Tuesday, December 27, 2011

Want to Invest in Indian Markets .Complete Details about FII — Foreign investment in India

Want to Invest in Indian Markets .Complete Details about FII — Foreign investment in India by Lokesh Madan

Foreign investment in India typically occurs either as foreign portfolio investment (FPI) or as foreign direct investment (FDI). FDI is generally characterized by an investor investing directly into a company, with the express purpose of exercising a significant degree of influence over the management and operations of that company. FPI is distinguished from FDI as being a passive investment, entailing no active management or control of the issuer by the investor. Purchases of shares in the stock markets are the most common form of portfolio investment. This Note addresses many of the issues relevant to foreign portfolio investment in India.

The following discussion of FPI will include information about the types of foreign investors recognized by India, the regulatory and registration requirements for foreign investment, approval time periods, entities eligible to be registered, tax considerations, the financial instruments available to FIIs, and investment limits imposed on foreign investment. In addition, this Note addresses some challenges for U.S. hedge funds as they seek registration in India. Finally, there is a detailed explanation of the FII registration procedures.

FOREIGN INVESTMENT

Foreign portfolio investment by investors in India is technically permissible only for investors registered with the Indian regulatory authority, the Securities and Exchange Board of India (SEBI),a as foreign institutional investors,more commonly referred to as FIIs, or as a sub-account of an FII.

The strength and vitality of Indias economy, accompanied by significant government reforms, have led to increasing interest in Indias financial markets among global investors. This phenomenon is best demonstrated by the number of registered foreign institutional investors (FIIs) registered with SEBI, up 66 percent in less than two years and more than doubling from 482 in 2001 to 1,057 in December 2006.

Total cumulative equity inflows, including portfolio investment and foreign direct investment, amounted to more than US$106 billion between FY1991 and March 2006 with US$50 billion arriving in the three-year period from FY2004 to FY2006.1 The bulk of the growth from FY2003s US$6 billion to FY2006s US$20 billion can be found in portfolio investments twelve fold increase, from $1 billion to $12.5 billion. For FY2009 $13 Billion cross

Background

In 1991, India began liberalizing its economy with economic reforms aimed at stimulating the moribund economy. Recognizing the extensive capital requirements necessary to bring about the desired growth and benefits of foreign investment, such as capital to fund business development and technology transfer, the government designed new policies to attract and manage foreign capital inflows. In a 1992 budget address, then Finance Minister and current Prime Minister Dr. Manmohan Singh introduced policies to give foreign institutional investors access to Indias financial markets.

Portfolio investment by FIIs in the primary and secondary markets was permitted for the first time in 1992. In addition, foreign direct investment (FDI) was also liberalized. Over the next year, a number of procedures and policies were implemented, many of which are still in effect from the policy written by the Ministry of Finance in 1992.

Statutes Regulating Investment by Foreign Institutional Investors

The primary regulation governing investment by foreign institutional investors is the Securities and Exchange Board of India (Foreign Institutional Investors) Regulations, 1995. This has been subsequently amended 23 times. The most recent amendment, called the Securities and Exchange Board of India (Foreign Institutional Investors) (Amendment) Regulations,2006, was issued on June 26, 2006. It addresses, among other issues,certain application procedures. Regulation 5(2) of the Foreign Exchange Management Act Notification No. 20, 2000 also governs the actions of FIIs with regard to their investments in India.

Types of Foreign Investors

A foreign investor may choose to participate directly in the Indian market either as a foreign institutional investor (FII), or as a sub-account.

_ An FII, as defined by SEBI, is an entity established or incorporated outside India which proposes to make investment in India.

_ A sub-account is an individual or entity established or incorporated outside India that invests in India through an FII.

FIIs and sub-accounts must register with the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI). There is a marked difference in both the eligibility criteria and the registration process between FIIs and sub-accounts, with sub-accounts of FIIs enjoying a less rigorous standard and process. This difference most likely accounts for the fact that an estimated 90 percent of the cumulative FII investments in India are through sub-accounts versus the balance of just 10 percent representing proprietary investments made by FIIs.

Eligible Entities

The following types of entities are eligible to register as an FII:

_ Pension funds

_ Mutual funds

_ Insurance companies

_ Investment trusts

_ University funds

_ Endowments

_ Foundations

_ Charitable trusts and charitable societies

_ Asset management companies

_ Institutional portfolio managers

_ Trustees

_ Power-of-attorney holders

Protected cell companies and cells incorporated in Mauritius cannot be registered as FIIs or as sub-accounts.

Registration Requirements

As per regulations presented in SEBI (Foreign Institutional Investors) Regulations,1995, and its subsequent 23 amendments, FIIs are required to fulfill the following conditions to qualify for registration:

1. They must have an established track record, professional competence, financial soundness, experience, general reputation of fairness and integrity.

