New foreign investment rule looms over AIFs, foreign investors
A draft regulatory change under the foreign exchange framework could alter how "foreign control" is determined for Alternative Investment Funds (AIFs), a category that has traditionally relied on Indian ownership of the fund's sponsor or manager to be classified as a domestically-owned entity.
Under the proposed shift, the extent of foreign investor funding within an AIF's corpus could itself determine whether the fund is treated as foreign-owned or -controlled, regardless of the sponsor/manager's nationality.
Such reclassification would matter most for investments in sectors where foreign investment is restricted or conditional, such as real estate.
Existing AIFs with established foreign investor bases are awaiting clarity on grandfathering provisions — whether funds raised under the old framework will be protected from the new control test — and on the final shape of the foreign investment rules.
FEMA, 1999 and the Non-Debt Instruments Rules Framework
The Foreign Exchange Management Act (FEMA), 1999 is the parent law governing cross-border capital flows into India, replacing the more restrictive Foreign Exchange Regulation Act (FERA), 1973. Foreign investment specifics — including into Alternative Investment Funds — are governed by rules framed under FEMA, principally the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules), issued by the Ministry of Finance.
Key Details
- FEMA, 1999 replaced FERA, 1973; administered by the Reserve Bank of India (RBI) with rule-making power vested in the central government (Ministry of Finance).
- The NDI Rules, 2019 consolidated and replaced earlier Foreign Direct Investment (FDI) regulations under FEMA.
- In July 2026, the RBI released draft Foreign Exchange Management (Foreign Investment) Rules, 2026 for public comment, proposing a shift from investor-centric to investee-entity-centric regulation and simplifying compliance, though downstream investment rules for AIFs remained an area needing further clarity.
The proposed change to how AIF "control" is determined is being worked out within this FEMA rule-making architecture — a Ministry of Finance/RBI domain, distinct from SEBI's separate regulation of AIFs as investment vehicles.
Downstream Investment and "Indirect Foreign Investment" Rules
Under India's FDI policy, when an Indian entity that itself has foreign investment further invests in another Indian company, that further investment is called "downstream investment," and may be treated as "indirect foreign investment" for the investee company, subject to the same sectoral caps and conditions as direct foreign investment. For AIFs, current rules generally treat the fund as domestically owned/controlled if its sponsor or manager is owned and controlled by resident Indians, even if a majority of the fund's corpus comes from non-resident investors.
Key Details
- If an AIF's sponsor/manager is owned or controlled by a non-resident, the AIF and its downstream investments are treated as foreign-owned/controlled.
- Where more than 50% of an AIF's units are held by non-residents, downstream investments made by that AIF can be treated as indirect foreign investment for the investee company under current interpretations.
- Real estate is a sector with specific FDI conditions (100% automatic route only for construction development under defined conditions; general real estate business/trading remains prohibited for foreign investment), making the control classification consequential.
The draft rule's proposal to weigh foreign investor funding levels (not just sponsor/manager nationality) in determining AIF control status would tighten the downstream investment test, directly affecting AIFs that route foreign capital into restricted sectors like real estate.
SEBI (Alternative Investment Funds) Regulations, 2012 and AIF Categories
AIFs are privately pooled investment vehicles registered with and regulated by SEBI under the SEBI (Alternative Investment Funds) Regulations, 2012, distinct from mutual funds or collective investment schemes. SEBI classifies AIFs into three categories based on investment strategy and risk profile.
Key Details
- Category I AIFs: venture capital, SME, social impact, and infrastructure funds — sectors considered economically/socially desirable.
- Category II AIFs: funds not falling under Category I or III and not using leverage beyond operational needs — includes private equity and real estate funds.
- Category III AIFs: funds using complex/leveraged trading strategies, such as hedge funds.
While SEBI regulates AIF registration and categorisation, the "foreign control" classification under scrutiny here is a FEMA/foreign-exchange law question — illustrating how a single fund vehicle can sit at the intersection of SEBI's securities regulation and the Ministry of Finance/RBI's foreign exchange regulation.
- FEMA, 1999 replaced FERA, 1973; foreign investment rules currently framed under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019.
- RBI released the draft Foreign Exchange Management (Foreign Investment) Rules, 2026 for public comments in July 2026.
- Current downstream investment threshold: an AIF with more than 50% units held by non-residents can trigger indirect foreign investment treatment for its investee entities.
- SEBI (Alternative Investment Funds) Regulations, 2012 classify AIFs into Category I, II, and III.