Foundation — The principle of pooling and the general pooling considerations

Forty people travel to the same town every morning. They can hire forty taxis or one bus.

The forty taxis are INDIVIDUAL PORTFOLIO MANAGEMENT. Each passenger has their own vehicle, their own route decisions and their own arrival time. The workbook describes it exactly: the individual investment corpus of each investor is KEPT DISTINCT and managed under a portfolio management agreement, and the essential feature is that it is A CUSTOMISED SERVICE OFFERED AT INDIVIDUAL INVESTOR LEVEL. Therefore, THERE WOULD BE AS MANY INVESTMENT MANAGEMENT OUTCOMES AS THERE ARE INVESTORS.

The bus is POOLED ASSET MANAGEMENT. Nobody owns a seat in particular; there is NO CONCEPT OF AN INDIVIDUAL CORPUS. The workbook adds the nickname: that's why it is also known as BLIND POOL INVESTING.

And what the bus buys is not merely cheapness. The workbook lists it: ECONOMIES OF SCALE; the ability to plan a BETTER AND BROAD-BASED INVESTMENT STRATEGY with a larger pool of underlying assets bringing RISK DIVERSIFICATION; and an enhanced RISK-TAKING CAPABILITY producing better returns to the common fund that would be enjoyed by ALL individual investors participating in it.

A single investor with Rs 2 crore cannot back forty start-ups. Four hundred investors with Rs 2 crore each can — and each of them then owns a fortieth of forty companies rather than the whole of one.

The workbook does note the modern qualification: managers increasingly offer BESPOKE INVESTING SOLUTIONS including co-investment options. But it settles the point firmly — special rights or options provided to some investors are ADD-ON FEATURES WHICH DO NOT ALTER THE AIF POOLING STRUCTURE IN ANY WAY. Someone may pay extra for a better seat. It is still a bus.

A tour operator takes four hundred foreign visitors to India. Either each visitor obtains their own documentation, or the operator handles it collectively.

That is the regulatory efficiency argument for offshore pooling, and the workbook states it precisely.

In the case of offshore investors with an India focus, IF THE FUNDS ARE POOLED OUTSIDE INDIA, THE REQUIREMENT TO OBTAIN A PERMANENT ACCOUNT NUMBER (PAN) AND FILING OF DOMESTIC TAX RETURNS IN INDIA WILL ONLY BE ON THE OFFSHORE FUND, AS OPPOSED TO EACH OF THE OFFSHORE INVESTORS.

The alternative is spelt out too: the burden falls on each investor in case of their DIRECT PARTICIPATION IN AN ONSHORE POOLING VEHICLE or taking DIRECT INVESTMENTS IN INDIAN INVESTEE COMPANIES THROUGH THE FDI POLICY.

Imagine the practical position without the offshore pool. A US pension fund, a Norwegian sovereign fund and a Singapore family office each apply for an Indian PAN, each file Indian returns, each track Indian withholding, each engage Indian tax advisers. Multiply by the number of investors in a large fund, and the compliance cost alone can exceed the tax saving anyone was arguing about.

Pool them in Mauritius or Singapore first, and India sees one taxpayer.

This is why the chapter treats pooling as more than an investment technique. Pooling also has REGULATORY EFFICIENCY IN EFFECTIVE COMPLIANCE MANAGEMENT — and for cross-border funds that efficiency is often the decisive structuring consideration, not the tax rate.

Four families drive to the same wedding. If each drives separately they pay one toll each. If they share a van and the van is charged five tolls, they have been penalised for co-operating.

That is what tax neutrality prevents. The workbook defines it: pooling should not put an investor in A COMPARATIVELY ADVERSE POSITION FROM TAXATION POINT OF VIEW AS COMPARED TO INVESTING AT INDIVIDUAL LEVEL.

And it names the exact situation where neutrality is hardest: it is especially relevant when CERTAIN STREAMS OF INCOME MAY BE TAX FREE AT INVESTOR LEVEL DUE TO THE STATUS OF THE INVESTOR, BUT TAXABLE AT FUND LEVEL.

Consider what that means concretely. A charitable institution or a pension fund may enjoy exemption on certain income. If the fund is taxed before distributing, the exemption is destroyed by the structure — the investor pays tax it would never have paid investing directly, purely because it went through a pool.

Which is why the AIF world cares so much about pass-through treatment, and why the workbook says the trust form is preferred primarily from a CLEAR TAX TREATMENT perspective.

Note the honest qualification in the workbook, however. Because the outcome depends on the provisions of the tax law, it is necessary to OPTIMISE THE STRUCTURE AS NEARLY AS POSSIBLE TO ACHIEVING TAX NEUTRALITY. Perfect neutrality is an aspiration, not a guarantee — and a manager promising it is overstating what any structure can deliver.

