To, 13th May 2020

Smt. Hon’ble Minister of Finance Government of North Block. New Delhi - 110001

Sub: Recommendations for Enhancing Capital Flows in the Economy

Respected Madam,

At the outset, we would like to thank you for giving us this opportunity to provide our recommendations for enhancing liquidity and capital in the economy.

Nations world-over are reeling under the high and rising human cost caused by the outbreak of COVID-19 pandemic, which has compelled governments to enforce isolation, lockdown and widespread closures in order to contain the spread of the highly infectious virus. As a consequence, global economic growth is projected to contract sharply at -3% in 2020 with India’s projections pegged at 1.9%. Further, the projections for the advanced economies of the world like United States of America, United Kingdom, and Germany also paint a grim picture at -6.1%, -6.5% and -7% respectively.1 Against this backdrop, our recommendations are focused around increasing flexibility in funding instruments for channelising capital from PE/VC investors particularly attracting this money into transactions which are commensurate with risk and reward of investing in the current situation; investments mobilization of domestic institutional funds into the market and certain suggestions under the Income-tax Act and GST law.

We would like to appreciate the effort made by the Government in being extremely forthcoming and receptive to the recommendations made by various advisory panels. Basis our discussions with various stakeholders and the investor community, we would like to make the following recommendations:

 Part A - Flexibility in funding instruments for raising capital from foreign investors and Alternate Investment Funds (‘AIFs’);

1 Overview of the World Economic Outlook Projections, Chapter 1 –The Great Lockdown, World Economic Outlook, published by International Monetary Fund. 1 | Page

806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in  Part B- Mobilization of domestic institutional funds; and  Part C - Incentives under Income tax Act, 1961 (‘IT Act’) and Goods and Service Tax (‘GST law’) to attract foreign capital

We, at IVCA, firmly believe that the above measures will act as a catalyst to enhance liquidity in the market and boost capital influx in the economy, which is a critical requirement to tide over the liquidity crunch during the Covid crisis.

We would be grateful for an opportunity to discuss our above recommendations with you. We shall be happy to provide you any additional information that you may require.

Respectfully,

Rajat Tandon President Indian Private Equity & Venture Capital Association (IVCA) +91 98100 90194 (M)

CC: Rahul Shah, IVCA +91 9702288252

CC: To, Shri Jayant Sinha Chairman, Parliamentary Standing Committee of Finance, Secretariat New Delhi - 110001

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in Part A - Flexibility in funding instruments for raising capital from foreign investors and AIFs

1. Hybrid Instruments under the Foreign Direct Investment (‘FDI’) route

Issue:

Foreign investors/ pooling vehicles are allowed to invest in equity capital or instruments which are compulsorily convertible into equity under the FDI route. They are not allowed to invest in hybrid securities (i.e. quasi debt-equity) such as Optionally convertible debentures or preference shares (OCRPS/ OCDs) under this route. Further, there are restrictions in structuring exit events through call or put options on securities at a commercially agreed price - usually based on performance of the company in future. This creates significant challenges in structuring private equity transactions wherein the investor needs to have the flexibility of conversion and part or full redemption in future through the cash flows available with the company.

Recommendation:

There is a need to allow issuance of hybrid securities, which bear characteristics of both debt and equity, under the FDI route, at least for a limited period, to enhance the fund-raising capabilities of the companies in this difficult time.

Rationale:

The Finance Minister in his Budget speech for FY 2016-17 had proposed key reforms in FDI Policy. Among others, was the proposal to expand the basket of eligible FDI Instruments to include hybrid instruments subject to certain conditions. The investor community was thrilled with this proposal. While, the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 issued in supersession of the erstwhile FEMA regulations have introduced the definition of “hybrid securities”, however, consequent provisions allowing foreign investment in hybrid securities have not yet been prescribed. Hybrid securities have been defined to include hybrid instruments such as optionally or partially convertible preference shares or debentures and other such instruments as specified by the Central Government from time to time, which can be issued by an Indian company or trust to a person resident outside India.

