In India, FDI (foreign direct investment) has always been an important source of funding for startups. FDI policy is traditionally regulated under the Foreign Exchange Management Act, 2000 governed by the Reserve Bank of India. However, start-up funding through alternate investment funds are becoming increasingly popular thus bringing into the regulatory ambit the Alternate Investment Fund Regulations. The second part of this paper deals with the intricacies of Alternate Investment Funds that channel foreign funding into Indian start-ups.
1. FDI POLICY AND AIF REGULATIONS
As per the Indian Foreign Direct Investment Policy of 2017, investment is divided up into the “automatic route” or the “approval route”. Under the automatic route, neither the foreign investor nor the Indian company, requires any approval from the government whereas for investment through the approval route, prior governmental approval is required. As per Section 5.2 of the FDI Policy, the sectors in which automatic investment is allowed and those sectors that require approval is tabularised. Some sectors, such as defence, allow investment up to 49% through the automatic route, beyond which government approval has to be sought. Along these lines, certain categories of AIFs also have an automatic route of funding, making it a preferable mode for foreigners interested in investing in Indian start-ups.
Alternate Investment Funds, as per Regulation 2(1) (b) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012, refers to any privately pooled investment fund, (whether from Indian or foreign sources), in the form of a trust or a company or a body corporate or a Limited Liability Partnership (LLP). AIFs, thus, are private funds that don’t come under the purview of any other regulations in India.
The AIF regulations divide investment into three categories: Categories I, II and III. Category I deals with investments in those sectors that are considered to create a positive effect on the economy, usually investments in start-ups, social sector companies infrastructure, start-ups or small and medium enterprises. Since they play a role in the growth of the country, several incentives are provided to them by the Government. Category I AIFs include Venture Capital funds, SME funds, Infrastructure Funds, Social Sector Funds etc. Category II AIFs include investments that undertake leveraging or borrowings to meet operational requirements as permitted under regulations by the SEBI. There are no incentives or concessions provided to these funds. Typically, these include certain debt funds, private equity funds etc. Category III AIFs include funds which undertake very diverse and complex trading strategies and can make investments in both listed and unlisted instruments. A typical example would be a hedge fund or a quant fund.
2. HOW INVESTMENT THROUGH AIFS WORKS IN INDIA
Foreign investment, that are not channelled through AIFs, usually comes in either by way of subscription to or purchase of equity shares or convertible preference shares or debentures of the start-up. The investment amount is normally remitted through normal banking channels or into a Non-Resident External Rupee (NRE) or Foreign Currency Non-resident (FCNR) account of the Indian company. The company later reports the details of the transaction to the RBI through the filing of a Single Master Fund Form.
The reason why AIFs have become increasingly popular for sourcing funds to start-ups is because of the lower regulation regime. Typically, an AIF must register itself with the SEBI as a Category I AIF through Form A in sub regulation 4 of the fifth schedule of the AIF regulations. AIFs can be incorporated in the form of a trust or a company or a limited liability partnership. Most AIFs are registered as trusts because of the flexibility, fewer hassles of administration and compliance and umpteen tax benefits that they offer.
Unlike a company or an LLP (both under the purview of the Ministry of Corporate Affairs), there is no separate supervisory authority that regulates trusts. The trust is governed by the trust deed, which is executed between the settlor and the trustee. The settlor or author is required to settle the trust with an initial settlement amount, which has to be transferred to the proposed trustee. Trusts usually have a board of trustees but in trusts that work as AIFs the trustee is often an independent institutional trustee, who agrees to provide trusteeship services in exchange for consideration.
Private trusts don’t usually have to be registered but the AIF Regulations require that the trust is registered under the Indian Registration Act, 1908. A trust structure permits “ring fencing” of the manager’s liability because the manager is only providing a service to the AIF, as opposed to a situation where the manager is on the board of directors of an AIF which could be a company, or is a partner in an LLP.
The trustee of a trust invests the trust’s assets as per the terms of the trust deed. There are 3 key stakeholders to an AIF: sponsors, trustees and an investment manager. Sponsors are individuals who set up the AIF and are responsible for the activities of the AIF. Trustees, who are independent professionals, overlook the activities of the fund. An Investment Manager, manages the fund at the ground level in exchange for a management fee. With respect to the AIF Regulations, the Trustee has to ensure compliance, for which it imposes relevant restrictions under the Fund Documents (for example, a proper exit mechanism to investors upon a material change in the PPM). But commercial operations of the fund (for example, distributions, notices, voting matters) are responsibilities of the Investment Manager. After the fund makes investments, and subject to the expiry of its tenure, the fund is then closed or liquidated.
