India’s balance of PE regulation and investor friendliness

Author: | Published: 1 Oct 2012
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Amid the global slowdown and local economic uncertainty, India has seen a reduction in both the number and size of its private equity (PE) and venture capital (VC) investments. While investors continue to believe in the India story in the long-term, PE and VC firms have become increasingly concerned about short and medium term-gains from investments. The Indian regulators recognise the importance of the role played by PE and VC investments in India, and have taken several steps to meet investor expectations while maintaining safeguards to avoid fiscal abuse.

Consequently, India has witnessed the introduction of new rules and regulations, along with significant changes in existing laws. While some have been lauded, others have been vehemently criticised. The government appears to have responded positively to some of the adverse reaction as well by modifying or postponing some proposals, such as the introduction of General Anti Avoidance Rules (GAAR) in the tax sector. That said, all PE and VC players must now navigate an increasingly complex regulatory framework,which, on a positive note, provides increased options as to how they may structure themselves or invest in India.

Securities laws: regulating AIFs

The Securities and Exchange Board of India's (Sebi) Alternative Investment Funds (AIF) Regulations are perhaps the most significant set of regulations that alter the PE regulatory landscape. Previously, Sebi regulated both domestic and foreign venture capital funds. Some PEs voluntarily operated under this framework, while others failed to comply with these requirements. Recognising the existing limitations, the regulators prepared draft regulations drawing on international and domestic experience for regulating PE and VCs. The draft regulations were circulated for suggestions among local players and were amended based on such feedback. Finally, Sebi (AIF) Regulations were brought in force from May 21 2012. The Sebi (VCF) Regulations now stand repealed.

All privately pooled investment vehicles (with domestic or foreign contributors) set up in India and which invest in accordance with a defined investment policy for the benefit of investors are considered AIFs. They must now be mandatorily registered with Sebi. Such vehicles have been given six months to register, which may be extended to 12 months upon application to Sebi. The AIF Regulations do not however apply to mutual funds, collective investment schemes, holding companies, ESOP trusts and securitisation trusts, among other vehicles. Given the said framework, it is always important while structuring investment vehicles in India to ascertain whether they would fall within the rubric of AIFs or not.

Broadly, a three-fold categorisation has been created for AIFs. Category I AIFs covers AIFs that invest in start-up and early stage ventures, social ventures, small to medium-sized enterprises (SMEs), infrastructure or other sectors which the government or regulators consider socially or economically desirable. Tax -pass-through status given only to VC funds has now been continued for Category I AIFs. Category II AIFs are AIFs that do not fall in Category I or III, and which also do not undertake leverage or borrowing other than to meet day to day operational requirements and as may be specifically permitted. PE funds and debt funds are included within Category II. Category III AIFs cover AIFs that employ diverse or complex strategies and may employ leverage including through investment in listed or unlisted derivatives. Hedge funds or funds which trade with a view to make short-term returns or such other funds which are open-ended are covered here. It is relevant to note that no concessions or incentives are granted by the government or regulators to Category II and III AIFs. While the categorisation appears sophisticated, certain issues still require clarification, such as which entities would be treated as start- ups or early stage ventures. No definition has been provided. For now, Sebi has left the regulations open for AIFs which do not fall within either of these categories.

Eligibility conditions have been prescribed for AIFs depending upon the nature of the legal entity. Certain conditions have been similarly stipulated for the sponsor and manager of the AIF. Once registered, AIFs may launch multiple schemes subject to filing of a placement memorandum 30 days in advance. Conditions for investment into AIFs have also been stipulated. Some of the pertinent ones are: (i) AIFs may issue units to domestic or foreign investors; (ii) a minimum corpus of INR 20 Crore ($3.63 million) has been prescribed, with the minimum investment for any investor to be INR 1 Crore; and (iii) manager or sponsor shall have a continuing interest in the AIF of not less than 2.5% of the corpus or INR 5 Crore for Category I and II AIFs, and not less than 5% or INR 10 Crore (whichever is lower) for Category III AIFs. AIFs can collect funds only by way of private placement and are not permitted to have more than 1000 investors.

