Low-ticket Gift City funds are almost here. But what holds them back?

These funds primarily attract foreign and NRI investors; however, their widespread adoption is limited by the high minimum investment requirement. Retail funds, which can accept investments as low as $100, are yet to be launched.

In the previous Union budget, the government extended favourable tax treatment to retail funds in Gift City, similar to what was earlier extended to non-retail funds. However, no asset manager has launched a retail scheme so far, largely due to the confusion regarding its structure. 

Also Read: Budget 2024: How tax-free retail funds will benefit NRIs

The tax confusion

There’s a tax rule that says if a foreigner or NRI invests in a Gift City fund, India will levy zero tax. The exception is when these funds invest directly in equities, in which case the investment is subject to capital gains tax.

For instance, Mirae Asset has a Gift City AIF Cat-3 Fund, which feeds into its mutual fund schemes in India. Since the fund does not invest in direct equities, foreign investors or NRIs don’t have to pay any tax on it in India. Such funds are called inbound funds which invest in India and are meant for foreign investors who want to invest in the Indian markets.

The same structure could be replicated in the retail fund model where the ticket size is very low. However, the International Financial Services Centres Authority (IFSCA), the Gift City regulator, mandates two things for retail funds.

-Retail funds in Gift City cannot invest more than 25% in their associates.

– Their investment in unlisted securities cannot be more than 15% of their assets.

The regulator had clarified in an October circular that such restrictions will not be applied to retail funds. However, on 27 January, the Central Board of Direct Taxes (CBDT), the tax authority, issued a notification stating that the two conditions are a prerequisite to qualify as a retail scheme in Gift City and avail tax benefits.

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Experts divided

According to experts, these two requirements are confusing. Let’s say an AMC’s Gift City unit launches a retail fund that feeds it into its own MF schemes in India. It makes sense to follow this structure to get the tax benefit. However, the question is whether feeding into one’s own scheme is considered investing in an associate. 

Experts differ on whether investing in mutual fund schemes run by their parents would qualify as an associate. 

Suresh Swamy, partner, tax and regulatory services, Price Waterhouse & Co. Llp-Gift IFSC Branch, said there’s a possibility that authorities might consider a retail scheme investing in its own MF scheme as investing in an associate. In this case, the investment may not be allowed to exceed more than 25%.

“While IFSCA Fund Management Regulations have given relaxation from the 25% investment in associates condition, the CBDT circular has not granted a similar dispensation, which would be a roadblock for such structures,” Swamy said.

Keyur Shah, partner and leader, financial services tax and regulatory, EY, agrees with Swamy. “Where any retail scheme in Gift City which is managed by a branch or subsidiary (of an Indian AMC) and such retail scheme makes investments in the schemes managed by the Indian AMC in India, then it may be construed that more than 25% of the AUM of the Gift Retail Fund is invested in associates and consequently, the tax benefits provided under the Indian tax law would not be available to such a retail fund.”

Meanwhile, Jay Kothari, SVP-Equities of DSP Mutual Fund, believes investing in own MF schemes would not be considered an associate. Let’s say the retail Gift scheme is investing in its parent or related entities stocks, then that would be considered investing in an associate, not investing in a mutual fund.

Another ambiguity is whether mutual funds qualify as unlisted securities, which would be subject to the 15% cap.

“Units of open-ended funds are not listed. Therefore, investments in such units would require adherence to the 15% investment limit in unlisted securities,” Swamy from PWC said. 

Shah from EY agreed. “There are MFs which could be listed (such as ETFs) or unlisted. Hence, due to the restriction which has been prescribed, a retail fund in Gift City cannot invest more than 15% in unlisted MFs, else they would not be eligible for the tax benefits.”

However, Kothari from DSP believes mutual funds will not be considered unlisted for this regulation.

Queries sent to CBDT last week seeking clarity on this issue did not elicit any response till press time.

Also Read: Rich foreigners will now get tax-free access to Indian MFs

Other challenges

Setting up a retail inbound fund targeting foreigners is another challenge, said Bibek Sengupta, director of sales at White Oak Capital Management. 

Accepting small-ticket investments from foreign investors may necessitate registration in foreign jurisdictions. Unlike AIFs, which are treated as private placements, retail funds from foreign citizens could face stricter licensing requirements. Even distributors selling retail funds to foreign citizens might be required to register themselves in the foreign jurisdiction, he added.

He said running an outbound retail fund through Gift City can be lucrative for AMCs. Such funds are meant for Indians wanting to invest in foreign securities and markets. The mutual fund industry’s $7 billion limit on overseas investment set by RBI has now been exhausted and as a result, most overseas MF and ETFs are no longer accepting fresh investments. 

An alternative to mutual funds in such cases is for people to invest in an outbound Gift City fund with a low ticket size. These funds avoid regulatory ambiguities around associate investments and unlisted securities, making them a more straightforward opportunity.