The Ministry of Civil Aviation (“MoCA”) had recently issued the Draft National Civil Aviation Policy (“Policy”) which, after public consultation, it may implement in its entirety or in part. The Government believes that this sector has a multiplier effect on the economy and hence wishes to promote it in a significant manner. While the Policy covers many important issues related to the aviation sector, this blog aims to highlight a few key takeaways relating to safety, single window system, 5/20 Rule, Scheduled Commuter Airlines, Code Share Agreements, airports and FDI which may help in taking the sector as a whole to the stratosphere.

Safety and Single Window

On the safety front, the Policy states that the government regards aviation safety highly and shall focus on pre-empting and preventing incidents and safety violations will be treated with zero tolerance. The Directorate General of Civil Aviation (“DGCA”) shall also implement safety programmes and plans along with safety management systems to proactively identify operational hazards and apply appropriate risk management principles for the mitigation of these hazards, which is definitely a move in the right direction and should bolster higher degree of care by the operators and confidence amongst the end-users. Additionally, as per the Policy, the DGCA shall also strive to create a single-window system for all aviation related transactions, queries and complaints. If implemented properly, this could also greatly help in cutting down red-tape.

5/20 Rule

As a big step towards rationalizing the “5/20 Rule” (which meant an airline had to have been flying on domestic routes for 5 years and also have a fleet strength of at least 20 aircraft before it could make an application to service foreign destinations), the Policy has invited suggestions on three possible options, namely (i) the 5/20 Rule shall continue as it is, (ii) the 5/20 Rule shall be abolished, or (iii) domestic airlines shall need to accumulate 300 Domestic Flying Credits (“DFC”) to fly to SAARC countries and countries with territory located entirely beyond a 5000 km radius from New Delhi and 600 DFCs before starting flights to the remaining parts of the world. One of the ongoing requirements suggested under option (iii) is that the domestic airlines will be required to accumulate at least 300 DFCs per annum after commencing international operations in order to maintain their international flying rights. In case of a new airline, this requirement shall commence from the financial year immediately following the year in which it accumulates its first 300 DFCs. Furthermore, airlines shall also be permitted to trade the DFCs while intimating the DGCA under option (iii). While the suggestion to do away completely with the 5/20 Rule might be optimal, it shall need to be seen over a period of time how effective and welcome the option (iii) will be.

Scheduled Commuter Airlines

The Policy also proposes to give a boost to regional connectivity through scheduled commuter airlines (“SCA”). The eligibility criteria for SCAs will be INR 20,000,000 in terms of paid-up capital to facilitate easy entry for new players. A SCA shall have no restrictions on number of aircraft and its aircraft can be with a capacity of 100 seats or less. One of the requirements they will have to meet is to operate a minimum number of flights per week to certain destinations under the Regional Connectivity Scheme (“RCS”). However, Route Dispersal Guidelines (“RDG”) (guidelines issued in 1994 to ensure better connectivity to Jammu & Kashmir, North-East India, island territories, tier-2 and tier-3 cities), which are applicable to scheduled commercial airlines, will not be applicable to SCA, thus giving an additional concession to SCAs. Other benefits proposed to be accorded to SCAs are (i) permission to enter into code-sharing arrangement with Indian and foreign airlines and freedom to sell their DFCs to other Indian carriers, (ii) permission to self-handle its aircraft, (iii) rationalisation by MoCA of certain fees and charges like those for landing, parking, navigation and other airport charges at non-RCS airports for SCA aircrafts for a period of 10 years for a particular route, and (iv) coordination by MoCA with the airport operators and Airport Authority of India (“AAI”) to ensure adequate space allocation at Indian airports for SCAs. It is hoped that smaller players shying away from investing in full-fledged scheduled commercial carrier may be attracted to the SCA model which should be beneficial to the entire sector in the long run.

Code Share Agreements

In a big move, code-share agreements shall be freely allowed between Indian carriers and foreign carriers for any destination within India on a reciprocal basis. In this regard, international codeshare between Indian and foreign carriers is proposed to be completely liberalized, subject to there being an air service agreement (“ASA”) between India and the relevant country, with no prior approval required from the MoCA, other than intimation by the Indian carrier to the MoCA 30 days prior to starting the code-share flights. This should make entering into such agreements much easier for Indian and foreign carriers and in turn boost their revenues.

Airports

The Policy states that calculation of tariff at all future airports will be on a ‘hybrid till’ basis and 30% of non-aeronautical revenue will be used to cross-subsidise aeronautical charges, which should be welcome by future airport operators. Furthermore, it is clarified that airports shall continue to be developed through public-private partnership (“PPP”) mode, however AAI will “closely monitor” the capital expenditure of all future greenfield and brownfield airports developed through the PPP model. Additionally, it has also been proposed that the operators of future airport projects will not levy airport charges, concession fee and royalties, etc. on MRO, cargo, ground handling, ATF infrastructure other than a reasonable lease rental. These appear to be a bit harsh on airport concessionaires as it greatly reduces the aeronautical revenues that can be earned by them.

FDI

The Policy states that subject to the Government deciding to go in for open skies (which essentially means permitting unlimited flights, above the existing bilateral rights, directly to and from major international airports within the country as notified by MoCA) for countries lying within a 5000 km radius of New Delhi, an increase in FDI limit in airlines from the current 49% to above 50% shall be examined. In case this increase in FDI limit does occur, we should definitely see more JVs in this sector as the foreign operators would then have control, hence making the deal much more appealing to such foreign carriers.

While the recommendations made in the Policy appear to be making the right noises at the right time when the Government is trying to give an impetus to the Indian economy as a whole, those keeping a close watch on the aviation sector shall have to wait and see how many of these recommendations (and in what form) shall eventually be implemented by the MoCA and in what form. Nevertheless, the right noises made by the Policy should definitely attract interest in this sector and give rise to some interesting deals in the near future.

The Indian Prime Minister speaking recently at the Economic Convention in Singapore had said that “Foreign Direct Investment” in short FDI to him is “First Develop India”. The Government of India through a host of measures such as relaxing provisions on ease of doing business in India and amendments to various laws has been trying to attract foreign investment and state of the art technology into India.

To take these efforts forward, the Department of Industrial Policy and Promotion (“DIPP”) has on November 25, 2015 issued a press note no. 12 which has eased the FDI restrictions in several sectors including Limited Liability Partnership (“LLP”) and construction development sector. This blog concentrates on the key changes that have been brought about in these sectors.

LLP

Earlier, LLP’s were considered to be less favorable as FDI was permitted into LLPs only through the government approval route, though the industry was of the view that if there are no or less restriction on a company with regards to FDI, then why was LLP not brought under the same automatic route. It appears that the lobbying by the companies has finally found an ear and the DIPP has now permitted FDI in LLP in those sectors where in 100% FDI is permitted and which don’t have any FDI linked performance metrics.

The circular has also clarified that LLP having foreign investment shall be permitted to have downstream investments in 100% FDI permitted sectors and which do not have any FDI linked performance conditions. The circular prescribes certain conditions for downstream investments such as intimating the SIA/ DIPP and FIPB about the investment within 30 days, even where the capital instruments have not been allotted, approval of the members of the LLP and adherence to the pricing guidelines. The funds for such downstream investment need to be brought in from abroad and not leveraged from the domestic market.

Construction Sector

To give you a quick background, the various issues faced by the construction development sector for the past some time were in relation to the limit of FDI permitted in the sector being less than 100%, lock in period of three years before the investment could be repatriated by the investor and approval requirement for repatriation of funds.

DIPP has put several of these issues to rest by its circulars and press releases. The circular issued on December 3, 2014 had clarified various points on investments and lock in period requirements of the investments made in the construction sector. Now, with the introduction of press note 12, there has been further tweaking of the requirements and one of the most awaited clarifications with respect to lock in and FIPB approval has been issued.

As per the said press note 12, an investor is permitted to exit a project on completion of the project or after development of trunk infrastructure i.e. roads, water supply, street lighting and drainage and sewerage (this was part of the December circular).

Further, now a foreign investor is permitted to exit and repatriate the investment before the completion of the project under automatic route, provided the lock in period of three years, calculated with reference to each tranche of foreign investment has been completed.

A transfer in the stake from a non-resident (“NR”) to another non-resident, without repatriation of investment, will neither be subject to any lock in period nor to any Government approval. This is a major change, as earlier any stake sale from NR to NR needed approval from FIPB on a case to case basis which has now been done away with. This provides the Investors the flexibility to plan certain structuring of investments at the parent level without the Governmental nod and one hopes that this would facilitate several deals and may increase the flow of foreign investment in the construction sector.

Conclusion

Having gone through the changes made to the FDI policy regarding these two sectors over a period of time one can definitely say that efforts are being made by the Government in the right direction to bring in the investments into India. However, it would be the implementation part of the same which shall prove how these hosts of measures shall work out for the foreign investors. Till then we need to wait and watch.

The idea of Indian domiciled hedge funds, though first mooted by the SEBI over a decade back, has not picked up steam yet. Even upon the AIF Regulations specifically permitting the formation of hedge funds, there were several missing pieces which held the sponsors from taking the plunge. The regime on hedge funds has since developed on a piecemeal basis with the operating and prudential norms governing them being notified by SEBI over the course of a year after the AIF Regulations came into force.

One of the larger concerns that remained unaddressed was with respect to the restriction on foreign investment in hedge funds. While the AIF Regulations had permitted for the same, the RBI or the FIPB had not come up with an enabling notification until recently when the RBI issued notification no. FEMA 355/2015-RB dated November 16, 2015 (“FDI Notification”) permitting FDI in all categories of AIFs. Prior to the FDI Notification, the FIPB was considering proposals for foreign investment in AIFs on a case by case basis and was reluctant in approving foreign investments in a Category III AIF – the category which encompasses hedge funds.

The FDI Notification permitted foreign investment in all categories of AIFs, including hedge funds, without the need of any approval. Further, any downstream investment by an AIF (even those having foreign investment) would be categorized as foreign investment only in case the sponsor or the investment manager of such AIF is not owned or controlled by Indian residents. The notification is indeed a big step towards making the regulatory environment more conducive for Indian hedge funds. However, the above relaxation may not ensure the participation of foreign capital unless certain issues in the hedge fund regime are adequately addressed.

Firstly, there are too many restrictions placed on Indian hedge funds with respect to their investments. For instance, the FDI Notification provides that hedge funds having foreign investment could invest in only such securities or instruments in which a registered foreign portfolio investor (“FPI”) can invest. This would mean that such a hedge fund would not be able to invest in commodity derivatives, which is an investment category much favored by hedge funds across the world. Also, the above limitation prescribed under the FDI Notification limits such hedge funds from entering into the sphere of private companies. While ordinarily hedge funds stay away from private companies due to the illiquidity issues, successful hedge funds dabbling in exciting start-ups, particularly in the tech sector, is not uncommon.

