“Raindrops on roses and whiskers on kittens
Bright copper kettles and warm woollen mittens
Brown paper packages tied up with strings
These are a few of my favourite things…”

Hearing my niece practice this iconic song made me introspect on the year gone by. So, here are select highlights of 2016 from the Alternative Investment Funds (AIFs) industry perspective.

1. Regulatory developments

• 2016 started with Report 1 of the Alternative Investment Policy Advisory Committee (AIPAC), and drew to a close with Report 2 of the AIPAC in December 2016. SEBI amended the AIF regulations in November 2016 to implement recommendations relating to Angel Funds. Our last post covers key recommendations made by AIPAC in Report 2. AIPAC has rightly focussed on structural and evolutionary changes needed for the AIF industry and thus 2017 will be the year to implement or build on these recommendations.
• In February 2016, subject to certain conditions, RBI permitted NRIs to invest in AIFs on a non-repatriation basis and for investments to be treated at par with investments by residents.
• In April 2016, the Pension Fund Regulatory and Development Authority permitted pension funds to invest in Category I and Category II AIFs subject to various conditions. However, these conditions have effectively stymied pension fund investing in Category II AIFs. AIPAC reports recommend the liberalisation of regulations to allow investments in AIFs by pension funds, insurance companies, banks and others.
• In April 2016, RBI amended the Foreign Venture Capital Investor (FVCI) regime under FEMA 20 to provide, inter alia, that FVCIs registered under the SEBI (FVCI) Regulations will not require RBI approval for investments as per amended Schedule 6. The RBI notification also stipulated that FVCIs can receive the proceeds on liquidation of venture capital funds (VCFs) or Category I AIFs. However, RBI’s October 2016 circular was a sting in the tail. That circular stated that downstream investment by VCFs / Category I AIFs that have been invested into by FVCIs will need to comply with Schedule 11 of FEMA 20 i.e. such downstream investments shall be subject to the sectoral caps and conditions under the foreign direct investment (FDI) policy.
• In September 2016, RBI amended FEMA 20 to permit 100% FDI in ‘other financial services’ industry subject to conditions prescribed by the relevant regulator and FDI in entities conducting unregulated or partially regulated financial services (FS) activities with the prior approval of the Foreign Investment Promotion Board (FIPB). While this liberalisation was eagerly awaited, the language of the notification stirred up concerns surrounding the interpretation of ‘regulated FS activities’. For example, would FDI in an AIF manager which is exempt from registration under SEBI (Investment Advisers) Regulations require FIPB approval? Or would FDI in an Indian advisor to an offshore PE fund or Foreign Portfolio Investment (FPI) manager qualify for the automatic route?

2. Tax developments: Tax controversies attracted the arc lights in 2016 and the following have been picked for discussion merely for the sake of brevity. The Central Board of Direct Taxes (CBDT) issued circulars clarifying the capital gains tax treatment on sale of listed shares (February 2016) and unlisted shares (May 2016). The former circular was a welcome amendment, while the latter created heartburn for AIFs/PE funds as it could lead to gains on ‘sale of unlisted shares along with control and management of underlying business’ being characterized as business income. The FAQs issued by CBDT in December 2016 on the ‘indirect transfer’ regime for FPIs, which could equally apply to AIFs/ PE funds thereby making redemption or transfer of certain LP interest in offshore master or feeder funds taxable in India, was another blow. The judiciary has held that CBDT circulars cannot go beyond the mandate of the tax statute or cast a greater burden on the taxpayer. Only time will tell if these rulings will come to the taxpayers’ rescue. Lastly, the transition from ‘residence’ based to ‘source’ based taxation of gains on sale of shares under the Mauritius and Cyprus tax treaties is in line with India’s metamorphosis from a developing to a developed nation.

3. Other legislative developments:

• Amended Section 7 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, notified in November 2016, permits “other category of investors including non-institutional investors as may be specified” to subscribe to security receipts (SRs) of an asset reconstruction company. The industry hopes that SEBI notifies AIFs as a category permitted to subscribe to SRs. This could be a big boost for special situation funds to be structured as AIFs to address the growing demand for distressed / stressed assets.
• Portfolio companies of AIFs/PE Funds reeled under the after effects of demonetisation, with working capital cycles and projections taking a beating. The exact impact will only be known over the next few quarters.

Overall, for the AIF industry, 2016 was a case of The Good, The Bad and The Ugly. But, the industry marches into 2017 with renewed hopes and expectations.