Fund Formation In India: A Comprehensive Legal Guide

Executive Summary

India has emerged as one of the most dynamic investment destinations globally, underpinned by a maturing regulatory ecosystem, a burgeoning startup landscape, and a rapidly growing pool of domestic and international capital. The fund formation landscape in India is governed by a confluence of securities law, foreign exchange regulations, tax frameworks, and sector-specific guidelines. This article provides a comprehensive overview of the legal structures, regulatory frameworks, tax considerations, and procedural requirements for establishing investment funds in India.

Whether you are a domestic promoter, a foreign sponsor, a family office, or a global asset manager seeking to tap India’s growth story, understanding the fund formation architecture is essential to structuring a compliant, tax-efficient, and commercially robust vehicle.

Introduction: India’s Investment Fund Landscape

India’s alternative investment ecosystem has witnessed unprecedented growth over the past decade. The Securities and Exchange Board of India (SEBI) introduced the Alternative Investment Funds (AIF) Regulations in 2012, creating a structured framework that has since channelled trillions of rupees of capital into the Indian economy. As of 2024, the AIF industry manages commitments exceeding INR 11 lakh crore (approximately USD 130 billion), spanning venture capital, private equity, real estate, infrastructure, and hedge funds.

India’s fund formation environment has matured substantially, with SEBI continuously fine-tuning the regulatory framework to balance investor protection with the need to attract global capital. The introduction of the International Financial Services Centre (IFSC) in GIFT City, Gujarat has further opened avenues for offshore structuring with onshore access which is a significant development for global fund managers seeking India-specific mandates.

Regulatory Architecture: Key Statutes and Regulators

Fund formation in India is a multi-jurisdictional regulatory exercise. The principal laws and regulations include:

The primary regulator for private investment funds is SEBI, operating under the Ministry of Finance. The Reserve Bank of India (RBI) oversees foreign exchange flows through its FEMA framework, while the Income Tax Department administers the tax treatment of fund vehicles and their investors.

Alternative Investment Funds (AIFs): Categories and Characteristics

SEBI’s AIF Regulations provide the principal framework for the formation and operation of pooled investment vehicles in India. An AIF is defined as any fund established or incorporated in India that is a privately pooled investment vehicle that collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy.

1. Category I AIFs

Category I AIFs are funds that invest in start-ups, early-stage ventures, social ventures, SMEs, infrastructure, and other sectors the government or SEBI considers socially or economically desirable. These include:

• Venture Capital Funds (VCFs): investing in unlisted companies
• Angel Funds: sub-category of VCFs, with a focus on early-stage investments
• SME Funds: investing in small and medium enterprises
• Social Venture Funds: investing in entities pursuing socially responsible objectives
• Infrastructure Funds: investing in infrastructure projects

2. Category II AIFs

Category II AIFs are funds that do not fall under Category I or III and do not undertake leverage or borrowing other than to meet day-to-day operational requirements. These represent the largest category by commitments and include:

• Private Equity (PE) Funds
• Debt Funds
• Fund of Funds
• Real Estate Funds (domestic)

Category II AIFs enjoy a tax pass-through status under Section 10(23FBA) of the Income Tax Act, with income being taxed at the investor level rather than the fund level, a commercially significant benefit.

3. Category III AIFs

Category III AIFs employ diverse and complex trading strategies and may use leverage including through investment in listed or unlisted derivatives. These include:

• Hedge Funds
• PIPE (Private Investment in Public Equity) Funds

Category III AIFs do not enjoy full pass-through tax treatment; income generated at the fund level may be subject to taxation before distribution to investors, though certain income streams receive partial pass-through treatment.

Fund Structure: Legal Vehicles for Indian AIFs

An AIF may be established as a trust, a company, a body corporate, or a Limited Liability Partnership (LLP). In practice, the overwhelming majority of AIFs are structured as trusts specifically, irrevocable private trusts established under the Indian Trusts Act, 1882 or applicable state legislation.

