SEBI bowls a googly

SEBI has recently come out with new rules for Foreign Portfolio Investors (FPI) that may appear innocuous at first glance.

But a closer look reveals that these can have a substantial impact on the kind of foreign investors who register in India for buying and selling in its stock markets. The capital markets regulator, in its latest regulations, has shortened the list of eligible FPIs, making it more difficult for the riskier categories to enter the country.

SEBI has now ruled that all foreign investors (barring foreign individuals) registering as FPIs have to be incorporated entities that are regulated by their respective country’s stock market, banking or any other relevant regulators.

This rule would make many foreign investors currently registered as ‘sub-accounts’ ineligible to register as FPIs.

Under the older rules, SEBI allowed even unregulated entities to register as sub-accounts – investors on whose behalf foreign institutional investors (FIIs) trade, but who were virtually treated on par with them.

The regulator has also corrected the anomaly that existed in FII regulations, under which the riskier category of investors (sub-accounts) had to submit to lax KYC (know-your-customer) rules while the relatively safer class — FIIs — had tighter compliance rules. The new rules also give the banks, which now have the onus of registering the new FPIs, the power to reject applications found unsuitable.

The fallout

The effect of these changes is already being felt. The number of FIIs registered with SEBI was 1,753 on September 2, this year. This declined to 1,746 by October 25. Foreign investors registered as sub-accounts declined more sharply from 6,416 to 6,365 in this period.

Another data-set that points towards impending change is the participatory notes (PN) issuances. The outstanding amount of such notes, offshore derivative instruments issued by FIIs to overseas entities who wish to invest in Indian markets without registering themselves with SEBI, jumped to Rs 1,71,154 crore towards the end of September, a 10-month high.

But this could be just the beginning. The number of foreign investors investing into India through the sub-account route is expected to decline further even as inflows through PNs increase.

While this move is expected to sanitise the foreign investor channel, there could be temporary pain as some investors choose to move out of India.

The overall flow of foreign portfolio flows might, however, not be all that greatly affected. There are enough authentic foreign investors who will be willing to invest into Indian equity. Inflow of around $15 billion in Indian stock market so far this year is a testimony to that.

Looking back

If you are wondering why SEBI allowed unregulated foreign investors such easy entry into India, this is how it happened.

Indian stocks were in a roaring bull market in 2006 and 2007, fuelled by FII money. But both SEBI and the RBI were worried at that point since over half of FII money flowing into India by August 2007 came in as PNs.

PNs, as pointed out, are opaque instruments where the end-owners of the assets aren’t easy to trace, making them a potential conduit for money launderers. In October 2007, SEBI clamped down on issue of PNs and at the same time made the norms for registering as sub-accounts easier; thus giving the users of PNs the invitation to register with SEBI and invest in Indian stocks directly.

The FII regulations

In order to understand the latest changes, the old rules for foreign investors need to be examined first. Earlier, foreign investors could register as FIIs, sub-accounts or qualified foreign investors (QFI).

FIIs could, in turn, be foreign funds, pension funds, sovereign wealth funds and so on – all incorporated outside India and regulated in their country of origin.

Sub-accounts included foreign companies, proprietary funds and high net worth individuals on whose behalf the FIIs would invest. QFIs were foreign residents who could invest directly into India.

While FIIs were required to be regulated entities, this was not required of sub-accounts. Again, while FIIs were required to furnish audited accounts of at least one year and other documents while registering, no documents were asked from sub-accounts.

Despite these lax regulatory requirements, sub-accounts were treated on par with FIIs on most matters and even allowed to issue participatory notes to entities outside the country.

The changes

SEBI has now sought to rectify the shortfalls in the FII regulations.

It has classified FPIs into three categories. The first category consists of government-owned investment funds, central banks or multi-lateral investment arms.

These are the safest and need to submit to least checks. The second category is made up of all regulated investment funds, including university, insurance and pension funds. The first two categories can now issue PNs. All the others, including foreign individual investors, hedge funds, foreign companies and so on, fall in the third category.

This class of investors cannot issue PNs and have to submit to stricter KYC checks. It needs to be noted that foreign investors who could earlier register as sub-accounts would mostly fall in the third category of FPIs.

The regulator has allowed the investors currently registered as FIIs or sub-accounts to continue to buy and sell equity, as long as their registration remains valid.

Since FIIs and sub-accounts need to renew their registration after five years, there will not be an immediate exodus.

But as the registration expires, sub-accounts will now have to check if they will be accepted under the new regime. Even if they are accepted, sub-accounts might prefer the more opaque PN route to invest in to India.

The GAAR setback

Foreign investors have also received a blow with the notification of the General Anti Avoidance Rules this September.

The rules come into force from FY 16. So all tax benefits earned from April 2015 from arrangements made with the intention of saving tax can come under the taxman’s lens.

The greater worry is that the rules have exempted only benefits earned prior to August 2010 from scrutiny.

That means that any tax benefits earned — by routing investments through countries with which India has double-tax agreements — from August 2010 can be investigated.

The rules have also retained the clause that tax residency certificates are necessary but not sufficient for claiming tax benefit under double tax treaties.

These rules could be another reason why FIIs or sub-accounts might now want to shut down the current arrangement and look up alternate route to investing into Indian equity.

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