Cleaning up

The Indian stock market regulator, Securities and Exchange Board of India’s bid to make it harder for unaccounted funds from being ‘round tripped’ back into Indian capital markets via offshore tax havens is clearly beginning to have some impact. This is a good sign. The long-term growth of the stock market will be healthier if it is fuelled by more dependable funds. Over the years, the stock market has received the largest chunk of overseas funds from the tiny island of Mauritius. These funds were channelled through brass-plate companies set up in Mauritius that helped conceal the identity of the true owner. The double tax avoidance treaty signed between India and Mauritius, that helped in avoiding tax on capital gains, was an added advantage. But data suggest that the Mauritian route is losing its sheen. In January 2012, foreign institutional investors from Mauritius held 28 per cent of FII assets in India but this share had fallen to 19 per cent by February 2016. This is largely because investments received from the US in the last four years have been thrice that received from Mauritius. Similarly, participatory notes, another popular mode used for round-tripping since they offer anonymity to investors, are also losing fancy. P-Notes as a percentage of FII assets were down to 10 per cent towards the end of February, from 18 per cent in 2010.

A series of regulatory changes over the last decade have made it increasingly difficult for entities posing as foreign investors to hide their identity. In 2010, SEBI had stopped registration of FIIs with opaque multi-layered structures such as Protected Cell Companies and Segregated Portfolio Companies. The regulator had also increased the disclosures required to be made regarding participatory notes so that onward issuances of these instruments were also reported. The most significant change was, however, the new Foreign Portfolio Investor regulation that came into force in 2014. This regulation classified foreign investors into three categories based on their profile. Investors in the high-risk Class III category, that includes hedge funds, foreign individual investors and overseas corporate bodies, have to go through stringent checks prior to registration. As the registrations of existing foreign investors lapsed, it is possible that some might have opted not to renew their registration, given the tighter rules in place now.

Besides, these regulatory changes, the imminent introduction of the General Anti Avoidance Rules from April 2017could also be leading to this shift. These rules will give taxmen the authority to go after arrangements set up mainly with a view to evading tax. Stock markets have witnessed sharp declines in the past, whenever the implementation of these rules was proposed. The Finance Minister has however rightly stuck to the April 2017 deadline for implementing GAAR. The threat of GAAR could make more foreign investors take the direct route to investing in India rather than the more circuitous one.