2. An applicant must be a fit and proper person.

3. Applicants should be in existence for at least one year. University funds, endowments, foundations, and charitable trusts should be in existence for at least five years.

4. Applicants should be registered with and regulated by an appropriate foreign regulatory authority in the same capacity in which the application is filed with the SEBI. Registration with authorities that are responsible for incorporation only is not considered an adequate regulatory authority to qualify as an FII.

5. An applicant should be a regulated entity for at least one year prior to application.

6. Applicants are required to obtain permission under the provisions of the Foreign Exchange Management Act 1999 from the RBI.

7. Applicants must be legally permitted to invest in securities outside the country of their incorporation/establishment.

8. Applicants should not have legal proceedings initiated against them by any statutory authority.

9. An applicant must appoint a local custodian and enter into an agreement with the custodian.

10. An applicant must appoint a designated bank to open and maintain foreign-currency-denominated accounts and nonresident rupee accounts, and to route transactions.

11. A registration fee of US$10,000 is required both for initial applications and for each renewal.

Applicants applying under the asset management company category must include a plan with details of the type of funds for which the applicant proposes to make investments for its clients (such as sub-accounts). It is not uncommon for applicants who apply for FII status under the asset management company category to also submit a simultaneous application for registration of a sub-account fund.

Once approved, FIIs must appoint a compliance officer to monitor compliance with the SEBI Act and all rules and regulations issued by SEBI and the government.

Debt-Only Investors

Standard FII registration requires the FII to invest not less than 70 percent of their total investments in equity-related instruments and up to 30 percent in non-equity instruments. For those FII applicants who are interested only in debt securities, FII regulations permit an FII or sub-account to apply as a debt-only investor who will make all of its investment in debt instruments.

This application is known as the 100 percent debt route. The registration procedure under the 100 percent debt route is similar to the non-debt application except for the addition of a statement by the applicant that it wishes to be registered under the 100 percent debt route.

Approval Time Period

The SEBI uses a time-period benchmark for approving FII applications of seven days from receipt, but some approvals for FIIs have been as short as three days. When the applicant is a bank or subsidiary of a bank, SEBI solicits comments from the Reserve Bank of India (RBI) and thus the approval process is usually extended as it becomes dependent upon the RBI review.

Incomplete applications or those requiring further information from SEBI will also require additional time.

Rejection of Application

Decisions to reject an application are communicated by SEBI to the applicant in writing stating the grounds on which the application was rejected. Such applicants have 30 days to apply to SEBI for reconsideration, and SEBI is required to give the rejected applicant a hearing.

Validity of Registration

Once registered as an FII, registration and subsequent renewals are valid for three years.

TAX CONSIDERATIONS FOR FIIS (Please Check This with Indian Income tax website for year 2011 2012)

The following Overview should be read as an overview only and as a method of introducing the reader to the many issues that should be considered when seeking registration. In no way should the information presented be viewed as timely beyond the printing of this note, as fully comprehensive, or as tax or legal advice. The reader is strongly encouraged to consult with appropriate tax and legal experts about these issues and their most up-to-date recommendations when seeking FII registration in India.

Foreign investors in India are subject to various taxes related to capital gains and business income. These taxes are applied to entities based on various factors including:

(1) the nature of the income and whether it is business income or capital gains income;

(2) the length of time of the investment (i.e.,long-term vs. short-term capital gains);

(3) whether the foreign entity has a business presence in India; and

(4) the tax jurisdiction of the foreign investor and whether that jurisdiction enjoys with India an Agreement for Avoidance of Double Taxation (AADT).

Long-term capital gains: Long-term capital gains derived from the sale of equity shares or convertible securities executed on a recognized stock exchange in India by an FII or sub-account are exempt from Indian income tax.However, as per an amendment to the Income Tax Act in April 2006,j there is a possibility of an alternative tax on the profits of 10.455 percent.

Short-term capital gains:

Short-term capital gains achieved through the execution on a recognized stock exchange of India by an FII or sub-account are subject to tax in India at a rate of 10.455 percent, but investors may be able to avoid this tax subject to the provisions of any applicable Agreement for Avoidance of Double Taxation.

Business income: Profits from the sale of securities, derivatives trading, and arbitrage trading can be deemed to be business income in certain instances by the Indian tax authorities.Such income might then be subject to India income tax of 41.82 percent. If the FII is a tax resident of a country with which India has a tax treaty, then such business income would be liable to the income tax in India only if the FII maintains a permanent establishment in India, as defined by the relevant AADT. It is for this reason that many FIIs investing in India carefully avoid establishing any kind of presence on the ground in India.

Interest income: Interest income earned by FIIs is taxable in India at a rate of 20.91 percent.

Dividend income: Dividend income earned from portfolio companies is exempt from Indian income tax.

Agreement for avoidance of double taxation: The government of India has entered into tax treaties with certain other countries for the purpose of encouraging investment. A key provision of these treaties is to provide protection to taxpayers against double taxation for capital gains and other income. The practical effect of this is that FIIs domiciled in a jurisdiction that has entered into such a tax treaty with India will not be subject to Indian taxes on their capital gains.

