Shutting out NRI/PIO-run funds, a bad idea

Faced with a shortage of capital and a compelling need to boost economic growth, successive governments have taken steps to attract foreign investment. But when the inflow happens to be of Indian money that left our shores in a clandestine manner and is coming back in the garb of foreign capital — ‘rounding tripping’ in common parlance — it raises many eyebrows.

Until a few years ago, the extant policy and regulatory environment hugely facilitated ‘rounding tripping’. There was little regulatory oversight on money leaving and there were tax havens ever ready to attract it. The shell companies, set up in those havens by the people to whom the money belonged, would then invest in India, fully leveraging benevolent tax treaties between India and those countries.

For instance, under the erstwhile India-Mauritius double taxation avoidance agreement (DTAA), India granted tax exemption on capital gains made by investors resident in Mauritius (the definition of ‘resident’ was so generous that even post-box/shell companies were eligible) from sale of shares of Indian companies. Since no capital gains tax was levied in Mauritius either, the income accruing from such gains escaped tax in both countries. The same dispensation applied to investors from Singapore.

In the first decade of the 2000s, investment from these countries was made mostly in offshore derivative instruments (ODIs) or Participatory notes (P-notes). ODIs are instruments issued by foreign portfolio investors (FPIs) registered with the Securities and Exchange Board of India (SEBI) against Indian stocks to overseas subscribers who themselves do not wish to get registered.

Though the stated rationale for allowing investment through this route was to avoid hassles of extensive documentation/compliance that go with registration, its real intent was to offer a veil of secrecy to those (round trippers) who were making such investments. No wonder, investments via P-notes reached a crescendo in 2007, when these were 56% of total portfolio inflows.

In 2011, SEBI initiated a series of steps which, on the one hand, simplified and rationalised the process of direct registration and, on the other, tightened norms for investment via P-notes. It started exercising greater regulatory oversight over the FPIs issuing such instruments. That did not help much as the root cause — the veil of secrecy surrounding these instruments — remained unaddressed. Unlike domestic investors who are subject to onerous Indian KYC (know your customer) norms, FPIs and subscribers of P-notes had only to comply with KYC norms of the jurisdiction where these entities were located. Indeed, the latter were very liberal.

The government has sought to stop ‘round tripping’ by (i) enactment of a law on black money (2015); (ii) revision in tax treaties with safe haven jurisdictions to bring the tax treatment for investors from there at par with that for domestic investors and (iii) tightening the norms for foreign investment.

The SEBI now subjects foreign investors to the same KYC norms as applicable to domestic investors. Their KYC status has to be reviewed annually. The FPIs are required to report information regarding their investment on monthly basis. The P-notes status has to be updated every six months. The issuer should immediately inform the financial intelligence unit (FIU) in the finance ministry when unusually high volumes of P-notes change hands. These instruments are not allowed to be issued to resident Indians, non-resident Indians (NRIs) or persons of Indian origin (PIOs).

The above requirements have sought to lift the veil of secrecy surrounding foreign investment coming via FPI and bring clarity about the beneficial owners.

New conditions

Meanwhile, in April 2018, SEBI issued a circular proposing a new set of conditions to be complied with by September 30. The deadline has since been extended to December 31. This time, the focus of the regulator is on determination of the beneficial ownership (BO) of the FPIs which manage foreign investment. In addition to the ‘economic criteria’ (it goes solely by majority shareholding of an entity), the criteria include ‘control’ as well. Thus, a person may not hold any shares yet, but may be having full authority to run the show.

If, in this sweeping sense, an NRI or PIO happens to be the BO of the FPI, then the entity won’t be in compliance with the KYC norm and hence becomes ineligible.

Apart from India-dedicated funds set up by NRIs, there are global FPIs who have appointed NRIs and PIOs as their fund managers. Under the norms now proposed by SEBI (April 2018 circular), all of them will stand disqualified from investing in India. No wonder, a lobby group named AMRI (Asset Management Roundtable of India) has gone so far as to say that this would lead to withdrawal of $75 billion in investments, causing mayhem in the stock market and building more pressure on the rupee.

There is an inherent flaw in SEBI’s approach. It is mixing up the beneficiaries of foreign investment (the sole concern due to ‘round tripping’ is centred around them) with the ownership and control of FPIs whose job is merely to manage the funds. The regulator should prevail upon the latter to keep tab on the former in preventing any wrongdoing.

While SEBI has every right to disqualify an FPI for abetting wrongdoing by its subscribers, but to do so merely because it is owned and/or controlled by NRI/PIO is bad. The bottom-line should be due diligence of the beneficiary/investor irrespective of who manages the fund — an Indian resident or a foreigner.

The powers-that-be should stop juggling around the ownership and control of FPIs (a committee under ex-deputy governor of RBI, HR Khan, has recommended 25%/50% shareholding of NRIs/OCIs (overseas citizens of India), exemptions for PIOs, etc., to get over the rigours of the SEBI circular) as this is not relevant to the main issue. Instead, the focus should be entirely on ensuring full compliance with KYC norms for the investors. This will address the concerns due to ‘round tripping’ without diluting the interest of foreign investors in India.

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