The unanswered questions in Sebi’s recent FPI regulation tweaks3 min read . Updated: 31 Oct 2019, 11:23 AM IST
- Till now, Sebi had classified FPIs into three categories
- Under the earlier categories, there was an additional indirect tax levied on the category 3 funds
Mumbai: Even as the equity markets hit an all time high on Thursday driven by record foreign inflows there are several unanswered questions surrounding changes in regulations by Securities and Exchange Board of India (Sebi) earlier this month on foreign portfolio investors (FPIs).
In October notified the reduction of the total number of foreign portfolio investor (FPIs) categories to just two. Till now, Sebi had classified FPIs into three categories, with the easiest set of compliance norms for Category-I FPIs and the strictest for Category-III FPIs. The classification of an FPI depends on the way the offshore entity is regulated in its home market or the number of investors in the fund. The most well-regulated FPIs fall into Category-I. However, Sebi has now removed the concept of Category-III FPIs. Going forward, it is possible that Sebi may further reduce it to just one category with increased focus on surveillance rather than on entry barriers. While there is no doubt that these measures make it easier for foreign investors, there are several unanswered questions that the market regulator needs to clarify.
To begin with, it is unclear whether the funds that belonged to category 3 would get a favourable tax treatment or not? The income tax department would need to issue a clarification whether post the reclassification these funds will get an exemption from indirect transfer provisions as currently available to category 1 and 2 funds.
Under the earlier categories, there was an additional indirect tax levied on these category 3 funds. This meant income accruing to non-resident or foreign investor could be deemed to be accrued in India and thereby falling under Indian income tax laws. These provisions were not applied to category 1 and 2 FPIs.
In November 2017 Central Board of Direct Tax (CBDT) exempted some of the category 3 funds from the indirect transfer provisions but a large proportion of private equity funds, venture capital funds and Category 3 FPIs were subjected to this levy. With the new Sebi classification there is no longer a category 3 which has left many funds confused on their tax liability. Sebi and tax department would need to issue a clarification whether post the reclassification these funds too will get the same favourable tax treatment which is available to category 1 and 2 funds.
Under the earlier regime FPIs belonging to category 1 and 2 were accorded the qualified institutional buyer status to become an anchor investor in public offers. However, with the new classification a lot of category 3 FPIs will migrate to category 1 and 2. This leaves room for clarification whether funds belonging to erstwhile category 3 will be granted QIB status or not?
Higher compliance burden
Private equity and VCs taking minority stakes in listed through the foreign direct investment route do not need to register with Sebi. However, now there is uncertainty surrounding it as Sebi has mandated that equity investment below 10% will be classified as portfolio investment. This can force many foreign funds, which had invested through the FDI route, to register as a foreign portfolio investor and increase their compliance burden.
The Mauritius and Cayman question
According to the Sebi rules, only FPIs located in Financial Action Task Force (FATF) countries or managed by an entity based in a FATF jurisdiction will be allowed to deal in participatory notes (PNs). Which means, FPIs from Mauritius, Cayman Island and countries not belonging to 39 members of FATF cannot issue P-Notes or subscribe to them. These two countries contribute to about 15-20% of FPI flows. Sebi is yet to announce the complete operating Know Your Client (KYC) rules which may potentially increase the restrictions on funds coming from these jurisdictions.