1. Trust Structure (Dominant Form)

The trust structure is preferred for its flexibility, tax-neutrality (at the trust level in pass-through categories), and commercially familiar governance for both domestic and offshore investors. Under this structure:

• A Sponsor (akin to the settlor) contributes the initial corpus
• A Trustee (typically a SEBI-registered debenture trustee or a trust company) holds assets for investors’ benefit
• An Investment Manager is appointed by the Trustee under an Investment Management Agreement (IMA) to manage the corpus
• Investors participate as beneficiaries through Contribution Agreements

2. LLP Structure

LLPs offer limited liability to all partners and are sometimes used for funds with a smaller, closely-knit investor base. The sponsor acts as the Designated Partner, with investors participating as limited partners. LLP structures may, however, present certain tax complications compared to trusts and require careful planning.

3. Company Structure

Funds structured as companies under the Companies Act, 2013 are relatively uncommon given the rigidity of corporate governance requirements and potential dividend distribution tax implications. However, they are occasionally used for specific strategies, particularly in situations where institutional investors require a company as the counterparty.

SEBI Registration Process for AIFs

All AIFs must be registered with SEBI prior to commencing fundraising or investment activities. The registration process involves the following key steps:

Key Constituent Documents

A well-structured AIF requires a suite of carefully negotiated legal documents. KS&K’s fund formation practice advises on the full spectrum of documentation, including:

• Trust Deed: establishes the legal foundation of the fund, defining the roles of the Trustee, Investment Manager, and Sponsor.
• Private Placement Memorandum (PPM): the offer document provided to prospective investors, containing investment strategy, risk factors, fee structure, governance, and subscription mechanics.
• Investment Management Agreement (IMA): governs the appointment, authority, duties, and compensation of the Investment Manager
• Contribution Agreement: executed between the fund and each investor, setting out commitment obligations, drawdown mechanics, and investor representations
• Side Letters: bilateral agreements providing certain investors with preferential terms (MFN clauses, reporting preferences, co-investment rights)
• Trustee Agreement: sets out the governance relationship between the Trustee and Investment Manager
• Co-Investment Agreements: govern the terms on which investors may participate in individual investments alongside the fund
• Portfolio Company Documentation: term sheets, SHA, investment agreements, and shareholder agreements for each underlying investment

Foreign Investment in Indian AIFs: FEMA Considerations

Foreign investment in Indian AIFs is permitted under FEMA and the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019. Key considerations include:

1. Eligible Foreign Investors: Foreign Venture Capital Investors (FVCIs) registered with SEBI enjoy a more liberalised regime and are eligible to invest in AIFs under a specific SEBI (FVCI) Regulations framework. Non-resident Indians (NRIs), Overseas Citizens of India (OCIs), and Foreign Portfolio Investors (FPIs) may also invest in AIFs subject to applicable FEMA provisions.
2. Downstream Investment: When an AIF receives foreign investment, its downstream investments into Indian portfolio companies may be characterised as indirect foreign investment, subject to sectoral foreign direct investment (FDI) caps, pricing guidelines, and FEMA reporting obligations. The ‘sponsor / manager test’ under FEMA provides a critical carve-out: if the sponsor and investment manager are Indian-owned and controlled, foreign investment in the AIF is not automatically treated as indirect foreign investment.
3. Reporting Obligations: AIFs receiving foreign investment are required to comply with FEMA reporting requirements, including filings with the authorised dealer bank and periodic reporting to RBI through the FIRMS (Foreign Investment Reporting and Management System) portal.

Tax Framework for Indian Funds

Tax efficiency is a central consideration in fund formation. India’s tax framework for AIFs operates under the Income Tax Act, 1961 and has evolved significantly through Finance Acts and CBDT circulars.

1. Pass-Through Taxation (Category I & II AIFs)

Under Sections 10(23FBA) and 115UB of the Income Tax Act, income accruing or arising to a Category I or Category II AIF (other than business income) is not chargeable to tax at the fund level. Instead, income is deemed to accrue to investors in proportion to their contributions and taxed in their hands in the year of accrual. Business income, however, is taxed at the fund level at the maximum marginal rate (approximately 42.74% for trusts) and then distributed to investors tax-free.

