Ever since India has embraced liberal economic policies by opening up its markets post 1991-92,1 capital inflows generated by foreign direct investment ("FDI") and foreign portfolio investment ("FPI") has proved to be indispensable for the cause of propulsion of economic growth of the country. While FDI is the use of long term capital flows to acquire control over local productive potentials by a foreign enterprise, FPI involves transfer of short term capital funds like shares and bonds without regard to managerial control. Post liberalization, investments through FPIs has been the major source of foreign investments in India.2 However, there has been lack of concretization of any fixed regulatory measure to manage FPIs.
In this backdrop, a working group on foreign investment in India ("WGFI") under the Ministry of Finance was set up on November 9, 2009. The WGFI was headed by the current chairman of SEBI, Mr. U. K. Sinha. The WGFI came out with its report ("Report 1") on July 30, 2010. SEBI, in its Board meeting on October 6, 2012, decided to prepare a draft guideline on the guidance of Report 1 so that necessary regulatory framework could be created based on the guidelines which the aforesaid committee would formulate. Accordingly, in order to implement the board's decision on June 12, 2013, a committee was formed by SEBI3 under the chairmanship of Shri K. M. Chandrasekhar, comprising of representatives from government, RBI and various market participants who came up with a report on the rationalization of investment routes and monitoring of foreign portfolio investments ("Report 2"). The present bulletin provides a close examination and analysis of both these reports which have attempted to chalk out a future roadmap for foreign inflows other than FDI.
1. Analysis of Report 1
The mandate of the WGFI was primarily to reflect on the existing policy on FPIs with a view to encourage foreign investment, to understand the financing needs of the Indian economy through foreign investment and identify specific bottlenecks and hurdles existing in the framework related to FPIs.4 Pursuant to the above mandate, the U.K. Sinha report sought to rationalize the arrangements relating to foreign portfolio investments by FIIs, NRIs and other classes of foreign investors like foreign venture capital investors ("FVCIs") and private equity entity etc. Therefore, it recommended (i) a single window for portfolio investment regulations i.e. FII & sub-accounts of FII5 and (ii) NRI and FVCI to be replaced by qualified foreign investors ("QFIs"). This would be monitored through KYC norms and KYC norms would be enforced only through SEBI regulated qualified depository participants6 ("QDPs"). The QFI route was introduced by the finance ministry as a separate route to encourage investments from those investors who did not qualify as FIIs or NRIs or FVCIs.
The findings and recommendations of Report 1 were primarily based on the premise that an integrated policy on foreign investments would reduce the overall complexity and number of regulations governing inbound investments. However, it had merged NRIs and FVCIs into QFIs in an attempt to achieve a single route of investments. NRIs and FVCIs, being of a different nature, had to be treated as a separate investor class.
Even though QDPs were successfully established under this scheme, QFIs investment turned out to be less than 50 in number which was attributed mainly to the lack of clarity on taxation.7 There were growing concerns over the fact that owing to lack of fixed criteria delineating FDI and FPI, most of the investments made were in the form of FPI, which in the longer run is not desirable owing to their temporary and volatile nature. Portfolio investments in any company made through various routes when clubbed together amounted to as high as 44%8 without being termed as FDI. This was addressed by the Finance minister while presenting the 2013-14 budget and he proposed to follow the international practice and laid down a broad principle where an investor has a stake of 10 % or less in a company, it will be treated as FII and if more, then it will be treated as FDI. The burden of creating necessary regulatory framework was to be borne by SEBI/RBI based on the U.K. Sinha Report. The committee under the chairmanship of Shri K.M. Chandrasekhar was thus constituted to prepare a concrete framework and address the loopholes of Report 1.
2. Recommendations of Report 2
The committee has proposed a new investor route to be formed which would be termed as foreign portfolio investor ("FPI") and will replace by merging all existing FIIs, sub accounts of FIIs and QFIs. Although NRIs and FVCIs, owing to their special nature, were to be considered outside the umbrella of FPI. For FPIs, it has been suggested that the aggregate investment limit will be 24% (which currently is the limit for FIIs) and for NRIs an individual investment limit of 5% and an aggregate investment limit of 10% has been recommended. It was felt by the committee that NRIs and FVCIs should be continued to be viewed as a separate investor class enjoying certain privileges in terms of investment permissions which are not available to other foreign investors.
