Relaxed Safe Harbour Rule to boost India-focused offshore funds

Naresh Makhijani To give an impetus to the fund management activities in India, the Union Budget 2016 and the subsequent guidelines from the Income Tax administration have further relaxed the conditions to mitigate probable income-tax exposure to offshore funds caused by the presence of its investment manager in India. These relaxations in the so called Safe Harbour rule are likely to be viewed positively by large India-focused offshore funds as the same provides an opportunity to manage these funds directly from India without creating a ‘tax residency’ risk in the country.In the earlier tax law, the threat of adversarial tax implications for an offshore fund on account of its investment manager’s presence in India triggered the said managers to shift base to tax-efficient offshore jurisdictions. The safe harbour rule was introduced last year with the primary objective of discouraging brain drain from India in the form of such offshore domiciliation of Indian fund managers. In its original form, the Safe Harbour rule laid out onerous eligibility criteria for both the offshore fund and its investment manager, the meeting of which seems to be an unrealistic ask for the likes of master feeder funds, multilayered fund – SPV structures etc. While the eligible offshore fund needs to be compliant with both the investor and investment diversification criteria, an eligible investment manager needs to be third-party and remunerated at arm’s length. Drawing from the recommendations of the SEBI-constituted committee chaired by Mr. Narayan Murthy, the government has relaxed the Safe Harbor rule. As a partial relief, a look-through concept has been introduced. As a result, two-tier fund structures having an offshore fund held by a broad-based upper-tier offshore entity shall also meet the investor diversification criteria. To not be disadvantaged caused by the non-compliance of specified eligibility criteria, operational relaxations have been coded subject to meeting specific conditions, a huge plus to cocoon funds in their initial fund raising stages. Further, to provide tax certainty, investment funds can seek prior approval from the income- tax administration to ascertain their eligibility status to access the Safe Harbour rule.The guidelines, however, act as a roadblock to the strategic buyout of funds as they continue to restrict an eligible offshore fund from investing more than 26 per cent stake in Indian entities. Also, uncertainty still looms over the mechanism in which the look-through provisions shall apply in case of multi-layered fund structures. Also, the conditions related to investor diversification may be difficult to comply with for small funds. Further, the restriction of a single investment to the extent of 20 per cent of the corpus of the offshore fund could also be difficult to comply with the multiple SPV structures commonly structured for offshore funds. Whilst the relaxations are a big positive for the fund management industry, further carve-outs from the stringent eligibility criteria are expected to go a long way in meeting the objective of retaining the Indian talent pool.Author is partner and head - financial services, KPMG in IndiaThe views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG in India.