A new opportunity to participate in Indian infrastructure

The government is finally preparing to launch its first IDF this year, albeit with a $3 billion corpus open to domestic investors alone. Vishal Shah and Smit Sheth hail IDF as a good beginning, but contend that the definition of infrastructure needs to be sharpened.

Infrastructure projects inherently have long gestations and are leveraged with debt-equity ratio in the range of 3 or 4:1. Besides promoter equity, the main sources of funding are:

• Banks, which are stretched in their loan book allocations for infrastructure financing
• Non-Banking Financial Companies (NBFCs), which typically charge high interest rates
• Private Equity (PE), which are expensive and could entail dilution of control
• External Commercial Borrowings (ECB), there is a high hedging cost and stringent regulations as to eligible lenders (restricted to overseas banks, equity holders, etc and does not allow private funds).

The private sector has been and is expected to play a significant role in bridging the infrastructure deficit in the country. So far, it has contributed 55 per cent of the infrastructure funding during the first three years of 11th Five Year Plan (Diagram 1).

EMERGING ALTERNATIVE

The constraints itemised in bullet points above for various financial institutions make it incumbent on infrastructure players and the government to look at alternative sources of funding avenues for infrastructure projects. One such attempt is the launch of Infrastructure Debt Funds (IDFs) by the Finance Minister Pranab Mukherjee, in his Budget Speech for 2011-12, with the intent to attract more foreign funds for infrastructure financing. IDF is a novel attempt by the Government of India to address the issue of availing long term debt finance for infrastructure projects in India. Given the substantial interest rate arbitrage play in India, this should be attractive for foreign investors.

On 24 June 2011, the Union Ministry of Finance issued a press release outlining broad structure of IDFs. IDFs were proposed to be set-up either in the form of a Company or a Trust. In the case of a Trust, an IDF would be regulated by the Securities and Exchange Board of India (SEBI); whereas for a Company it would be regu­lated by the Reserve Bank of India (RBI). The detailed guidelines governing IDFs were proposed to be issued by the respective regulator.

The SEBI Board approved the Trust framework for setting up of IDFs as Mutual Funds (IDF-MFs) and has now notified the Operating Guidelines thereof. Further, on 23 September 2011, RBI has released broad para­meters for setting up of IDFs as a Non-Banking Financial Company (IDF-NBFCs). The detailed guidelines in this context are expected to be released shortly by the RBI.

The key differentiators of IDFs being a Trust (IDF-MFs) and Company (IDF-NBFCs)1 is summarised in Table 1.

The SEBI Framework for IDF-MFs

The framework for IDF-MFs has been prescribed by SEBI by inserting a separate chapter in the existing SEBI Mutual Funds regulations. The likely IDF-MF structure is depicted in Diagram 2.

Who can invest in IDF-MFs: IDF-MFs are required to have minimum five investors with no single investor holding more than 50 per cent of the net assets. The term 'net assets' has not been defined in the guidelines. Minimum investment in IDF-MFs should be at least Rs 10 million with a unit size of at least Rs 1 million.

Further, IDF-MFs need to obtain firm commitments of at least Rs 250 million from strategic investors before it can commence marketing the scheme to potential investors. Strategic investors are defined to mean:

• Infrastructure finance company registered as an NBFC with RBI;  
• Scheduled commercial bank; or
• International multilateral financial institution.

As regards foreign investors, the window to invest in mutual funds (which has been recently liberalised) would apply for investments in IDF-MFs. The foreign investors' category along with the prescribed debt ceil­ings is as given in Table 2.

As could be observed, while the objective of IDFs is to promote flow of foreign funds into infrastructure sector, the overall ceilings prescribed for investments by FIIs and foreign investors in IDF-MFs seem to be on a lower end, especially considering the humongous investment requirement in infrastructure space. One expects the government to liberalise the ceilings in times to come.

Investments by IDF-MFs: An IDF-MF has to invest its funds in the asset classes, given in Table 3.

These investment restrictions are to be complied with by the IDF-MFs over its life cycle and with reference to the total amount raised. Operational clarity is awaited as to how the NAV adjustments on a daily basis would be tracked to ensure adherence.

Further, the term 'infrastructure' for this purpose is defined to include sectors as specified by guidelines issued by SEBI Board or as notified by Ministry of Finance, from time to time. In this context, one would note that under the Annexure X to the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009, the term 'infrastructure' has been defined widely. However, there are other versions (around 13) of defi­nition of 'infrastructure' under various Acts and Rules/Regulations (like RBI Circular, IRDA, Income Tax Act, etc). Thus, the term 'infrastructure' has been defined differently in various regulations by SEBI and MoF and a specific clarity stating which specific sectors are intended to be covered, would be handy. In fact, recent news reports suggest that the government is seeking to converge on a single definition of 'infrastructure'.

Further, it is pertinent to note that the term 'infra­structure companies' and 'infrastructure capital com­panies' have not been defined in these guidelines.

Separately, the following concentration limits are prescribed for investments by IDF-MFs:

• Investment in a single infrastructure company/pro­ject not to exceed 30 per cent of net assets under all schemes
• Each scheme restricted to invest only up to 30 per cent in single infrastructure company/project. However, this limit can be raised up to 50 per cent with prior approval of board of trustees and board of AMC
• Maximum investment of 25 per cent in listed security of the sponsor/its associate or group company or bank loan in respect of completed and revenue generating projects of infrastructure companies/SPVs of the sponsor/its associate or group companies, subject to the approval of trustees and complying with the disclosure requirements
• Maximum investment of 20 per cent in any asset/securities owned by the sponsor/AMC/its associates not below investment grade, subject to approval of trustees and compliance with the disclosure requirements. What constitutes 'investment grade' has not been specified in the guidelines.