A trader sets up an office in a low-tax town. It has a nameplate, a postbox and nobody in it. Every decision is still taken in his home city. A tax inspector visiting would find a signboard and no business.

That is what GAAR is written to catch, and the workbook's footnote defines it in exactly those terms: a set of rules to ensure that assessees do not resort to TAX AVOIDANCE/EVASION BY SETTING UP COMPLICATED STRUCTURES AND PRACTICES THAT DO NOT HAVE ANY GENUINE BUSINESS PURPOSE. GAAR CAME INTO EFFECT FROM APRIL 1, 2017.

The operative test is LACK OF COMMERCIAL SUBSTANCE, and the consequence is severe: GAAR allows Indian tax authorities to RE-CHARACTERISE TRANSACTIONS.

The structuring advice that follows is practical rather than moral. The workbook says the structure should NOT BE TOO COMPLEX such that it is perceived to be EXPLOITING REGULATORY AND TAX ARBITRAGE and may come under THE SCRUTINY AND WRATH OF REGULATORS. And the standard to aim for: while taking advantage of available options under law, the structure SHOULD SEEM GENUINE AND NOT TO OBFUSCATE THE UNDERLYING OBJECTIVES OF CREATION OF THE POOL.

The shift this produced is described later in the chapter and is the single most important sentence about offshore structuring: India has moved away from FORM OVER SUBSTANCE to a SUBSTANCE OVER FORM approach in the determination of the legitimacy of such structures — both for domestic taxation and in their treatment for double tax avoidance under tax treaties.

A Mauritius entity with real directors, real decisions and real staff is a fund. The same entity with a nameplate is a risk.

A father leaves a house "to my children, in such shares as the caretaker thinks fit." A second father leaves the same house "half to each of my two sons." The second document can be acted on; the first cannot, until somebody decides.

That is the distinction between an indeterminate and a determinate trust, and it is why AIFs are structured as they are.

The workbook sets out the trust taxonomy in three pairs. A trust may be PRIVATE (set up to administer family properties and inheritance requirements) or PUBLIC (for a wider purpose of serving the general public usually with a charitable service motive). It may be REVOCABLE or IRREVOCABLE — the trust property can be REVERTED BACK TO THE SETTLOR if it is revocable, while in an irrevocable trust the ownership of the property is PERMANENTLY VESTED with the trust. And it may be DETERMINATE or INDETERMINATE — in a determinate trust, the share of each beneficiary is CLEARLY DEMARCATED, while in an indeterminate trust such demarcation is not present and the trustee may allocate its benefits in a way he determines fit.

For AIF purposes, an IRREVOCABLY SETTLED, DETERMINATE TRUST is considered more appropriate, PRIMARILY FROM A CLEAR TAX TREATMENT PERSPECTIVE.

And here is the mechanism by which determinacy is actually achieved, which is the examinable part. To achieve determinacy the AIF needs to ensure that its investors and their respective beneficial interests are ASCERTAINABLE as per the terms of the INDENTURE OF TRUST or the TRUST DEED, AT ALL TIMES DURING ITS EXISTENCE.

THIS IS THE REASON WHY THE CORPUS IS DIVIDED INTO UNIT CAPITAL AND INVESTORS ARE ALLOTTED SPECIFIC NUMBER OF UNITS representing their determinate share.

So units are not an administrative convenience. They are the device that makes the trust determinate, and therefore the device that secures the tax treatment.

Three families store grain. One uses an earthen jar — cheap, discreet, and the shape can be adjusted by the potter. One uses a steel drum bought under licence — sturdier, but the purchase is on record at the shop. One uses a municipal silo — safe, and every deposit and withdrawal is entered in a public register.

Those are the three AIF constitutions, and the workbook ranks them plainly.

The TRUST is the most preferred option for a domestic fund structure, incorporated under the Indian Trusts Act, 1882 — and note that under the AIF Regulations a body corporate set up under an Act of Parliament or State Legislature is also included. Its advantages: the ability to incorporate SPECIFIC TERMS OF GOVERNANCE as may be agreed between the manager and the investors, plus tax benefits. Its peculiarity: though the trust is a registered body, IT DOES NOT HAVE THE ABILITY TO SUE OR BE SUED like other legal entities. It is represented by its TRUSTEE, which is primarily entitled to sue or be sued for and on behalf of the trust.

