For years, India has been receiving a majority of its foreign investment from tax havens such as Mauritius, Singapore, Dubai, Cyprus and Cayman Islands. These jurisdictions provide excellent regulatory, tax, and legal framework and protection for investors and the fund managers to set up and operate private equity/venture capital funds (‘offshore funds’).

The clarity in the tax and regulatory landscape coupled with the availability of the financial sector infrastructure (robust capital markets, intermediaries), experienced professionals, and excellent social infrastructure has made these jurisdictions favourites of both the investors and the fund managers.

In contrast, in India, the perception of ‘tax terrorism’ and uncertainties on the views of the government on various tax issues have kept foreign investors at bay. These sentiments were reinforced by the Vodafone saga in the indirect transfer case.

Amidst the limitations discussed, the Indian private equity and venture capital fund industry remained positive and gained a strong foundation over the decade. The private equity/venture capital alternative investment funds registered in India (‘AIFs’) have increased from 121 in 2014 to 816 in 2021 year-to-date with a manifold increase in the funds mobilised.

The growth of the domestic fund industry could largely be attributed to the dynamic financial sector and investment professionals, the entrepreneurial spirit, as well as the robust start-up ecosystem and India, being one of the largest markets in the world and gradual opening of the sectors for foreign direct investment (‘FDI’) by the government.

However, the increase in FDI did not proportionately culminate from direct pooling in India. The majority of the AIFs are not yet directly pooled in India but offshore special purpose vehicles/offshore funds.

Bringing in substantial clarity

The Indian government has, over the years, responded to the requirements of the domestic AIF industry and introduced various tax and regulatory reforms bringing in substantial clarity concerning the operations and tax implications for the domestic fund as well as the foreign investors.

Some of the significant reforms include introducing complete tax pass-through for the domestic AIFs, allowing the pooling of monies from foreign investors under the automatic route, treating the pooled capital as a domestic investment under the Indian exchange control regulations and various reforms in the regulations for domestic AIF.

However, despite all these efforts, FDI has eluded India due to some inherent limitations under the Indian tax and regulatory laws, mainly on account of India not being able to provide the flexibility of operations, investments, and tax laws to compete with some of the financial hubs and tax havens.

The introduction and set-up of the International Financial Services Center (‘IFSC’) in 2015 were envisaged as the answer to some of the above issues. With the IFSC, the government of India adopted the mainland – hinterland model to develop a world-class financial services hub in India to compete with the financial centres and offshore fund jurisdictions around the world. Almost six years into the IFSC, after a slow start, a slew of reforms in the recent past has helped the IFSC find a place in the comparative charts with offshore fund jurisdictions around the world.

Reforms and flexibility

Reforms on the tax front include an exemption to non-residents from obtaining permanent account number (PAN) or filing return of income in India, clarification on the receipt basis taxation vis-à-vis pass-through of the funds in the IFSC making overseas investments, tax holidays for fund management entities, portfolio investments from the IFSC by funds enjoying the benefits of FPI taxation.

Reforms on the regulatory front include flexibility in co-investments, leverage, relaxation of investment diversification norms and permissibility for residents to be sponsors of funds registered as foreign portfolio investors (FPI) in the IFSC.

The proposed introduction of the variable capital company structure shall help funds set up in the IFSC enjoy flexibility comparable to any other competent jurisdictions.

Moreover, the recent controversy around the applicability of GST to performance fees to fund managers also does not impact the AIFs set-up in IFSCs as there exist complete exemption for fund management activities domiciled in the IFSC under the GST. Further, tax havens such as Mauritius and Cayman entering the FATF grey list lends India more credibility and attraction as an offshore fund jurisdiction.

However, a few pitfalls still remain. India has terminated bilateral investment agreements with 58 countries which are yet to be negotiated and reviewed.

Also, there is extensive limitation and flexibility for Indian investors to participate in the funds set-up in the IFSC because of the current restrictions under the India outbound regulations, specifically, the liberalised remittance scheme and round-tripping concerns. The response from many development financial institutions (DFIs) have remained timid to date.

There is a need for an IFSC Authority to engage with overseas institutional investors including DFIs, directly educating them about the IFSC, its products, its benefits, its credibility, addressing their concerns and invite them for making investments in India and overseas through the IFSC-based funds.

The author is partner at Bhuta Shah & Co LLP

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