In addition, hedge funds are currently not permitted to invest outside India. The regulations only permit AIFs to invest in unlisted companies abroad, with specific approval from the SEBI and subject to several other restrictions. This greatly reduces the ability of the Indian funds to hedge the risk caused by their over exposure to Indian securities and to make investments based on international conditions.

The success of a hedge fund lies in its ability to take quick decisions and information motivated trading strategies. The investment restrictions enumerated above goes against the investment philosophy of hedge funds and could undermine their success.

Another predicament for a foreign investor is the denial of pass through status to hedge funds for taxation purpose. While all other categories of AIFs are treated as pass through vehicles with their income being taxed directly in the hands of the unitholders, Category III AIFs are not accorded such treatment due to which a hedge fund would have to pay capital gains tax in India prior to making any distribution. This affects the ability of a foreign investor in a hedge fund to manage its tax outgo by appropriate tax planning.

Yet another issue that has plagued the Indian hedge fund industry is the lack of legislative clarity or certainty. For instance, while the SEBI in the AIF Regulations identified that hedge funds could utilize “diverse or complex trading strategies” and may invest or trade in securities having “diverse risks or complex products including listed and unlisted derivatives”, until recently, the SEBI used to instruct Category III AIF applicants to declare that they would not invest in commodity or currency derivatives. Even more disconcerting is the fact that there was no official notification from the regulator in this regard and the applicants were faced with this predicament only at the time of registration with SEBI. It is imperative that the regulators clearly notify the instruments in which hedge funds could invest for the investors to take an informed decision.

The above issues coupled with other long standing issues such as restriction on leverage makes the Indian hedge funds an unattractive avenue for foreign investments; and we may continue to witness global hedge funds shying away from the space and operating in India through the FPI route.

The Companies Act, 2013 (“2013 Act”) was enacted to replace the Companies Act, 1956, with one of its primary objectives being to lighten the compliance burden on businesses in India. Since its enforcement in April 2014, many sections of the 2013 Act have already undergone amendment and several exemptions have been granted by the Ministry of Corporate Affairs (“MCA”) to private companies, with the intention of reducing procedural requirements.

Despite the positive responses to this recent slew of reforms, the industry has called for further amendments to several provisions of the 2013 Act. In this blog, I would like to discuss some compliance ambiguities of the 2013 Act, which do not deter investment transactions but can cause drawn-out discussions on the correct corporate actions to be taken for deal closings.

1. Conversion of preference shares

Typically, private equity / venture capital investors are allotted convertible preference shares in the target company, which are convertible into equity shares upon the occurrence of certain specified events. The reason why investors prefer to purchase convertible preference shares is two-fold: (i) preference shareholders are given priority for repayment in case of liquidation of the target company, and (ii) conversion of preference shares into equity can be timed to occur upon the achievement of performance milestones by the target company, allowing investors some flexibility in the event of any mismatch in future valuation expectations of the investors and the target.

While the 2013 Act permits the issuance of convertible preference shares, it does not specify the manner in which such securities are converted into equity shares. At present, there are divided opinions on the correct procedure for conversion of securities – one point of view is that the preference shares would, by way of an appropriate resolution passed by the target company, convert directly into equity shares, reflecting a simultaneous increase in equity share capital and reduction in preference share capital, while the other interpretation is that conversion is effected by simultaneously redeeming the preference shares and making an issuance of equity shares in lieu thereof.

Investors in particular are keen to have clarity on this issue, and would be reassured by any clarifications that the MCA may issue on the corporate actions to be taken by target companies for effecting such conversion in a manner that is valid and compliant with the provisions of the 2013 Act.

2. Disclosures in explanatory statements

The MCA, vide a notification issued in June 2015, eased compliance burdens on private companies by permitting them to make provisions in their Articles of Association to do away with the requirement of providing their shareholders with detailed explanatory statements along with the notices calling general meetings (“ES Exemption”). This liberalization has been very well received, particularly by closely-held private companies where the small group of shareholders are themselves engaged in running the company.

However, the scope of the ES Exemption in practice remains ambiguous, since several rules framed under the 2013 Act mandate certain disclosures to be made in explanatory statements. For instance, companies are required to obtain the consent of their shareholders prior to making preferential allotments of securities to any persons (including investors). As per the Companies (Share Capital and Debentures) Rules, 2014 (“Rules”), certain disclosures relating to the preferential offer, including details of number of securities, price, valuation, objects of the allotment, pre and post-issue shareholding pattern, etc., must be made in the explanatory statement issued to the shareholders. There is no doubt that these details are relevant and necessary for the shareholders to consider before providing their consent to a preferential allotment. But the question remains – can companies now avoid issuing explanatory statements to their shareholders altogether, by virtue of the ES Exemption? Or will the failure to issue an explanatory statement containing the mandated disclosures amount to a violation of the Rules?

Investee companies would prefer to avail the benefit of the ES Exemption so as to reduce the paper-work required for closing an investment transaction. On the other hand, investors would insist that companies issue such explanatory statements despite the ES Exemption, as they are concerned that allotments made to them without issue of explanatory statements could be struck down as being invalid due to non-compliance with the Rules. Clarifications from the MCA on the intended scope of the ES Exemptions would therefore be welcomed by the investor community and investee companies alike.

3. Compliance with secretarial standards

The 2013 Act mandates all companies to comply with the secretarial standards (“SS”) issued by the Institute of Company Secretaries of India. The SS relating to board and general meetings were approved by the MCA, and made applicable to all meetings held from July 1, 2015 onwards. The SS sets out, in great detail, the practices to be followed by companies in conduct of meetings, and preparation and maintenance of notices, minutes, and other records relating to meetings.

The intent behind the SS appears to be positive, and the SS is primarily aimed at ensuring that good corporate governance practices are followed so that disputes and litigation relating to mismanagement of affairs are minimized. However, private companies are concerned that the SS have raised the compliance burden by imposing greater requirements than currently prescribed by the 2013 Act. For instance, the MCA introduced the ES Exemption for private companies because it recognised that many private companies are owned and managed by a small group of promoters. While such private companies now do not have to prepare and issue explanatory statements for general meetings (which are typically held only a couple of times a year), they are required to prepare extensive notes on the agenda for board meetings (which may be held as often as once a month).

The SS prescribes many more compliances on a similar vein, which seem unnecessary for closely-held private companies, as they impede the making and implementation of day-to-day management decisions. On the other hand, private equity / venture capital investors are afforded added comfort as the SS would boost compliance standards in portfolio companies. From the perspective of investment transactions, the procedures and timelines for corporate actions required for closing of deals would be affected by the additional compliance requirements introduced by the SS. The MCA should consider re-visiting the SS, and attempt to bridge the gap between the exemptions granted under the 2013 Act to private companies and the compliances imposed by the SS.

Reports indicate that the MCA has established a 6 member expert panel to review comments and concerns of stakeholders and recommend further amendments and clarifications to the 2013 Act to make it easier for corporates to do business in India. The panel is expected to focus on easing provisions related to corporate governance and management, amongst other matters, and I hope they would consider clarifying some of the compliance-related issues discussed here.

The Payment and Settlement Systems Act, 2007 (“PSS Act”) prescribes certain conditions for companies to comply with, prior to setting up a payment system in India. As per the PSS Act, any system that enables a payment to be effected between a payer and a beneficiary is called a payment system; this would include credit and debit card operations, money transfer operations, smart card operations and other similar processes. While the PSS Act governs all types of payment systems, the Reserve Bank of India (“RBI”) has issued a set of specific guidelines for the issuance and operation of prepaid payment instruments in India. Instruments that have a value stored on them which represents the value paid for by the holders of such instruments, by cash, by debit to a bank account, or by a credit card are called prepaid instruments. Thus, smart cards, internet wallets, mobile wallets and internet accounts are all types of prepaid payment instruments. Further, the RBI has also issued circulars permitting AD Category I banks to offer facilities to repatriate export related remittances by entering into standing arrangements with online payment gateway service providers for the export of goods and services.

The RBI has continuously been trying to strike a balance between security and convenience with respect to payment systems and online payment gateways through its policies and regulations, while at the same time trying to keep up with technology that is constantly changing. Thus, a number of amendments in the regulations pertaining to payment systems arise only once it is brought to light that a potential security risk is created due to certain activities of the payment system provider or if a regulatory norm is flouted due to a loophole in the law. More often than not, these changes in policies or the introduction of new regulations lead to enraged customers and unhappy service providers.

Case in point: Paypal India’s operations. Paypal was first established in the United States of America as a payment system to facilitate financial transactions that take place on the online market place website, ebay.com. While buyers and sellers meet on ebay.com they can use their Paypal accounts, which are linked to their bank accounts, to accept money when selling goods and the same may be used to buy other goods or send money to other users with Paypal accounts. When Paypal began its operations in India the RBI noted, that one of the services offered by Paypal was the cross border transfer of money. As discussed above, money transfer operations fall under the ambit of the PSS Act, and Paypal had not obtained authorizations for the same from the RBI. Further, Paypal allowed Indian exporters to retain their export proceeds abroad without repatriation, resulting in violation of the provisions of Foreign Exchange Management Act, 1999. Paypal would have had to obtain a banking license to conduct such operations and thus the RBI issued a set of regulations in November, 2010 causing Paypal to tweak its Indian operations. As per the circular issued by the RBI, Indian exporters were permitted to accept payments into their Paypal accounts, however such amounts could not be used to make any more purchases and the same had to be transferred to their bank accounts within 7 days of receipt of the money. Further, this facility was available only for the export of goods and services of a value not exceeding USD 500. Thus PayPal made changes to its user agreement for Indian users wherein it specified (in compliance with RBI’s directives) that no balance or future payments could be used by the seller in India to buy any goods or services outside India and that the money had to be transferred to an Indian bank account immediately. Further, PayPal disabled the option to send and receive personal payments to and from India as this violated the provisions of the PSS Act. Additionally, the RBI also stopped permitting domestic transfers between domestic Paypal users as this required registration under the pre-paid payment instrument guidelines and Paypal had not obtained the same.

In October 2011, the RBI increased the export limit to USD 3000, following which in July 2013, the limit was further increased to USD 10,000 and this is the current limit for the export of goods and services using any online payment system. In September, 2015 the RBI further liberalized the conditions for cross border e-commerce transactions by the release of a circular that allowed both the import and export of goods, thus Paypal users were now permitted to import goods and software upto a value of USD 2,000 from overseas websites. This relaxation came close on the heels of the RBI’s announcement of permitting 11 companies to start payment banks in India – we’ll cover the implications of this announcement in another blog post.