Tenure and listing requirements: Given the intent to provide long-term debt finance, it is proposed that IDF-MFs can either be a close-ended scheme with a maturity of more than five years or an interval scheme with a five-year lock-in period and an interval period not exceeding a month. Fully paid-up units of IDF-MFs are required to be listed on a recognised stock exchange. Partly paid-up units may be issued to investors subject to certain conditions.

Thus, the investments in IDF-MFs would be subject to a minimum lock-in of five years. However, considering that the units would be listed, a window would be available for the investors to exit on the stock exchange. However, the liquidity of the trades on the stock exchange may not be significant to provide easy exit to the investors.

AMC Fees: There is no specific mention of ceiling on management fee payments by IDF-MFs to AMC. Guidelines to mutual funds prescribe a limit of 1-1.25 per cent of management fees which can be charged by AMC depending on the fund size.

The RBI Framework for IDF-NBFCs2

In the recent press release, RBI has outlined broad parameters for setting up IDF-NBFCs. The likely IDF-NBFCs structure is depicted in Diagram 3.

The salient features of IDF-NBFCs are as under:

• Minimum NOF of Rs 3 billion
• Tier-II capital not to exceed Tier-I capital; CRAR at 15 per cent of risk weighted assets
• IDF-NBFCs to have minimum credit rating 'A' or equivalent of CRISIL, FITCH, CARE, ICRA or other accredited rating agencies
• IDF-NBFCs permitted to invest only in PPP; and infrastructure projects which have completed at least one year of satisfactory commercial operation post the COD and IDF-NBFC is a party to a tri-partite agreement with the concessionaire and project auth­ority for ensuring a compulsory buyout with termi­nation payment
• Exposure norms linked to the total capital funds, ie, Tier I and Tier II
• Concentration norms – IDF-NBFCs can invest maxi­mum 50 per cent of its total capital funds in a borr­ower or a group of borrowers. Additional 10 per cent exposure can be taken at the discretion of Board of IDF-NBFCs. Exposure in excess of 60 per cent would require prior RBI approval.

SEBI Framework (IDF-MFs) vis-à-vis RBI Framework (IDF-NBFCs)

One would have expected only legal framework differences between the SEBI and RBI proposed scheme for IDFs. However, while the detailed operating guid­elines from RBI are awaited, it appears that there are key deviations on the operational aspects vis-à-vis both the frameworks. The key operational deviations in IDF-MFs and IDF-NBFCs entail:

• Nature of projects eligible for investments
• Capital adequacy requirements
• Nature of participation by investors
• Return to investors
• Stake by sponsors, etc.

The above differences would be the key drivers in deciding upon the structural framework for IDFs by the potential industry players. The differential tax treatment in both the frameworks, as discussed hereunder, would also be a relevant aspect for consideration.

Tax Regime needs a re-look

Budget 2011 provisions: As an initiative to pro­mote IDFs, the Budget 2011 introduced the tax regime for tax­ation of the IDF constituents. While IDFs, per se, are exempt from tax; interest payments to non-resi­dents on money borrowed by IDF are sought to be sub­ject to a lower withholding tax rate of 5 per cent instead of 20 per cent. The income in the hands of investors in case of IDF-MFs (unit holders) is exempt as per the current provisions of the Act.

IDF-MFs tax aspects: With the SEBI operational guidelines contemplating a Trust (mutual fund) structure for IDF, the palatability thereof with the proposed tax regime needs to be examined. The investment by foreign investors in the IDF-MF would be by way of subscription to the units and the return thereon may not qualify as 'interest', so as to avail of the lower tax withholding rate of five per cent. Also, it seems that the distribution by IDF-MF to the investors would be subject to dividend distribution tax at the rate of 30 per cent (see Diagram 4). Thus, while the income of the IDF-MF and the inv­estors would, per se, be exempt; the distribution could be subjected to distribution tax at 30 per cent. Obviously, this does not seem to be the intent and one hopes that Budget 2012 would extend the 5 per cent rate to distri­butions by IDF-MFs.

Also, one more aspect which merits consideration from tax perspective is that the long-term capital gains exemption and the preferential short-term capital gains rate of 15 per cent on sale of units of equity oriented fund, do not apply to sale of listed units of IDF-MFs, as the said exemption is restricted only to the listed equity-oriented funds and not listed debt-oriented funds.

IDF-NBFCs tax aspects: The income of the IDF-NBFCs would be exempt from tax and the interest payment by IDF-NBFCs to foreign investors would be subject to beneficial tax withholding rate of 5 per cent. The IDF-NBFCs would also not be subject to minimum alternate tax. However, distribution of dividends by IDF-NBFCs would be subject to dividend distribution tax (DDT), applicable on distribution by companies at16.22 per cent. Thus, distribution of profits by IDF-NBFCs would be liable to DDT at 16.22 per cent.

To sum up

While the issue of IDF guidelines is a welcome and positive move, the operational guidelines issued by SEBI in relation to IDFs being set up as mutual fund do throw up some open areas, say, as to which sectors should be covered within the definition of 'infrastru­cture' as the Ministry of Finance and SEBI have defined the said term differently. One expects some more guid­ance on this and other operational aspects in times to come. Also, align­ment of intended beneficial tax treat­ment with the pro­posed Trust (Mutual Fund) structure, would give boost to the investors.

Further, we await similar set of operating guidelines, which is expected to be released by RBI for IDFs to be set-up as NBFCs. There are various open areas at this point of time on operations of IDF-NBFCs and the expected operating guidelines may throw some cla­rity on them.

Shah (left) is Executive Director and Sheth is Senior Manager at PwC India.