Mumbai: Hedge funds located in India are less than half-a-billion dollars in assets, but a recent regulatory change may help their case. The Reserve Bank of India (RBI) on 16 November removed restrictions on alternative investment funds —of which hedge funds are a sub-category—based in India accepting foreign capital. This paves the way for India-based funds to capture a bigger part of the multi-billion dollar India-dedicated hedge fund assets.

The total amount managed by all India-dedicated hedge funds is $3.6 billion, of which $3.2 billion, or 88.63%, is managed by managers based outside the country. That is of course, only a minuscule portion of the global hedge fund industry, which has a size of $2.24 trillion, according to data from hedge-fund tracker Eurekahedge.

The preference for India-dedicated funds to be managed outside the country comes despite the better track record of funds located within the country. Local hedge fund managers have outperformed foreign ones on seven out of nine occasions since 2007.

The higher returns are attributed to the advantages of local knowledge and having feet on the ground, compared with offshore managers who may be hampered by distance.

“The new dispensation allows foreign investors to put their money in all alternative investment funds, including hedge funds. Hence, subject to prescribed conditions, investments are likely to happen," said Tejesh Chitlangi, partner at IC Legal, a law firm. Earlier, India-based hedge funds wanting foreign capital had to approach the Foreign Investment Promotion Board, usually without success.

While the relaxation in regulatory criteria is welcome, hedge fund managers point to taxation policies that may throttle any inflows.

“Unlike Category I and II AIFs (alternative investment funds) that are generally eligible for tax pass-through, Category III AIF trusts are taxed in accordance with trust taxation principles which are complex and could potentially lead to uncertainty in tax treatment for such AIFs and its investors," said Nehal Sampat, executive director, financial services—tax and regulatory services at PricewaterhouseCoopers Pvt. Ltd. Category I and II AIFs refer to primarily venture capital and private equity funds.

A pass-through would mean that income is taxed in the hands of the investor rather than at the fund level. This is considered a more convenient form of taxation administratively for funds.

There are other tax issues plaguing hedge funds, points out Chitlangi. Their income is classified as business income which is liable to taxation at the highest marginal rate as opposed to long-term or short-term capital gains. Almost a third of gains from funds which are locally managed may be lost.

As in many other cases involving capital flows in India, the tax man still holds the keys.

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