While today, Paypal operates as a payment platform in India, and allows users to purchase goods and services overseas as well as permits merchants to receive payments, the transfer of money between Paypal accounts of two users is still not permitted. Further, merchants in India are still bound by restrictions that require them to immediately transfer money from their Paypal accounts to their bank accounts within 7 days of receipt of such money. Similarly, immediately upon receipt of funds from an Indian importer and in no event, later than 2 days from the date of credit to the collection account, the sale / import proceeds is required to be remitted to the respective overseas exporter’s bank account.

Even though Paypal is one of the largest and most reliable payment systems in the world today, it has still not received a very welcoming response in India or garnered a large customer base, primarily due to the many restrictions and regulations that continue to be doled out by the regulatory authorities. One can only wait and watch to see what the next step of the RBI will be in its effort to strike a balance between convenience, security, and regulatory control.

This blog post will discuss two recent merger control orders passed by the Competition Commission of India (“CCI”), Cairnhill CIPEF Limited & Anr. (“Cairnhill”), and Caladium Investment Pte. Limited (“Caladium”), and their implications for minority/significant minority acquisitions by investment funds. These orders indicate the manner in which the CCI will regard affirmative rights and board representation rights – terms often found in agreements between investment funds and their targets – during its merger review process.

A. Background

The Competition Act, 2002 (“Competition Act”) enacts a ‘suspensory’ merger control regime. This means that transactions which fall under the Act’s definition of ‘combination’ will not take effect unless they are notified to the CCI, and subsequently approved by it. The CCI is allowed a maximum of 210 days to complete the exercise of scrutinizing a combination for possible anticompetitive effects, a time period which may be lengthened by the CCI.

Regulations made under the Act (“Combination Regulations”) provide that an acquisition of shares or voting rights, even though a “combination”, need not normally be notified to the CCI for its approval if:

(a) it is made solely as an investment (emphasis added);

(b) the acquisition does not exceed 25% of the total shares or voting rights of a target company; and

(c) the acquisition does not lead to an acquisition of ‘control’ (emphasis added) over the target (“Investment Exemption”).

The Investment Exemption, if available, is beneficial for investment funds because it tends to substantially reduce deal timelines and transaction costs.

B. Cairnhill and Caladium

In Cairnhill, two private equity funds (together, “Cairnhill Fund”) acquired an 11% stake in Mankind Pharma Limited (“Mankind”) through secondary transactions, and contended before the CCI that they could avail of the Investment Exemption. Cairnhill Fund’s agreements with Mankind provided for a seat on its board, and certain affirmative rights for Cairnhill Fund (typically, this is accomplished by providing for a list of ‘reserved matters’ in the deal documentation – matters on which the investee cannot proceed without the investor’s consent). The CCI denied Cairnhill Fund the Investment Exemption due to those terms, and observed that “an acquisition could be considered to be made solely as an investment if the acquirer has no intention to directly or indirectly participate in the formulation and determination of the business decisions of the target”.

The takeaways from Cairnhill are (a) in the CCI’s eyes, the mere presence of affirmative rights (in particular, Cairnhill Fund’s veto over Mankind commencing any new businesses) and board representation rights evidenced the Cairnhill Fund’s intent to participate in the target’s management; and (b) a transaction on such terms will not satisfy the “solely as an investment” criterion.

In Caladium, the presence of similar (but slightly more extensive) affirmative rights, led the CCI to conclude that Caladium Investment Pte. Limited, (an affiliate of a sovereign wealth fund), had acquired ‘joint control’ over its target – control being ‘joint’ because it was shared with the target’s existing shareholders. The Investment Exemption was not discussed in Caladium.

C. CCI Jurisprudence

The stance taken by the CCI in Cairnhill and Caladium with regard to affirmative rights is not a novel one. In a notification by Alpha TC Holdings Pte. Limited and Tata Capital Growth Fund I (“Alpha”), who had acquired around 17% of their target’s equity, the CCI, upon being confronted with an extensive list of ‘reserved matters’ found that the investing funds’ consent was needed when the target made “strategic commercial decisions”. In the CCI’s view, this could not be regarded as a ‘mere minority protection right’. Consequently, the CCI found that the funds had acquired ‘joint control’ of their target, and denied them the Investment Exemption. It is noteworthy that the CCI seemed to perceive ‘joint control’ as sufficient to deny an acquirer the Investment Exemption, whereas the text of the Investment Exemption speaks only of ‘control’.

Conversely, in a notification by Omega TC Holdings Pte. Limited and Tata Capital Limited upon their acquisition of a 26.33% stake in Tata Projects Limited (“TPL”), the CCI observed that the funds “do not enjoy any veto rights regarding the strategic or commercial decisions” of TPL and thus, had not acquired ‘control’ over TPL.

The CCI’s thinking on affirmative rights in the above cases seems to stem from two of its earlier orders: SPE Mauritius Holdings Limited (“SPE”), and Deepak Fertilizers (“Deepak Fertilizers”). In SPE, the CCI laid down that two persons are in ‘joint control’ of a company when one person is able to block “strategic commercial decisions” and cause a deadlock, and acknowledged that contractual arrangements could lead to a situation of ‘joint control’, but cautioned that “mere investor protection rights” should be differentiated from ‘control’ rights. In Deepak Fertilizers, the CCI observed that having affirmative rights or board representation rights would enable an acquirer to participate in the target’s business decisions, and if an acquisition is made with intent to “participate in the formulation, determination or direction of the basic business decisions of the target”, or is “likely to cause or result” in the same, then such acquisition would not be regarded ‘solely as an investment’. However, the CCI also observed that an acquisition made by a passive investor would be regarded as being made ‘solely as an investment’.

D. Analysis & Conclusion

The goal of merger review is to act as a preventive measure to ensure that strategic M&A activity does not beget entities that can exert their market power to cause anticompetitive effects. The Investment Exemption focuses the scope of the Competition Act’s merger review provisions by recognizing that (a) there are two kinds of investors – strategic and financial, and (b) acquisitions by the former merit antitrust review, while acquisitions by the latter do not.

The Investment Exemption aims to distinguish these two categories of investor by employing the words “solely as an investment”, but issues arise with the test the CCI uses to distinguish the two kinds of investors: it looks into the underlying documentation and the rights contained therein, and then uses these as a proxy to characterize the investor. Another issue is the CCI’s idea of when ‘control’ over a target is acquired.

Thus, what investment funds may perceive as necessary protective covenants when investing in companies where they hold minority stakes (and cannot be certain of high corporate governance standards), the CCI regards as rights that result in the holder crossing the fault line between a ‘financial’ and a ‘strategic’ investor, and possibly, acquiring ‘control’ over the company. The development of the CCI’s jurisprudence in this regard, culminating in Cairnhill, has hollowed out the Investment Exemption to the point where it may not be very useful to investment funds.

The brevity required of a blog post means that this may not be the right place to delve into the correctness of the CCI’s interpretation of ‘control’ under the Competition Act. However, in my view, the CCI is not entirely right in regarding the presence of affirmative rights and board representation rights in deal documentation as a solid indicator that an investor is ‘strategic’ as opposed to ‘financial’. In fact, their presence supplies the opposite inference: that the investor is not interested in the day-to-day running of the business, knows that its lack of involvement may lead to negative outcomes, and is protecting its interests by ensuring that it can exercise oversight, or in a worst case scenario, cause a deadlock. Further, in my view, in Cairnhill (as well as in Alpha), the CCI has interpreted the Investment Exemption in a restrictive manner that is contrary to its intent.

Going forward, as regards acquisitions that breach the Competition Act’s thresholds for merger review, a minimal ‘reserved matters’ list structured to leave intact the target’s ability to make “strategic commercial decisions” on its own may persuade the CCI that the acquirer is not in ‘joint control’ of the target. However, the CCI orders cited above provide only suggestive guidance on what “strategic commercial decisions” are, and thus, this is a significant grey area.

In any case, going by Cairnhill, the mere presence of affirmative rights and board representation rights might prove fatal to an attempt to invoke the Investment Exemption, unless an acquirer can demonstrate that the ‘reserved matters’ list does not give it a right to participate in the target’s “basic business decisions”. In conclusion, it is hoped that the CCI will, in future, interpret the Investment Exemption in a manner more aligned with its intent, and with market realities.

Earlier this month the Bankruptcy Laws Reforms Committee (“Committee”) submitted its final report to the Ministry of Finance with recommendations for some sweeping changes. The report contains both the findings and recommendations of the Committee and the draft Insolvency and Bankruptcy Code (“Code”). This final report has been submitted after an interim report was submitted in 2013, which was considerably limited in its scope and recommendations when compared to the Code. While bankruptcy laws have been well developed and codified in other developed jurisdictions, the same could not have been said of India where a plethora of laws existed ranging from the Companies Act, 2013 (“CA”), Sick Industrial Companies (Special Provisions) Act, 1985 and Securitisation and the Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, which had their own shortcomings owing in some cases to their vintage and in others to their inefficient enforcement and inordinate court delays. This blog aims to highlight some significant provisions/recommendations of the Committee in relation to corporate insolvency.

Thankfully, the proposed law does not aim to govern only certain types of entities and covers insolvencies of “corporate persons”, including companies, limited liability partnerships, and all other entities having limited liability along with individuals, firms etc.

A positive step proposed is the setting up of the Insolvency and Bankruptcy Board of India, whose primary functions would be registration of insolvency professionals (including the administrators and liquidators playing a role in both pre and post liquidation stages) and information utilities (organizations tasked with the storage of financial information like security interests, defaults, etc.), to provide guidelines with respect to the conduct of bankruptcy resolution, amongst other functions. In addition, the Code also specifies the National Company Law Tribunal (“NCLT”) as the Adjudicating Authority (the primary quasi-judicial body presiding over the entire process of bankruptcy) in case of corporate persons and Debt Recovery Tribunal in case of any other persons.

While not delving into the details, a big positive step in ensuring speedy resolution has been the Code requiring that the insolvency resolution process be completed within a mandatory 180 day period (from the date of admission of an insolvency application). During this period of 180 days, a mandatory moratorium is imposed during which creditor actions remain suspended. It may be pertinent to note that there is no provision for automatic moratorium under the CA and only the NCLT has the discretion to grant a moratorium of up to 120 days. However, it has also been provided in the Code that in case the creditors’ committee resolves to approve the liquidation of the entity before the expiry of the aforementioned 180 day period, then the moratorium will cease to have effect. If the resolution plan is rejected, then the company in question goes into liquidation based on the recommendations of the resolution plan, or failure to submit the plan within the maximum time period permitted, or based on a vote of the creditors’ committee.

