This Newsletter contains an analysis of the following -

  • Restriction on issuance of P-notes against naked derivative exposure prescribed by SEBI;
  • Key relaxations to FPI registration and compliance norms proposed by SEBI; and
  • Clarity provided in tax provisions impacting FPIs, their investors and P-note holders.

Indian regulatory and tax authorities have rolled out certain key changes to reform and upgrade the country's regulatory and tax regime for entities registered, or seeking registration, with the Securities Exchange Board of India (SEBI) as Foreign Portfolio Investors (FPIs) under the provisions of SEBI (Foreign Portfolio Investors) Regulations 2014 (FPI Regulations). Such changes can broadly be classified as: (i) narrowing the regulatory arbitrage between the regime for investments in P-notes issued by FPIs and that of making direct FPI investments in Indian securities; (ii) proposing regulatory reforms aimed at easing the norms of registration and compliance for FPIs; and (iii) providing clarity in respect of tax implications in the hands FPI including application of General Anti Avoidance Rules (GAAR) and tax on indirect transfer of Indian securities.

We have summarised the key regulatory and tax updates relevant to the FPI regime along, with our analysis, in the following three sections.

Section I: Tightening of Norms of Issuance of P-Notes

Historically, Participatory-Notes (P‑notes) or overseas derivative instruments (ODIs) with Indian securities as their underlying assets, being instruments issued by FPIs outside India to non-resident investors, were subject to lighter compliance related obligations, when compared to the direct investments of FPIs in Indian securities. One reason for such treatment to P‑notes was that the issuer FPI were already required to adhere to the various compliance related obligations at the time of making any underlying investments in India. However, in the recent past, SEBI has undertaken multiple changes to its regime concerning P‑notes, viewing them as opaque routes of investment in India and to end the regulatory arbitrage that existed between an investment in P‑notes issued by an FPI and an investment in securities of Indian entities. Such amendments include extending domestic know-your client (KYC) requirements and anti-money laundering related compliances to investors of P‑notes, and permitting transfer of P‑notes only with prior consent of the issuer FPI which have been notified by SEBI in the past year.

Restriction on P-notes issued against Underlying Derivatives

Continuing with its approach of further curbing the use of P‑notes as a route of investment in India, SEBI has now barred FPIs from issuing P‑notes with derivatives as their underlying securities, with the exception of those derivative positions that are taken by the FPI for hedging the equity shares held by it, on a one to one basis. Further, in the case of issuance of fresh P‑notes with underlying derivatives, a certificate has to be issued by the compliance officer (or equivalent) of the issuer FPI, certifying that the derivatives position, on which the ODI is being issued, is only for hedging the equity shares held by it, on a one to one basis. This certificate has to be submitted along with the monthly 'ODI reports' of the FPI.

SEBI has also prescribed that the existing P‑notes which have been issued with derivatives as underlying, where the said underlying derivatives positions are not for the purpose of hedging the equity shares held by it, the issuer FPI has to liquidate such P‑notes latest by the date of maturity of the P‑note instrument or by 31 December 2020, whichever is earlier.

Levy of Regulatory Fees on P-note Subscription

Pursuant to a SEBI board meeting held on 21 June 2017, it has been decided to alevy a "Regulatory Fee" of USD 1000 on each P‑note subscriber, which is required to be collected by the concerned issuer FPI. The issuer FPI is required to deposit the collected Regulatory Fee once every 3 (three) years, starting from 1 April 2017. Formal notification / circular is expected to be issued by the SEBI in this regard.

Comment: In view of the recent regulatory amendments notified by SEBI, it clearly appears that the SEBI does not view P-notes favourably and wishes to end any regulatory arbitrage or advantage of investing in P-notes when compared with direct investments on Indian securities market. It is expected that going forward, the use of P-notes as a means of investing in India would further decrease.

