By Uday N Kajaria
Chartered Accountant and Company Secretary
SEBI (Alternative Investment Funds) Regulations 2012 (hereinafter referred to as ˜AIFR™) notified on 21st May, 2012 provides a platform to the investor to pool their resources for investment in specified sectors such as start-ups, early stage ventures, SME, Infrastructure sector, subscribing to unsubscribed portion of Initial Public Offer(IPO), debt funds, hedge funds etc. Successful implementation of AIFR will attract additional funds from the investor to the above-mentioned sectors which will prove beneficial to all stakeholders and our economy.
AIFR requires minimum investment of Rs 1 crore per Investor in an Alternative Investment Fund (hereinafter referred to as ˜AIF™), minimum investment in an AIF scheme Rs 25 crores and maximum investors in an AIF scheme must not exceeds 1,000. Domestic and Foreign Investors are permitted to investment in AIF, and AIF are permitted to invest in India and abroad as per detailed guidelines given in AIFR.
Categorization of AIF
Tax treatment, Investment conditions and other rules applicable to AIF depends upon category in which an AIF is registered with SEBI. As per AIFR, an AIF may be categorized in anyone of following 3 categories
- Category I AIF which may be further sub-categorized as-
- AIF Venture Capital Fund (which may invest funds in start-up or early ventures)
- AIF Social Venture Funds (which may invest funds for promoting social welfare)
- AIF SME Funds (which may invest in SME sector)
- AIF Infrastructure Funds (which may invest in Infrastructure sector)
- AIF Others (other sector or area, which the government or regulators consider as socially or economically desirable)
- Category II AIF (other than AIF-I or AIF-III which does not undertake leverage or borrowing other than to meet day-to-day operational requirements. An AIF such as private equity or debt fund for which no specific incentive is given by the government/Regulator will be included in this category.)
- Category III AIF (hedge funds and other funds which employ diverse or complex trading strategies and may employ leverage through investment in listed or unlisted derivatives and for which no specific incentive is given by the government/Regulator.)
Certain critical issues of AIFR are discussed below:
1. Tax Consideration
(a) Section 10 (23FB) of Income-Tax Act (hereinafter referred to as ˜IT Act™)
Explanation for AIF-I under clause 3 (4)(a) of AIRF states that:
¦¦¦ such funds which are formed as trusts or companies shall be construed as venture capital company or venture capital fund as specified under sub-section (23FB) of Section of Income Tax Act 1961
As per clause 2 (1) (b) of AIFR, AIF may be any fund established or incorporated in India in the form of a trust or a company or a limited liability partnership or a body corporate
The above-mentioned explanation for AIF-I excludes LLP and body-corporate (other than a company) though AIF-I can be in form of LLP or a body corporate. Does it mean that AIF-I in form of LLP or a body corporate is not eligible to get benefit of section 10(23FB)? It may be an inadvertent error. SEBI may clarify.
As per Finance Act, 2012, AIF-I™s income will be exempted from Income-Tax, but income accrued to AIF-I will be considered as income for its Investors on accrual basis even though AIF-I has not distributed/paid the income to its investors. In other words, the investor cannot postpone his tax liability for income earned by AIF-I and not distributed by AIF-I. AIF-I will also be required to deduct TDS from amount credited or paid to its investor™s accounts. The changes are effective from AY 2013-14.
(b)Listing of units of AIF and Section 115 U of IT Act
Clause 14 of AIRF permits listing of units of close ended AIF with minimum tradable lot-size of Rs 1 crore.
Securities Transaction Tax (STT) can be charged on equity shares or on units issued by equity oriented Mutual Fund as defined by section 97(5) of IT Act. As per clause 2 (1) (b) (ii) of AIFR, AIF excludes Mutual Fund. Hence, no STT will be levied on AIF units traded on the exchange.
This means that units of AIF will neither be eligible for the beneficial rate on short-term capital gain tax of 15% under section 111A of IT Act nor exemption of long-term capital gain under section 10(38) of IT Act.
If units of AIF are not eligible to get benefit under section 111A or section 10(38) of IT Act, there may not be any benefit by listing AIF units as permitted by clause 14 AIFR. Listing of units will result in an avoidable cost of listing fees to AIF and will require compliance with Listing Agreement by AIF. Since marketable lot is with minimum size of Rs 1 crore, trading in units of AIF is expected to be very negligible.