Provision has also been made for a fast track corporate insolvency resolution process which is supposed to be completed within a period of 90 days. The Code provides such fast track process to corporate debtors having assets or income up to such level as may be notified by the Central Government or such other category of corporate person as may be notified by the Central Government.

Additionally, voluntary liquidation has also been covered by the Code in detail to ensure it comes under the umbrella of the Code (considering how long and painful it currently is to wind-up a company in India). Under the Code a company, after providing a declaration from its directors about its solvency and other matters and documents as mentioned in the Code, may have a special resolution passed to liquidate itself. In case the company in question has any debtors, it needs to be shown that creditors representing two-thirds in value of the debt have also supported the shareholders’ resolution.

Another point of significance of the Code is its insistence on a timely completion of the liquidation process as well. Considering that most delays take place due to matters getting stretched before the adjudicating authorities, the Code tries to put some sort of rein on NCLT and National Company Law Appellate Tribunal (“NCLAT”) about timely disposal of matters by requiring them to dispose of the matters within the time limits, failing which the forum shall be required to record the reasons for not doing so and the President of NCLT or the Chairperson of NCLAT, as the case may be, may extend the period by a maximum of 5 days. Though not technically a stick, this should put some onus on the NCLT and the NCLAT to dispose of the matters expeditiously.

To sum up, the Code does aim to drastically improve the legal framework surrounding bankruptcy in India and as aptly put by the RBI Governor Raghuram Rajan, a new bankruptcy code will help bring pure capitalism back where aiming to make borrowers accountable to their loan contracts with banks.

Much ink has been spilt of late over a United States (“US”) federal law called the Foreign Account Tax Compliance Act (“FATCA”) and hence we thought it fit to spend some time trying to analyse for the readers the aspects which may affect them. FATCA is a part of the US’ Internal Revenue Code, and is aimed at combating tax evasion by comprehensively collecting information about US taxpayers’ offshore interests and assets. Put very simply, FATCA forces non-US entities in which US taxpayers have interests or assets to report details of these interests or assets to the Internal Revenue Service (“IRS”; the US tax department). Here it is pertinent to note that, amongst all developed countries, the US is the only country that levies tax on the entire income of its taxpayers, whether made in the US or overseas; this is known as ‘worldwide’ taxation.

The stick employed by FATCA is a withholding tax regime that, as one commentator puts it is “designed to have such a significant impact on the [non-compliant entity’s] business…that non-compliance would result in its isolation from the global financial markets”. Given FATCA’s enormous extra-territorial reach, the US has been working with countries around the world to help it implement the legislation.

The Central Government and the Central Board of Direct Taxes (“CBDT”) have, vide Notification No.62, dated 7th August, 2015, inserted certain provisions (“FATCA Rules” or “Rules”) into the Income Tax Rules, 1962 (“ITR”). These Rules give effect to FATCA by imposing reporting requirements on certain Indian entities. Towards this end, certain amendments have also been made to the Income Tax Act, 1961.

This article aims to examine the impact of the FATCA Rules on domestic funds, and will proceed in three parts by: (I) describing their background & design, (II) looking into the conditions for its applicability, and (III) providing an overview of the compliances required under it.

I. Background & Design

The US implements FATCA by, inter alia, entering into ‘intergovernmental agreements’ (“IGAs”) with other countries (“Signatory Countries”). Under an IGA, a Signatory Country is required to put in place rules (“Local FATCA Rules”) that make it mandatory for its resident entities to report the details of the US persons who hold interests in such resident entities to the local tax authorities, and the information thus collected needs to be passed on to the IRS by the local tax authorities. If an entity in a Signatory Country complies with the Local FATCA Rules, then it is deemed to be compliant with FATCA itself.

The rationale for entering into IGAs to accomplish FATCA’s aims is two-fold, and turns on the introduction of FATCA reporting obligations into a Signatory Country’s domestic law vide the Local FATCA Rules: First, IGAs obviate the need for entities in a Signatory Country to report directly to the IRS; entities in Signatory Countries need only report to the local tax authorities, thereby reducing the compliance burden on them. Second, by the same token, entities in a Signatory Country can report the details of US persons holding interests in them to the local tax authorities without fear of violating data protection & privacy laws that may have otherwise prevented them from making such reportings to the IRS.

India executed an IGA with the US (“US FATCA”) on 9th July, 2015, pursuant to which the CBDT has inserted the FATCA Rules into the ITR, effectively importing FATCA compliances into Indian law. As indicated above, under the US FATCA, an entity that is in compliance with the FATCA Rules is deemed to be in compliance with FATCA itself.

The cornerstone of the FATCA Rules is the definition of a ‘financial institution’ (“FI”) and the enquiry of whether an Indian entity in question falls within the four walls of the definition. Another important definition to keep in the forefront while studying the FATCA regime is the definition of a ‘financial account’ (“FA“), which is defined as, inter alia, any equity or debt interest in an FI. The FATCA Rules further identify ‘specified US persons’ (“SUSPs”), which essentially means US residents, partnerships, certain trusts and corporations (subject to a long list of exceptions). Non-US entities which are controlled or beneficially owned by SUSPs (“NUSEs”), though not specifically mentioned in the Rules, are also important from a reporting perspective: FAs held by SUSPs and NUSEs are called ‘US Reportable Accounts’ (“USRAs”). ‘Passive non-financial entities’ controlled by persons resident outside India and the US for tax purposes (“PNFEs”), are also relevant in this context.

FIs are required to comply with Rules 114G & 114H of the FATCA Rules, under which an FI must conduct a due diligence and maintain information regarding FAs held in them by SUSPs, NUSEs, & PNFEs and then report this information electronically in Form No.61B. A failure to file Form 61B will carry an INR 100 fine for every day on which the failure continues, with this fine going up to INR 500 in case the FI does not file Form 61B even after a notice has been given to it by the Revenue. Inaccurate reporting will, under certain circumstances, result in an INR 50,000 fine for the FI. An FI is also required to register with the IRS and obtain a Global Intermediary Identification Number.

II. Applicability

The applicability of the FATCA Rules to a domestic fund can be ascertained via two litmus tests: (I) analysing whether the fund falls under the definition of an FI, and (II) determining whether the Limited Partners (“LPs”) in the fund fall under the definition of SUSPs, NUSEs, or PNFEs who hold FAs in the fund.

Coming to the first test, an FI is defined as any one of a ‘custodial institution’, a ‘depository institution’, an ‘investment entity’ (“IE”), or a ‘specified insurance company’. An IE is defined as an entity that primarily conducts businesses such as trading in money market instruments, transferable securities, commodity futures, etc., or individual and collective portfolio management, or otherwise investing, administering, or managing financial assets or money on behalf of other persons. In addition, any entity whose gross income is primarily attributable to investing in securities, and is managed by another entity that is itself an IE, is also regarded as an IE. As can be seen, the definition of FI is very wide, and aims to capture not only domestic funds, but also domestic fund managers, and possibly even trustee companies.

While we are discussing the applicability of the FATCA Rules, we would like to point out the exemptions provided therein as well. Entities that qualify as non-reporting financial institutions (“NRFIs”) under the FATCA Rules, such as qualified credit card issuers, or the Employees’ State Insurance Fund or a pension fund, are exempted from the reporting requirements. However, the NRFI exemptions are not likely to be very useful to domestic funds since they come with numerous strings attached. For example, to be regarded as a ‘sponsored closely held investment vehicle’, which is one kind of NRFI, the fund cannot act as an investment vehicle for unrelated parties, and at the most, can have twenty or less LPs, amongst other conditions. Another possibility which may be explored is an NRFI exemption called a ‘sponsored investment entity’, wherein one entity may register with the US as a ‘sponsor’ of the IE and perform FATCA compliances on the IE’s behalf.

Moving on to the second test, the definition of FA encompasses partnership interests as well as interests held by settlors and beneficiaries in trusts, either directly or indirectly. An LP may be regarded as an NUSE if it is beneficially owned by US-based persons. Further, the beneficial ownership in such is cases to be determined by the application of anti-money laundering/KYC circulars issued by the Securities & Exchange Board of India and the Reserve Bank of India. Consequently, the second test may be satisfied if an LP in a domestic fund is a US taxpayer. Given the expansive nature of the definitions involved, and the assertion made in a guidance note released by the CBDT (“CBDT Guidance”), that an FA may need to be reported because of the controlling person behind the FA holder, it is also possible that a vehicle set up by a US-based investor in an intermediate jurisdiction to invest in a domestic fund maybe caught in the net cast by the FATCA Rules. The definition of PNFE is both wide and elaborate, and may capture LPs who are neither SUSPs nor NUSEs; determining whether an LP is a PNFE or not should be done on a case-by-case basis based on the facts.

To sum up, domestic funds will now have to closely examine the FATCA Rules to determine their status, and the status of their LPs, to ascertain the applicability of the FATCA Rules to them. These are largely fact driven enquiries, but at first blush, it seems as though a domestic fund that has US-based investors may have to make reportings under the FATCA Rules. It is also worth noting that even if a domestic fund does not have any FAs that are held by SUSPs, NUSEs, or PNFEs, it is still required to furnish a nil reporting statement to the Director of Income Tax (Intelligence and Criminal Investigation) or the Joint Director of Income Tax (Intelligence and Criminal Investigation). The CBDT Guidance suggests that if a domestic fund is structured as a trust, the reporting requirement will lie on the trustee.

Lastly, even though fund managers fall under the definition of FI, they seem to have been provided with an exemption, such that the fund managing entity will not have to report equity or debt interests held in it by SUSPs, NUSEs or PNFEs.

III. Compliances

The primary compliance to be undertaken under the Rules is the collection, maintenance and reporting of the names, addresses, taxpayer identification numbers, and certain other particulars of SUSPs, NUSEs and PNFEs that hold FAs in the fund; in certain cases, similar particulars of the controlling person behind an FA holder will also have to be reported. The fund will have to report any distributions made to SUSPs, NUSEs and PNFEs during a relevant calendar year. The Rules also require a fund to name a person as a ‘Designated Director’, who must verify and furnish reportings. The Designated Director must obtain a registration with the Principal Director General of Income Tax (Systems).

It should be noted here that the reporting requirement is not merely prospective: FIs are also required to make certain reportings pertaining to 2014 and 2015; importantly, the deadline to make the reportings for 2014 is 10th September, 2015.

Another major compliance required to be undertaken under the FATCA Rules is the due diligence requirement found in Rule 114H. Rule 114H delineates FAs into six categories: (i) ‘individual’ FAs and (ii) ‘entity’ FAs, with the distinction between the two being self- explanatory, (iii) ‘pre-existing’ FAs (FAs maintained on 30th June, 2014), and (iv) ‘new’ FAs, (FAs opened on or after 1st July, 2014) (these are the dates applicable for USRAs), (v) ‘high value’ FAs (pre-existing individual FAs having a value of more than USD 1 million), and (vi) ‘lower value’ FAs (pre-existing individual FAs having less than USD 1 million).

