Source based taxation

A country can tax an investor's gain on one of two logics: because the investor lives there (residence-based), or because the gain arose there (source-based).

The workbook states India's rule plainly (section 8.5.1): "India follows source-based taxation on capital gains." A foreign investor who sells shares of an Indian company is taxed in India on that gain, regardless of where the investor is resident — because the source of the gain, the Indian company, is in India.

Source-based taxation is why offshore fund structures exist in the AIF industry at all. If India taxes the gain at source and the investor's home country also taxes the same gain by residence, the same rupee of profit can be taxed twice. The workbook's answer: "offshore fund structures are used for offshore investors to invest into India to avoid double taxation on the same income stream."

The mechanism runs through treaty protection: offshore funds are typically formed in jurisdictions that have a Bilateral Investment Promotion and Protection Agreement (BIPA) with India, which the workbook says gives investors access to "fair and equitable treatment, protection against expropriation, capital repatriation" and "an efficient dispute resolution framework."

Two further pieces of the same picture, both from the workbook:

• Route of entry matters. Investments by offshore funds into India are regulated either by registering under the SEBI (FPI) Regulations or the SEBI (FVCI) Regulations; an unregistered fund has to invest through the FDI policy administered by the Government and regulated under FEMA by the RBI.
• Outbound Indian money has its own ceiling. The Liberalised Remittance Scheme (LRS), issued by the RBI, allows a resident Indian to remit up to USD 2,50,000 per person per financial year for a permissible current or capital account transaction — relevant when a resident Indian invests into an offshore fund rather than the other way round.

The workbook also flags that structuring purely to dodge source-based tax is now harder to sustain: after India adopted the OECD's Base Erosion and Profit Shifting (BEPS) project through the Multilateral Instrument in 2018 and enacted GAAR in 2017, the test has moved from "form over substance" to "substance over form" in deciding whether an offshore structure is respected for tax purposes.

Illustrative figures, following the workbook's offshore/onshore framework.

A Singapore-domiciled fund, Meridian Growth Fund Pte Ltd, invests Rs 80 crore in unlisted shares of an Indian logistics company through the FVCI route. Three years later it exits, realising a gain of Rs 45 crore.

Because the gain arises from the sale of an Indian company's shares, India taxes it at source under Indian capital gains rules — the FVCI's country of domicile is irrelevant to whether India has the first right to tax. If Singapore's own law would otherwise also tax that same gain by residence, the India–Singapore tax treaty, sitting on top of the BIPA-style protections the workbook describes, is what stops Meridian being taxed twice on the identical Rs 45 crore.

A resident Indian investor, Ms Vandana Iyer, wants to commit to the same Singapore fund. Her commitment is capped by the LRS limit of USD 2,50,000 for that financial year — a separate constraint from Meridian's own tax position, but part of the same offshore-structuring picture the workbook lays out in section 8.5.1.

Chapter 8 (Alternative Investment Fund Structuring), section 8.5.1 (Off-shore and On-shore Funds), states the source-based taxation rule as the reason offshore fund structures exist at all, then builds FPI/FVCI registration, BIPA protection, the LRS limit and the BEPS/GAAR substance-over-form shift on top of it. Expect a question on why offshore funds are used for inbound investment into India (to avoid double taxation, given India's source-based rule) and one testing the LRS figure of USD 2,50,000.

• Source-based, not residence-based — India taxes the gain because it arises here, regardless of where the investor lives. Do not answer "residence-based."
• Offshore structures manage double taxation; they do not exempt the investor from Indian tax. The gain is still taxed at source — the structure is about not being taxed a second time elsewhere.
• The LRS limit (USD 2,50,000) applies to a resident Indian investing abroad, not to a foreign investor coming into India — the two flows are opposite directions and have different rules.
• BEPS and GAAR narrowed, not widened, what an offshore structure can achieve — the workbook frames the shift to "substance over form" as making treaty-shopping harder, not as a new relief.
• Do not confuse this with Place of Effective Management (POEM), a separate risk the same section flags for an offshore fund's Indian advisory office — POEM is about where the fund itself is managed from, not about the source rule for capital gains.