AIFs and the Draft Foreign Investment Rules, 2026: A Critical Regulatory Gap

The Reserve Bank of India (RBI) has released the Draft Foreign Exchange Management (Foreign Investment) Rules, 2026 (Draft Rules) which, once finalised, will supersede the Foreign Exchange Management (Non-Debt Instrument) Rules, 2019 (NDI Rules). The Draft Rules propose to streamline the existing foreign investment regulatory framework to increase the ease of doing business in India. However, by omitting certain AIF-specific clarifications, the Draft Rules create a significant interpretational gap, making the treatment of AIFs a key area of focus under the proposed framework.

The 2019 Paradigm: Manager-Led Control

For nearly a decade, India's AIF industry has operated under a unique regulatory construct. Under the NDI Rules, an AIF is treated as a domestic entity for downstream investment purposes, regardless of the extent of its foreign capital, provided its sponsor and investment manager are Indian-owned and controlled. This construct was first introduced in 2015 and carried through successive regulatory iterations into the NDI Rules. It has permitted AIFs, where the sponsor and manager are Indian citizens or entities owned and controlled by resident Indian citizens, to make downstream investments as domestic investments, enabling them to channel foreign capital into restricted or capped sectors such as Real Estate, Defence, telecom, and financial services.

Concerns Regarding Regulatory Arbitrage

SEBI highlighted concerns in its 2024 consultation paper that foreign-funded AIFs with domestically owned and controlled sponsors or managers were being used to bypass FDI sectoral caps, pricing norms, prohibited-sector restrictions, FPI and external commercial borrowing requirements for foreign investment in debt.

Further to inter-regulatory deliberations, the RBI recommended that investments by AIFs in which non-residents hold more than 50 per cent interest be treated as indirect foreign investment.

Revised Construct under the Draft Rules

The Draft Rules introduce the concept of a foreign-controlled entity (FCE), defined to include a resident company, LLP, or investment vehicle owned or controlled by a person resident outside India. Ownership and control of such investment vehicles are to be determined in accordance with applicable provisions prescribed by the relevant sectoral regulator or, in the absence of such regulations, the incorporating law, such as the Companies Act, 2013 for companies and the SEBI (Alternative Investment Fund) Regulations, 2012 (AIF Regulations) for AIFs. Since sectoral regulations do not define ownership and control at the investment fund level, a critical gap exists in the foreign exchange treatment of AIFs. Without the specific manager-led control carve-out, an AIF predominantly funded by foreign limited partners could be classified as an FCE, stripping it of its domestic downstream investment status and departing from a decade-long policy treatment of such vehicles.

Although intended to address regulatory arbitrage, this approach would penalise the onshore fund industry India seeks to develop and raise serious concerns.

First, the absence of AIF-specific ownership and control tests disregards the commercial reality of the AIF structure. Investment discretion typically lies with the investment manager, not the contributing investors. Foreign limited partners who contribute to the capital of an AIF may lack governance rights or investment decision vetoes. Treating passive capital providers as 'owners' or 'controlling entities' conflates economic exposure with control.

Second, the approach inadvertently captures compliant structures alongside the abusive ones. The mischief identified by SEBI and the RBI involved AIFs used as conduits to bypass sectoral restrictions. However, the same structural feature, that is, foreign capital and domestic management, is also a feature of legitimate, well-governed funds that have operated transparently for years and pose no circumvention risk.

Third, the Draft Rules provide no grandfathering or transition mechanism. Their savings language is a general preamble clause that protects past conduct but not the ongoing regulatory status of existing AIFs that were domestic entities under the NDI Rules and could now be reclassified as FCEs upon notification of the Draft Rules.

A Targeted Carve-Out as the Way Forward

The FEMA 20 provisions were intended to provide certainty on the treatment of downstream investments by investment vehicles and to support India as an onshore fund management jurisdiction, recognising the distinction between a fund's investor base and the persons controlling its investment decisions. SEBI has also addressed regulatory arbitrage concerns by imposing a general obligation under Regulation 20(20) of the AIF Regulations on AIFs, their managers and KMPs to conduct due diligence on their investors and investments to not facilitate the circumvention of applicable laws, including those administered by financial sector regulators. A more proportionate approach under the Draft Rules would therefore be to retain the manager-led control paradigm, clarifying that an AIF will not be classified as an FCE merely because most or all capital commitments are from non-residents, provided investor rights are limited to customary protective, informational, and economic rights. Where foreign investors cannot dictate investment decisions, governance decisions, or day-to-day policy, the AIF should continue to be treated as a domestic entity for downstream investment purposes. This would address regulatory concerns without unsettling legitimate fund structures that have facilitated significant foreign capital participation in India.

SEBI data shows that AIFs are now a key pillar of India’s capital markets, with commitments reaching approximately Rs 16.9 trillion in March 2026. Given the scale and importance of the AIF ecosystem, the Draft Rules should adopt a calibrated approach that targets genuine circumvention risk without inadvertently reclassifying India-managed AIFs that do not confer control rights on foreign investors.

Disclaimer: The opinions expressed above are of the author and may not reflect the views of DSIJ.