India has spent the last decade building a credible destination for global private capital.Foreign pension funds, sovereign wealth funds, endowments and other institutions increasingly use India-domiciled alternative investment funds (AIFs) to access Indian private markets. The proposed Foreign Exchange Management (Foreign Investment) Rules, 2026 could unsettle that success by making an AIF’s level of foreign participation relevant to whether it is a “Foreign Controlled Entity” (FCE) - a significant conceptual shift.
Under the existing framework, the treatment of an AIF’s downstream investments generally turns on the ownership and control of its sponsor and investment manager, rather than the extent of foreign capital in the AIF’s corpus. This is consistent with the underlying structure of an AIF: investors contribute capital, while the sponsor and investment manager retain control over the fund’s affairs and investment decisions.
The concept of “control” is also not new to the regulatory framework. Under the current rules, control of an investment vehicle is generally attributed to its investment manager, with other stakeholders not ordinarily treated as exercising control. Against this backdrop, what regulatory gap is the proposed framework intended to address?
India wants more foreign capital, yet an Indian private equity fund with an Indian sponsor and investment manager could be treated as foreign-controlled simply because it successfully raises 70% of its capital overseas - even if its governance, management and decision-making remain unchanged.
That classification matters: once treated as foreign investment, the AIF’s downstream investments could be subject to entry routes, sectoral caps and other conditions when it deploys capital into Indian businesses. It could also require managers to monitor investor-level foreign participation throughout the fund’s life, as subscriptions, transfers, redemptions and exits alter relevant thresholds and regulatory treatment - an awkward burden for a pooled vehicle.
The draft rules also leave existing funds in limbo: Will existing AIFs, their prior investments or both be grandfathered? And what happens to the rights and regulatory treatment of funds established under the current regime? These questions create uncertainty for existing structures.
The implications extend to GIFT City’s International Financial Services Centre (IFSC), promoted as an international financial services hub but treated as foreign territory for exchange-control purposes. Evidence suggests that GIFT City is used primarily by Indian general partners to pool offshore capital, rather than by global firms. The proposed FCE framework could undermine GIFT City’s viability as a fund domicile, disproportionately hurting Indian GPs and stunting its growth, contrary to the Government’s policy push.
Global fund structures distinguish capital from control for a good reason: an institutional investor may provide most of a fund’s capital without determining its investments, appointing its management or controlling its affairs. Economic participation and managerial control are fundamentally different.
If the concern is regulatory arbitrage, such as using 100% FDI routes to bypass sectoral restrictions, the answer is better enforcement of existing rules, not a blunt capital-based test. The framework should identify actual control or misuse without treating foreign capital as a proxy for either. SEBI’s 2024 due-diligence obligations for AIFs, managers and key management personnel already provide tools to identify structures raising financial-sector compliance concerns.
An investor-level foreign ownership test also sits uneasily with the draft rules’ stated aim of reducing compliance burdens and providing operational flexibility, as it would add structural monitoring and uncertainty. The final Rules should preserve the existing sponsor/manager-centric approach for determining an AIF’s FEMA character and address genuine foreign control through objective governance and control tests.
India’s AIF industry has grown because the regulatory framework has recognised the distinction between who supplies the capital and who controls the investment vehicle; that distinction should not be lost as FEMA is redesigned. The tax and talent consequences also matter: Indian GPs already pay among the highest tax rates and operate from India, yet penalising their ability to raise foreign capital could push them to shift operations to the UAE, Singapore or other fund centres, risking a capital drain and ultimately resulting in a self-defeating outcome for India.
As India competes with Singapore, Dubai and Luxembourg for global private capital, the message should be clear: bring capital to India; regulate genuine foreign control, but do not turn foreign capital itself into foreign control. With comments open until 31 August 2026, this is an opportunity to submit comments to help ensure that the new framework does not make successful foreign investment in Indian AIFs a regulatory disadvantage.