Rule 114H prescribes due diligence procedures for the different kinds of FAs, and this is another characterization that a domestic fund will have to make while profiling its LPs for FATCA purposes.

By way of a brief illustration, the due diligence procedure specified for ‘pre-existing entity’ FAs involves a review of information about the FAs held by the fund for regulatory or customer relationship purposes (including information maintained under anti-money laundering rules) to determine whether the FAs are held by SUSPs or NUSEs, and further review of the entities that hold FAs to determine whether they are ‘non-participating financial institutions’ or ‘passive non-financial entities’, as defined under the Rules. The due diligence procedures laid down in Rule 114H seem to be ‘two-way’ i.e., the fund cannot perform them single-handedly, but will require the cooperation of its LPs to complete them effectively.

One point to highlight here is that it is understood that the US FATCA has come into force on the 3rd August, 2015. The date of the US FATCA’s entering into force is relevant because Rule 114H offers an alternate procedure for performing the prescribed due diligence on USRAs opened between 1st July, 2014 and the date of entry of the US FATCA. Under the alternate procedure, an FI has one year from the date of entry into force of the US FATCA to complete the prescribed due diligence and information requests, with the reporting to be made within a prescribed time period of the identification of an FA as one which requires reporting. A further alternate procedure exists for entity FAs opened by SUSPs and NUSEs between 1st July 2014 and 1st January 2015. If the prescribed due diligence on these FAs cannot be completed within a year of the entry into force of the US FATCA, the fund may be forced to ‘close’ these FAs. However, this appears to be an unlikely situation, since both the countries are working in tandem to ensure the effective implementation of FATCA without undue distress to stakeholders.

Going forward, while certain reporting deadlines seem to be some way off, others are close at hand, and it would be prudent, and in tune with best practices and good corporate governance, to begin the process of ascertaining FATCA applicability and due diligence, if necessary. Further, domestic funds may capture the data necessary to comply with the FATCA Rules from LPs during the fundraising process itself to avoid later scramble for such information prior to the requisite filings. As mentioned above, the CBDT has tried to bring clarity to what is viewed as a complex law by releasing the CBDT Guidance, but this is simply a work-in-progress, and the CBDT has said that it will be taking feedback from stakeholders to update the CBDT Guidance.

For the US, FATCA represents a positive step towards collecting the information necessary to effectively combat tax evasion. Co-operation with the US in this regard is a good idea for India too: the US FATCA’s emphasis on reciprocity will allow India to get a clearer picture of assets held abroad by Indians, thereby lending impetus to the current Government’s “bring home the black money” campaign. While it does impose another compliance burden on certain Indian entities, this will hopefully lead to better KYC and information collection practices.

As published on https://www.vccircle.com/fatca-impact-domestic-funds.

This budget could have been much more impactful had it considered some transformational changes in the system.

Finance Minister Arun Jaitley presented his first union budget yesterday. It was a budget that was awaited with much anticipation and that was beginning, even before it was presented, to be described in certain sections of the media and in the tweetosphere as #SuperBudget. For a nation that had been reeling under the shock of one cluster of bad news after another on the economic front for the past 3 years, #SuperBudget seemed like an inspiring sobriquet that highlighted the hopes and aspirations of its economic stakeholders.

It is not my goal here to imprudently attempt a comprehensive analysis of this budget. Rather, what I seek to do is to share my thoughts on whether the budget presented by the Finance Minister yesterday is indeed a “SuperBudget” from point of view of turbocharging the floundering Indian economy, and whether it can be reasonably expected to reinvigorate investments into Indian industry, both by Indian businesses as well as by foreign investors.

Foreign Direct Investment (FDI)

The Finance Minister announced the following reform measures relating the FDI laws:

● Insurance – The sectoral cap for insurance has been increased from the existing 26% to 49%. While this is certainly a welcome and long-awaited reform move, an enhancement of the FDI ceiling from 26% to 49% does not achieve much from a foreign investor’s perspective. Whether a foreign investor owns 26% or 49%, from a control and management perspective, it is really the same thing!

Therefore, this reform is not likely to cause a deluge of investments from international insurance companies that are looking to enter the Indian market, as they would still not be able to own a controlling stake in the Indian JV.

However, private equity investors looking at growth equity deals in the insurance and insurance-related sectors (like TPAs, insurance broking etc) will undoubtedly welcome this move as it enables them to take larger stakes in these companies. Therefore, we can expect healthy volume of PE deals in the insurance sector, which is good for the sector.

Notably, while the Finance Minister’s budget speech did not include reference to any “strings attached” to this reform, news reports prior to the announcement of the budget strongly suggested that the Government might impose conditions which limit the voting rights of the foreign shareholders to 26%. One will have to wait and read the fine print to see what kind of restrictions, if any, are imposed.

Also, while the announcement of Government’s decision to liberalize FDI in insurance is a positive move, this move will require suitable amendments to the Insurance Act (which requires parliamentary approval) and the regulations issued by the IRDA, all of which could take some time.

● Defence – The sectoral cap in defence too, was enhanced from the existing 26% to 49%. I fear this will turn out to be a damp squib reform measure that will probably not attract much investment interest.

In a sector like defence, where the companies with the best technologies have to spend billions of dollars and huge amounts of time on R&D, any international company that is keen on entering the Indian market would be very anxious about protecting its technology and know-how and in this background, would expect at the very minimum that they are able to exercise control and management over the Indian JV and to be able to treat the Indian JV as their subsidiary.

While I don’t think 100% FDI needs to be allowed, at the minimum, the Government should have been a bit bolder and permitted 51%. I consider this an opportunity missed for India to attract some big-ticket investment in this sector, and also the opportunity for partially indigenizing the manufacture of certain defence equipment.

● Real Estate/Urban Construction – The norms under the existing Press Note 2 of 2005 have been relaxed a bit – the minimum investment limit has been reduced from USD 10 million to USD 5 million, and the minimum built-up area requirements have been reduced by half. This measure will surely benefit smaller scale greenfield real estate development projects as they can now look to bring in foreign investors.

● Railways – While the railways budget announced by the Railways Minister two days ago expressed clear intent to open up certain segments of the railways sector to private sector participation and FDI, there was no reference to the same in the union budget presented by the Finance Minister yesterday. While the notion of railways sector projects being privatized and being thrown open to foreign investors is very exciting and promising, I am inclined to restrain my optimism till it becomes clear as to what kind of policies and rules are eventually made by the Government in this regard. This is a sector which could seriously benefit from attracting private sector capital and foreign technologies.

● No Ecommerce – There were strong expectations that this budget would include a reform permitting 100% FDI in ecommerce. It is therefore, very disappointing that there has been no mention of ecommerce at all in this budget. An announcement pertaining to ecommerce would have provided an immense boost to a sector that is already growing at an astonishing rate in India and one that needs levels of growth capital that simply cannot be provided by the Indian market alone. In order for this sector to thrive and reach its multi-billion dollar potential, allowing FDI would be a key factor. I hope the Government re-considers its decision here and announces a liberalization of this sector at the earliest.

● No Automatic Route for FDI in AIFs – Disappointingly, the ambiguity over the eligibility of AIFs registered under the SEBI AIF Regulations to raise funds from foreign LPs continues to exist, as this budget has not provided any clarity in this regard. This is an issue that has been plaguing the funds industry in a major way and impeding AIFs in their fundraising efforts, as they are not specifically permitted to raise funds from foreign investors other than registered FVCIs. This is a huge limiting factor that needs to be done away with by clearly permitting FDI under the automatic route into all categories of AIFs.

Another long-standing issue has also not been addressed in the budget speech, and that is the issue of exempting non-FVCI foreign LPs in Indian AIFs from the pricing restrictions applicable to other FDI investors. This is again an impediment to AIFs from raising money from foreign LPs that are not FVCIs – a much bigger one than is commonly acknowledged.

If foreign LPs are subject to pricing restrictions under FEMA upon redemption of their units in the AIF, that pretty much hits at the very basis of investing in alternative investment funds!

Infrastructure Projects

As expected, this budget had a strong thrust on infrastructure projects. The Finance Minister announced the following decisions with respect to infrastructure projects:

● Development of metro projects in several Tier 1 and Tier 2 cities on a PPP basis.

● Allocation of Rs. 1000 crores for augmenting and developing rail connectivity in the North-eastern part of India, which again presents opportunities for PPP concessionaires and EPC companies.

● Picking up a cue from the Vajpayee-led last NDA Government’s vision of a “Sagar Mala”, the Finance Minister announced development of sea ports and augmenting capacity at existing ports.

● Development of industrial corridors across the country.

● Development of airports in several cities on a PPP basis.

The above are all great ideas and it is hard to argue with the benefits that these proposals could bring, if executed in a time-bound fashion.

Direct Taxation

The budget stayed a fairly conservative course on direct taxes. While several minor tweaks to various aspects of taxation, the following are the important ones that could impact deal-flows into India:

● Retrospective Taxation – While he did not announce withdrawal of existing cases and did not give a very strong statement in this regard, he did quite clearly say that his Government would not normally pursue a path of retrospectively taxing transactions. He did talk about the need for rational and predictable tax administration and emphasized that tax authorities are not mere enforcement authorities. All this points towards Governmental thinking that retrospective taxes may not be levied by his Government, but some in the international market may wish for more assurance from the Finance Minister than this.

● Pass-Through for REITs and Infra Investment Trusts – He made a specific proposal that REITs and Infrastructure Investment Trusts would get tax pass through status, which is an excellent announcement, in my view. Our country has long needed a rational and workable REITs regime with a tax pass-through status for such trusts. This is a very welcome move.

● But…..No pass-through for AIFs – While the Finance Minister’s decision to allow tax pass through for REITs and Infra Investment Trusts was very heartening, what was disappointing is that his speech gave no clarity on tax treatment of AIFs registered under the SEBI AIF Regulations, 2012.

This will therefore, continue to be a nagging uncertainty for the funds industry. In my view, clarity on tax pass-through for AIFs should have been a bigger priority for the Government than REITs, Infra Trusts etc.

After all, a bird in hand is worth several in the bush!

● Investment Allowance for Manufacturing Units – An investment allowance of 15% has been announced for a period of 3 years for manufacturing companies that set up new plants and machinery with an investment of Rs. 25 crores or more. This is a great move that will provide a good incentive for Indian businesses to invest much needed capital in new industrial facilities. Given that there has also been a fall in India’s Industrial Production Index in recent years, this move should contribute to shoring up the manufacturing sector and also create some manufacturing jobs.

● New DTC – Since the existing DTC has lapsed with the change of Government, the Finance Minister announced that a new DTC would be put in place after comments and feedback has been received from the public.

