In a sticky situation: Sebi's Special Situations Fund may run into tax wall

The introduction of a new sub-category for investments in stressed assets through alternative investment funds (AIFs) will bring in a new set of investors and create a more efficient market for buying distressed assets, but may run into tax hurdles, said market players.

On Tuesday, the Securities and Exchange Board of India (Sebi) board amended the AIF regulations to introduce a Special Situations Fund (SSF), a sub-category under Category I AIF, which can invest in certain kinds of ‘stressed assets’.

This includes stressed loans available for acquisition in terms of the Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021, or as part of a resolution plan approved under the Insolvency and Bankruptcy Code, 2016. It also includes security receipts issued by asset reconstruction companies (ARCs), securities of companies in distress, and any other asset/security as may be prescribed by the Sebi board from time to time.

“This is a welcome move and in line with the representations made by the market participants. The proposed new framework also permits the direct acquisition of loans in accordance with the Reserve Bank of India's (RBI's) new direction on transfer of loan exposures, in addition to investment in securities receipt issued by ARC trusts,” said Tushar Sachade, partner, Price Waterhouse & Co.

AIFs have a minimum ticket size of Rs 1 crore and offer investors access to sophisticated strategies across different asset classes. The RBI’s (Transfer of Loan Exposures) Directions, 2021, is aimed at ensuring proper credit-risk pricing, better identifying stress in the banking system, and resolution of stressed-loan exposures.

SSFs will be exempt from investment concentration norms in a single investee company and there will be no restriction on investing their investible funds in unlisted or listed securities of the investee company. The minimum corpus requirement is Rs 100 crore.

“SSFs will provide wealthy investors the opportunity to invest in stressed assets and securities and will provide AIF managers an opportunity to generate superior returns from potential rise in valuations that the special situation presents,” said a securities lawyer.

There are already three mutual fund schemes under the thematic category, which have already been providing opportunities to take calculated risks by investing in special situations. The recent market rally has also worked for investors by investing in special situations, said experts.

According to the lawyer quoted earlier, SSFs will come in handy for those entrepreneurs or strategic investors who may have the ability to augment the business or management of a company, but may need financial support or may want to partner an AIF specialising in such investments.

Experts believe the taxation for these funds is not favourable at present. This may deter foreign investors with deep pockets from investing.

“Currently, business income earned by AIFs I and II is taxed at the fund level. It is important for the government to align this new framework with appropriate changes to the tax law in the ensuing Budget, allowing pass-through of business income to enable participation by foreign investors in these structures,” said Sachade.

The tax rate for business income is 42.7 per cent after surcharge and cess.

The assets of AIFs have crossed the Rs 5-trillion mark this year as an increasing number of wealthy investors scout for alternatives to derisk their portfolios and maximise returns.