Having said that, it should be borne in mind that P-notes offer an attractive route of investments for foreign investors, with added structuring flexibility. For instance, P-notes may be issued against a combination of underlying securities, to the liking of an investor. Further, P-note holders may also engage in leverage outside India, which is not feasible for investments made under the FPI route, on account of restrictions on creation of encumbrances on securities. Such added advantages and ease of investment associated with P-notes are an important contributor to their popularity outside India. While SEBI's efforts of creating a level playing field amongst the various routes of investments is appreciated, in our view, curbing the creative crafting of customised P-note products may not be viewed as a progressive regulatory reform by the international investor community. It is noteworthy that in the past SEBI had mandated adherence to Indian KYC and anti-money laundering guidelines in issuance of P-notes, adding transparency and credibility to these instruments. With such norms having been prescribed already in the past, restricting the issuance of Pnotes against underlying derivative instruments may amount to disentitling the investor community from benefits associated with a modern-day sophisticated instrument like Pnotes.

Section II: SEBI Consultation Paper – Proposals to Reform of the FPI Regime

SEBI has released a 'Consultation Paper on Ease of Access Norms for Investments by FPIs'1 (Consultation Paper) with the objective of easing registration and compliance norms for FPIs. The Consultation Paper also provides proposed amendments to be carried out to the FPI Regulations and the SEBI Frequently Asked Questions (FAQs) on the FPI Regime.

The key proposals of the Consultation Paper are summarised below.

  •                 Ease of Conditions for Registration / Continuance of Registration of FPIs
  •                   Expansion of Eligible Jurisdictions for Category I FPIs

As per the current FPI Regulations, FPI applicants are required to be residents of a country whose securities market regulator is a signatory to the International Organization of Securities Commission's Multilateral Memorandum of Understanding or a signatory to bilateral Memorandum of Understanding with SEBI.

Noting that applicants of Category I registration are essentially Government and related entities or Multilateral agencies and perceived to be the highest quality and lower risk investors, with a long-term investment horizon, SEBI has proposed that the list of eligible jurisdictions should be expanded to include jurisdictions which are compliant with extant regulatory framework laid down in the Foreign Exchange Management Act, 1999 and which have diplomatic ties with India.

Comment: It has been reported in the media that as a part of Government of India's objective of improving the ease of doing business in India, SEBI has been actively looking to accommodate US and Middle East investors (including sovereign wealth funds of Kuwait and Saudi Arabia, US banks who are regulated by State level authorities and investors from certain provinces of Canada) who are not regulated by regulators being members of IOSCO or by central banks of their countries. The expansion of eligible jurisdictions for entities seeking Category I FPI registration should aid the entry of such investors into Indian capital markets. In our view, this proposal would rationalise the eligibility conditions for applicants seeking registration as Category I and II FPIs.

  •                   Rationalisation of Eligibility Conditions for Category I and II FPIs

The FPI Regulations require an FPI applicant to fulfil the 'fit and proper criteria' along with the following additional conditions:

  • the applicant should be legally permitted to invest in securities outside the country of its incorporation or establishment or place of business;
  • the applicant should be authorized by its Memorandum of Association and Articles of Association or equivalent document(s) or the agreement to invest on its own account or on behalf of its clients;
  • the applicant should have sufficient experience, good track record, be professionally competent, financially sound and should have a generally good reputation of fairness and integrity; and
  • the grant of certificate to the applicant should be in the interest of the development of the securities market.

Considering that the fit and proper criteria is very broad and generally covers the aforesaid conditions, and that Category I and II FPIs are essentially Government and regulated entities, SEBI has proposed that such additional conditions need not separately apply to applicants seeking Category I or II FPI registration. Furthermore, no additional documentation needs to be obtained from such applicants in relation to the aforementioned conditions. However, the fit and proper criteria has been proposed to become a part of the 'General Obligations and Responsibilities' of FPIs under the FPI Regulations. This has been done so that in addition to the obligation of Designated Depository Participants (DDPs) to ascertain the same, it also becomes obligatory on FPIs to meet this eligibility norm. Notably, Category III FPIs shall continue to be subject to the above mentioned additional conditions.

Comment: The proposal to waive off the additional conditions for entities seeking Category I and II FPI registration are expected to iron out duplication in eligibility norms and would add efficiency to the registration process. The proposal hence, is a pragmatic one and should aid in inflow of credible institutional capital in India.