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in Hybrid securities combine the benefits of both equity and debt and offer a lucrative opportunity for both investors and companies. The investor is able to structure the capital infusion as equity for gaining controlling rights and upside sharing and have the option of downside protection and ease of repatriation which is akin to debt. It also helps the companies to raise capital as equity and have the flexibility to pay off the investor from the future cash flows of the company. Usually, repatriation of equity through buy back or capital reduction is restrictive, time consuming and subject to conditions, making it cumbersome.

Currently, hybrid securities such as OCPs/ OCDs are covered under the ECB route and are permitted subject to underlying conditions. ECB route has restrictions relating to maximum interest / coupon, end use restrictions, mandatory hedging requirements, minimum maturity period (3 to 10 years), approval process, etc. The raising of ECB for working capital requirement, general corporate purpose and repayment of rupee loans is extremely restrictive and is permitted only in case of borrowings with 7 to 10 years of average maturity. In the current times, given the liquidity constraints that companies are grappling with, they are not able to access this route resulting in funding pressures on the domestic market.

Therefore, it is important that foreign investment in hybrid securities under the FDI route is allowed in order to enhance the capability of companies to raise capital at commercially suitable terms. This will also give the flexibility and comfort to the investor community to provide the requisite capital and undertake transactions in accordance with the deal commercials.

2. Expansion of the list of eligible sectors under the FVCI route

Issue:

Presently, investment under the FVCI route is permitted only in limited sectors, viz., Infrastructure, VCFs, Start-ups and a few other sectors as set out in Annexure 1. There is a need to expand the list of permitted sectors allowed for investment under the FVCI route as this route provides a flexible investment framework and hence will be able to attract significant capital in the economy.

Recommendation:

The sectors in which FVCIs are allowed to invest should be expanded to include all sectors where FDI investment is permitted.

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in Rationale:

An FVCI is registered with SEBI and is allowed to make investments in compliance with the SEBI (FVCI) regulations. Investments under this route offers complete flexibility on the form of instruments that could be adopted for making investments. The only limitation of this route is that it permits investment in certain specified sectors of the economy. This significantly restricts the flow of money under this route.

Most of the large institutional players have been investing in the infrastructure sector under this route. FVCI route can be opened up to allow investments in all sectors where FDI is currently permissible. At minimum, given there are certain critical sectors of the economy which would require funding under the present environment, it is suggested that the list of sectors permitted for FVCI investment is expanded to include all least the sectors where FDI is permitted. This would help in attracting additional funds into these sectors on an immediate basis.

3. Rationalize pricing guidelines under various regulations for investors

Issue:

Investment by foreign investors under the FDI route is subject to pricing regulations and needs to comply with the pricing methodologies prescribed under the multitude of laws – SEBI, IT Act, Companies Act, FEMA. Investment by domestic AIFs is also subject to pricing regulations under IT Act and Companies Act.

There is no consistent valuation approach prescribed across different laws, thereby creating complexity in interpretation of laws and unintended challenges in compliance requirements on investment by foreign investors and AIFs.

Recommendation:

The pricing guidelines prescribed under the various laws should be made consistent to provide a certain and simple framework for facilitating investments by foreign investors and AIFs in India.

Under the current environment, given that the businesses are stressed for liquidity and valuations of businesses have softened, there is a need to adopt a more pragmatic approach on applying FMV principles in transactions between independent parties. Given that the price negotiated between two unrelated parties represents the value it would fetch in the open market, the requirement to demonstrate that such 5 | Page

806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in FMV be supported by a valuation report based on internationally accepted valuation methodologies should be made consistent across all regulations for unlisted securities. For listed securities, given steep decline in valuation across all segments, only 2 weeks average price should be taken (as against higher of 2 weeks or 26 weeks average price). This approach should be consistently adopted across all the relevant applicable laws.

Rationale:

India has seen significant investment in shares and securities from large institutional and private equity players in the recent years. These transactions between unrelated players are undertaken after rigorous diligence of the underlying assets. The deal value / transaction price is heavily negotiated between the parties and hence represents the price in an uncontrolled environment. There is no ‘one’ set method/parameter for determining the fair market value of a share or instrument and it is dependent on factors such as economic outlook, future prospects, business requirements, etc.