Indirect Taxation

While the Finance Minister announced a slew of good tweaks on indirect taxes, the decision to rationalize import duty on various different grades of coal by bringing them under the same tax rate caught my attention as a key change which could have a positive impact on development of infrastructure projects in the country. With coal being a major imported input for most independent power projects in India, the delays, disputes and transactional costs of attempting to grade the imported coal for determining the applicable import duty rate was a wasteful exercise, which will now be done away with on account of this rationalization.

Concluding Remarks

Overall, I would say that this budget is a good balancing act, one that manages to be bold while still being sensitive to the prevailing realpolitik on the ground. The assessment of impact potential of any budget has to be a contextual exercise, and given the context in which this budget was presented, I’d say it is a responsibly thought-through and very positive-sounding budget that will surely restore a lot of confidence amongst global investors as well as Indian businesses on the attractiveness of the Indian market.

However, as I have discussed above, I do believe that this budget could have been much more impactful had it considered some transformational changes to the system and gone all the way with some reforms rather than announcing measures that in some cases, seem moot. One hopes that the Government keeps constantly looking for ways to better the policy framework to grow the economy in a rational and balanced manner.

The ultimate test of the impact that this budget, though, lies not in the content of this budget speech alone, but in the execution! While the budget seems to have been well-received by the markets, the skeptics will turn believers if the Government demonstrates a consistent ability to walk the talk on its promises!

The Indian Government (“Government”) has consistently been trying to introduce schemes and routes to bring in foreign investment to an ever depleting economy, where the need for foreign exchange is only increasing. Since access to foreign institutional investment opportunities in India was by and large limited to foreign institutional investors (“FII”) and foreign venture capital investors, a new and less cumbersome regulatory framework was sought to be established by the Government.

One such scheme saw its birth in August 2011 in the form of a circular issued by the Reserve Bank of India (“RBI”). The scheme was christened the qualified foreign investor scheme and the protagonists went by the name of qualified foreign investors (“QFIs”). This route permitted foreign individuals and corporations to invest in a portfolio of Indian stocks without specific registration with the Securities Exchange Board of India (“SEBI”). A QFI is an individual, group or association, resident in a foreign country that is compliant with Financial Action Task Force (“FATF”) standards and is a signatory to the International Organization of Securities Commission’s Multilateral Memorandum of Understanding. As per the 2011 circular QFIs were first allowed to invest only in equity schemes of domestic mutual funds as well as infrastructure debt schemes. Subsequently, with the Government aiming to attract more foreign funds, and reduce market volatility, QFIs were permitted to directly invest in the Indian equity market via a circular issued by the RBI in January 2012. A number of checks and balances were also introduced in terms of the limits of investment such as a maximum ceiling of USD 10 billion in debt schemes of mutual funds. Further, QFIs could only invest through the SEBI registered qualified depository participants (“DPs”) who had to ensure that applicable KYC requirements were met.

Despite the flourish with which the scheme was introduced, the incoming fund flows did not reflect the desired outcome as envisaged by the Government. To give further impetus to foreign investors, the RBI and SEBI issued a number of circulars in July 2012 to allow QFIs to invest in the Indian corporate bond market for the first time. Norms related to the procedural mechanism for incoming foreign investments were also eased. For example, QFI’s were permitted to invest in certain eligible debt securities without a lock-in period or a residual maturity clause. Further, QFIs were also permitted to open a bank account in India in their own name, thus addressing the drawback of the earlier scheme where DPs had to hold fund inflows and outflows of all their QFI clients in a single rupee pool, which had its own set of logistical difficulties. The definition of the term QFI was also expanded to include residents of countries that were members of groups which themselves were compliant with the FATF standards. Thus, residents of countries which were members of groups such as the Gulf Cooperation Council and the European Commission would be eligible to invest in India as QFIs. Subsequently, the RBI allowed QFIs to protect their investments from exchange rate volatilities through the hedging mechanism and issued a circular in August 2012 to that effect. To further expand the avenues for foreign investments, the RBI in April 2013 issued a circular, permitting QFIs to invest in Government securities up to a limit of USD 25 billion and increased the ceiling of investment in corporate debt securities to USD 51 billion.

Despite the consistent introduction of positive changes in the QFI scheme, the route was struggling to attract investors, with hurdles being faced with respect to ambiguity in tax treatment of the gains. Kindly put, the tepid response received from investors was proof that the QFI scheme was not turning out to be much of a success. In October 2013, with the economy continuing its downtrend and the Government trying its best to deepen the Indian capital market and lower the current account deficit, the SEBI via a press release approved the SEBI (Foreign Portfolio Investors) Regulations, 2013. As per these regulations, the SEBI plans to club the existing FII regime, Sub-Accounts and the QFI regime into a new investor class to be termed as foreign portfolio investor (“FPI”). Further, instead of qualified depository participants, FPIs would be required to register themselves with designated depository participants, whose qualifications would be intimated by the SEBI. With no word yet on the implementation of these regulations, the fate of the QFI scheme still looks murky and overcast with uncertainty. Whether the Government will scrap this route all together and go ahead with the merger of schemes as suggested or formulate added modifications to revive interest in this route is left to be seen and one can only wait and watch until the next effort of the Government is announced.

The interest of private equity (PE) funds and other investors has continuously been on the rise in the water sector over the past few years, though, it still can’t be said that the flood gates have been opened up in the sector. Earlier, for many years it was only the Government which was ‘investing’ in the sector in its sovereign capacity.

It’s been a slower process and the amounts invested by PEs are not as large when compared to other sectors like power, IT & ITES or education, but there have been constant investments in recent times which have gone a long way in bolstering the faith of investors in this sector.

The core difference in the investment philosophy, and hence how these investments have been handled so far, could be said to be the focus of PE funds primarily on an exit horizon of 4-7 years and a definite IRR goal as opposed to the Government, which acts merely in its sovereign capacity and does not focus on profits.

Here it may be ideal to mention that the Public Private Partnership (PPP) model, where private investments have started flowing into services which were earlier the sole domain of the state, has been trudging along well, though again not a runaway success in this sector yet.

A few examples are (i) Jindal Water Infrastructure Limited working on a project relating to setting up, maintaining a sewage treatment plant and supply of treated water to industries in Bhavnagar, Gujarat costing approximately $18.8 million on a BOOT basis for a period of 25 years, and (ii) Konark Water Infra Projects Private Limited (which is a joint venture of VA Tech Wabag Limited, which has recently attracted PE investment, and Konark Infrastructure Limited) being commissioned a BOOT project for planning, construction, and operational management of the Ulhasnagar drinking water treatment plant of a value of approximately Euros 50 million by Ulhasnagar Municipal Corporation.

Within the water sector, which comprises of mass water supply/distribution, water and wastewater treatment, desalination, etc., PE and other investors have been known to ideally invest in segments where private players have already entered and have gained some traction over a period of time and more specifically in companies in the EPC (engineering, procurement and construction services) space.

Companies in the water sector are also keen on raising funds from PE and other investors to meet their capital requirements and are seeing this as a viable alternative to other avenues of raising funds in the recent years. The following examples would provide some sense of PE investments and exits in this sector in recent past:

● In 2011, Aditya Birla Capital Advisors invested about $9 million for a minority stake in New Delhi-based SMS Paryavaran Ltd. involved in undertaking turnkey projects in water transmission, treatment, storage, distribution, sewerage, and effluent collection,

● In the same year, Saisudhir Infrastructures, an EPC player, raised over $23 million in its second round of funding from US based Global Environment Fund, a fund dedicated to clean technology, emerging markets, health care services and sustainable forestry,

● During 2011, Olympus Capital Holdings Asia, a leading venture fund which also focuses on companies involved in environmental services, acquired a minority stake in Vishwa Infrastructures and Services, a company providing water management infrastructure in urban as well as rural areas, from Axis Infrastructure Fund 1 for a consideration of $50 million.

● Axis had invested $15 million in 2008 and hence got a more than three times return to its investment. Vishwa had also received funding of about $22 million earlier from a PE fund, New Enterprise Associates in 2011.

● Last year, the Capital Group, one of the leading global privately-owned investment management companies, acquired about 10 per cent stake in VA Tech Wabag, a leading engineering services company focusing on water and wastewater treatment in a secondary transaction wherein it bought-out ICICI Ventures’ stake for about $35 million.

● This, together with earlier exits gave ICICI Ventures approximately 7-8 times return on their investment in about 5 years. In the same year itself, ICICI Ventures completely exited VA Tech Wabag by selling its remaining 4.65 per cent stake to Japan’s Sumitomo Corporation for about $15.8 million, giving it a 10 times return on its investment.

But, at the same time, there are a few factors that make investing in the water sector not so palatable, or rather a daunting exercise for many PE players.

The first is the clear absence of a good business model, wherein the capital cost and the recurring operating costs are recovered within a reasonable time-frame. Then, there is the requirement of huge capital investments in infrastructure.

Thirdly, there is excessive political interference, especially in the areas of tariff regulation – which in itself is quite labyrinthine in terms of factors affecting its determination, leading to uncertainty and low margins.

Fourthly, excessive presence of non-revenue water, which is the water that is produced but ‘lost’ before reaching the consumer due to reasons like metering fault or poor infrastructure leading to leakages and non-detection of the same.

Fifthly, the inability of local bodies to generate a sturdy internal revenue base due to disassociation between the method of functioning of their officials and the mode of execution favoured by PE funds.

And, lastly, the main aim of a PE fund being to garner profits as opposed to a local body, whose primary aim and ethos are to provide a public service leading to misunderstandings, among others.

However, despite the issues and problems plaguing this sector, the recent investments and good returns that PE funds have received should be a good indicator about the massive potential in the sector.

The overarching focus of the Government on development of infrastructure, a robust economy fuelled by internal consumption rather than being dependent on an export oriented model and the fact that investments in other ‘sought after’ sectors may reach a saturation point at some point in time leading to fewer opportunities, are a couple of factors which go on to showcase the glimmer and bright future of this sector further.

Unless the final guidelines places additional and more stringent fetters on its invocation, given the extensive discretion granted to the tax authorities under the GAAR, the excessive tax and compliance burden will be worrisome.

The issuance of draft guidelines for the implementation of the General Anti Avoidance Rules (GAAR) for public comments (Draft Guidelines) has brought the much-discussed GAAR back into the spotlight. The GAAR was, initially proposed in the Direct Taxes Bill, 2010 (DTC) to codify the principle of “substance over form” and give the Indian tax authorities sweeping powers to invalidate or otherwise ignore an arrangement as an “impermissible avoidance arrangement” in the event that such arrangement was entered into with the main objective of obtaining a tax benefit. While the DTC is yet to become operational, the applicability of the GAAR was, against strong industry sentiment, advanced by the Ministry of Finance by inserting certain operative provisions in the Finance Act, 2012. The draft guidelines, which is yet to be approved, invites comments from industry stakeholders on the regulatory framework that would govern the implementation of the GAAR. The Prime Minister’s Office, as well as the Finance Ministry, has clarified that the draft guidelines is in preliminary form and will need to be approved, after taking into consideration industry feedback, by the Prime Minister (who has recently taken charge of the finance portfolio).

