New foreign investment rule looms over AIFs, foreign investors

Mumbai: A new potential rule could disrupt the plans of numerous alternative investment funds (AIFs) - pools used by affluent investors and institutions to speculate on unlisted equities and startups. These funds, operating for a decade, have operated under a distinctive regulation: AIFs with majority foreign investors are classified as domestic if the fund's sponsor and investment manager are Indian-owned and controlled.

Consequently, when such a fund acquires a stake in a local company, it's classified as a local entity purchasing another, rather than foreign direct investment (FDI). The draft Foreign Exchange Management Act (FEMA) rules 2026 may alter this scenario, according to experts.

Parul Jain, a tax and funds formation specialist at Nishith Desai Associates, suggests that the draft may shift the focus from sponsor/investment manager ownership and control to the fund's capacity to be regarded as foreign controlled based on funds raised from foreign investors. This could designate even Indian-owned AIFs with foreign investors as foreign-controlled entities (FCE), impacting their status and treatment.

Richie Sancheti, founder of Richie Sancheti Associates, warns that the draft rules leave open the question of whether foreign ownership and control should be evaluated at the AIF level or by reference to the sponsor and/or investment manager. This uncertainty could have significant repercussions for the AIF landscape, particularly in sectors with FDI restrictions or caps, such as real estate, financial services, defense, telecom, and retail.