Hence, listing clause 14 of AIFR may not be beneficial. Hence, the listing of AIF units may not become reality.
(c) Service Tax under new Service Tax Regime of Negative List
(i) Domestic Investors in AIF will be required to pay service tax @ 12.36% on fees to be paid AIF. Since income from AIF to the investor is not subject service tax, the investor will not be able get benefit of cenvat credit for Service Tax paid by him to AIF on fees charged by AIF. In other words, service tax of 12.36% will be additional cost to the AIF investor.
(ii) Foreign Investors in AIF may not be required to pay service tax at 12.36% on fees to be paid to AIF as he may not hit by Rule 4 of Place of Provision of Services Rules, 2012 (hereinafter referred to as ˜POPS™) which, inter alia, provides that place of service will be place where goods are given to the service provider for getting the service provider™s service. However, as per section 2 (7) of Sale of Goods Act, 1930 money is specifically excluded from the definition of Goods. Hence, service rendered to a Foreign Investors may be covered by default Rule (3) of POPS which, inter alia, provides that place of providing service will be place of recipient. Since the recipient of AIF™s service (i.e. Foreign Investor) will be outside India i.e. Non-taxable territory, service rendered to a foreign investor may not attract service tax.
2. Hedging facility
Clause 15 (1) (a) of AIFR permits all types of AIF to invest in securities of companies incorporated outside India subject to guidelines from RBI and SEBI. Clause 2 (1) (b) (i) permits all AIF to get funds from a foreign investor.
Clause 17 (d ) of AIFR permits AIF-II to hedge subject to SEBI guidelines and clause 18 of AIFR permits AIF-III to invest in derivatives (which may be used by AIF-III for hedging). However, AIF-I is not empower to hedge by AIFR though AIF-I are eligible to get investment from Foreign Investor and also permitted to invest in companies incorporated outside India. Hence, AIF-I should also be permitted to hedge.
3. Placement Memorandum (hereinafter referred to as PM)
(a) Contents of PM
To enable an investor to take informed decision for investing his funds in an AIF, clause 11 of AIFR requires an AIF to raise the funds through private placement by issue of a document known as PM which should contain all material information about the AIF and its scheme such as background of key management team, targeted investors, fees and other charges payable by an investor, tenure of AIF/scheme, investment strategy, risk management tool, conflict of interest, disciplinary history and such other information.
SEBI™s comment on PM
Since PM is an important document for investment in AIF, clause 12 of AIFR requires that an AIF must file PM with SEBI at least 30 days prior to launch of the scheme alongwith prescribed fees. As per clause 12 (3) of AIRF, SEBI may communicate its comments, if any, on the PM and AIF is required to incorporate the same in PM before launch of the scheme.
Investment of funds by AIF strictly as per PM and change in PM requires prior approval of two third of its investors in value
Since clause 9 (2) of AIFR requires AIF to take prior approval of at lease two-third of its investor by value for change in fund strategy and clause 7 (1) (b) of AIFR requires that AIF shall not carry activity other than permitted activities, AIF should take utmost care while preparing PM for pooling investors™ funds in AIF through private placement.
(b) Precautions which may be taken by an Investor before investing in an AIF
(i) He should review PM in details to ensure that his interest is duly safeguarded.
(ii) AIFR does not prescribe maximum fees which may be charged by an AIF. Hence, he must check that fees and other charges payable by him to AIF are fair and reasonable. Looking to past experience in financial market in India and abroad of financial irregularities committed by market intermediaries, SEBI may prescribe maximum total fees which may be charged by an AIF to its investor. This should ensure that AIF and the investor get fair treatment.
(iii) He should check where the AIF will invest his funds. Clause 16(2)(b)(iv) of AIFR permits AIF-I to invest not more than one-third of corpus in a ˜financially weak company or a sick industrial company whose shares are listed. Clause 16 (2) (c ) and clause 17 (e) of AIFR permits AIF-I and AIF-II to invest in unsubscribed portion of an IPO by entering an agreement with a Merchant Banker. Investment of funds in sick company and/or unsubscribed portion of an IPO require proper check and control to ensure that the investment does not become non-performing asset.
(iv) Since listing of AIF units are not beneficial to the investor as explained above at para 1 (b), an investor may insist that AIF units are not listed.
