Mumbai aspires to be a financial hub on the lines of New York, London, Hong Kong and Singapore. For that to happen, a good ecosystem with availability of talent, ease of regulations, a conducive tax environment and an ability to attract global capital is a prerequisite. No country has created a global financial centre without also creating a vibrant domestic fund business. Unfortunately, the current regulatory environment in India has created aplaying field that is stacked heavily against the domestic industry.
Globally, private equity and hedge funds have assets under management of over $3.5 trillion and $2.5 trillion respectively. In India, the domestically domiciled Alternate Investment Funds (AIF) have total commitments of less than Rs 25,000 crore (roughly $4 billion), with the actual inflows just a fraction of the commitments. By any measure, the AIF industry in India is sub-scale and not commensurate with the size of a $2-trillion economy.
Foreign institutional investors (FIIs) and foreign portfolio investors (FPIs) route their investments via Mauritius and other tax havens with double taxation-avoidance agreements and pay zero tax on their business income and capital gains and a maximum 10% withholding tax on their interest income in India. Also, all securities held by FIIs/FPIs including derivatives were reclassified as capital assets in last year’s Budget.
With pass-throughs denied for AIF Category 3 funds, the investors in these funds see even their equity returns classified as business income, if there is any interest income or other income from derivatives, and all income taxed at maximum marginal rates. AIF Category 2 fund investors, even with the benefit of pass-throughs, still have their derivative income classified as business income.
The result of the perverse tax rules is that while even equity returns of investors in AIF Category 3 funds get re-characterised as business income resulting in higher tax liability, for foreign investors, what was previously business income now gets re-characterised as capital gains, enabling them to enjoy lower or nil taxes.
A large global top-tier hedge fund like AQR, DE Shaw or Renaissance Technologies that deploys quantitative strategies and invests in Indian equities and derivatives via the Mauritius route pays zero tax, while a domestic AIF Category 3 fund deploying similar investment pays peak marginal rates. The very business case for incorporating an AIF Category 3 fund in India becomes questionable.
Domestic funds are further handicapped by Sebi regulations that restrict leverage and prohibit them from investing in commodities and forex markets. This handicap reduces the amount of capital that can be deployed and returns earned. It creates a unique situation where both an individual investor with limited capital and a corporate house from a non-financial services industry with large treasury operations enjoy far more leverage and risk-taking ability than a professionally-managed fund deploying sophisticated risk capital.
The underdeveloped nature of the debt markets in India also means that domestic funds are restricted to equity markets alone. Foreign funds, on the other hand, can invest in multiple asset categories globally and have lower leverage restrictions. This enables foreign funds to outperform domestic funds while taking lesser overall risks.
It is more attractive to incorporate outside India and invest in India via the FII/FPI route, or in rupee-denominated assets in foreign markets, rather than get an AIF licence and invest in local markets. This results in export of capital and underdeveloped capital markets in India. A significant chunk of the rupee-denominated securities and currency markets has already moved out to Singapore and Dubai and investment capital continues to move out of India to foreign fund managers.
To mitigate the handicaps the fledgling local industry faces, these steps should be immediately taken:
1. Remove the leverage restrictions on AIF Category 3 funds and subject them to the same exchange-based risk management and margin rules that all categories of investors are subject to.
2. Allow domestic funds to invest in commodities and foreign exchange markets starting with non-agricultural commodities.
3. Include investments made by the local AIFs in Section 2(14) of the Income-Tax Act, thereby giving capital asset classification to those investments as was done for FIIs/FPIs.
4. Grant pass-throughs to AIF Category 3 funds as was done for AIF Category 1 and 2 fund assets immediately as an interim measure.
5. Over the longer term, a mutual fund-like regulatory regime for AIFs where the funds are not taxed but the unit holders pay capital gains tax on their units, would be a solution to the current discriminatory regime.
In every country, domestic and foreign capital are treated at par, while in India, foreign capital continues to get far better terms and tax treatment and domestic capital is discriminated against. The time has come for the ‘Make in India’ concept to be also applied to the domestic AIF industry to create a vibrant ecosystem, enabling India to achieve the objective of having a global financial centre located here.
(Source: Extracts from an Article by Mr T V Mohandas Pai, ex-CFO, Infosys and Mr V Balkrishnan, Chairman, Exfinity Venture Partners.)
