India needs stable rules, should resist special concessions for FPIs

India needs long-term stable foreign investment. Ad hoc short-term concessions serve a limited purpose

Facilitating foreign investment has always been a priority for the government. The subject has taken centre stage and gained urgency in recent times, considering the need to shore up the Indian currency. 

Foreign funds could come through various modes, such as foreign direct investment (FDI), remittances, external commercial borrowings (ECBs), and foreign portfolio investment (FPI). Of these, FPIs, by their very nature, are fickle and the least dependable in ensuring sustained long-term foreign capital. It is relatively quick to attract portfolio investment by taking short-term measures, and the government and regulators are constantly on the lookout for ways to facilitate this. One could lose count of the number of committees set up over time to suggest ways to rationalise the processes regulating them. 

To what extent should the government and regulators go in wooing FPIs to invest in India? This column examines this. 

The share of FPIs in market capitalisation has been substantial, though it has declined over the past few years. It was around 20 per cent a decade ago and has come down to about 16 per cent now. The market share vacated by them has been gradually occupied by retail investors and mutual funds (MFs). This trend started with demonetisation in 2016. It gathered further momentum from 2020 onwards, initially on account of the low interest rates maintained by the Reserve Bank of India during 2020-22, and later due to increased investor awareness, especially regarding the tax benefits of investing in the equity market vis-à-vis keeping money in banks. MFs’ share of market capitalisation has increased from about 4 per cent in 2015 to above 10 per cent now. 

Even so, FPIs continue to be major players in the Indian capital market. Their most important role has been in providing liquidity, thereby facilitating better price discovery. This is even more relevant for companies with dominant promoter shareholding, where adequate free float is an issue. As FPIs operate in different markets across the world, and have the option to move their capital across countries, their investment decisions signal market trends and can sway domestic investors. 

The stance of the government and regulators towards FPIs has kept changing from time to time, and swung between being too liberal and adopting a cautious approach. In the name of “rationalising” regulations, the rules have often been relaxed or tightened, and different FPI corporate structures have been allowed or disallowed depending on the prevailing market situation. 

Some of the procedural “ease of doing business” measures, including the categorisation of FPIs, the prescription of risk-based know your customer (KYC) norms, and a common application form to streamline the onboarding process by consolidating Securities and Exchange Board of India (Sebi) registration, Permanent Account Number (PAN) allocation, and the opening of bank and demat accounts, have made life easier for FPIs. More procedural simplification is needed. 

The caution stems from the fear of possible round-tripping and money laundering by unscrupulous elements through the FPI route. Unfortunately, this is a genuine concern. That is the reason the regulator follows a cautious approach in prescribing the beneficial ownership (BO) norms for FPIs. However, even on this aspect, the stance has varied over time. For example, the participatory notes (one of the opaquest structure as far as BO identification is concerned) constituted as much as 50 per cent of total FPI investment in India in 2006-07; their share dropped to about 3 per cent in 2017-18. 

Many FPI structures follow a layered ownership approach, with member entities and their further step-down entities located in different tax haven jurisdictions. Many of these jurisdictions follow overly lax regulations, ostensibly to attract more investments, making it almost impossible for the Indian regulator to identify the ultimate BOs, on a see-through basis, of such FPIs investing in India. 

One of the non-negotiable principles that ought to be followed by the regulator is to allow only those FPIs where the ultimate BO, down to the natural person level, could be easily traced. This should uniformly apply to all FPIs, irrespective of their quantum of investments in a single company or across all companies. Further, as non-resident Indians (NRIs) have a separate investment route, the proportion of their participating interest through FPIs should be controlled and closely monitored. 

Should the government allow concessional capital gains tax rates for FPIs vis-à-vis domestic investors? It shouldn’t. It would only encourage round-tripping of funds. It would also run contrary to the oft-repeated claims that domestic investments have come of age and that they now effectively provide a cushion for abrupt FPI movements. 

Thankfully, the recent government decision to remove long-term capital gains (LTCG) tax from FPIs’ investments in Government Securities does not apply to equities. Instead of tax concessions, the government should rationalise the tax structure for all participants — both FPIs and domestic investors. In this context, notwithstanding the loss of tax revenue, the government should withdraw the securities transaction tax, which was introduced in 2004 when the LTCG tax was removed. A consistent and logical tax policy would remove uncertainty and comfort investors. 

To summarise, FPIs play an important role in capital markets, wherein they improve liquidity, leading to better price discovery. The tax structure needs rationalisation; but both FPIs and domestic investors should bear the same tax rates. While “ease of doing business” is a continuing process, there should be no dilution of the BO norms for FPIs, and these should be strictly enforced. 

FPIs have a limited role in shoring up the currency on a sustained basis. There is no point in giving them any short-term and ad hoc concessions for this purpose. Rather, the government should double down on getting more FDI. Some would say that this is a long-term solution and doesn’t address the immediate concern. Remember that the subject of encouraging foreign investment has been deliberated upon ever since the economic reforms of the 1990s; a three-decade-plus time period is long enough! 

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The writer, a distinguished fellow at ORF, is a former chairman of Sebi