It has also attempted to classify FPIs and FDIs according to the global standards by proposing that single overseas investments by any single investor or group of investors that exceeds 10% in the equity of a company to be classified as FDI and those less than 10% as FPI. Report 2 has succeeded in delineating the border between FPI and FDI. As compared to Report 1 where the boundary remained unclear, this report surely intends to lower the cap where FPI transcends into the horizon of FDI by marking 10% as the critical line. The 10% threshold is also the standard OECD rule and will bring India at par with policies of Brazil, South Korea etc. The act of delimiting to 10% will surely reduce excessive portfolio investments which are volatile in nature and prevent FIIs from their propensity of withdrawing at the hint of slightest alarm as we are witnessing in the current debt-ridden Indian economic scenario. It will also increase FDIs which are more permanent and long term in nature. Also this would prevent an FPI investor from taking the benefits of larger shareholding without qualifying as an FDI.
Further, the committee has recommended for categorization of FPIs into 3 categories with low risk FPIs (like government and government related entities) being subjected to less scrutiny while moderate (regulated entities like banks, asset management companies and broad based funds) high risk FPIs (all FPIs which do not belong to moderate or low risk category) being subjected to greater scrutiny. As regards procedural aspects, registration was again kept simple with the committee recommending that prior direct registration of FIIs and sub accounts with SEBI to be dispensed with. All KYC details are to be handled by SEBI regulated QDPs (qualification of QDP to be prescribed by SEBI only) and KYC data to be handled in a risk based approach based on which stronger registration requirements would be imposed. Similarly, issuance of offshore derivative instruments/participatory notes and their acceptance would be dependent on the category of FPI being disallowed for high risk FPIs.
The committee has again treaded on the lines of U.K. Sinha report with respect to the procedural aspects by keeping the registration procedure and compliance measures simple; and now it has even been eased it further for NRIs. The object of the KYC approach is to carve out a pragmatic approach which will increase the sense of security in the market and make portfolio investments more reliable than before.
In order to implement its proposals effectively, the committee had suggested amendments to be made to a number of legislations like: (i) FII regulations prescribed by SEBI and QFI framework prescribed by SEBI and the RBI would need to be repealed and replaced by a new framework for FPIs; (ii) FEMA (Transfer or Issue of Security by a Person Resident Outside India) Regulations, notably Regulations 5 (2), 5(6), 7A, 8 and Schedule 2, 5, 8 and other related provisions would have to be amended and replaced to prescribe the permissible caps and investment levels applicable to foreign portfolio investor; (iii) Necessary amendments in FEMA to replace references to FIIs with FPIs; (iv) Necessary amendments to PML Rules; (v) Necessary amendments in Income Tax Act, 1961; (vi) General permission granted by RBI to FIIs dated December 17, 2003; (vii) Government guidelines dated September 14, 1992; (viii) RBI's foreign exchange management framework; (ix) Consolidated FDI Policy dated April 5, 2013; (x) SEBI (ICDR) Regulations, 2009; and (xi) SEBI (SAST) Regulations, 2011.
In the alternative, it had suggested that a clause may be introduced in the aforesaid legislations stating that the term FII shall mean FPI registered with Designated Depository Participants. SEBI in its Board Meeting on June 25, 2013 has accepted the recommendations of the committee and while accepting the recommendations of the committee, the Board has decided that the recommendations concerning SEBI would be implemented by SEBI and the other recommendations would be recommended to the government of India for implementation. Till then, we have our fingers crossed.
This bulletin is prepared by Satish Padhi (under the supervision of Rohitaashv Sinha, Associate), a 4th year law student of National Law University, Odisha.
1 Report of the P.V Narasimhan Rao Committee in 1991 led to major Economic Reforms.
2 http://www.sebi.gov.in/sebiweb/investment/statistics.jsp?s=fii (last visited on July 18th, 2013).
3 SEBI is the regulator with the mandate to protect the interest of investors and to promote the development of the securities and to promote the development of the securities market. See the Long Title of the Securities and Exchange Board of India Act, 1992.
4 See the Terms of Reference provided to WGFI by the Ministry of finance on November 19, 2009.
5 The phrase "sub-account‟ has been defined in SEBI (FIIs) Regulations, 1995 as any person resident outside India, on whose behalf investments are proposed to be made in India by a foreign institutional investor and who is registered as a sub-account under these regulations. A sub-account could be a broad based fund, foreign corporate, foreign individual or university fund or charitable societies who are eligible to register as a foreign institutional investor.
6 QDPs would have higher capital requirements and would need to pass a detailed fitness test administered by SEBI.
7 India's Taxation Regime keeps getting altered every year through the Finance Act passed in the respective year. Also, we follow source based taxation rather than resident based taxation.
8 (FII-24%, NRI-10%, FVCI-10%).
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