Home >market >stock-market-news >Sebi to make P-Notes less lucrative

The Securities and Exchange Board of India (Sebi) will tighten norms for participatory notes (P-Notes) further in an attempt to curb round-tripping or money laundering through this route, said two people familiar with the regulator’s thinking.

Among the changes being considered are increased disclosure requirements and restrictions on transferring P-Notes, both of which help regulators keep track of the beneficial owners of these instruments.

The proposed changes come on the heels of an amended tax treaty with Mauritius under which India will get to tax capital gains on investments made through the island republic—a move aimed at curbing tax evasion, round-tripping and other treaty abuses.

There has long been a belief that some of the money that is being invested in India through P-Notes is black (or unaccounted) money of Indian businessmen and politicians stashed away abroad and coming back into the country in the garb of capital.

P-Notes, or off-shore derivative instruments (ODIs), are instruments issued by registered foreign portfolio investors (FPIs) to overseas investors who wish to invest in Indian stock markets without registering themselves with Sebi.

By their very nature, P-Notes are seen as an opaque route for investment which leave room for round-tripping and money laundering.

“Sebi is likely to impose stricter norms for transferability of the P-notes; increase reporting and compliance standards. By these proposed norms, the P-Note holder will be brought under the ambit of Indian know-your-customer (KYC) and anti-money laundering norms," said the first person.

Round-tripping, in the context of the financial markets, is when money leaves the country through various channels and returns through an investment in listed securities. This can artificially boost the stock price of the listed entity.

The second person quoted above said that the new proposals follow recommendations made by the Supreme Court-appointed Special Investigation Team (SIT), which was set up to address the issue of black money.

“Some of these changes were proposed after the Supreme Court SIT’s recommendations, which in its report had some critical observations on P-Notes and had suggested more regulations. Any suspicious transaction that comes to the notice of the issuer would need to be reported to the Financial Intelligence Unit (FIU). These changes will be formalized during the Sebi board meeting," said the second person.

The Sebi board is set to meet on 20 May.

An email sent to the Sebi spokesperson on Wednesday did not elicit a response.

One of the more significant changes being discussed by Sebi is regarding the transfer of P-Notes, a big draw of the product.

According to a Sebi board note which has been reviewed by Mint, transfer of P-Notes will be restricted and allowed only after prior consent of the issuer. This means that for every downstream transfer of a P-Note, prior consent of the issuer would be needed. Sebi may also consider allowing transfer of a P-Note only to a pre-approved list of subscribers.

“The increased compliance for transfers is to ensure that an audit trail is available to prevent tax leakage and possible money laundering," said the second person.

Imposing restrictions on transfer will help cleanse the system, said Tejesh Chitlangi, partner, IC Legal.

“Since Sebi can exercise little control over the downstream purchasers and there is where this route has been misutilized the most, the logical step would be to make the issuer FPI more accountable in the entire issuance process, said Chitlangi.

According to the board note the issuer will also need to report who controls the management and operations of a P-Note subscriber.

In addition, issuers will need to verify entities that hold more than the predefined thresholds. For companies, the predefined threshold would be 25% and for proprietorship and partnership firms and trusts, the limit has been set at 15%.

“These changes are along the lines suggested by the apex court committee. By these moves, we want to ensure that the money could be traced down to the ultimate beneficiary," said the first person.

Some of these rules are already being followed by issuers, said an official at a foreign brokerage. “Most of the changes being proposed are already followed under the current practice, be it know-your-customer or compliance with anti-money laundering norms, due diligence by issuers of offshore derivatives, reporting on end beneficiaries, transfer or re-issuance of offshore derivatives, identifying the controls and jurisdictions of subscribers. Now these norms will be stated explicitly in writing, which will bring clarity," said U.R. Bhat, managing director, Dalton Capital Advisors (India) Pvt. Ltd.

Legal experts disagree and say tighter norms are needed.

“There has been a long-felt need to cast more obligations on issuers in form of greater know-your-customer checks, not only with respect to the first subscriber, but also with respect to subsequent purchasers," said Chitlangi.

While Sebi does not disclose data on the location of the beneficial owners, the report of the SIT released on 25 July 2015 showed a majority of them are based out of Cayman Islands (31.3%), the US (14.2%), the UK, (13.5%), Mauritus (9.9%) and Bermuda (9.1%).

To be sure, investments via P-Notes as a percentage of FPI flows have been falling over the years. Their contribution to foreign flows in India was at an all-time high of 55.7% in June 2007, and fell to 15.1% in December 2010. As of March 2016, it was 10%.

Still, policymakers are keen to keep a tight check on flows via this route. On Tuesday, the government signed an amended tax treaty with Mauritius, which allowed India to tax capital gains out of that country. This change will also apply to the treaty with Singapore. Since nearly two-thirds of P-Notes are routed through these two locations, this will have an impact on foreign inflows via such notes.

“Sebi’s (proposed) norms, read with the changes done recently in the tax treaty with Mauritius and Singapore, will provide more clarity on P-note issuances, their taxation and the money trail. These norms are meant to prevent tax leakage and remove uncertainties involved with P-Notes, but will make P-Notes less attractive, which is not a major issue," said Bhat.

Anirudh Laskar contributed to this story.

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