Regulatory and tax framework:

Presently, there are different valuation requirements prescribed under various laws (FEMA, Income tax, SEBI, Corporate law) applicable to a foreign investor and AIFs investing in India. It would be more appropriate to align SEBI pricing norms for listed entities and all other laws should follow the pricing guidelines set out by SEBI. We have summarized these along with recommendations below:

S. Regulation Valuation aspects Issue and Recommendation No. 1. SEBI Issuance of securities under Issue: (applicable preferential allotment: Given that the trading price and for listed The price of shares offered needs to be valuations of the companies have declined companies) computed as higher of (a) the average significantly, the pricing norms based on of the weekly high and low of the average of past 26 weeks high and low volume weighted average prices of the does not reflect the present business equity shares during the preceding reality and hence is a significant deterrent twenty six weeks; or (b) the average of to raise capital. the weekly high and low of the volume weighted average prices of the equity Recommendation:

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in shares during the preceding two The pricing norm should therefore be the weeks. average of the weekly high and low of the volume weighted average prices of the Transfer of securities: equity shares during the preceding two In case of a block deal, the orders weeks. Whilst SEBI has recently proposed placed needs to be within ±1% of the relaxation in pricing norms for distressed applicable reference price. listed companies, there is a need for extending similar relaxation for all listed companies. 2. FEMA (Non- For issuance and transfer of listed These pricing guidelines are fine. debt securities: Instruments) Price should be in accordance with Rules SEBI guidelines (applicable for foreign For issuance and transfer of unlisted investment) securities: Price to be in accordance with any internationally accepted pricing methodology undertaken by a Merchant banker registered with SEBI, Chartered Accountant or Cost Accountant. 3. Income tax Section 56(2)(x) of the IT Act provides Issue (Listed Shares): Act, 1961 that income shall be deemed in the It is difficult to match lowest price on the (applicable hands of the buyers in case the buyer date of transaction as benchmark for off for both acquires property (which includes market transactions because in such deals foreign and shares and securities) for a price if fixed much before the domestic consideration which is less than the implementation date. investment) fair market value determined as per Rule 11UA of IT rules2. Recommendation: For issuance and transfer of listed For off market transactions in listed shares and securities: securities, SEBI pricing guidelines of two • For off market transaction, the weeks average should be made applicable. price needs to be as per lowest That would be in line with FEMA

2 Refer Annexure 1 for the formula prescribed under Rule 11UA 7 | Page

806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in price of such shares or securities requirements. on the transaction date. ● For on market transaction, the Issue (Unlisted Shares): transaction value shall be The ‘book value’ method was introduced considered as the price. as an anti-abuse provisions to prevent laundering of unaccounted income under For issuance and transfer of unlisted the garb of gifts, particularly after equity shares: abolition of the Gift Tax Act. However, Price needs to be determined as per due to the wide scope of the section, it is prescriptive formula based on the ‘net applicable even on transactions between asset value’ (i.e. book value) of the unrelated parties. It is common for company after making certain companies engaged in capital intensive adjustments. sectors like Infrastructure to have a high ‘book value’. This may not necessarily For issuance and transfer of unlisted reflect the FMV of the business securities (other than equity shares): determined on the basis of future cash FMV of the security shall be as per the flows. This results in an unintended tax price it would fetch if sold in the open cost for the buyer in genuine third-party market on the transaction date. A transactions, thereby making the valuation report from merchant transaction unviable and/ or resulting in banker or an accountant can be significant delays in deal closure. obtained for this. Recommendation Taxpayer should be given an alternative to choose applicability between book value and fair value for the purposes of all unlisted securities.

4. Companies For issuance of any securities under Issue Act, 2013 preferential allotment: An additional compliance requirement (applicable The price needs to be as per valuation increases complications in deal for both undertaken by a Registered Valuer in structures. foreign and accordance with prescribed valuation domestic standards. The valuer can compute the Recommendations investment) value on the basis of (a) Asset A proviso may be included to the effect approach; (b) Income approach; (c) that if the issue price is determined in

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in

Market approach. accordance with SEBI or FEMA, then this provision should not separately apply.