The draft guidelines offers some solace to assessees in as much as it proposes, amongst other things:

(i) that the GAAR will not be invoked retrospectively and instead will only be applied to income accruing or arising on or after April 1, 2013;

(ii) the need for a monetary threshold below which the GAAR would not be invoked (one hopes that the threshold when prescribed will be a meaningful one); and

(iii) that where only a part of an arrangement is held impermissible, the tax consequences of an ‘impermissible avoidance arrangement’ will be limited to only that part of the arrangement and not the entire arrangement.

That said, unless the final guidelines places additional and more stringent fetters on its invocation, given the extensive discretion granted to the tax authorities under the GAAR, the excessive tax and compliance burden will be worrisome.

The GAAR had triggered concerns among PE funds in relation to the usage of Mauritius as a holding company destination for investments into India. Consequently, this might increase the attractiveness of Singapore as a holding company destination as the comprehensive economic cooperation agreement entered into between India and Singapore provides certain inherent ‘substance requirements’ to qualify for its benefits and, hence, it could be argued that Singapore-based entities that meet these ‘substance requirements’ are not ‘impermissible tax-avoidance arrangements’. On the other hand, this may well come to naught as the tax authorities could argue that these ‘substance requirements’ are mere thresholds to determine eligibility under the agreement and are not sufficient, on their own, to demonstrate commercial substance when tested against the GAAR.

With the GAAR set to take effect, as of now, on April 1, 2013, reportedly, several FIIs and PE funds have already begun the process of strengthening the commercial rationale for locating their investment entities in Mauritius and Singapore, including by increasing senior-level headcount and acquiring independent office infrastructure in these jurisdictions. Expect this trend of re-examination to continue and accelerate as the international investing community utilises this window of opportunity to bolster their investment structures to provide more robust arguments against potential challenges under the GAAR.

At the end of the day, the choice of jurisdiction is going to have to be driven by business considerations that will best allow the fund to demonstrate clear and substantial commercial rationale for that choice.

The need of the hour is for the Indian government and regulators to carve out specific exemptions for crowd funding with effective checks and balances.

Crowd funding, also popularly known as crowd financing or equity crowd funding, could broadly be described as the raising or pooling of monies by a group of people, driven by common goals/objectives and trust to support an effort initiated by like-minded people or organisations.

The medium of collaboration and raising of monies is usually the internet and given the prevalence of social networking, which is enmeshed in our day-to-day lives, it is not a far-fetched idea that this hyper-interconnectivity shall drive our lives and economy to a large extent in the years to come. In the past, crowd funding has been used for disaster relief, movies, funding startup companies, music by upcoming artists, etc. In return, the investors may get CDs, customised memorabilia, special tickets to shows, special fan sneak peeks, etc. Crowd funding has often been used by small startup companies to raise capital, for which a certain amount of equity may be issued to the investors. The money is usually raised through social networking or specialised crowd funding websites like start.ac, kickstarter.com, indiegogo.com amongst others. To give an indication of its success in the U.S., I would like to lay forth a few facts and figures.

Till date, kickstarter has launched more than 63,000 projects, out of which more than 24,000 have been successfully funded, giving the website a success rate of 44 per cent. All these projects have collectively received more than $280 million. Some of the most successful projects under kickstarter platform have been Pebble (an e-Paper watch for iPhone and Android phones), which amassed more than $1 million and Double Fine Adventure (a video game developed by Double Fine, company involved in the production, promotion, and distribution of the video games), where a staggering $3,336,371 was raised. Another website indiegogo, which was founded in early 2008, has launched 100,000 projects from more than 196 countries and has raised around $16.5 million in total.

Though crowd funding has not kicked off in a real sense in India, websites like wishberry.in, which is broadly designed after kickstarter and provides a platform for projects to get access to contributions, has already made inroads into the heavily networked Indian population, mostly urban, eager to be a part of a cause they believe in or be part of a core fan group by paying a small amount.

Furthermore, due to a common belief in the business, enterprise or idea, the participation of the crowd funding ‘investors’ in a start-up company is much more collegial and passionate than what may be the case with a VC or an angel investor, which in most cases is driven by IRR goals and a definite exit horizon. In this article, I shall focus on the possible regulatory issues that may affect crowd funding in India, wherein shares or securities are issued to investors by the fund raising company and the current regulatory position in the US.

The Indian regulatory framework

As we’ve see, although there is a lot of buzz around crowd funding as an alternate investment opportunity for startup companies, in the Indian market, a few regulatory hurdles could be major impediments to its success. The first and the most significant issue arise from Section 67 of the Indian Companies Act, 1956. Section 67 requires that in case an offer or invitation is made to 50 or more persons for the issuance of securities, such an offer could fall within the purview of a ‘public offer’, requiring a prospectus and associated compliances, including listing of such securities on a recognised stock exchange, which could be quite meaningless for a startup. The company can stay out of the purview of this section by making distinct offerings, each of which offering is made to less than 50 persons. However, a company may not be out of the woods by merely making the offer to less than 50 persons. It may be noted that under Section 67, if the offer or invitation to subscribe for shares can be accepted only by persons to whom it is made, then it shall not be regarded as an offer to the public. However, typically in case of crowd funding, the offer or invitation is made through the internet to unknown and not specified persons, and hence, there would typically be no ability to control the number of offerees.

In this regard, we also need to look at the Securities Appellate Tribunal’s (SAT) order dated October 18, 2011, with respect to the issue of securities by two Sahara Group companies, both of which were unlisted, to more than 30 million persons. The Indian securities regulator, the Securities and Exchange Board of India (SEBI), in its order dated June 23, 2011, had found that the companies had raised sizable amounts of money from the public without adhering to norms governing public issues in India in relation to disclosure and investor protection. One of the main findings of the SAT in its order was that a private placement is made to a handful of known persons whose number is less than 50 and therefore an issue to more than such a number is a public issue. The SAT observed that in the current case the companies had made a ‘public issue’ by approaching more than thirty million investors, but by avoiding the requirements of the law. SAT expressly stated in this regard- “the fact that information memorandum was circulated to more than thirty million persons through ten lakh agents and more than 2,900 branch offices is nothing but advertisement to the public”. Another important issue deliberated upon by the SAT was whether the SEBI has jurisdiction to regulate unlisted companies.

SAT held that SEBI has jurisdiction over unlisted companies too as long as the same can be said to be ‘persons associated with securities market’. Therefore, so long as the unlisted company is making a ‘public offer’, as discussed above, SEBI shall have jurisdiction to regulate it. The SAT also went on to state that when it comes to regulating the securities market and protecting the interests of investors in securities, the SEBI Act, 1992 , is a standalone enactment and SEBI’s powers under it are not fettered by any other law including the Companies Act.

Going by this order of the SAT, which has been appealed to before the Supreme Court and is currently sub judice, raising of funds by companies (even if they are unlisted) through the internet using crowd funding, where the number of investors to whom securities are being issued is 50 or more who are not specified, may be termed as a public offer and hence attract stringent and onerous compliance requirements including listing of such securities on a recognised stock exchange in India.

Another issue that we need to keep in mind while analysing the regulatory framework for crowd funding is whether the internet websites that offer/deals in these securities shall require registration as an intermediary who may be associated with securities market under the SEBI Act, and hence subject to the SEBI (Intermediaries) Regulations, 2008, and other securities regulations. More specifically, Section 12(1) and (2) of the SEBI Act states that no intermediary who may be associated with securities market shall buy, sell or deal in securities, except in accordance with the conditions of the certificate of registration obtained from the SEBI as per the SEBI Act and the Regulations. “Securities”, as defined under the Securities Contracts (Regulation) Act, 1956 (SCRA), includes shares of any incorporated company and includes rights or interest in securities as well. Going by this definition, if securities are being issued by a company, which is raising funds through the crowd funding website, in all probability, the website may be considered as an intermediary dealing in securities, which is bringing the fund raising company and the investors together and hence may require a certificate of registration from the SEBI. In addition, such intermediary shall be bound by the norms listed in the Regulations including making regular disclosures, maintenance of books, accounts and records, ensuring redressal of investor grievances, appointment of a compliance office, abiding by a code of conduct specified in the Regulations and being subject to scrutiny and inspection by the SEBI. From a reading of these related legislations and sub-ordinate legislations, it seems like the website offering services to bring the crowd and the investee company together resulting in issuance of securities may be considered an intermediary and be subject to registration requirements and other ongoing compliances, which may or may not be palatable to most such service providers.

The US regulatory framework

While discussing the regulatory framework that governs crowd funding in India, I believe it is pertinent to briefly discuss the recent regulatory changes introduced in the US as well. On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act), which is a law designed to encourage funding of small businesses without the need to adhere to various existing securities regulations issued by the US securities regulator, the Securities and Exchange Commission (SEC). What is interesting to note is that the JOBS Act specifically deals with crowd funding as well and provides an exemption from the requirement to register public offerings with the SEC for some small offerings, subject to certain conditions. The JOBS Act has amended the Securities Act of 1933 by adding an exemption to Section 4, whereby transactions involving the offer or sale of securities by an issuer would be exempt from the requirement of filing a registration statement provided certain conditions relating to the aggregate amount sold by the issuer during the previous 12-month period and the aggregate amount sold to any investor during the previous 12-month period are met. It has also been clarified that an intermediary shall not be required to register as a broker under SEC Act of 1934 with respect to transactions relating to crowd funding, giving a much needed breather to such websites.

It should also be noted that the SEC has not given a carte blanche to the crowd funding websites to raise funds from investors without any duty of care or reporting requirements to the SEC. It has added a few requirements under Section 4A of the Securities Act, which needs to be complied with by the intermediaries in order to qualify for the crowd funding exemption like warning investors of the speculative nature of the investment, carrying out background checks of the issuer’s principals, taking reasonable measures to reduce the risk of fraud, maintaining proper books and records, refraining from offering investment advice, providing the SEC with notice of the offering including the stated purpose and intended use of the proceeds of the offering and the target size, and providing the SEC with continuous investor-level access to the intermediary’s website. It has also been clarified that in the absence of an intermediary, the issuer would still have to comply with these requirements, hence placing the onus of complying with these requirements on the company even if no intermediary is involved in the crowd funding exercise.

