain income tax provisions so that they are subjected to tax only when receiving dividend or interest income during the holding period, or realize capital gains at the time of exit.

In order to attract more foreign investors into India-centric private equity and venture capital fund vehicles the panel recommended that the central board of direct taxes should clarify that investors in the holding companies are not subject to the indirect transfer provisions.

The panel suggested that AIFs should be allowed to invest in charitable and religious trusts also.

“Some of the recommendations of the Sebi panel are very pertinent to address the concerns of the industry. One of the most important ones is the rationalisation of the tax and regulatory regime in India to prevent the loss of business to overseas jurisdiction,” said Hemal Mehta, senior director, Deloitte Haskins & Sells.

“India in recent past has started losing out business to jurisdictions such as Singapore. The loss of business to India results in loss of tax revenue that would have otherwise come to India,” he added.

AIF and angel investments are typically long term and create new enterprises and jobs. Yet they operate under less favourable terms than mutual funds, the Sebi panel said.

AIFs should not pay taxes higher than those paid by foreign portfolio investors or domestic institutional investors.

Accordingly, the panel suggested that AIF investments held for a year must qualify as long-term capital gains (LTCG) to encourage investment in risk capital that creates new ventures, jobs, and encourages entrepreneurship.

“The current rate of 20% tax with 3 year holding is punishing for AIFs backing an entrepreneur. AIFs have huge reputational risks amongst others, and can be relied upon for full compliance. 0% LTCG regime must apply to all Sebi registered AIFs,” the report said.

In order to create more domestic channels of investments into the AIF space, the panel suggested that the government should work on ways to unlock those domestic pools of capital that currently do not contribute enough to the AIF industry.

According to the panel, large capital pools from pensions, insurance, DFIs and banks, and charitable institutions, which currently constitute only around 10% of the total private equity and venture capital invested in India annually, should contribute more to develop the AIF industry.

The panel said all banks, pensions, provident funds, insurance companies and charitable endowments must create an internal management system and utilize a minimum of 2-5% of the corpus to invest in Sebi-approved Category 1 AIFs.

Also, the panel urged the regulators to increase the investment limits for banks and insurance companies in AIFs from the current 10% to 20% of the total corpus of an AIF.

Domestic pension funds in India including the National Pension System and the Employee Provident Fund Organization should allocate up to 3% of their assets to AIFs by 2017, rising to 5% by 2020, the panel recommended.

The panel felt that the existing norm on investment limits for AIFs restricts diversification and should be done away with.

“It is recommended that restrictions placed by RBI limiting FVCI (foreign venture capital investor) investments to only 10 sectors should be removed. The rationale for this is that almost every significant sector of the Indian economy is in need of private equity and venture capital and hence a wide array of sectors should be accessible to FVCI investors,” the panel said.

The panel also suggested that Sebi change its eligibility norms for investors to invest in AIFs. The present norms require an investor to invest at least Rs.1 crore in an AIF. Any individual with a total annual income of at least Rs.50 lakh should be allowed to put money in AIFs if he is capable of identifying potential investments and its risks, according to the panel.