Time to shut door

P-NOTES REGIME : Why have a system where everyone is dissatisfied? Modi should crack the whip by saying

Early last month, the Narendra Modi government revised the India-Mauritius DTAA (double taxation avoidance agreement) to withdraw exemption from tax on capital gains made by foreign investors from sale of shares of Indian companies from April 2019. That was a major attempt to kill the incentive for rounding tripping of Indian black money through that tax haven jurisdiction. The tax treaty with Singapore is being re-negotiated on the same lines.

Now, the Securities and Exchange Board of India (Sebi) – the national regulator for investment in Indian stocks - has taken the fight against money laundering and round tripping to the next higher level by drastically amending the norms for foreign investment via offshore derivative instruments (ODIs) or Participatory notes (or P-notes as these are known in common parlance).

The P-notes are instruments issued by foreign portfolio investors (FPIs) registered with Sebi against Indian stocks to overseas entities/subscribers who themselves do not wish to get registered with the national regulator. Prima facie, the rationale for allowing investment through this route is to help them avoid the hassles of extensive documentation and compliances (that go with registration) and yet, participate in India’s growth story.

The instrument also offered a fortuitous shield of secrecy which made it far more attractive an option to foreign investors than direct investment in Indian shares. As a result, huge amount of funds came to India via P-notes reaching a crescendo in 2007 when these accounted for more than 50% of total portfolio inflows. But it is also a known fact that a major slice of these funds were nothing but Indian black money stashed abroad and coming back under the garb of foreign investment.

The Sebi initiated a series of steps since 2011 which on the one hand simplified and rationalised process of direct registration and on the other, tightened norms for investment via P-notes. The latter involved greater regulatory oversight over the institutions/FPIs issuing such instruments. As a result, their share in total inflows has declined to less than 10% currently (April, 2016). Yet the amount continues to be substantial at around Rs 1,80,000 crore.

That is because the root cause remained un-addressed. That has to do with the identity of beneficiaries of P-notes that was fully shielded under subsisting arrangements. Unlike domestic investors who are subject to onerous Indian KYC (know your customer) norms, issuers and subscribers of P-notes had only to comply with KYC norms of the country/jurisdiction where these entities are located.

The Indian authorities not being able to know their identity/whereabouts and activities (source of fund generation and pattern of investment) was bad enough. What made the scenario even more gruesome is that even the issuer of ODIs/P-notes (read FPIs) was not expected to know their identity. This is because when the original subscriber sells to another person, he is under no obligation to inform the issuer about the transaction, forget taking latter’s prior concurrence.

The situation was so pathetic that an Indian company won’t even know its share holding pattern viz., who owns how much. Under extant dispensation regarding foreign investment, an individual cannot own more than 10% share in a company whereas, the holding of an institution/corporate entity cannot exceed 25%. A sizeable portion of equity resting with investors whose identity is not known seriously undermines the effectiveness of the policy.

The scenario could be pregnant with dangerous possibilities. For instance, money launderer could end up having a controlling stake in an Indian company. What if persons/entities holding sizeable shares have funded this with money garnered from all sorts of illicit activities such as terrorism, extortion money, sm-uggling, drug trafficking etc? All of this could have serious security implications.

In this backdrop, the norms have been amended – rightly so – to subject subscribers of P-notes to the same KYC norms as applicable to the domestic investors. The KYC status of the former has to be reviewed annually. The issuers will be required to report to Sebi information relating to their investment on monthly basis. The original subscriber will be mandatorily required to seek prior approval of the issuer before selling the instrument to another person.

Veil of secrecy

The issuer will also be required to ‘immediately’ inform the financial intelligence unit (FIU) as and when unusually high volumes of P-notes change hands. The P-notes status has to be updated every six months. In short, amendments have sought to lift veil of secrecy around these instruments and bring clarity about beneficial owners.

However, the success is predicated on “alertness” of the regulator and “speed” with which it gets in to action mode to act against the violators. If, Sebi does not act and merely sits on the information thus received from issuers/FPIs, then the purpose of the entire exercise would be defeated. There is another flip side.

Already, many of the P-note holders have said that they want to remain as anonymous investors. The FPIs/issuers (who had earlier given their nod to norms tightening) too have raised concerns more so in regard to tax treatment of their capital gains. Others opine that the new rules are too cumbersome. Then, why have the system which keeps every one dissatisfied and intended outcomes not guaranteed?

Why should the government not prohibit investment via P-notes? Post-amendments, Sebi Chairman U K Sinha opined that henceforth, a foreign investor would be prompted to invest directly in Indian stocks instead of taking an indirect route. Why not take this forward by completely shutting the P-notes window?

At present, confidence in Indian economy is at its peak and foreign investors are looking at India with unprecedented interest with a stable and predictable policy regime in place and “ease of doing business” on top of government’s agenda. The foreign investors are very much willing to invest directly and won’t need extra sops. Modi should therefore crack the whip by saying “no” to foreign investment via ODIs/P-notes.

(The writer is a New Delhi-based policy analyst)