2. Category III AIFs: Partial Pass-Through

Category III AIFs are entitled to a partial pass-through only for income characterised as capital gains. Other income streams (business income, interest, etc.) are taxed at the fund level. Short-term capital gains on listed securities attract a 20% rate (post-Finance Act 2024), while long-term capital gains above INR 1.25 lakh are taxed at 12.5%.

3. Management Fees and Carry

The Investment Manager’s management fee (typically 1.5–2.5% per annum) and carried interest (typically 15–20% of profits above the hurdle rate) have distinct tax treatment:

• Management fees are treated as service income in the hands of the Manager and attract Goods and Services Tax (GST) at 18%.
• Carried interest received by the Investment Manager is characterised as capital gains (if structured as return on an equity stake) or as business income, depending on the structure and specific facts.

GIFT City: An Offshore-Equivalent Option within India

GIFT City’s International Financial Services Centre (IFSC), regulated by the International Financial Services Centres Authority (IFSCA), provides a unique jurisdiction that combines the regulatory stability of an Indian sovereign-backed framework with the tax and operational attributes of an offshore financial centre.

1. Fund Formation at IFSC

Under the IFSCA (Fund Management) Regulations, 2022, fund management entities (FMEs) may be set up at GIFT City to manage investment funds including:

• Retail Schemes (subject to SEBI-like investor protection requirements)
• Non-Retail Schemes (including private placement funds for sophisticated investors)
• Special Purpose Acquisition Companies (SPACs)

2. Tax Benefits at IFSC

Funds and fund management entities at the IFSC enjoy significant tax concessions under Sections 10(4D), 10(4E), 10(4F), and 80LA of the Income Tax Act:

• 100% tax exemption on income of Eligible Investment Funds for 10 years.
• 0% withholding tax on distributions from IFSC funds in certain structures.
• Exemption from GST for IFSC-based financial services.
• Stamp duty concessions under applicable IFSC framework.

Fund Manager’s Obligations: Ongoing Compliance

Post-registration, an Investment Manager of an AIF bears continuous regulatory obligations, including:

• Quarterly reporting to SEBI via the AIF reporting portal (SEBI AIF Module).
• Annual report to SEBI within 180 days of year-end, including audited financial statements.
• Mandatory disclosure of all conflicts of interest and related-party transactions.
• Compliance with SEBI Circular obligations on valuation, portfolio diversification, and risk management.
• Maintenance of books of accounts and records for a minimum of 8 years.
• Filing of annual secretarial compliance reports (for LLP / company structures).
• Compliance with AML / KYC obligations under the Prevention of Money Laundering Act, 2002.
• FATCA and CRS compliance for funds with foreign investors or international investors.

ESG and Sustainability Considerations

Environmental, Social, and Governance (ESG) integration has become an increasingly significant feature of Indian fund formation. SEBI’s BRSR (Business Responsibility and Sustainability Reporting) framework, while directly applicable to listed entities, indirectly influences fund managers who manage capital on behalf of institutional investors with ESG mandates.

Key Legal and Structuring Challenges

Fund formation in India, while well-regulated, presents several nuanced legal challenges that require specialised advice:

• FEMA Characterisation Risk: mischaracterisation of downstream investments as indirect FDI can trigger regulatory consequences; careful sponsor/manager ownership structuring is essential.
• Business Income Risk: investment managers must structure their fund’s activities to avoid characterisation of capital gains as business income, which carries a materially higher tax burden.
• Trustee Liability: SEBI has increasingly focused on trustee accountability; trust deeds must carefully delineate responsibilities and indemnity provisions.
• Investor Concentration: regulatory limits on investor numbers and minimum investment thresholds require careful capital raise planning.
• Side Letter Fairness: side letters granting preferential treatment to anchor investors must not conflict with the PPM or disadvantage other investors.
• Exit and Liquidity Planning: AIF structures must provide clear mechanisms for fund termination, extension, and investor exit, including secondary market transfer provisions.

Conclusion

India’s fund formation landscape offers a sophisticated, regulation-backed framework that continues to evolve in line with global best practices. The AIF regime, complemented by the IFSC framework at GIFT City, provides a comprehensive toolkit for domestic and international asset managers to access India’s growth capital markets through well-structured, tax-efficient, and commercially robust investment vehicles.

https://ksandk.com/

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.