Since a decade, these funds have flourished on the back of a unique rule: an AIF with even majority foreign investors is treated as ‘domestic’ as long as the fund’s ‘sponsor’ and ‘investment manager‘ are Indian-owned and controlled. So, when such a fund acquires stake in a local company, it’s not foreign direct investment (FDI) – rather, a local entity buying into another.
Also Read: FEMA rules revision: Exporters flag at least half-a-dozen worries
This regulatory exception is now subject to change, thanks to the draft FEMA (Foreign Investment) Rules 2026 released recently. “The draft seems to suggest a shift from the sponsor/ manager ownership and control test to also whether the investment vehicle itself could be regarded to be foreign controlled based on funds raised from foreign investors,” said Parul Jain who leads international tax and funds formation practice at law firm Nishith Desai Associates.
The fear is that even if both sponsor (who chips in initial capital) and asset manager are locally owned and controlled, the AIF could still be regarded as ‘foreign controlled entity‘ (FCE) if majority investors are foreign. While SEBI will have the final say on this, the draft lays open the possibility of dramatic change in AIF regime.
For years, setting up of AIFs with the intent to circumvent FDI restrictions, has been a regulatory concern. This is borne out from SEBI’s letter to RBI in March 2016, and a 2024 consultation paper.
“Such investments could be through master-feeder structures where the feeder, set up in an overseas jurisdiction, feeds into an AIF owned and controlled by an Indian manager or sponsor. The draft rules may put a question mark on the status of existing AIFs which have raised money from foreign sources but are Indian owned and controlled, in the absence of specific grandfathering rules,” said Jain.FCE, the concept introduced in the draft, would be later defined by SEBI in consultation with government. Viewing FCE through foreign unit-holder ownership of AIFs could significantly alter the treatment of AIF investments, said Punit Shah, senior partner at RegFin Legal.
INDIRECT FDI?
“It could trigger indirect foreign investment rules for AIF which have pooled in majority contribution from foreign sources. This will impact sectors where FDI is either prohibited or where sectoral caps or FDI linked performance conditions are applicable such as real estate, financial services, defence, telecom and retail. Also, pricing and reporting norms may kick in,” said Shah.
There are over 2000 AIFs. While total foreign contribution is estimated at 40%, for many it exceeds 50%.
Also Read: FEMA probe against Apollo Hospitals, 5 directors closed after compounding order, ED says
The draft rules leave open an important question for AIFs – whether foreign ownership and control is to be assessed at the AIF level itself or by reference to sponsor and/or investment manager, said Richie Sancheti, founder of the law firm Richie Sancheti Associates. Given that investment discretion under AIF framework is vested in manager rather than investors, it would be helpful to clarify the intended approach so as to avoid uncertainty in determining the foreign ownership and control status of downstream investments, he said.