  •                   Simplification of Broad Based Criteria

Currently, funds seeking registration with SEBI as Category II FPIs are required to meet the 'broad-based criteria' which requires them to have at least 20 investors, with no single investor holding more than 49% of the shares or units of the fund. Considering that in certain situations (such as redemptions, portfolio rebalancing etc.) the number of investors of a fund may go below 20, SEBI had earlier provided a clarification that in case an FPI applicant has a bank as an underlying investor, then such FPI shall be 'deemed to be broad based'. The Consultation Paper now proposes to extend the same status of 'deemed to be broad based' to cases where the FPI applicant has other institutional investors viz., Sovereign Wealth Funds, Insurance / Reinsurance Companies, Pension Funds and Exchange Traded Funds, subject to the condition that such underlying investors jointly or individually hold majority stake in the applicant fund, at all times.

Additionally, SEBI also proposes to clarify that in case any fund loses its broad-based status due to the exit of an offshore global investor, then it may not immediately result in the loss of Category II FPI status of such fund and that it may be provided with a time period of 3 (three) months for it to regain its broad-based status.

Comment: The expansion of the list of the underlying investors to include Sovereign Wealth Funds, Insurance / Reinsurance Companies, Pension Funds, Exchange Traded Funds is a pragmatic move by SEBI and is bound to reduce compliance obligations for FPIs. Such entities inherently represent interest of a large number of ultimate beneficiaries and hence worthy of being viewed as automatically fulfilling the broad-based test, provided that they hold a majority stake in the investor-applicant

Having said that, it is noteworthy that the Consultation Paper does not propose to extend the same benefit to university related endowments seeking to register as FPIs afresh. Currently, only such university related endowments which were registered with SEBI as Foreign Institutional Investors (FII) or as sub-accounts [under the erstwhile SEBI (Foreign Institutional Investors) Regulations 1995 (SEBI FII regulations)] are considered for Category II FPI registration and the balance endowment funds are treated as eligible for Category II FPI registration. Given that endowments related to universities too represent the interests of multiple beneficiaries and are credible investors, SEBI should consider making them eligible for granting Category II FPI registration, irrespective of their registration status under the erstwhile SEBI FII regulations.

  •                   Expansion of the list of Entities considered as Appropriately Regulated

The FPI regime provides for a requirement of Category II FPI applicants being 'appropriately regulated persons' and for this purpose includes 'appropriately regulated persons such as banks, asset management companies, investment managers/advisors, portfolio managers'.

The Consultation Paper proposes to broaden the aforesaid definition vide FAQs on the FPI regime to include broker-dealer, swap dealer etc. that are regulated by 'appropriate regulator' as eligible applicants for Category II FPI registration. However, this is provided that such entities shall provide beneficial ownership details of their clients to SEBI and/or other enforcement agencies, as and when required.

Comment: The FPI Regulations provide that entities seeking registration as Category II FPIs should be 'appropriately regulated' as one of the eligibility conditions. The above proposal, which is a clarification in furtherance of this requirement, affirms that the list of entities specifically mentioned in the FPI Regulations is not exhaustive, and includes additional entities such as broker-dealer, swap dealer etc. that are regulated by an 'appropriate regulator'.

  • Rationalisation of PCC / MCV Declarations and Undertakings and Investor Grouping Requirements at time of continuance of Registration

At the time of seeking continuance of registration, FPIs are required to re-submit declarations and undertakings (D&Us) to the effect that it is not a protected cell company (PCC) or a Multi-Class Vehicle (MCV) along with the information regarding FPI investor group and a confirmation that there is no change in structure.

Considering that the PCC / MCV related D&Us and information related to investor group are provided at the time of FPI registration and that the details thereof are recorded in National Securities Depository Limited (NSDL) portal, the Consultation Paper proposes to do away with the requirement to re-submit these details at the time of seeking continuance of registration, provided that there is no change in the information already submitted. However, it seems that upon this proposal coming into force, the DDPs would require a separate declaration regarding 'no change in information', by FPIs seeking continuance of registration.