Specific conditions regarding tenure and investment have also been stipulated based on the categorisation of the AIF. Units of close-ended AIFs may also be listed on stock exchanges subject to a minimum tradable lot of INR 1 Crore. Certain general obligations and transparency requirements to mitigate conflicts of interest and to increase disclosure of relevant information to investors have also been provided. Sebi in its latest meeting has also approved AIFs' contribution up to 10% towards fulfillment of promoter's contribution in public offerings.

Overall the new AIF regulations are welcome, as they provide clarity on the regulatory regime governing different kinds of PE funds. Moreover Sebi has also specifically permitted debt funds and hedge funds as well as fund of funds to operate in India. However, the said regulations also increase reporting and compliance obligations by AIFs with ample powers given to Sebi to seek any further information. The consequential changes to the Foreign Direct Investment (FDI) Policy regarding AIFs are also awaited. The stipulation of minimum investment limits may affect launching of new schemes.

Foreign investment regulations

Options for FVCIs widened

Previously, foreign venture capital investments (FVCIs) registered with Sebi could purchase eligible securities (such as equity, equity-linked instruments, debt, debt instruments, debentures of an Indian Venture Capital Undertaking (IVCU) or VC fund, units of schemes and funds set up by a VC fund) only through initial public offering (IPO) or private placements. The FDI Policy and the Foreign Exchange Management Act (FEMA) now allow FVCIs to invest in these eligible securities by way of private arrangement or purchase from a third party. It has also been clarified that Sebi-registered FVCIs would also be allowed to invest in securities on a recognised stock exchange subject to the provisions of the Sebi (FVCI) Regulations. However, such an amendment has yet to be made in the SEBI (FVCI) Regulations to freely permit FVCIs to invest on recognised stock exchanges.

QFIs definition widened

What began as a means of liberalising foreign portfolio investments in the country sometime in the second half of 2011 has now become a favoured foreign investment route. In 2012, qualified foreign investors (QFIs) were also allowed to invest in the equity shares of listed Indian companies through qualified depository participants. The individual and aggregate investment limits for the QFIs have been stipulated as 5% and 10% respectively of the paid up capital of the company. These ceilings are over and above the foreign institutional investor (FII) and non-resident Indian (NRI) investment limits through the Portfolio Investment Scheme (PIS). From July of this year, they have also been allowed to purchase on a repatriation basis corporate debt instruments subject to conditions issued by the Reserve Bank of India (RBI). To facilitate these transactions, QFIs are allowed to hedge the currency risk on account of their permissible investments with the AD Category-I bank with whom they are maintaining the rupee account opened for the purpose of investment.

QFIs were earlier defined as non-resident investors (other than Sebi registered FII and FVCIs) who (i) meet the KYC (Know Your Client) requirements of Sebi; and (ii) is a member of Financial Action Task Force (FATF). The definition has been recently widened upon the basis of representations made to the Indian regulators to include members of the European Commission and the Gulf Cooperation Council.

These amendments are positive as they now provide for a new class of investors which at times can also include PE funds, permitting them to invest in mutual funds, equity and corporate bonds.

Two way fungibility for IDRs

With the intention of encouraging greater participation in the Indian capital market, Sebi and RBI have reviewed their respective guidelines to allow limited two-way fungibility of Indian depository receipts (IDR). Earlier, IDR could be redeemed only after one year from the date of issuance only if they were infrequently traded on the Indian stock exchanges. After the following amendments, partial fungibility of IDRs in a financial year to the extent of 25% of the IDRs originally issued has been allowed. The conversion and reissuance shall be subject to the guidelines issued by RBI on the subject in 2009, as well as the Sebi ICDR Regulations. A further cap of $5 billion to be monitored by Sebi has also been put in place for raising capital by issuing IDRs by eligible foreign companies in Indian market.

