A Symbiotic Arrangement

The instrument was structured in the form of zero coupon bonds so as to get all earnings in the form of capital gains rather than interest. How earnings booked on zero coupon bonds should be taxed - as interest or capital gain - is a grey area under the Indian Income Tax Act at the moment. FIIs would prefer their income to come in the form of capital gains as the Indo-Mauritius Double Taxation Avoidance Tax Treaty does not provide for any capital gain tax for a company located in Mauritius. In contrast, interest earned is taxed at 5 per cent Hence, most FII money invested in debt- like equity is routed through Mauritius.

 

Since FIIs are not permitted to invest in primary debt, all the issues which are chiefly placed with FIIs are supposed to obtain listing on a stock exchange. These loans, therefore, are structured in the form of retail debt instruments which can be easily listed. Once they are listed, a corporate or financial institution is asked to buy them from the company, and the very next day they are sold to FIIs. Though these loans are of short tenure and do not require rating, a rating is obtained only to satisfy requirements. This explains why all instruments specifically issued to FIIs, even those of three months tenure, are invariably rated.

Enthused over the success of this deal, FIIs have now started trying different index-related structures. One such index that has recently been used is linked to property prices. In this specific deal, the FII has given the loan at an extremely competitive rate. In return, the borrower investing funds in real estate has to share income with the lender. Interest rates are here linked with property prices in Mumbai. In case prices increase, the borrower would pay higher interest rates. Furthermore, a ceiling and a cap on interest rates is mutually agreed upon. Markets are tossing up other possible indices such as the sensex, inflation rate, etc., that might be used later.

Another major change is that earlier, most deals were done for tenures of three months. Now, the period of exposure has been increased. Three month deals replace the inter corporate deposit (ICD) or commercial paper (CP)market. Since ICDs cannot be structured in the form of debt instruments eligible for listing, these instruments are issued in the garb of unsecured debentures or promissory notes. They might be in the form of CPs, too.

Getting around cumbersome strictures

Last year, a high profile NBFC was looking for short term funds. The best option available to it was commercial paper that was then available at 15-16 per cent. The company had reached its eligibility limit of commercial paper.

The next best option was the ICD route, but it had to pay high rates for which it was not prepared. The company then issued a promissory note to an FII, which for all practical purposes, was like commercial paper and carried the same features. Since, the terminology used was different, the instrument did not come under the purview of commercial paper ceiling and the company raised money at less than 16 per cent rate.

Another FII launched a new debt instrument modelled on this one, terming it a three month loan - unsecured debenture. On debentures beyond

90 days tenure, the borrower has to pay .5 per cent stamp duty. To save stamp duty, the tenure of

this instrument was kept at 89 days. This instrument was issued to the same NBFC. Once

again, it did not come under the purview of the commercial paper ceiling.

A rather interesting feature of this new trend is that most such instruments have been traded by the original holder. This indicates a strong secondary market

potential for these debt instruments. With greater innovations in the offing, this new-found interest may well be more

sustained than one would have imagined last year. That is, if the rupee-dollar movement continues to offer the current level of comfort.