(v) Clause 15 (1) (b) of AIFR provides that co-investment in an investee company by a Manager or Sponsor shall not be on terms more favorable than those offered to AIF. An Investor may insist that a Manager or a Sponsor may not make co-investment as permitted by the said clause, but they should invest their minimum funds of rupees 25 lakhs in AIF as provided by a proviso to clause 10 (c) of AIFR. SEBI may put such change in AIFR to avoid conflict of interest
(vi) Receipt of foreign exchange as investment from a foreign investor and/or investment outside India exposes an AIF to foreign exchange fluctuation risk, which requires additional cost in form of hedging. Hence, domestic investor may insist for exclusion of foreign exchange transaction to keep his return at fair level.
(vii) An investor may request for an appropriate clause in PM for consequence for default in investment of his funds in areas other than stated in PM. To ensure that his funds are invested in area specified in PM only, the clause may treat such unauthorized investment as null and void from ab inito and make AIF, its sponsor and Manager personally liable to the investor to make good loss for unauthorized investment. This should ensure that the investor funds are invested in areas specified in PM.
(viii) An investor may insist for proper and timely reporting for his investment from AIF to get early signal for unsatisfactory performance or detect unauthorized investment, if any, by an AIF. Clause 22 (g) and (h) of AIFR requires AIF-I and AIF-II to provide specified information on yearly basis within 180 days and AIF-III should provide the specified information on quarterly basis. SEBI /Investor should require AIF-I and AIF-II to provide information on quarterly basis, otherwise it may be too late to take corrective action.
4. SEBI (Substantial Acquisition of Shares and Takeover) Regulations 2011 (hereinafter referred to as Takeover Regulations)
Clause 38 of AIFR specifies through clause 3 of Third Schedule attached to AIFR that
(i) AIF and its sponsor, trustee company and manager will be consider as Persons acting in concert for Takeover Regulations.
(ii) Acquisition of shares from AIF-I by the promoters of the target company is exempted from making open offer under Takeover Regulations. However, it may be noted that similar exemption from making public offer is not given to AIF-II and AIF-III.
Clause 2 (c ) of AIFR defines an associate as a company or LLP where specified persons, individually or collectively holds more than 15% of paid-up capital of a company or partnership interest. However, Promoter and Promoter Group as defined by SEBI (Issue of Capital & Disclosure Requirements) Regulations 2009 consider a body corporate as Promoter Group if a promoter holds more than 10% equity capital of the body corporate or vice versa. Stricter requirement for ˜Associates™ for AIF as provided by SEBI (ICDR) Regulations would have been better from the investor point of view.
6. Appointment of a Compliance Officer
Though appointment of a Compliance Officer is made compulsory by SEBI for a share-broker, a depository participant, a Portfolio Manager, a Merchant Banker etc, AIFR does not provide for appointment of a Compliance Officer for AIF. To ensure compliance with AIFR and other applicable regulations, SEBI may provide for appointment of a Compliance Officer. Meanwhile, AIF may appoint Compliance Officer to ensure compliance with AIFR and act as watch-dog for SEBI/Investor.
7. Venture Capital undertaking (hereinafter referred to as ˜VCF™)
Clause 2 (1) (aa) defines VCF as a domestic unlisted company engaged in business of providing service or production of good. But, VCF excludes NBFC, gold financing and other activities not permitted by government. Since the definition of VCF is unclear on real estate company and non-NBFC companies rendering services in financial sector, SEBI may clarify the same.
8. Re-registration of existing Venture Capital Fund under AIFR
Second proviso to clause 3 ( 2 ) of AIFR provides that the Venture registered under SEBI ( Venture Capital Fund) Regulations 1996 may get re-registered under AIFR if they wish to launch new scheme and / or increase its corpus amount. To avoid additional cost, time and paper-work, SEBI may treat existing registered VCF as AIF registered under AIFR after getting minimum information required from the registered by VCF within time to be specified by SEBI.
9. Application for registration as AIF Category
Clause 3 (4) of AIFR states that AIF shall seek registration for one of categories of AIF as explained above. This means that AIF cannot make application for multiple categories including multiple sub-categories applicable to AIF-I. The relevant clause is reproduced below
(4) Alternative Investment Funds shall seek registration in one of the categories mentioned hereunder and in case of Category I Alternative Investment Fund, in one of the sub categories
As per clause 7 (2) of AIFR, registration granted for a category cannot be changes without SEBI™s prior approval.