FDI limits

The Indian government has continued its cautious process of liberalising FDI policy caps. The government, in a potentially landmark move, has notified that 100% FDI in single-brand product retailing via government approval is permitted, subject to various riders – one of them being sourcing of at least 30% of the value of the products from Indian small industries. The Government has recently decided to allow 51% FDI in multi-brand retail trading.

In view of the spate of acquisitions of domestic pharmaceutical companies by international majors, and the growing threat of non-availability of drugs at reasonable rates internationally, the Ministry of Health and Family Welfare muscled a review of the foreign investment policy in the pharmaceutical sector. Foreign investment in pharmaceutical companies was freely allowed up to 100% earlier. Now greenfield investments will continue to enjoy 100% investment via the automatic route, while all brownfield investments up to 100% shall be subject to Foreign Investment Promotion Board (FIPB) approval.

Corporate Laws

Preferential allotment goes hybrid

In light of recent judicial pronouncements, the Unlisted Public Companies (Preferential Allotment) Amendment Rules have redefined 'preferential allotment' in the literal sense. While the earlier definition covered only preferential issue of shares, or issue of shares through private placement under the Companies Act 1956, the new definition has also brought within its ambit allotment of instruments convertible into shares including hybrid instruments convertible into shares on a preferential basis. Certain procedural restrictions that apply to preferential allotments have also been introduced. Among others, they include considering an offer not in compliance with section 81(1A) and section 67(3) of the Companies Act as a public offer and it should be compliant with Securities Contract (Regulations) Act and Securities Exchange Board of India Act. Therefore, any offer or invitation made to 50 persons or more shall be considered as a public offer.

Financial disclosures revised

For financial statements issued as on March 31 of this year the central government has revised schedule VI of Companies Act regarding the format of balance sheets and profit and loss accounts to be submitted by Indian companies to the Registrar of Companies at the end of each financial year. The formats have been harmonised with the disclosure requirements in the Accounting Standards, which will prevail in case of any conflict between them and the schedule. The revised schedule VI aims to facilitate an unbiased portrayal of the financial and liquidity position of a company in line with the IFRS. The new financial disclosure requirements shall not apply to insurance or banking companies. They also do not apply to any company engaged in the generation or supply of electricity, or to any other class of company for which a form of balance sheet and profit and loss account has been specified in or under any other Act governing that class of company. More detailed information in the financial statements of Indian companies would provide PE and VCs with more information while they make investment decisions.

Competition law

Over the last few years the Competition Commission of India (CCI) has become increasingly active in the investigation of antitrust activities. As part of the merger control functions, since the CCI (Procedure in Regard to The Transaction of Business Relating to Combinations) Regulations 2011 (Combination Regulations) took effect, the CCI has begun to hear and pass orders upon the validity of combinations in terms of the Competition Act.

The Combination Regulations have been amended this year to exempt certain transactions from seeking the approval of CCI. In line with the increase (from 15% to 25%) in threshold for making a public offer in terms of the Sebi Takeover Code 2011, consequential amendments have been incorporated. Therefore, the direct or indirect acquisition of a non-controlling stake in a company – up to an aggregate of 25% (earlier 15%) of the total shares or voting rights of such company – has been exempted from a filing requirement. In addition, exemptions have been provided for the increase in shareholding or voting rights consequent to a share buyback programme, provided it does not result in change of control. The exemptions also apply to mergers and amalgamations involving a holding company and its subsidiary, or among the subsidiaries of the same group, provided that such subsidiary is wholly-owned by such holding company and enterprises belonging to the same group.

Another significant amendment to the Combination Regulations applies when, as a part of a series of steps in a proposed transaction, particular assets of an enterprise are transferred to another enterprise which is then acquired by any third party for the purpose of calculating the stipulated thresholds for Combinations under the Act. The amendment provides that the entire assets and turnover of the selling enterprise will also be considered while making such calculations.