The LLP, under the Limited Liability Partnership Act, 2008, gives legal entity status with limited liability distinct from that of individual partners. It contains elements of both a corporate structure and a partnership firm structure; there is NO PERSONAL LIABILITY of a partner EXCEPT IN THE CASE OF FRAUD; and a partner is not liable for another partner's misconduct or negligence, as there is NO JOINT AND SEPARATE LIABILITY as in a normal partnership. Every LLP must have at least TWO DESIGNATED PARTNERS. It is most popular in foreign countries for AIF management.

But the workbook names three Indian downsides. Higher compliance requirements as compared to a trust. All investors become partners which makes their ENTRY AND EXIT A CUMBERSOME PROCESS under the LLP deed and needs to be UPDATED ON THE MCA WEBSITE. And the details of investors come under PUBLIC DOMAIN — the SECRECY which is maintained under Trust level is LOST under LLP/company level.

The COMPANY is the LEAST PREFERRED, being cumbersome in management and compliance, and carrying a fatal structural limit: companies are restricted in making private placements to NOT MORE THAN 200 INVESTORS though the AIF regulations permit up to 1000 (accredited investors excluded from the count).

Passengers from Mauritius and Singapore want to reach a conference in Mumbai. Either they all fly to one hub and take a single onward flight together, or each group flies direct.

The hub is the MASTER-FEEDER STRUCTURE — a SUBORDINATED structure in which offshore investors invest THROUGH A FEEDER FUND, WHICH IN TURN INVESTS IN THE DOMESTIC MASTER FUND. The master fund also takes DIRECT INVESTMENTS from domestic or foreign investors — institutional investors, HNIs, banks, insurance companies, pension funds, large corporates, fund of funds.

Why a feeder exists at all: for many investors, investing directly in a fund registered with SEBI in India might be TAX-EFFICIENT AND REGULATORY-EFFICIENT — those are the direct investors. But for another group, that might not be the most efficient way, and to address the tax/regulatory issues specific to that group, SUCH AS MAURITIUS AND SINGAPORE INVESTORS, the sponsor needs to set up a FEEDER VEHICLE.

The fee mechanics are examinable: management fees typically are charged AT THE MASTER FUND LEVEL. At the feeder fund level, usually ONLY A SYMBOLIC FIXED ABSOLUTE AMOUNT (e.g. USD 1000) is charged. The main expense is PASSED ON TO THE FEEDER FUND THROUGH THE NET ASSET VALUE ALLOCATED to the relevant feeder by the master fund.

The direct flights are the PARALLEL STRUCTURE — offshore investors invest through SEPARATE POOLING VEHICLES in different jurisdictions, and the Offshore Fund then invests DIRECTLY IN THE INVESTEE COMPANIES ALONGSIDE the domestic AIF, INSTEAD OF INVESTING IN THE MASTER FUND. Large investors do not need to allocate funds to a registered AIF in India.

And because each offshore fund has its own manager, the workbook warns: the FEE STRUCTURE IN A PARALLEL STRUCTURE MAY BE EXPENSIVE AS COMPARED TO THE MASTER FEEDER STRUCTURE. Two flights, two crews.

Two neighbours each buy shares in the same company on the same morning. They have not invested together. There is no agreement between them, and each decided alone.

The workbook makes exactly this point about parallel structures, and it is the kind of distinction examiners like because it looks like a contradiction until the reasoning is seen.

Under the parallel structure, INVESTMENTS MADE DIRECTLY BY THE OFFSHORE FUNDS ARE NOT REGARDED AS CO-INVESTMENTS — and two reasons are given.

First, IN THE ABSENCE OF ANY SUCH DOCUMENTATION (CO-INVESTMENT AGREEMENT) WITH THE ONSHORE AIF. Co-investment is a contractual arrangement; without the contract it does not exist.

Second, and more fundamentally, because of the INDEPENDENT DECISION MAKING AUTONOMY GIVEN TO SUCH OFFSHORE FUNDS. The offshore fund is not taking up an opportunity offered by the AIF's manager — it is choosing for itself.

That autonomy has a visible consequence in how the structure operates. Since Offshore Funds make INDEPENDENT INVESTMENT DECISIONS, the Investment Manager of the AIF in India can provide NON-BINDING INVESTMENT ADVISORY SERVICES to the Offshore Funds, by entering into an INVESTMENT ADVISORY ARRANGEMENT. Advice, not instruction — and the arrangement must be documented as such.

And the autonomy is also the point of the structure. Among the advantages the workbook lists is SELECTION OF INVESTMENTS TO BE MADE: if a particular investee company is not suitable to an offshore Fund due to any LEGAL, REGULATORY, TAX OR OTHER SIMILAR REASONS as per the stated investment mandate and risk-return profile captured in the Offshore Funds' documents, THEY ARE FREE TO OPT-OUT of that particular investment.

A co-investor takes what is offered. A parallel fund decides.