Views on News. Missing the elephant in the room

The third report of the Special Investigation Team on black money begins well, pointing out the manner in which stock markets are used by money launderers. It dwells at length on two modes of converting unaccounted money through stocks — promoters and intermediaries colluding with others to make stock prices spiral, resulting in long-term capital gains that is exempt from tax and the misuse of participatory notes (P-notes) for round-tripping. But the report has not mentioned the more direct route used by money launderers — foreign portfolio investment.

Everyone and their aunt know that not all the money that comes into the country as foreign portfolio money is from genuine investors. A portion of it, quite a large one at that, is unaccounted wealth that is moved out of the country and then brought back camouflaged as foreign portfolio investment. The SIT is not wrong in talking about the role of P-notes in money laundering, one of the conduits for these activities. But a far larger amount is moved into the country dressed as FPI money. The SIT needs to address this too if it is serious about its task.   

According to data disseminated by SEBI, P-notes outstanding accounted for ₹2,75,000 crore towards the end of June 2015. P-notes are derivative instruments issued by foreign portfolio investors to investors outside India. These instruments could be drawn on stocks, debt or derivatives. If P-notes on only equity were considered, the amount of outstanding P-notes was ₹1,77,815 crore.

Now SEBI also provides details on foreign portfolio investors and a closer look at these throws up some interesting statistics. The website provides a break-up of the countries from where foreign portfolio investors originate. The data is a little dated, only up to May 2014, but will serve well to prove our point. Of the total FII assets in India as of May 2014, the largest portion, or 32 per cent, originated from investors based in the US. But the second largest source of FII funds is Mauritius at 23 per cent. Similarly, investors from other jurisdictions that have double taxation avoidance treaties with India, such as Singapore (8 per cent) and Luxembourg (8 per cent) top the list of countries from where portfolio funds are flowing into the country.  

There could be two reasons why investments are routed through such offshore business centres. One, for saving on tax payments since the tax treaties enable payment of lower and, at times, negligible, capital gains tax on equity investments routed through these destinations. Two, the money coming from these routes could be black money that is channelled into the Indian stock market through brass-plate entities set up in such destinations.

The equity assets owned by investors from Mauritius, Singapore and Luxembourg taken together are more than three times the amount of P-notes outstanding on equity.

If the break-up of the assets according to the foreign investor category is considered, foreign mutual funds account for the largest share of FII assets at almost 41 per cent. This would mostly comprise genuine foreign investors wanting a slice of the India growth story.

But the second largest category of FIIs, according to this list, is broad-based funds or portfolios. SEBI’s FPI regulations define a “broad-based fund” as a fund established outside India which has at least 20 investors with no single investor holding more than 49 per cent of the units of the funds. Those who wished anonymity could invest through a multi-layered web of entities into these broad-based funds, laying them open to misuse.

The manner in which foreign portfolio investors go on a selling spree every time the government gives the merest hint about introducing the General Anti-Avoidance Rules or GAAR, goes to show the extent to which many of our ‘foreign portfolio investors’ value anonymity. The GAAR rules would give tax authorities the power to scrutinise arrangements that have been set up mainly with the intention of evading tax. It was to pacify foreign portfolio investors that the finance minister further postponed the implementation of GAAR by two years.

P-notes are the focus of all attention currently but these instruments have ceased to be material in recent times, since they account for only 11 per cent of total equity investments. According to the SIT report, 31 per cent of the P-notes are owned by investors from Cayman Islands followed by the US (14.2 per cent), the UK (13.49 per cent) and Mauritius (9.91 per cent). Many hedge funds prefer to use offshore jurisdictions to operate from and Cayman Islands is one of their top favourites.

It is no secret that hedge funds are one of the largest users of P-notes since they prefer to move in and out of a country quickly without the hassle of registering with a country’s regulator. Fear of ‘hot money’ from hedge funds causing undue volatility in the market was one of the reasons why SEBI was unhappy with the increase in P-note usage in 2007.

P-notes might still be used as a channel for money laundering, but many foreign investors outside India use this route for the speed and convenience it offers. If the SIT’s suggestions to make the regulator ask for the name of the final beneficiary (not a company but a person) and to make it non-transferable are adopted, P-notes will stop being a threat.

Instead of going on about P-notes, it will be bolder to go after those laundering money through the FPI route.