The IBFM tax regime: A non-starter
Despite best intentions of the government, there have been little or no takers for India-based fund managers
In 2015, the Indian government took a commendable step by introducing a new provision in the Income-tax Act, 1961 (i.e. section 9A), to promote India as a fund manager jurisdiction, and to encourage offshore funds to appoint India-based fund managers (IBFMs). The IBFM tax regime was intended to be in line with “international best practices” and was targeted at all types of foreign financial investors—public market funds, sovereign wealth funds, pension funds and private equity funds. The IBFM tax regime provides that an offshore fund that appoints an IBFM would (1) neither be considered an Indian tax resident, (2) nor be considered as having a business connection in India or a Permanent Establishment in the country, and (3) nor be taxable in India on its non-India-sourced income by virtue of the presence of the IBFM. To qualify for the aforesaid tax treatment, the offshore fund needs to satisfy 13 conditions, and its IBFM needs to satisfy four conditions.
Recently, the Central Board of Direct Taxes (CBDT) issued a notification introducing certain Rules in the Income-tax Rules, 1962, to help make the new IBFM tax regime operational. In these Rules, the CBDT has (1) prescribed 10 conditions that relate to the aforesaid 17 conditions with the objective of simplifying the conditions prescribed in section 9A, (2) provided for a new approval mechanism whereby an offshore fund may at its option apply to the CBDT for a ruling as regards its eligibility to qualify for the IBFM tax regime and to achieve certainty on the issue, and (iii) prescribed the forms through which various reporting tasks need to be done for qualifying for the IBFM tax regime.
The move to introduce a fund manager regime in India is well intended and is a step in the right direction. Establishing India as a viable fund manager jurisdiction was expected to tackle several issues in one go.
* It would stem the “talent drain” of fund managers from India to global financial centres such as Singapore, London and Hong Kong;
* Result in higher tax collections for the government by way of being able to tax the IBFM and its employees who will be based in India;
* Create employment opportunities
* Validate the government’s commitment of being investor-friendly.
What is unfortunate, though, is that despite the best intentions of the government, there have been little or no takers for the IBFM tax regime. The reasons are manifold, and the government needs to sort out these issues on a priority basis.
First, the IBFM tax regime does not complement the intent with which it was introduced, as it is onerous and prescriptive; failure to satisfy even a single condition by either the offshore fund or the IBFM could result in the IBFM tax regime being denied to the offshore fund, leading to adverse and material Indian tax consequence for the offshore fund. The recent Rules for implementing the IBFM tax regime have not helped simplify the regime; in fact, the Rules create their own set of challenges.
Second, most of the conditions prescribed in section 9A are essentially “non-tax” ones, such as relating to the residence of the fund, corpus size of the fund, the investor base, investment diversification by the fund, and nature of activities that the offshore fund, its IBFM and any connected person can undertake in India. Some of these conditions were prescribed on similar lines in the past by some of the Indian regulators (such as Sebi and RBI). Over the years, even Sebi and RBI have done away with several conditions/restrictions, and have liberalised the regulatory framework to encourage enhanced capital flows into India.
For example, Sebi removed the investor base condition for Category-III FPIs, in its FPI Regulations of 2014; it removed the 25% investment diversification condition from its FVCI Regulations in 2004.
Another issue sought to be addressed through the IBFM tax regime is “round tripping”. This is perhaps why a condition has been imposed in section 9A to restrict the total Indian resident investment in an offshore fund to a maximum of 5% of the corpus of the fund. Once again, “round tripping” is a concern that Indian regulators should tackle under exchange control regulations and/or the Prevention of Money Laundering Act. Using the tax law to address this concern only leads to complicating matters further for international investors.
Third, the regime creates compliance issues for offshore funds. For example, the IBFM tax regime requires that the IBFM be compensated directly by the offshore fund—this could work against offshore funds that invest from countries that require the offshore fund to appoint a local fund manager (like Luxembourg). The fund manager, in turn, delegates part of its functions to other service providers and directly compensates them, without involvement of the offshore fund. Another example is how would transfer pricing regulations for determining arm’s length compensation to the IBFM be tested, given that the offshore fund and the IBFM may be unrelated parties. Also, it is unclear whether the offshore fund or the IBFM can get upfront certainty on this issue by approaching the CBDT either under the recently notified Rules or under the APA regime under transfer pricing regulations. Yet another example could be in a situation where the offshore fund makes net losses, and it has to compensate the IBFM for its fund management activity at a maximum of 20% of the profits that arise to the offshore fund from transactions carried out by the IBFM.
Fourth, the IBFM tax regime is not in line with “international best practices”, as was originally intended. Countries such as the UK, Japan, Singapore and Hong Kong, which are established fund manager jurisdictions, have enacted provisions in their domestic tax laws to provide tax amnesty to offshore funds, where the fund appoints a fund manager that is based in their country. However, the tax amnesty schemes that are provided by these countries are simple, with just 4-6 tax conditions to be satisfied.
There are some key conditions/restrictions that are imposed by such countries.
* That the offshore fund should not have a presence in the source state;
* That tax residents in the source state are allowed to invest in the offshore fund but not up to 100% of the fund;
* That the fund manager must be acting in the ordinary course of its business;
* That the offshore fund should not be able to influence or restrict the decision-making abilities of the fund manager.
The government must relook at the entire IBFM tax regime and have it simplified in a manner that it has a few critical conditions which address the tax concerns of the government (such as no loss of potential revenues to the exchequer) and delete all “non-tax” conditions.