  •                 Simplification of Process for Addition of Share Class

Currently, in case of an addition of share classes, FPIs are required to obtain prior approval from SEBI / DDP. SEBI has now acknowledged that this requirement sometimes impedes the launch of new share class in the home jurisdiction of the FPI, thus impacting the fund and its investors. It now proposes that in a fund where common portfolio is maintained across all share classes and broad-based criteria is fulfilled at the portfolio level, prior approval for additional share class may not be required. Further, the Consultation Paper notes that in case of a change in the structure due to the addition of a share class, FPIs are nevertheless required to notify the same to the DDP.

In case segregated portfolios are maintained, FPIs are required to obtain prior approval of SEBI / DDP for an addition of a share class. In such cases, the DDP shall obtain a declaration and undertaking with respect to the PCC and MCV status of the applicant. The Consultation Paper further proposes that for the addition of non broad-based share class, DDP may obtain an undertaking from the FPI that all the newly added share classes shall attain the broad-based status, within 180 days from the date of approval issued by the DDP.

Comment: The proposal to do away with the requirement of obtaining prior approval of the DDP for issuances of a new class of shares for funds where common portfolio is maintained across all share classes and broad based criteria is fulfilled at the portfolio level is justified and pragmatic given that the same does not breach the broad-based requirement for the share classes. This would help ease compliance obligations for funds seeking to issue additional classes of their shares in ordinary course of their business.

  •                 Ease of Process of Change of Custodian/DDP

Currently, a FPI seeking to change its custodian / DDP is required to obtain the prior approval of the SEBI. Additionally, at the time of change of custodian / DDP, the new custodian / DDP is required to carry out the adequate due diligence requirement to ascertain the eligibility of the FPI.

To ease the process of change of custodian / DDP, the Consultation Paper proposes that either the FPI, or its global custodian (authorised by the FPI in this regard) may request for a change of the FPI's custodian / DDP by forwarding a request for change to the new custodian / DDP, without having to take approval from SEBI. The change may be effected by the new custodian / DDP upon obtaining a no-objection certificate from the prior custodian / DDP. Subsequently, the new custodian / DDP shall intimate SEBI of the change. Further, to ease the process of transition of the FPI from one custodian / DDP to another, it is proposed that at the time of transition the new DDP may be permitted to rely on the registration granted by the previous DDP. However, the new DDP will be required to carry out the adequate due diligence at the time when the FPI applies for continuance of its registration on an ongoing basis.

Comment: The proposal to do away with the requirement of obtaining prior approval of SEBI for a change of the custodian / DDP by FPIs is another step in the process of de-cluttering the regulations for the FPI regime. This step is also expected to create level playing field for service providers and may boost the standards of custody services in India given the increased ease of transition of the FPI account from one service provider to another.

  •                 Specific Relaxations for Multi-Manager Structures

Vide the Consultation Paper, SEBI has proposed the following specific relaxations for Multi-Manager Structures.

  •                 Free of Cost Transfer of Assets

Under the present regime, free of cost transfer of assets by FPIs is permitted where the transferor and transferee FPIs have the exact same beneficial owners. Further, the application for free of cost transfer of assets is currently forwarded by the DDP to SEBI for its consideration. However, the Consultation Paper proposes that the requests for free of cost transfer of assets by FPIs registered under the Multiple Investment Manager (MIM) structure may be processed by the DDP, without requiring a specific SEBI approval. Having said that, for non MIM FPIs, the request for free of cost transfer of assets may be forwarded to SEBI through the concerned DDP, for its consideration.

Comment: Since any transfer of assets held by an investor (in the case the FPI), attracts capital gains tax implications under the Income-tax Act, 1961 (IT Act), there should be a specific provision in the IT Act to exempt such free of cost transfer from being regarded as taxable event and no provision of IT Act should be attracted for this action of the FPI.

  •                 Appointment of Multiple Custodians

The current FPI regime permits entities engaging MIMs to obtain multiple FPI registrations. However, such FPIs are required to appoint the same local custodian and investments made under such multiple registrations are clubbed for the purposes of monitoring investment limits as per the extant regulatory framework.

