Background:

In order to facilitate location of fund managers of offshore funds in India, the Finance Act, 2015, with effect from April 1, 2015, had introduced a specific safe harbour regime by way of section 9A in the Income-tax Act, 1961 (“ITA”) providing that an ‘eligible investment fund’ shall not be construed to have a business connection in India or be regarded as a tax resident in India merely because an ‘eligible fund manager’ undertaking fund management activities on its behalf is located in India.

The availability of benefit under section 9A is subject to the conditions provided in sub-sections (3), (4) and (5) of that section. Sub-section (3) of section 9A provides for the conditions for the eligibility of the fund. These conditions, inter-alia, are related to residence of fund, corpus, size, investor broad basing, investment diversification and payment of remuneration to fund manager. Further, these provisions are to be applied in accordance with Rules 10V to 10VB of the Income-tax Rules, 1962.

One of the conditions for availing the benefit of section 9A was that the remuneration paid by the offshore fund to an eligible fund manager in respect of fund management activity undertaken on its behalf is not less than the arm’s length price of such activity. The arm’s length price of the remuneration was to be determined as per transfer pricing provisions, and the fund manager was required to undertake transfer pricing compliances and maintain transfer pricing documentation.

However, the condition of payment of arm’s length remuneration to the fund manager was relaxed by the Finance (No. 2) Act, 2019, with effect from April 1, 2019, by amending clause (m) of sub-section (3) of section 9A so as to provide that the remuneration paid by the fund to an eligible fund manager in respect of fund management activity undertaken on its behalf should not be less than the amount calculated in the prescribed manner.

Method prescribed for calculating fund manager remuneration

The manner for calculation of the minimum amount of remuneration that should be paid to the eligible fund manager in India by an offshore fund for the purposes of availing the benefits under section 9A of the ITA has now been prescribed by the Central Board of Direct Taxes (“CBDT”), vide Notification dated May 27, 2020[1]. As per the CBDT notification, the amount of minimum remuneration shall be calculated as under-

(1) The amount of remuneration shall be 0.10% of the asset under management (“AUM”) if the offshore fund is a Category-I Foreign Portfolio Investor (“FPI”) under the Securities and Exchange Board of India (FPI) Regulations, 2019, and is any of the following entities –

(a) Government and Government related investors;

(b) Pension funds and university funds;

(c) Appropriately regulated entities such as insurance or reinsurance entities, banks, asset  management  companies,  investment  managers,  investment advisors, portfolio managers, broker dealers and swap dealers; and

(d) University  related  endowments of  such universities  that  have been  in existence for more than 5 years from the Financial Action Task Force member countries, or from any country  specified by  the  Central  Government.

(2) For other funds, the amount of remuneration shall be as under:

(a) 0.30% of the AUM; or

(b) 10% of profits derived by the fund in excess of the specified hurdle rate[2] from the fund management activity undertaken by the fund manager, where it is entitled only to remuneration linked to the income or profits derived by the fund; or

(c) 50% of the management fee[3] (after reducing operational expenses), whether in the nature of fixed charge or linked to the income or profits derived by the fund from the management activity undertaken by the fund manager, paid by such fund in respect of the fund management activity undertaken by the fund manager, in a case where the fund is also making payment of management fee to any other fund manager.

The CBDT notification also provides for a pre-approval mechanism under which a fund can seek approval at its option from the CBDT for a remuneration lower than the prescribed remuneration under Rule 10VA of the Income-tax Rules, 1962.

Some Observations:

1. The condition of payment of arm’s length remuneration to the fund manager was saddled with onerous transfer pricing compliance obligations and rigors of transfer pricing audits. Further, there was a risk of section 9A benefit being impacted if the remuneration paid or payable by the fund to the fund manager was determined to be not at arm’s length price for a period of 3 consecutive previous years or for any 3 out of the preceding 4 previous years. This was a significant impediment in implementation of the safe harbour regime for offshore funds, owing to the subjectivity and uncertainty involved. The method prescribed now for determining the amount of remuneration is an objective criterion which takes into account the different remuneration models prevalent in the industry based on assets, profits, fixed charges, etc.  Further, the additional flexibility to adopt a pre-approved lower remuneration should mitigate hardship in genuine cases. This rationalisation of the fund manager remuneration norms would ensure greater tax certainty and minimal litigation thereby removing a key constraint in onshoring of fund management.

2. The lower threshold of 0.10% of the AUM prescribed for managers of government funds, pension funds, universities, etc, holding Category-1 FPI license, may be based on the market rate of remuneration prevalent for this segment. Further, this is in continuation of the avowed objective of the Government to promote investments by sovereign funds in India, which was also evidenced by the recent tax exemption, with respect to dividend, interest and long-term capital gains, provided to certain specified sovereign wealth funds and pension funds with respect to investments in infrastructure sector.

3. AUM has been defined to mean “the annual average of the monthly average of the opening and closing balance of the value of such part of the fund which is managed by the fund manager”. In order to avoid any ambiguity regarding valuation, the rules may clarify the books of account or any other source that may be used for determining the amount of AUM of the offshore fund, as has been done in certain other taxation rules.

Author:
Akansha Aggarwal, Partner

Footnotes:

[1] Notification No. 29/2020/ F. No. 142/15/2015-TPL
[2] “Specified hurdle rate” means a pre-defined threshold beyond which the fund agrees to pay a share of the profits earned by the fund from the fund management activity undertaken by the fund manager.
[3] Then amount of management fee is required to be certified by an accountant (as defined under Rule 11UB of the Income-tax Rules, 1962).