This development in the US has come as a shot in the arm for the crowd funding industry and we are bound to see exponential growth in funding of start-ups, which would not have otherwise been able to raise funds or may have been reluctant to do so due to regulatory requirements or fear of the loss of their freedom in the way they may be running their companies.

Though the potential for crowd funding to change the investment landscape in India and provide a cheap and effective form of investment for small start-up companies is very high, unless the regulatory framework in India is effectively addressed, as has been done in the U.S., the proverbial Damocles Sword of registration, restrictions and on-going onerous compliance requirements shall keep hanging on the websites propagating crowd funding and the companies wishing to raise funds through this channel. The need of the hour is for the Indian government and regulators to carve out specific exemptions for crowd funding in applicable Indian legislations, of course with effective checks and balances, to ensure that regulations enable wealth generation, rather than act as an impediment to it.

The Government seems to be attempting to turn the clock back through its proposals in the Finance Bill 2012 (“Budget” or “Bill”), made with the objective of ‘reiterating the intent of the legislature’. Read in the light of the recent decision of the Supreme Court (“SC”) in January 2012 on the 2007 USD 11 billion Vodafone-Hutch deal, the Budget gives rise to new controversies concerning income tax liability of non-residents on the transfer of Indian assets through overseas transactions.

Let us put this in perspective and look at the changes that the Budget makes to the existing tax regime. The Income Tax Act, 1961 (“ITA”) at present taxes non-residents on income that accrues or arises, directly or indirectly, from the transfer of a capital asset situated in India. The Budget expands the scope of this charging provision by clarifying that a share in a foreign company shall always be deemed to have been a capital asset situated in India, if the share derives its value substantially from assets located in India. In addition, the Budget also amends the definition of the term ‘capital asset’ to include rights of management or control over an Indian company. The implication of these amendments is that when a share in a foreign company is transferred and it indirectly causes the transfer of control over an Indian Company, any capital gains in the hands of the foreign investor arising from such transfer becomes liable to be taxed in India.

To fully appreciate the effect of the retrospective character of this amendment, we must revisit the decision of the SC in Vodafone International Holdings B.V. vs. Union of India (“Vodafone judgment”), where the SC rejected the jurisdiction of the Indian tax authorities (“Revenue”) to tax capital gains arising from a purely offshore transaction and quashed a tax demand of USD 2 billion against Vodafone. The facts are, briefly, that Hong Kong based Hutchison Telecommunications International transferred shares held by it in a Mauritius based company, which indirectly held shares in an Indian Company – Hutchison Essar, to U.K. based Vodafone. The sale resulted in Vodafone acquiring control over the Mauritius Company as well its subsidiaries, which included Hutchison Essar. The Revenue argued, adopting a purposive construction of the provisions of the ITA, that the charging provision taxes non-residents on income arising out of direct as well as indirect transfers of capital assets, and that the control over the Indian Company is a capital asset situated in India, thus making the transaction liable to tax in India. The SC ruled that such indirect transfers of assets would not be chargeable to tax in India since it was a purely offshore transaction involving only non-resident entities, although the underlying assets were in India.

The ‘clarificatory’ retrospective amendments in the Budget, which will come into effect from 1st April, 1962 if the Bill is passed by the Parliament, were clearly proposed with the intention of defeating the ruling of the SC in the Vodafone judgment. In fact, the Budget has gone so far as to draft the amendments along the lines of the arguments made by the Revenue which were expressly rejected by the SC.

The question we must answer is: What is the legal status of such retrospective amendments? The general rule, as discussed by the SC in National Agricultural Co-operative Marketing Federation vs. Union of India (2003), is that the legislature cannot ‘statutorily overrule’ a court’s decision through a retrospective amendment. This view is supported by a recent Press Release (“PR”) issued by the Ministry of Finance (“FM”), where the FM asserted that tax cases which have been assessed and finalized up to April 1, 2012 would not be reopened. However, the Explanatory Memorandum to the Budget declares that the amendments “shall operate notwithstanding anything contained in any judgment, decree or order of any Court, Tribunal or Authority.” This validation clause makes it possible for the Revenue to demand tax in cases which are currently in various stages of litigation, including cases where Courts have already ruled against the Revenue. As a result, Vodafone now faces a tax demand of an estimated USD 3.7 billion, including interest and a penalty, on its 2007 deal.

The Bill, if enacted will have serious consequences for a wide range of Indian and International businesses. The industry fears tax uncertainty and is apprehensive that these amendments will discourage foreign investments in India, severely affecting India’s growth prospects. Furthermore, foreign investors are beginning to question the stability of the Indian tax regime. This does not bode well for the image India has been projecting so far – one of a stable and progressive economy based on the rule of law. The Government’s response to these concerns is that the amendments are not substantive in nature, but merely clarify the ‘original intent of the legislators’, defending its move on the ground that many other countries such as the U.K. and China have also made retrospective amendments to their tax legislations. The U.K. had amended its tax rules retrospectively because it feared losing revenues to tax havens, while China, like India, tightened its laws to tax offshore transfers of assets located in the country.

The FM has taken the stand that companies earning capital gains from the assets located in India will have to pay taxes, either in the country of their origin or in India, stating in a PR that “it is not a case of double taxation but ensuring that companies that are liable to pay tax must pay some tax.” All things considered, the Revenue seems to be the biggest (and only!) winner, netting an estimated gain of approximately USD 7 billion, while the country loses out on foreign investments, which are indispensable for a growing economy like India. In my view, India has compromised on its image as an investor friendly nation at the cost of reaping short-term gains, and the Budget proposals will sooner or later adversely affect the Indian economy.

It is too early to conclude as to whether the SEBI has “changed its mind” on some of the worrying proposals.

The SEBI issued a press release last Friday announcing that it has decided to approve the issuance of the SEBI Alternative Investment Fund Regulations (“AIF Regulations”). The SEBI had put out a draft of the AIF Regulations last year, inviting public comments. I had written a blog back then, summarizing some of the concerns stemming from the draft AIF Regulations upon a quick read.

The SEBI has not yet issued the text of the final AIF Regulations, and one would of course, have to study the actual text of the AIF Regulations as and when they are issued in order to offer a more detailed and meaningful commentary on the proposed changes from a legal perspective. However, the contents of the press release issued by SEBI make the intent and decision of SEBI on certain key aspects very clear. If one were to go by the language of the press release, and (perhaps, naively!) assume that the text of the final AIF Regulations will not contain any material surprises, the decisions taken by the SEBI broadly seem to be positive. Here’s a summary of some of the key issues/points as proposed by the SEBI, based on the press release. I would again reiterate that it is too early to conclude as to whether the SEBI has “changed its mind” on some of the worrying proposals contained in the draft AIF regulations issued last year.

● Repeal of existing VCF Regulations – The existing SEBI (Venture Capital Funds) regulations, 1996 will stand repealed from the date of notification of the AIF Regulations. However, existing VCFs registered under the VCF Regulations will continue to be governed by VCF Regulations till the life of the fund/scheme comes to an end. Fresh fundraisings by existing VCFs will not be permitted unless they first register under the AIF Regulations. However, to the extent that any commitments have already been formally tied up by existing VCFs on or prior to the date of notification of the AIF Regulations, such commitments will be governed by the existing VCF Regulations.

● Rationalization of AIF Categories – The draft AIF Regulations put out by the SEBI last year sought to classify AIFs into as many as 9 different categories, each requiring a separate registration. This would have been a very burdensome, compliance-heavy and strategy-limiting move which would have greatly impeded the operational efficiency of AIFs. In what appears to be a welcome move, the SEBI press release states that the SEBI has now decided to rationalize the classification of AIFs by limiting it to just 3 categories. This may still impede the ability of a “private equity fund”, for example, to invest in an “early stage venture deal” without registering a separate affiliate entity as a “venture capital fund”. But the reduction in the number of categories is still certainly a very welcome move. One would have to wait for the actual text of the AIF regulations to evaluate how clearly the definitional aspects differentiating these categories of funds are laid out, and one cannot rule out that some level of ambiguity may still find its way into the detail!

● Cap on Corpus Size for VC Funds Removed – The earlier draft AIF regulations had proposed a rather puzzling requirement that AIFs registered as “venture capital funds” could not have a corpus higher than Rs.250 crores (USD 50 million). This curious restriction now appears to have been done away with. There is only mention of a limit of no more than 1000 investors in the SEBI press release. If one assumes that the corpus size limit will not quietly find its way back into the final text of the AIF regulations, this is again, a very welcome move.

● Tax “Pass Through” for AIFs – The SEBI press release states that SEBI will work with the central government to obtain “pass through” treatment for AIFs for tax purposes. This is an interesting proposal because under the existing income tax laws, only “VCFs registered with SEBI” are eligible for this tax treatment. Therefore, if the central government agrees to provide tax “pass through” treatment for all AIFs, that will be a very encouraging move that could facilitate fund investments in general. However, having said that, till the Income Tax Act is formally amended to provide for such “pass through” treatment, there will be a lot of ambiguity around the tax treatment of AIFs registered under the AIF Regulations. If there is significant delay in passing the necessary amendments to the Income Tax Act to effect “pass through” status for AIFs (and this kind of thing has happened before – with LLPs, for example, when it took more than a year to get clarity on the tax status of LLPs), that could adversely affect investment strategies and structuring of AIFs in the interim.

● Listing of AIFs – This is an interesting move proposed by SEBI, wherein AIFs will be permitted to list on recognized stock exchanges in India. However, the minimum tradable lot for AIFs will be Rs. 1 crore (USD 200,000). Raising of fresh funds through the stock market is not permitted. While this may not exactly result in a flurry of capital market activity involving AIFs anytime soon, it is still a significant first step to bringing the Indian market more in line with international norms and practices which in recent times have seen a marked increase in cases of alternative investment firms preferring to list themselves on stock exchanges. Many of us may be aware of a couple of instances in India where PE firms tried to list but which were hindered by unclear regulations in this regard.

As can be seen from above, at least based on the SEBI press release, it appears that the SEBI has been to a lot of pains to take into account industry feedback on the earlier draft AIF Regulations and tried to address many of the concerns. The proof of this pudding, however, will be in reading the actual text of the final AIF Regulations, as and when they are issued.

One crucial implication that strikes me though, is that with the press release having been issued, but the AIF Regulations themselves not being notified, there could be some sort of a temporary “suspense period” as far as fundraising process goes. Many funds that are in the process of being raised will surely now choose to wait and watch till the actual text of the AIF Regulations is issued, before proceeding with the process to closings. Given this factor, it would be good if the SEBI reduces this “suspense period” and proceeds to issue the final text of the AIF Regulations at the earliest, so as to remove the atmosphere of ambiguity that is usually associated with transitionary periods without an expiry date!