The last few years have seen the introduction of several pro-funds industry measures on the tax side in India. One notable measure was the insertion of a ‘safe harbour’ provision into the Income Tax Act, 1961 (“ITA”) to protect offshore funds (hereinafter, “funds”) from the adverse tax consequences of having an onshore fund manager (“Safe Harbour Rules”). Recently introduced rules now attempt to make the Safe Harbour Rules more effective, and provide the mechanics for their working (“New Safe Harbour Rules”). This blog post will offer a brief overview of the Safe Harbour Rules and the New Safe Harbour Rules.

Safe Harbour Rules: The Background

The presence of an onshore fund manager would expose a fund to two risks under the ITA:

(i) the fund might be perceived to be managed from India by the onshore fund manager; and

(ii) the fund’s income would be regarded as India-sourced since the onshore fund manager will be the fund’s ‘business connection’ in India (under the ITA, a non-resident’s income arising from ‘business connection’ in India is deemed to be India-sourced).

Due to these risks, the fund management industry migrated out of India. For example, a fund set up in the Cayman Islands and investing in emerging markets in South East Asia would usually choose not to have its advisory team located in India so as to avoid having its income dragged into the Indian tax net.

Safe Harbour Rules: The Issues

In an effort to make India an attractive destination for the fund management industry, the Safe Harbour Rules were introduced in 2015. The Safe Harbour Rules exempted ‘eligible’ funds from key provisions of the ITA by providing that: (i) an eligible fund managed by an eligible fund manager would not be regarded as being managed from India; and (ii) an eligible onshore fund manager would not be a ‘business connection’ of an eligible fund.

However, the Safe Harbour Rules came with numerous strings attached – to be a eligible fund, such fund: must be broad based i.e., have more than 25 limited partners (“LPs”); must not have LPs with interests in the fund exceeding certain limits (e.g., Indian LPs cannot hold more than 5% of the fund’s corpus); must be resident in a country that has a Double Taxation Avoidance Agreement (“DTAA”) or tax information exchange agreement with India; must not (directly or indirectly) control Indian companies; and must have a monthly average corpus of INR 1 billion. In addition, to access the Safe Harbour Rules’ exemptions, an eligible fund manager cannot be connected to, or be an employee of, the concerned fund; must be remunerated by such fund at arm’s length, and cannot receive more than 20% of such fund’s profits.

These conditions were hard to comply with, given the variety of structures that are employed by funds (by way of an example, in a situation where the fund in question is merely a Singapore or Mauritius based intermediate holding entity of a pooling vehicle based elsewhere, such fund would not be able to satisfy the ‘broad based’ criterion since it would have just one, or at best, a few investors). More generally, the above conditions would affect/compromise key commercial and economic considerations of the fund (by way of another example, the condition specifying that no LP should hold an interest greater than 10% in a fund would disqualify funds that may have a large anchor investor).

As a result, the Safe Harbour Rules were viewed as impractical, and met with a negative response from the funds industry.

The New Safe Harbour Rules

The New Safe Harbour Rules clarify that the criteria regarding the number of LPs in an eligible fund, the extent of their interests, and the connection between the LPs can be satisfied by ‘looking through’ the LP entities. This clarification will prove useful when evaluating master-feeder structures, or LPs that are fund-of-funds, under the Safe Harbour Rules.

The New Safe Harbour Rules also relax the timelines for complying with certain criteria for eligible fund status. For example, if a fund, at a certain stage of the fund raising process, has raised commitments only from Indian LPs, or has not yet obtained applicable registrations in its home state, these would not immediately operate to deprive such fund of ‘eligible fund’ status under the Safe Harbour Rules.

Regarding the condition that an eligible fund must not control any Indian company, the New Safe Harbour Rules provide an objective test (the trigger being: holding more than 26% of the investee’s share capital or voting power) for determining control – but provide no guidance on whether holding affirmative rights would constitute ‘control’ of an Indian company.

Significantly, the New Safe Harbour Rules clarify the manner of computing the ‘arm’s length price’ (the minimum price at which an eligible fund must remunerate its eligible fund manager), and relax the ‘arm’s length price’ condition substantially if a fund complies with all other conditions prescribed by the Safe Harbour Rules. However, there is no relaxation of the Safe Harbour Rules’ condition that no more than 20% of an eligible fund’s profits can flow to the onshore fund manager (and connected entities) – this restriction might cause issues when putting in place the fee structure of a fund.

The New Safe Harbour Rules also provide for an advance ruling procedure: a fund can approach the Central Board of Direct Taxes (“CBDT”) for an ‘approval’ regarding its status as an eligible fund under the Safe Harbour Rules. This is a very welcome development given that the approval seems to be a time-bound process that should give certainty to a fund regarding the potential tax outcomes of its structure.

Conclusion

The Finance Bill, 2016 has proposed that funds based in certain notified countries having no DTAA with India will be able to benefit from the Safe Harbour Rules. With these developments, and going by the old adage that actions speak lounder than words, it appears that the Government’s invitation to the fund management industry is heartfelt and sincere.

However, certain roadblocks still remain. The Safe Harbour Rules’ conditions regarding the extent of LPs’ interests in an eligible fund still need to be navigated through, as does the condition that an onshore fund manager cannot be an employee of, or be connected to, an eligible fund. The Safe Harbour Rules’ condition that an eligible fund cannot hold a controlling stake in an Indian company has not been diluted, thereby denying buyout funds the ‘eligible fund’ status. The condition that an eligible fund must have a monthly average corpus of INR 1 billion has also not been rationalized.

Specifically with regard to India-focused funds, the New Safe Harbour Rules do not really address the concern that an onshore fund manager may be a ‘permanent establishment’ of the fund in India under a DTAA, which is a significant issue for India-focused funds.

Going forward, it remains to be seen whether funds/fund managers are willing to sacrifice a degree of flexibility in exchange for tax certainty by complying with the Safe Harbour Rules – in the event they are, close attention must be paid to the fine print of the New Safe Harbour Rules during the fund formation process (as well as on an ongoing basis), particularly, the timelines for satisfaction of the Safe Harbour Rules, the composition of LP entities ‘one level up’, and the possibility of obtaining a CBDT approval to ensure ‘eligible fund’ status and the corresponding beneficial tax treatment.