The sharp fall in the stock market over the past month, coupled with the slide in the rupee, has once again turned the focus to foreign portfolio outflows from Indian markets this year.

Foreign portfolio investors (FPIs) have pulled out ₹30,536 crore from Indian equity, and ₹49,251 crore from Indian debt since April 2018. This outflow comes after net inflows of ₹48,411 crore and ₹1,44,682 crore in Indian debt and equity in FY17 and FY18, respectively.

But a rapidly sliding rupee, strengthening bond yields and a relatively over-priced stock market have caused outflows from both equity and debt this fiscal. Tightening global liquidity, with the US Federal Reserve tightening its monetary policy and hiking rates, has also played a part in shrinking FPI inflows.

But besides these, another key factor dampening foreign investments in the Indian equity is the clamp-down by the market regulator — Securities and Exchange Board of India — on suspected money laundering through the FPI route.

Reversal in stance

With the country running a current account deficit over the past few decades, foreign portfolio and foreign direct investments have been helping bridge the deficit in the balance of payment. It is probably due to this that despite the RBI repeatedly raising the red flag over money laundering taking place through the FPI route — especially through brass-plate companies set up in low-tax jurisdictions overseas — the government had been wary of clamping down on these flows for the fear of destabilising the external account.

But SEBI has been pushing ahead towards the goal of getting the stock markets rid of black money that is round-tripped into the country through the FPI channel. The gradual tightening of regulations is beginning to show results.

P-Note route shut down

Participatory notes or P-Notes are derivative instruments issued by FPIs registered with SEBI, to overseas investors who wish to buy Indian equity and debt instruments without registering with SEBI. This instrument was initially quite opaque, requiring limited disclosure regarding the ultimate beneficiary. Further onward issuances of these instruments also made the trail complicated. These features made P-Notes a popular channel for round-tripping funds.

The clamp-down on P-Notes in 2007 was the first step towards phasing out these instruments. P-Notes accounted for almost 56 per cent of FPI assets in June 2007. After the crack-down, issuances on P-Notes shrank over the years, and stood at 7 per cent of FPI assets in December 2016.

In June 2017, SEBI fired a fresh salvo — it laid down that fresh issuances of P-Notes with derivatives as underlying will be allowed only if they are bought for hedging purposes. It also said that all outstanding P-Notes on derivatives issued for speculative purposes have to be wound up within a specified period.

Following this move, total P-Notes outstanding as a percentage of FPI assets under custody now accounts for just 2.5 per cent of FPI assets.

Removing DTAA advantage

Along with the growing intolerance towards P-Notes, the Indian tax authorities have also managed to remove the tax advantage that the Double Tax Avoidance Agreement with Mauritius provided to firms investing in India from the island nation. Earlier, the tax treaty provided for taxing capital gains tax in the country where the investor resided. For instance, if a Mauritian company invested in an Indian company, it had to pay capital gains tax in Mauritius. Since Mauritius does not tax capital gains, the companies evaded this tax altogether.

But the Indo-Mauritian DTAA was amended in 2016 to provide that capital gains tax arising from an investment in an Indian company will be taxed in India. The transition to the new regime was, however, done in a phased manner. One, the change was prospective — capital gains on shares purchased only after April 1, 2017, was made subject to Indian tax.

Two, companies that could show that they have substantial operations in Mauritius were allowed to pay just 50 per cent of the prevailing capital gains tax on shares purchased from April, 1, 2017, to March, 31, 2019. From April 1, 2019, full domestic rates of capital gains tax will apply on FPIs investing from Mauritius.

Along with the removal of tax benefits under the Indo-Mauritian DTAA, the General Anti Avoidance Rules (GAAR) — which gives tax authorities the power to take a closer look at innovative tax structures formed with the intention to evade tax — also becomes enforceable from 2018-19. Brass-plate companies set up in low-tax jurisdictions such as Mauritius and Singapore are likely to be under greater scrutiny hereafter.

The effect

It’s obvious that FPIs are aware of the changing regulatory landscape. Data put out by SEBI regarding FPI flows from various countries show that incremental flows from FPIs from Mauritius has been declining over the years. Between February and August 2018, FPIs from Mauritius pulled out ₹32,172 crore from the Indian equity market. FPIs from the US, Luxembourg and Singapore moved money into Indian stocks in this period. Share of FPIs from Mauritius, in incremental annual flows into Indian equity, has reduced from 22 per cent in January 2014 to 15 per cent in August 2018.

The data seem to indicate that higher scrutiny and tightening regulations are resulting in reduction in use of the FPI route in money laundering.

The portion of FPI flows composed of such funds is, therefore, likely to shrink further in the coming years.