Investment in category I AIFs are subject to the type of investment- largely divided between an angel fund and a foreign venture capital investment fund. If the mode of investment is the foreign venture capital investment fund, investments will have to be made according to schedule 7 of the FEMA 20 (R) notification which specifies the sectors in which such investment can be made. AIFs generally don’t have any minimum capital requirement and while a minimum corpus has to be maintained, this amount is significantly lesser for Angel or Venture Capital funds. So while other AIFs have minimum corpus requirements of 20 crore and minimum investment per investor of atleast one crore, category 1 AIFs involved in start-ups have minimum corpus requirements of 10 crores and minimum investment per investor of a lesser amount of 25 lakhs.
Angel investors prefer an AIF investment structure as it helps start-ups by exempting them from angel tax , while investors felt that it created an equal opportunity for angel funds and venture capital seed funds. It is evident that the Government of India is trying to establish a climate that is conducive for raising investment from foreign investors. The government has also tried to lower pricing norms for foreign direct investments, clarify call options, and ensure liberalisation of investment caps in the AIFs. Additionally, tax benefits to these funds are that the end-investor bears the tax liability, not the private funds. Investment gains on unlisted shares, that most AIFs invest in , are eligible for long-term capital gain taxation benefits, by reducing the holding period for from three years to two years. There is also a “safe harbour status for fund managers” which allows investment gains to be treated as capital gains. This has enticed many investment companies to register as investment funds and many high net worth investors to put their money in these funds.
LetsVenture, in October 2018, registered as an AIF, claiming that the move would allow them to push investments up to Rs 1,000 crore in the next two years, as compared to Rs 450 crore invested in the past five years. AIFs “empower entrepreneurs, while also allowing investors to invest smaller amounts and diversify their portfolio.” Similarly, giants such as ITC have also invested in alternative AIFs which further invest in fast moving consumer goods start-ups. The Kolkata-based company has put their money into Fireside Ventures and is closing an investment round in another fund as well. Several foreign portfolio investors (FPIs) are now using the AIF route to make debt investments in India as it gives offshore investors the flexibility to participate in various kinds of private debt issuances. It is no surprise then that almost hundred new AIFs have come into existence as of 2018 and investments in AIFs have risen by 30 percent.
3. THE SUCCESS OF AIFs IN INDIA
If AIFs have allowed funding to be done in a more efficient manner than ever that benefits both the entrepreneur and the investor, why then has a mere 5% been invested in start-ups? Finance Minister Nirmala Sitharaman’s recent announcement that the Angel Tax is inapplicable to start-ups registered with the Department for Promotion of Industry and Internal Trade (DPIIT) was a huge success but the fact remains that of whatever money you raise, you will be exempt “till total share capital plus share premium touches INR 25 crore.” So in order to qualify for the exemption, the total amount of capital issued, should be below INR 25 crore. But AIFs falling in Category I are exempt from this completely. The ambiguities that still persist around felling the angel tax has pushed AIFs to be a more desirable form of investment.
While the AIF investment structure has been a boon in many ways there have been pleas for further change. Firstly, there is a need to shift to unit-based taxation. This can make the AIFs more attractive to investors. Under current tax laws, the costs incurred by investors in generating capital appreciation through AIFs are not deducted for income tax. This causes issues because the costs in AIFs tend to run high as investors commit to a pool of funds and not their individual investment. The current system also doesn’t allow net losses to be set off. A shift from the pass-through taxation system at the fund level to a unit-based taxation system can level the playing field between AIFs and other vehicles such as mutual funds and greatly contribute to the vehicle’s popularity.
Secondly, applicability of GST is still an issue. Overseas pooling vehicles do not pay service tax and current GST rules clearly exempt export of services from GST. However, pooling of dollars in AIFs managed by Indian asset management companies and the profits that are exported are not exempt from GST. This adds 18% to the cost of management and creates significant barriers to creating more AIFs. The management company make their profits not from fees, but from ‘carry’ based on the fund’s financial success. Government authorities usually demand tax on these carry payments to the management company as service tax and not long term profits. This dismantles the entire point of an AIF.
Thirdly, there has been a call for the publication of reliable date to appraise how the AIF industry is fairing in India. As AIFs are a developing asset class in India, foreign investors would want to know how the AIF industry is faring before they commit their money. There needs to be an industry wide database with information on AIFs in India. Proactive action needs to be taken by SEBI to convene these agencies.
Mending these few gaps may work wonders for the Indian start-up funding eco system. India’s potential is well known in the world market, only the process needs to be made easier to work with.
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