Income tax laws


The Supreme Court's landmark judgment this year in the Vodafone case was welcomed by all foreign investors. The judgment categorically held that, given the provisions of the Income Tax Act (ITA), the Indian tax authorities could not tax a shares transfer between non-residents of a foreign company which, in turn through step down subsidiaries, had underlying assets in India. The success was short-lived as the Indian government brought in retrospective amendments to the ITA to tax overseas transfers that indirectly transfer assets, shares, management or control in India. Clear obligations have also been inserted with respect to withholding of tax by non-residents in such transactions, even if the parties to the transaction do not have a business connection or presence in India.

General Anti Avoidance Rules (GAAR)

The GAAR were introduced in the Finance Act 2012 to be implemented from April 1 2013 with the objective of restricting and restraining aggressive tax arrangements. Given the lack of preparedness of the tax authorities themselves, along with the vague and ambiguous provisions, the investment community vigourously opposed the proposals and a number of representations were made to the Indian Ministry of Finance. Consequently, the government has deferred the implementation of GAAR by one year. An expert committee headed by Parthasarathi Shome was also constituted for finalising and providing recommendations on GAAR. The committee in a recent report has recommended the deferment of the implementation of GAAR by three years, to become effective from AY 2017-18, and has made certain recommendations like abolishing tax on gains from transfer of listed securities, whether in the nature of capital gains or business income, and irrespective of the residence. It has also been recommended that amendments should be made to the ITA to provide that only arrangements which have the main purpose (and not one of the main purposes) of obtaining tax benefit should be covered under GAAR. Along with these recommendations, the Commission has reiterated that the onus of proving tax avoidance is on the tax authorities.

Dividend Distribution Tax (DDT)

To remove the cascading effect of DDT in multi-tier corporate structures, an amendment was made to the ITA this year. This provides that when a holding company receives any dividend from its subsidiary which has paid DDT, then dividend distributed by the holding company in the same year, to that extent for which such DDT has been paid, shall not be subject to DDT again.

Long-term capital gains (LTCG)

To bring parity among the non-resident investors regarding the sale of unlisted securities, the rate of LTCG has been reduced this year from 20% to 10%, without giving effect to currency fluctuations and indexation.

Looking forward

India is a vast country with rich human capital and entrepreneurial spirit. The potential for development is immense, and these factors bode well for India's long-term growth story. India recognises that this growth story can only be sustained by investments. However, as a regime undergoing transition from a protected economy to an open economy, the government's tendency to make short-term rollbacks as a reaction to certain transactions or non-compliances affects the investment environment. Coupled with delays in decision making and execution of crucial projects, short and medium-term investments have been affected in India. Recognising its past changes and its limitations, the Indian government has brought in regulatory changes to foreign investment laws along with deferring the implementation of GAAR to send strong signals to the investment community. Though much needs to be done, the Indian government is clearly paving the way for investments into India.

L Badrinarayanan

Lakshmikumaran & Sridharan

Badrinarayanan is a joint partner with Lakshmikumaran & Sridharan in New Delhi, India. He specialises in advising technology companies on corporate, commercial, intellectual property and tax laws. He has handled several projects for technology companies entering, collaborating and operating in India, and has advised on structuring investments into India, availing tax benefits and complying with India's regulatory scheme, particularly in relation to intellectual property and enforcement. He represents clients before various judicial bodies in India, is an expert in technology transfer agreements, and has drafted and negotiated IP licensing and cross-licensing arrangements. He has handled a variety of issues including protection of software in India, shrink-wrap and click-wrap contracts, introduction of new licensing models for distribution of software, open source software, taxability of software in India and transfer pricing and customs valuation studies.

Karan Talwar

Lakshmikumaran & Sridharan

Talwar is a joint partner and practice head, and leads the corporate and commercial laws team of Lakshmikumaran & Sridharan in Hyderabad, India. He is an expert in both corporate advisory and commercial litigation, and advises clients on joint ventures, M&A, foreign exchange laws, special economic zone laws, securities laws, plus direct and indirect tax laws. He has been actively involved in drafting contracts, negotiations and conducting due diligence. He has also represented a number of clients on behalf of the firm before the Supreme Court, High Courts, CESTAT, Civil Courts and Sebi.

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