Death knell for home-grown India-dedicated funds

A new CBDT directive actively makes India-dedicated funds comparatively unattractive for institutional investors. It makes no sense, says Akash Prakash.

Illustration: Uttam Ghosh/Rediff.com.

I must state upfront that I am an interested party in the tax debate highlighted in this article.

The Central Board of Direct Taxes issued a clarification on December 23, 2016, laying out under what circumstances foreign portfolio investors are impacted by the indirect transfer provisions (effectively the Vodafone case).

The clarification says that if an FPI has more than 50 per cent of its assets in India, with a value greater than Rs 10 crore, then any investor with a greater than five per cent interest in or contribution to the assets under management (AUM) of the FPI will be covered by the indirect transfer rules and will be subject to Indian tax whenever this investor sells or redeems its shares in the FPI/fund.

If these clarifications were to be implemented, it will sound the death knell for the home-grown India-dedicated fund industry. Most boutique India funds (mine included) would find it incredibly difficult to operationalise these rules.

These rules will only impact India-dedicated funds, mostly niche investment boutiques focussed on institutional capital and setup by Indian professionals.

The big foreign firms such as Capital, Fidelity, KKR, Blackstone etc will be unaffected as they do not invest in India through India-dedicated vehicles and hence have less than 50 per cent of assets in India, or focus on retail investors, with no investor greater than five per cent.

There will be at least 50 funds ($30-35 billion in AUM) affected, across both public and private equity.

Funds such as Kedaara, Multiples, Nalanda, Westbridge etc -- all are India-dedicated, set up by Indians and have a very sophisticated and concentrated investor base, which in most cases have each contributed more than five per cent of the fund’s AUM.

Most funds of this type only have 15-20 core investors, who provide the bulk of their capital.

These concentrated core investors are endowments, family offices and foundations.

This is the most sophisticated capital in the world and they like being the majority of a fund’s AUM. Exactly the type of money that is long-term and which India should want.

These funds also, by and large, tend to focus on mid-sized companies. That is their USP, and why investors give them capital.

Prime Minister Narendra Modi has mentioned he wants our capital markets to support entrepreneurship and provide capital to smaller companies. This is exactly what these boutique India funds do.

Being India-dedicated, the capital is also far more stable, it cannot be simply shifted to some other geography, unlike in a regional or global fund construct.

If these rules were to be implemented, we would discriminate against exactly those funds who are the biggest ambassadors for India, whose business it is to market the country to global investors and support local entrepreneurship.

Why would the government implement rules which will destroy an industry set up to raise long-term sophisticated capital to invest into Indian mid-sized and growth companies?

The rules actively discriminate against exactly the type of funds the country should be encouraging and make India-dedicated funds comparatively unattractive for institutional investors. It makes no sense.

Why are the rules unworkable?

Firstly, it amounts to double taxation of the investor.

All funds, irrespective of jurisdiction, will pay a minimum of 50 per cent of local taxes (capital gains) from the financial year 2018 (FY18) onwards and full Indian taxes within two years.

The gains the investor makes in net asset value (NAV) are after the fund has paid local taxes.

As an example, under these rules, an investor has invested at a NAV of 100 in 2016, in 2020 she redeems at a NAV of 125, she will have to pay capital gains on this appreciation of 25, despite the fund’s NAV being calculated post local taxes.

Even though the subscription to the fund and redemption will both be done offshore, wherever the fund is incorporated (Cayman or Singapore etc.), the investor will still have to pay tax, assuming the investor has contributed more than five per cent of the fund’s corpus.

The US-based investors may even face triple tax as they may not get a set-off on the Indian taxes paid on redemption.

Investors tell me they have not seen this type of indirect transfer provisions being applicable on funds in any other jurisdiction that they operate in. 

Secondly, the rate of tax will be between 30 and 40 per cent for short-term capital gains (less than three years) and 10 and 20 per cent for holdings greater than three years, depending on the structure of the investor.

These investors will not get the concessional rates on capital gains available to local investors. Tax rates of this magnitude will significantly reduce the attractiveness of Indian equity assets.

Thirdly, the onus of withholding taxes on redemption falls on the FPI. Non-compliance can lead to penal interest and other penalties according to the Indian domestic tax law.

Most FPIs will not be willing to take on any potential tax liability linked to investor redemptions.

Investors into these India funds, whose gains may be taxable under these indirect transfer provisions, would need to obtain a tax ID in India, file tax returns in India and comply with all Indian procedural requirements (facing scrutiny?). I cannot imagine any global investor willing to do this.

Most endowments and foundations do not pay any tax in their home country. They have little internal capability to handle paying taxes in India!

It is true that while these indirect transfer provisions have been a part of the law since 2012, the tax authorities have not applied these provisions against FPIs till date.

These recent clarifications have got investors and funds worried. Will we see a slew of tax notices now?

There is also a growing sense of fatigue among investors.

Given the complexity of dealing with tax issues in India, I get a sense that some investors are questioning the wisdom of allocating money to India-dedicated funds.

Are the returns worth the administrative overhead? 

I hope that a clarification is issued exempting FPIs from these indirect transfer provisions.

If the government were to go ahead and implement these provisions, I am afraid that most India-dedicated funds will face existential questions.

India will lose access to a very large pool of sophisticated long-term capital, and for how much incremental tax revenue? Has anyone done a cost-benefit analysis?

Whatever incremental tax we may receive as a country through these indirect transfer provisions on FPIs will pale in comparison to losing access to these long-term pools of capital.

I hope better sense prevails, it cannot be the intention of the government to kill all India-dedicated funds. We seem to be collateral damage.

The writer is at Amansa Capital. These views are his own.