Given the plethora of pricing guidelines that are applicable to investments by foreign investor and AIFs and the inherent inconsistencies inter-se each other and with the business realities, there is a need for such pricing guidelines to be done away with in case of third-party transactions.

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in Part B- Mobilisation of domestic institutional funds

1. Creation of more institutional Fund of Funds in India

Issue:

There are currently only 6-7 institutional Fund of Funds operating in India with their focus either limited to a particular sector (such as agriculture, electronics) or segment (such as MSME or startup). This is in stark contrast with developed economies of the world such as USA, which have as many as 183 professionally managed Fund of Funds attracting institutional capital3. These Fund of Funds will help mobilize greater capital across the economy.

Recommendation:

(i) Pension Fund Regulatory and Development Authority (‘PFRDA’) and National Pension Scheme (‘NPS’) may be encouraged to invite bids from professional fund managers for running a Fund of Funds programme. (ii) SBI and other major banks like Bank of Baroda, Canara Bank, and some leading private sector banks may be joining hands to float a Fund of Funds. (iii) LIC, GIC and private sector insurance players may float another Fund of Funds programme. (iv) Foreign Development Finance Institutions may also be encouraged to participate with local asset management companies to set up Fund of Funds structures, particularly in social impact, healthcare and venture/start-up sectors.

Rationale:

While there are large pools of domestic capital available with pension funds, provident funds, and charitable organizations, they are not being used as investment sources in the country. These funds should be allowed to invest in private equity and venture capital by setting up of Fund of Funds platforms. Different set of institutions/corporations should be encouraged to constitute different Fund of Funds programmes through public private partnership model (as has been successfully seen in the case of NIIF). This will allow diversity of strategies with diverse players. In addition, this will eliminate the current

3 Private Equity Funds by Market Type, Prequin Quarterly Update: Private Equity and Venture Capital (Q1 2019) 10 | Page

806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in

limitation of each institution to evaluate each AIF for making contributions. All these measures will help in funding the capital needs of businesses across sectors and decrease the dependence on foreign capital.

It is also possible to think of having specialized fund of funds who opt for preferred return models or who prefer short term credit linked structures or structured solutions for a fixed IRR where investors may feel comfortable participating. A beginning has already been made by SEBI towards benchmarking of performance by AIFs through independent agencies. With multiple fund of funds programme, it is possible to get the comparative performance figures of daughter funds being published by these agencies which will gradually enable larger contribution flowing from HNIs and Family offices.

2. Relaxing the investment and exposure restrictions applicable for insurance companies, pension funds and banks:

Issue and Recommendation:

Type of Issues under current regulatory Recommendation institution regime Insurance ● Insurance Regulatory and Development ● Insurance companies (both life and companies Authority of India (‘IRDA’) has non-life) must be given more permitted both general insurance and latitude to invest in Fund of Funds life insurance companies to invest in along with a higher exposure cap. Category I AIFs such as infrastructure ● Further, investments by insurance funds, small and medium enterprise companies in AIFs must be carved (‘SME’) funds, venture capital funds and out under a separate category while social venture funds (as defined under calculating the applicable exposure the AIF Regulations) and Category II limits and must not be clubbed with AIFs (which will invest at least 51% of other investments under the funds in infrastructure, SME, ‘unapproved investments’. venture capital and/or social venture entities). ● The permission to invest in AIFs from IRDA however, comes with certain additional restrictions. o For one, insurance companies are not

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in permitted to invest in AIFs, which seek to invest in securities of companies incorporated outside India, will take leverage and/or will be classified as Fund of Funds. o In addition, any investment by the insurance company in AIFs is categorised as an ‘unapproved investment’ and requires approval of the board of directors in addition to the approval of the investment committee of the insurance company.