The feedback received from FPIs that by appointing a single entity as the local custodian/DDP, they are exposed to a higher counter-party risk. The aforesaid requirement was introduced under the erstwhile FII regime in order to ensure that investments made under multiple registrations are clubbed for the purposes of monitoring of investments limits. This is no longer required under FPI regime, in view of the requirement of providing investor group information to DDPs being applicable to FPIs and depositories clubbing of investments made under multiple registrations for the purpose of investment limits. In light of the above, SEBI proposes to permit FPIs operating under MIM structures to appoint multiple custodians.

  •                 Permitting FPIs holding FVCI to appoint multiple custodians

The current SEBI regulations permit an applicant to obtain registration both as an FPI and a Foreign Venture Capital Fund (FVCI) under the SEBI (Foreign Venture Capital Funds) Regulations, 2000. SEBI had, vide a circular advised that an applicant holding both FPI and FVCI registrations should have a custodian.

For reasons similar to those noted above i.e. permitting FPIs with MIM structures to appoint multiple custodians, SEBI now proposes to permit applicants holding both FPI and FVCI licenses to appoint separate local custodians for FPI and FVCI registrations of the same entity.

The existing mechanism of monitoring of investments by NSDL ensures that the aggregate holding by the FPI and FVCI entities that form part of the same investor group is below 10% of the issued share capital (as stipulated under the FPI regulations). It is therefore proposed that, FPIs should report the details of all FVCI accounts that share 50% or more of common beneficial ownership to their DDP, at the time of seeking registration. Subsequently, this information on group accounts may be passed on to NSDL by the custodian. Similarly, the proposal is to mandate that FVCI applicants should provide details of 'group' FPI accounts to SEBI at the time of their registration application and this information can be further shared with NSDL by SEBI for monitoring purposes. Additionally, it is also proposed that custodians be required to provide details of physical securities held by FVCI accounts that are part of any investor group to NSDL on a daily basis for the purpose of monitoring the below 10% of the issued share capital limit.

  •                 Permitting Private Banks/Merchant Banks to invest on behalf of their Clients

Currently, private banks and merchant banks that are regulated by an "appropriate regulator" may be classified as Category II FPIs. However, such entities are permitted to undertake only proprietary investments.

It is now proposed that private banks / merchant banks should be permitted to undertake investments on behalf of their investors provided the private bank / merchant banks submit a declaration that:

  1. The details of the beneficial owners are available and will be provided as and when required by the regulators; and
  2. The banks do not have any secrecy arrangement with the investors and secrecy laws do not apply to the jurisdictions in which such private bank / merchant bank is regulated.
  •                 Rationalisation of Requirement for Equity Shares to be Free from Encumbrances

As per the FPI Regulations, DDPs are required to ensure that equity shares held by FPIs are free from all encumbrances. However, the Consultation Paper observes that the lien / set-off on investments of FPIs is required for regulatory reasons such as Irrevocable Payment Commitment (IPC), payment of clearing & settlement obligations, custody fees, administrative fees / charges, and as such, these may not be treated as encumbrance for the purpose of the aforesaid condition.

Accordingly, the Consultation Paper proposes to amend the terms of the FPI Regulations to provide that obligations created to meet statutory and regulatory requirements should not be considered negatively by DDPs while ensuring that the equity shares of FPIs are free from encumbrances.

Section III: Tax Aspects

  •                 Permitting e-PAN for KYC of FPI

Previously, with a view to bring about operational flexibility and in order to ease the Permanent Account Number (PAN) verification process for FPIs, SEBI had permitted DDPs to verify the PAN of FPIs online on the Income Tax website without insisting on the original PAN card, provided that the client had presented a document for Proof of Identity other than the PAN card.

Considering that the Central Board of Direct Taxes (CBDT) has recently introduced a facility of E-PAN(electronic PAN card, which is sent by e-mail in addition to issue of physical PAN card), SEBI has, vide a Circular dated 30 June 2017 clarified that E-PAN issued by CBDT can also be produced by FPI for KYC compliance.