In view of different regulations applicable to different categories of AIF, Tax-consideration at para 1 and Take-over Regulations as explained at para 5, all relevant aspects should be considered in detail before applying for AIF registration under appropriate category.
SEBI may clarify how an AIF apply for registration if the AIF likes to get registered under more than sub-category under AIF-I and/or registration under more than one category.
10. Minimum Investment in AIF
( a ) Manager or Sponsor
Clause 10 (d) of AIFR provides that the Manager or Sponsor of AIF-I and AIF-II should have continue interest in the AIF of not less than 2.5% of the corpus or Rs 5 cr whichever is lower while the Manager or Sponsor of AIF-III should have continue interest in the AIF of not less than 5% of corpus or Rs 10 crore whichever is lower. Though the clause uses term the Manager or Sponsor, it should be read as ˜the Manager and/or Sponsor™ to mean that total investment by them should meet minimum requirement.
(b) Employee or a Director
Proviso to Clause 10 ( c ) provides that an employee or a director of AIF/ the Manager may invest minimum amount of Rs 25 lakh per investor. The concession may be used by AIF for getting funds from an investor (by appointing him as an employee/director) who may like to invest funds less than Rs one crore.
( c ) Per Scheme
Clause 10 (b) of AIFR provides that minimum investment per scheme must be Rs 25 crores, and clause 10 (f) provides that maximum investors per scheme cannot exceeds 1,000. AIFR does not prescribe minimum investor per scheme, which means that a scheme may have one investor only.
11. Tenure of AIF
(a) Clause 13 ( 1 ) and ( 2 ) AIFR provides that AIF-I and AIF-II must be close ended with a minimum period of 3 years which can be extended maximum upto 2 years subject to approval of two thirds of its investors in value.
(b) Clause 13(3) provides that AIF-III may be open ended or close ended. However, clause 13 is silent on minimum tenure for AIF-III. SEBI should specify minimum tenure for AIF-III for closed ended scheme.
12. Investment by AIF
(a) AIFR provides detailed regulations no 16, 17 and 18 for investments by AIF-I, AIF-II and AIF-III respectively and the same are broadly stated above.
(b) Clause 15 (1) (c) provides that AIF-I and AIF-II will not invest more than 25% of its corpus in an investee company and clause 15
(1) (d) provides that AIF-III will not invest more than 10% of its corpus in an investee company.
(c) Clause 15 (1) (e) AIF will not invest in associates except with the approval of 75% Investors in value in the AIF.
13. Conflict of Interest
Clause 21 of AIFR requires AIF to act in fiduciary capacity and have written policy to identify, monitor and mitigate conflict of interest, and the policy is to be implemented by the AIF. SEBI may prescribe minimum requirement for Conflict of Interest policy by an AIF and also specify consequences for non-compliance with Conflict of Interest policy. Such regulations should mitigate conflict of interest by AIF.
Clause 22 of AIFR requires periodical disclosure of important information to the investor. However, specified format of reporting at specified shorter interval, say, monthly, will develop standard practice in AIF sector. This should highlight problem area at early stage and dispute, if any, can be minimized. AIF may adopt such practice to have confidence of its investor in its working and garner maximum funds through AIF.
SEBI should have mandated reporting through email to support initiative to go green, reduce cost of reporting and reporting at shorter time-interval of the requirement, as is done for other market intermediary.
Clause 23 of AIFR requires AIF to inform valuation procedure and methodology for valuing its assets. It also requires periodical valuation of its assets by independent valuer appointed by AIF. Looking to need for providing true and fair value of AIF assets to the investor, better comfort and better results may be achieved, if AIFR would have provided for valuation of AIF assets by independent valuer appointed by SEBI instead of AIF.
In conclusion, it may be submitted that SEBI may modify AIFR in light of suggestions made above to ensure that AIF sector is further strengthen to enable investor to earn reasonable return, new business gets required finance, general public get new products and services, professional/others get employment in AIF sector and SEBI does not get cases for enquiry &, application for consent term for settling pending enquiry (which claims substantial time and cost of all concerned parties including SEBI.)