⮚ Further, overall exposure to AIFs is capped at 3% of respective fund in case of life insurance companies and 5% of investment assets in case of general insurance companies. ● Vis-à-vis a single AIF, insurance companies (both life and general) are permitted to invest the lower of 10% of the AIF fund size and 20% of the overall exposure permitted, provided that in case of infrastructure funds, the limit is to be read as 20% of the AIF fund size. ● Further, insurance companies cannot invest in an AIF, the sponsor of which is a part of the promoter group of the insurer and/or the investment manager is either directly or indirectly controlled or managed by the insurer or its promoters. Pension funds ● PFRDA permits private sector national ● Restrictions such as minimum pension system scheme (NPS) corpus of AIF being an eligibility subscribers to invest in Category I and criterion for pension fund Category II AIFs albeit with the investment, credit rating for AIF condition that such category of units and requirement to only

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in investment has to be in listed invest in listed AIFs, create a instruments or fresh issues that are considerable roadblock for proposed to be listed. Given the lack of a investment by NPS in AIFs. definitive listing regime for AIFs, this ● The rules must be liberalized to peculiar condition has created a allow pension funds to invest in challenge for pension funds to invest in AIFs with corpus lower than INR 1 AIFs. billion, while doing away with the ● Further, the guidelines prescribe that requirement of investing in AIFs such NPS should invest into units of AIF, with a particular credit rating as which have minimum AA equivalent well as investment in only listed rating in the applicable rating scale from units of AIFs. one credit rating agency registered with ● The government should encourage SEBI, albeit such credit rating would not pension funds to channelize a be required in case of a government- portion of their corpus into AIFs. owned AIF. Pensions funds regulated by PFDRA ● Other conditions prescribed by PFRDA and EPFO could allocate 1% of their are similar to the conditions imposed by corpus into AIFs by 2020 which IRDA in respect of investment into AIFs could be gradually increased to 5% by insurance companies, such as the 51% by 2025 as they gain more fund utilization conditions for Category experience. II AIFs, exposure of 10% of the AIF size in a single AIF, restriction in respect of AIFs who would invest in companies incorporated outside India and the group sponsor and manager restrictions. ● In addition, the guidelines prescribe that pension funds should only invest in such AIFs whose corpus is equal to or more than INR 1 billion. Banks ● The Reserve Bank of India (‘RBI’) has ● The current exposure limits permitted scheduled commercial banks applicable to banks need to be (excluding regional rural banks and enhanced. urban co-operative banks) in India to ● Banks should be permitted to invest invest in Category I and Category II in Category III AIFs also. AIFs, albeit with certain conditions. ● Banks are permitted to invest not more

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in

than 10% of the paid-up capital/unit capital in a Category I/Category II AIF and if investment exceeds 10% of the paid-up capital/unit capital in a Category I/Category II AIF, the bank would require prior approval from the RBI. The regulatory maximum for investments in AIFs (Category I and Category II) has been capped at 20% of the bank’s net worth permitted for direct investments in shares, convertible bonds/debentures, units of equity- oriented mutual funds and exposures to AIFs. ● Investments by banks in Category III AIFs continues to be prohibited. ● Banks are required to maintain additional capital basis a risk assessment on account of investments in AIFs made either directly or through their subsidiaries.

Rationale:

Traditionally, institutions in India such as banks, insurance companies and pension funds have shied away from taking exposure to alternative asset classes and their investments are limited to public markets. While globally such institutions make significant contributions in alternative asset classes, the model can be replicated in India by removing certain regulatory hurdles surrounding investments by these institutions. There is a need to provide relaxations on the restrictions imposed on banks, insurance companies and pension funds for investment in AIFs.

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in Part C - Other relaxations under IT Act and GST law to attract foreign capital

1. Long term capital gains exemption on fresh investments made by Private Equity (‘PE’) and Venture Capital (‘VC’) funds for certain period

Issue:

The current law governing the taxation of long-term capital gains is highly complex due to varying tax treatment of income from capital gains based on varied parameters such as holding, tax rates that range from 10% to 40% and allowing indexation only in respect of certain assets. For example, the capital gains tax rates for investment in unlisted shares by domestic investors can range from 28.49% to 42.74%. The complex tax regime dampens the enthusiasm of investors in the PE/VC fund space eyeing Indian investments. There is a need to incentivise large PE/VC funds to invest in the private sector and provide necessary capital to cash crunched companies.

Recommendation:

One-time exemption on levying long term capital gains tax for fresh investments made from the notified date upto a period of 2 years by private equity and venture capital funds in India, provided that they stay invested for a period of 36 months.

