By Tejas Desai & Brenden Saldanha
Over the last 25 years, FPIs have been key drivers of Indian capital markets. Even with assets under custody of $487 billion (as of October 2019), at times, they have been forced to encounter the volatility associated with the Indian regulatory and tax landscape through frequent and unexpected changes (and roll backs) such as the ban on P-notes and NRI ownership of managers, sudden imposition of MAT, indirect transfer tax, higher surcharge, etc.
With this background, Sebi's new FPI Regulations, 2019 along with the Operating Guidelines are a whiff of fresh air. Following an extensive consultation process (post the HR Khan committee), these regulations liberalise some of the existing entry barriers, as also simplify, rationalise and consolidate over 100 circulars to provide a hassle-free experience.
These stipulate elimination of the 'broad based' criteria for funds, reduction in the number of FPI categories from three to two, and linking of the eligibility to seek Category-I FPI status to FATF membership of the fund/fund manager as well as permitting reliance on the global custodian for KYC purposes.
The changes represent a significant shift in Sebi's mindset and its willingness to move beyond and away from its affinity for upfront documentation. Evaluation of the broad-based criteria has been a key reason for delays in market entry with Sebi having issued over 25 FAQs under the old regulations. This move will hasten the registration process for many reputed asset managers, who launched funds with a restricted set of investors and had to settle for a Category-III FPI license. Lifting of restrictions on opaque structures will lend flexibility to investment structures with segregated liability.
The requirement for funds or their fund managers to be domiciled in FATF member countries is forward looking and stringent. On one hand, it relies on Sebi's ability to gain access to information from FATF member countries. It is strict because it replaces the earlier criteria, which placed an applicant in Category-III only if it was resident of a country identified in the FATF's public statement as a jurisdiction having deficiencies in its AML laws etc. Since the list of FATF member countries is restricted to 37, this seemingly restricts funds/fund managers from countries such as Mauritius and Cayman Islands from a Category-I FPI status.
This move has resulted in over 80% of FPIs now moving into Category-I status which allows for higher trading limits, more relaxed KYC of ultimate investors. Funds (both in Category-I and II) have been granted QIB status that enables better access to primary issuances, etc.
The Regulations also open the door for private banks to invest on behalf of clients and creates an opportunity for a new segment of global HNI investors and family offices to gain exposure to Indian markets. Some clarifications in terms of operating through separate demat accounts would be required along with clarity on tax implications of investing through these structures.
With the easing of entry barriers for FPIs, Sebi has continued to maintain its neutral stance on ODIs or P-notes. Regulations reiterate that ODIs underlying derivatives would not be permitted. Further, investors intending to subscribe to ODIs must be 'eligible' to obtain a Category I registration having regard to the criteria specified (but need not actually obtain a registration) eg. a Mauritius Fund with an appropriately regulated Singapore-based manager may subscribe to ODIs without having the manager register as a Category-I FPI.
Overall, this is a positive sign. The tax administration should take note of the recategorisation and make suitable amendments to clarify non-applicability of the indirect transfer tax provisions to all FPIs (earlier this was still applicable to Category-III FPIs). They should also rely on bilateral agreements to obtain information and remove onerous conditions, such as the requirement to provide details of indirect ownership while granting safe harbour to onshore managers (under section 9A). In terms of its own unfinished agenda, Sebi should deal with the merger of NRI-PIS route and allow for FPIs to also access the commodity derivatives market.