  •                 Permitting issue of PAN within 1 day

In accordance with the Ease of Doing Business initiative for newly incorporated corporates, CBDT has tied up with Ministry of Corporate Affairs (MCA) to issue PAN and Tax Deduction Account Number (TAN) in 1 (one) day.

Applicant companies would need to submit a common application form INC 32 on the MCA portal and once the data of incorporation is sent to CBDT by MCA, the PAN and TAN are issued immediately without any further intervention of the applicant.

  •                 Tax on indirect transfer

As per the tax laws in India, Indian capital gains tax on indirect transfer of Indian assets is triggered where the offshore entity whose shares or interest is being transferred, derives at least 50% of its fair market value from assets located in India and the fair market value of such Indian assets exceeds INR 100 million.

The Finance Act, 2017 has however exempted direct or indirect investors in the Category I & II SEBI registered FPIs under the FPI Regulations from the applicability of capital gains tax on indirect transfer of Indian assets. Thus, any investment in Category I and II SEBI registered FPIs (including by P-note holders) would not attract the rigour of indirect transfer in the hands of the investors in such FPIs.

  •                 Applicability of General Anti Avoidance Rule

The General Anti Avoidance Rule (GAAR) has come into force, with effect from 1 April 2017, and enables the tax authorities to disregard any entity or any step or part of a step in an arrangement and treat an arrangement as an 'impermissible avoidance arrangement' if the main purpose of such an arrangement is to obtain tax benefit and the arrangement satisfies one of the tainted elements tests. The tainted element test would be satisfied if:

  1. The arrangement lacks commercial substance or is deemed to lack commercial substance;
  2. Results directly or indirectly in the misuse or abuse of provisions of the IT Act;
  3. Creates rights or obligations which are not ordinarily created between the parties; or
  4. Carries out by any means or in a manner, which are not ordinarily employed for bona fide purposes.

Thus, GAAR would apply in circumstances where the structure / arrangement has been set up or a transaction has been entered into primarily with the intention to obtain tax benefits in India. Concerns were raised regarding the applicability of GAAR to a FPI located in a tax efficient jurisdiction, which has issued P-notes based on underlying Indian securities to investors. It was however clarified by the Indian government earlier this year, that GAAR would not apply to FPI merely because it is located in a low tax jurisdiction, if the FPI jurisdiction is finalised based on non-tax commercial considerations and their main purpose is not to obtain tax benefits.

  •                 Concerns regarding long term capital gains tax exemption

Long term capital gains from transfer of listed securities are exempt from capital gains tax under the domestic law in India, if securities transactions tax (STT) has been paid. The Finance Act, 2017 has restricted this exemption from long-term capital gains on sale of equity shares, only if STT is paid both on purchase and sale of such equity shares. However, there are certain exceptions which have also been notified from this rule, to protect genuine cases where it was not possible to have paid STT for acquisition of listed shares.

Pursuant to this, the CBDT has issued a notification which specifically excludes an investment made by FPIs from the requirement to have STT paid at the time of acquisition. Thus, such investor would be able to avail the benefit of the capital gains tax exemption.


The recent regulatory and tax reforms introduced in relation to the FPI investment regime should serve as an upgrade of the current FPI regime and should bring great cheer to the investor community. We expect that the regulatory and tax changes should also ease procedural and compliance related obligations for FPI investors, particularly Category I and II FPIs, and decrease regulatory involvement. This would automatically result in an increased ease of operations for FPIs.

One key takeaway from the proposals is the expressive prohibition placed on FPIs issuing P‑notes with derivatives as underlying securities. By way of this prohibition, the use of P‑note as an investment route into India is expected to substantially reduce in near future. However, from a long-term perspective, the move may prove to be beneficial for investors since it would add transparency to the process of investments and encourage direct investments in Indian securities.


1 Issued on 28 June 2017

The content of this document do not necessarily reflect the views/position of Khaitan & Co but remain solely those of the author(s). For any further queries or follow up please contact Khaitan & Co at