Rationale:

Various developed jurisdictions, such as US, UK and other EU countries do not tax capital gains earned by foreign investors. Even closer to home, countries such as Singapore do not have any capital gains tax, which attracts investors to pool/ invest in Singapore.

In order to incentivise investment by certain funds such as sovereign wealth funds of foreign governments and notified pension funds, the Finance Act, 2020 introduced an exemption for income on investments made by such funds in the Indian infrastructure sector. This exemption is available for investments made before 31 March 2024 subject to the investment being held for a period of at least 36 months and is likely to encourage investment in infrastructure related projects in India. In line with the exemption provided to the notified funds, other PE/VC funds (both domestic and foreign) should also be incentivised to invest in India to encourage inflow of capital for investments held for more than 36 months.

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in While infrastructure is one of the primary sectors for PE/VC investment, various other sectors such as financial services, technology, e-commerce, telecommunication etc. are also sectors that have also been focused on by PE/VC investors. Given that the Indian economy is reeling under the post COVID – 19 crisis and various sectors need capital to recover, such exemption should be provided to long-term and patient capital invested in all sectors. Therefore, it is recommended that the tax on long-term capital gains should be waived off on profits made from investments till the economy recovers. The exemption could be granted for long term investments made during a specified time window.

Acceptance of such a proposal will not have any impact on Government revenues over the next three years and the current economic benefits would outweigh the future costs. Even beyond three years, the related wider economy benefits will far outweigh any potential tax revenue losses.

2. Removal of the interest ceiling prescribed for availing the beneficial tax rate of 5% on debt availed from FPIs under Section 194LD

Issue:

Presently, the beneficial tax rate of 5% under Section 194LD of the IT Act is available for Foreign Portfolio Investors (‘FPIs’) if the interest coupon on bonds does not exceed the rate prescribed by the Central government. In July 2013, the Government had prescribed that for claiming the lower tax rate, ‘the rate of interest shall not exceed 500 basis points over the Base rate of State Bank of India applicable on the date of issue of the bonds’. The interest cap makes it difficult for FPIs to avail the beneficial tax rate where the commercially negotiated interest is higher than the prescribed cap.

Recommendation:

The interest cap prescribed under Section 194LD of the IT Act for availing the benefit rate of tax should be removed.

Rationale:

Investments by FPIs are regulated by SEBI. Such investments are usually made at commercially agreed terms after taking into account the associated risks. The beneficial tax rate of 5% on interest income under Section 194LD was introduced to incentivise and encourage greater offshore investment in debt market (in rupees) by FPIs and Qualified Foreign Investors (‘QFIs’). Due to the stringent interest cap 16 | Page

806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in provided under the IT Act, many debt investments by FPIs fail to be eligible for the beneficial tax rate of 5%. This leads to higher tax cost on the income earned by the FPI investors and thereby, indirectly increasing the cost of debt for Indian companies, thereby making it difficult for companies to raise debt from FPIs.

RBI has prescribed an overall limit of INR 4.3 lakh crores for period ending September 2020 for investments by FPIs in corporate debt. Out of this limit, only INR 1.63 lakh crores has been utilized till date. In the current environment, where businesses are struggling for liquidity to fund working capital requirements, there is a need to incentivize FPIs to infuse greater debt in the market. A beneficial rate of tax on commercially agreed coupon could play a significant role in incentivising FPIs to pump a large pool of funds in the Indian market.

Also, since the overall debt limit remains significantly unutilized, removing the interest cap will not impact the exchequer adversely.

3. Clarification on extension of pass-through status to an AIF under GST regulations

Issue:

Levy of GST is emerging as a challenge in attracting foreign investments to AIFs thereby impeding the onshoring of investment in India and the growth of the Indian asset management industry. Under the GST legislation, AIF are largely set up as contributory trusts which are considered as distinct persons from overseas investors with its location being in India. Thus, any services (from Fund Manager and any other service provider) availed by the AIF are liable to GST, and typically the fund management fee is the most significant service. Since AIF is only a pooling vehicle for investments and does not provide any service, the GST paid on fund management fees is a sunk cost even though it is consumed by the non- resident investors of the AIFs for their investment activity.

