Identifying an offshore investor

FPIs incorporated under different structures in different jurisdictions create regulatory loopholes and make it difficult to identify the true beneficiary of foreign investing entities

For obvious reasons, identifying the actual beneficiary of an investment in an asset is extremely important for law enforcement agencies across the world.
 

In India, the Prevention of Money Laundering Act, 2002, defines “beneficial owner” to mean an individual who ultimately owns or controls a client of a reporting entity, or the person on whose behalf a transaction is being conducted, and includes a person who exercises ultimate effective control over a juridical person.

The Prevention of Money-laundering (Maintenance of Records) Rules, 2005, prescribe the procedure for maintaining the identity records of clients of banking companies, financial institutions and intermediaries. This article examines the provisions under these Rules in the context of investments made in India by foreign portfolio investors (FPIs), which are incorporated abroad.

FPIs constitute a significant proportion of capital flows — in and out of our market. The economy could be severely impacted by sudden large movements in such capital. To bring in perspective, there was a net FPI inflow of $37 billion into Indian equities in FY21, followed by a net outflow of $18.5 billion in FY22. During the current year, the trend has been quite unpredictable, considering the global economic uncertainty and the rising interest rates in major economies, especially the US. In the April-October period this year, there was a net outflow of $7.7 billion with significant month-wise variations — the highest net outflow was in June of $6.4 billion, and the highest net inflow was in August of about similar amount. Knowing the true beneficial ownership (BO) of FPIs is important.

Rule 9, which deals with “client due diligence” (CDD), casts responsibility on the reporting entity to report on the BO of a client. It prescribes in detail as to what exactly is to be reported depending upon the operational structure of the client, viz whether the client is a company, partnership firm, unincorporated association or a body of individuals or a trust.

Various possible structures of the client, as enumerated in the Rules, are based on a general understanding of such structures or, more specifically, as they are incorporated under the Indian laws. For instance, when we think of a company structure, we have in mind a company incorporated under the Indian Companies Act. Similarly, a trust is assumed to have the structure as per the Indian Trusts Act.

However, different jurisdictions across the world, though following similar nomenclature, may not necessarily prescribe the same regulatory requirements for different structures. Thus, FPIs incorporated abroad, say, as companies or trusts under laws of those jurisdictions may have structures different from those of the companies and trusts incorporated under the Indian laws. Nevertheless, the Rules prescribe the same reporting requirements for such FPIs as are applicable for the investing entities incorporated in India.

The position is likely to be more complex in respect of tax-haven jurisdictions, which are often the favourite locations for many of the FPIs to get incorporated. Globally, these jurisdictions compete amongst themselves to attract investments. The critics of tax-haven jurisdictions claim that in some of these regions several companies have their registered offices in the same room of a building; at times even in different drawers of a table in that room!

These jurisdictions provide highly flexible options for corporate structures. Some jurisdictions have a concept of management companies. The companies incorporated there could even outsource various core activities to management companies, including providing directors and nominee shareholders. There are other jurisdictions which have a “variable capital company” regime for fund management activity — such companies could freely redeem shares and have dispensation from disclosing data to the public. Note that the tax-haven jurisdictions have incentives to evolve more and more of such structures over time. 

Multiple layering, with investing entities at different layers incorporated in different jurisdictions, add to the complexity. Identifying the true beneficial ownership in such structures could prove to be a difficult task.

The Financial Action Task Force or FATF, the global anti-money laundering watchdog, has developed recommendations/ standards with a view to ensuring a coordinated global effort to prevent money laundering. Since countries have diverse legal, administrative and operational frameworks and different financial systems, they naturally cannot take identical measures. The FATF’s recommendations, therefore, set standards that countries should adopt based on their particular circumstances. The identification of BO is governed by recommendation 10, which specifies that each country may determine how it imposes specific CDD obligations. Recommendation 37 deals with mutual legal assistance requirements amongst jurisdictions to facilitate information sharing.

We need to perhaps take a closer look at the regulatory systems prevalent in each of the tax-haven jurisdictions — more importantly, the operational nitty-gritties, and satisfy that the existing CDD and BO requirements under the Rules serve the desired purpose in respect of the FPIs incorporated, under different structures, in these jurisdictions. In case some changes are required in the Rules, the same may be brought in forthwith.

Different law enforcing agencies in India have information sharing arrangements with their counterparts in other jurisdictions in the world. Such mechanisms ought to be effective — the information sharing should be swift and meaningful. Based on the experience gained, our agencies may assimilate the shortcomings and then we may take up the issue with the FATF and International Organisation of Securities Commissions at their plenary meetings, where India is a member.

One important question is, do the tax-haven jurisdictions remain truly compliant, on a continuous basis, with the FATF standards in letter and spirit? In the past, the FATF has been able to re-evaluate a jurisdiction only after a gap of 10/12 years from its earlier evaluation. This is largely on account of resource constraints with the body. The FATF should develop a standing mechanism to evaluate the tax-haven jurisdictions more frequently — say, at least every three to five years, with the cost burden being borne by these jurisdictions themselves. We should take it up with the FATF.

The writer is a retired IAS officer and former Sebi chairman