The Reserve Bank of India (RBI) has effectively removed foreign direct investments (FDI) restrictions for Alternative Investment Funds (AIF). Thereby downstream investments by AIFs in restricted sectors such as ecommerce can bypass FDI laws.

In a notification, the RBI said that any AIFs which are sponsored or managed by an Indian resident can now be considered a domestic investment vehicle, regardless of what percentage of the AIF’s money comes from overseas funds. (hat tip: Mahesh Murthy).

Venture capital firms are considered as AIFs and are regulated by the Securities Exchange Board of India (SEBI). So far, venture capital firms could not invest directly in ecommerce companies as they would violate the FDI regulations. However, VCs can invest in back-end warehousing firms which are usually listed as a seller on the market place. An example of this would be WS Retail which is a funded warehousing firm rather than Flipkart which is unfunded and incorporated in Singapore.

From the notification:

The extent of foreign investment in the corpus of the Investment Vehicle will not be a factor to determine as to whether downstream investment of the Investment Vehicle concerned is foreign investment or not.

With the new RBI notification treating AIFs with Indian managers as as a domestic entity, it effectively means that all investments made will be treated as domestic investments. Mahesh Murthy, CEO of Pinstorm, illustrates this:

Let’s say I’m Walmart. Till now I couldn’t invest in an Indian retail company. FDI restrictions, you see. But here’s what I decide to do.

I set up an AIF, under SEBI. Let’s call this the Martwal Fund. I find an Indian manager for this AIF. I put, say a billion dollars into it from Walmart’s balance sheet. My Indian manager puts his fair share, say a hundred dollars. The Indian manager affirms that he acts independently.

And, voila, Martwal is now a domestic entity. Which can invest in any sector under the sun. So Martwal then backs a company building a chain of supermarkets in India. Sounds like a good idea?

FIPB approval is still required: However, it needs to be pointed out that AIFs will still have to get approvals from the Foreign Investment Promotion Board (FIPB) to get funds from overseas. The Economic Times also points out that AIFs will have to set up feeder investment vehicles which collects funds before transferring it for investment in companies and assets in India.

Tax pass through

Finance minister Arun Jaitley also announced a tax pass through for for AIFs in this year’s Union budget which would allow a VC firm to pass on the tax liability to the end-investor (the person who has invested in the fund), as indicated by this Business Standard report.  Usually foreign firms route investments through feeder vehicles in Mauritius and the capital gain will “pass through” to the Mauritius entity which pays no capital gains tax in India because of a double taxation avoidance treaty between the two countries.