Recommendation:

Suitable clarifications should be released under GST law stating that the underlying investors of an AIF should be considered as the service recipients by extending the “pass through” status for GST purposes in line with the intent of the law. This will ensure parity between direct tax and GST laws and ensure that the services provided to an AIF to the extent of non-resident investors in the AIF would be considered as export of services and can be supplied without payment of tax. 17 | Page

806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in Rationale:

A non-resident investor investing directly into a start-up or growth company is not subjected to GST liability. GST is also not applicable on services provided by an overseas fund manager to an offshore pooling vehicle since it is an export of service. Given below is a comparison of an AIF in India having 100% foreign investments versus an offshore fund investing into Indian equities:

Particulars AIF with 100% offshore funds Pure offshore fund Size of fund $100 million $100 million Annual management fee 2% 2% Total management fees over life of the fund (typically 7.5 years) $15 million $15 million GST (at 18%) $2.7 million Nil Investible surplus that goes into companies in the country over the life of the fund $82.3 million $85 million

If the pooling vehicle is formed offshore, then the services provided to such offshore pooling vehicle would be regarded as export of services for the service provider. Accordingly, the fund manager would not charge any GST to the offshore fund and would also be eligible to claim a refund of GST paid on any input services. Thus, an offshore Fund will not incur any GST. In comparison, a domestic/onshore AIF suffers from GST of 2.7 million (approx. 2.7% of the amount invested) which is an additional cost. Given the above anomaly, offshore VCPE Funds are encouraged to pool funds outside India, resulting in growth of the Asset Management industry abroad and not in India.

Most nations waive or commute GST on overseas funds pooled onshore, as the ultimate investors in these funds are located overseas. This will ultimately result in the government earning incremental revenues from local ecosystem employment in banking, consulting, finance and law firms, and from the secondary effects of their consumption.

The intent of the law providing the “pass through status” to AIFs as introduced by the Finance Minister in the speech for the Budget 2015-16 was to enhance foreign investments in the domestic economy (extracted below).

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in “I propose to undertake a series of steps in this direction to attract capital, both domestic and foreign. Tax ‘pass through’ is proposed to be allowed to both Category-I and Category-II Alternative Investment Funds, so that tax is levied on the investors in these Funds and not on the Funds per se. This will step up the ability of these Funds to mobilise higher resources and make higher investments in small and medium enterprises, infrastructure and social projects and provide the much required private equity to new ventures and start-ups.”

Therefore, suitable clarifications may be released under GST law stating that the underlying investors of an AIF should be considered as the service recipients by extending the “pass through” status for GST purposes.

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in Annexure 1 - Permitted sectors under the FVCI route: (i) securities, issued by an Indian company engaged in any sector mentioned below and whose securities are not listed on a recognised stock exchange at the time of issue of the said securities :- a) biotechnology; b) IT related to hardware and software development; c) nanotechnology; d) seed research and development; e) research and development of new chemical entities in pharmaceutical sector; f) dairy industry; g) poultry industry; h) production of bio-fuels; i) hotel-cum-convention centres with seating capacity of more than three thousand; j) Infrastructure sector. The term “Infrastructure Sector” has the same meaning as given in the Harmonised Master List of Infrastructure sub-sectors approved by Government of India vide notification F. No. 13/06/2009- INF, dated the March 27, 2012 as amended or updated. (ii) units of a Venture Capital Fund (VCF) or of a Category I Alternative Investment Fund (Cat-I AIF) or units of a scheme or of a fund set up by a VCF or by a Cat-I AIF. (iii) equity or equity linked instrument or debt instrument issued by an Indian ‘start-up’ irrespective of the sector in which the start-up is engaged. The definition of ‘start-up’ shall be as per Department for Promotion of Industry and Internal Trade’s Notification No. G.S.R. 364(E), dated the 11 April 2018

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806, 8th Floor Akash Deep Building 26A, Barakhamba Road Connaught Place, New Delhi-110001 +91 11 49876992, [email protected] CIN: U74900DL2010NPL198236, www.ivca.in