Mauritius and Its Indian Bilateral Tax Treaty

The country of Mauritius is home to a large majority of Indias registered FIIs primarily because it is among a very few countries that has a bilateral tax treaty with India, since 1983, that includes capital gains among its protected income classes. Thus, as explained above, the Indian-based capital gains earnings of a Mauritius-registered entity are exempt from certain Indian capital gains taxes. As a result, a majority of FIIs set up and register investment vehicles in Mauritius to take advantage of these tax advantages to which such Mauritius-based entities are entitled. It is interesting to note that flows originating from Mauritius increased from 26 percent of all flows in the 20032004 period to 41 percent in 20052006, while those originating from the United States fell from 20 percent to 10 percent of all flows in the same period. It should be recognized that country of origin indicates where the FII is incorporated and where the remittance into India came from, not necessarily the origin of its ultimate end beneficiary.

Investors seeking FII status would be wise to seek tax advice from appropriate experts to ascertain whether such a structure, or another structure, is the most suitable for their purposes. SEBI officials have been clear, however, that when they review applications and eligibility, they do look through such vehicles to the home country of the underlying investor as if the application were submitted from that entitys home country.

While Mauritius-registration has tended to be a popular approach to address these tax issues, there has been talk of a recent tax ruling by the Indian tax authorities with regard to a large American-based fund management company. The fund company is believed to have successfully argued to the Indian tax authorities that, as its business is the buying and selling of securities, the profits from such business activities should be deemed business income rather than capital gains income. Furthermore, if deemed business income, any associated taxes against such income should not fall under capital gains rules but rather business income rules. Further, it argued, this business income, from a foreign entity with no business presence in India, may in fact not be subject to any taxes at all. Based on the success of that argument, the fund company bypassed Mauritius incorporation and registered directly from the United States. While this situation and ruling cannot be verified at this printing, the implications of such a ruling would impact how potential FIIs might structure their application.

This section should give readers an appreciation for many of the issues to be taken into account when structuring an FII registration, and the possible complexities associated with creating a tax-efficient investment structure. Furthermore, the reader should gain an appreciation of the value that can be obtained from clever tax advice received from an Indian tax and legal expert.

REPATRIATION OF INVESTMENT FUNDS

Although India maintains strict control over the movement of funds by domestic entities to offshore jurisdictions, the investment funds of FIIs are expressly granted full repatriation rights, as granted in the Foreign Exchange Management Act (FEMA). As per the FEMA, approved FIIs are permitted to open special nonresident rupee accounts dedicated purely for inward remittances and for meeting payment obligations for transactions in the securities market. All balances in these special nonresident rupee accounts can be repatriated in full.

CHALLENGES FOR U.S. HEDGE FUND FIIS

Hedge funds registered in the United States under the Investment Advisors Act of 1940 tend to meet most of the criteria for registration under the asset management companies category. However, there is considerable reluctance within SEBI and the government to approve or encourage such applicants.

This reluctance is discussed in detail in the November 2005 Report of the Expert Group on Encouraging FII Flows and Checking the Vulnerability of Capital Markets to Speculative Flows.

While the eligibility guidelines for FII registration are very specific, issues that often elicit requests from SEBI for further elaboration from the applicant (and thus slow down application approvals) revolve around requirement

Registration Requirements:

(1) the requirement of being regulated in ones home country;

(2) the nature of the regulation itself under which it is regulated; as well as

(3) the nature of the specific regulator regulating it.

Eligibility requirements state that the applicant must be a regulated entity in its home country for at least one year and that the nature of the investor/applicants regulation by its home country is in a capacity similar to that for which the application is being filed, but SEBI extends these requirements when considering applications. SEBIs opinion of the nature of the foreign regulator and the nature of the regulation regulating the applicant is subjective. It asks questions such as:

(1) Is the regulatory regime under which the applicant operates a rigorous regime, or is it a

loose oversight? And

(2) Is the nature of the specific regulation under which the applicant operates considered adequate by SEBI as to the depth of the regulation, or is that regulation considered inadequate for the interests of SEBI?

Home Regulator

Simply being regulated by a regulator in ones home country is not enough to meet SEBIs requirement. Instead, SEBI is interested in the nature of the regulator and the strictness of the regulatory regime. Are the local rules strict and enforced, or are they loose and ignored? Generally, if an applicant is regulated by one of the internationally accepted regulators of developed marketsregulators such as the SEC (U.S.), FSA (UK), ASIC (Australia), SFC (Hong Kong), or MAS (Singapore)SEBI is satisfied with the quality of the regulator.

However, if a regulatory regime is not known to be rigorous, the application may be delayed or rejected. In situations where the applicant is applying as an entity from a tax haven jurisdiction, such as Mauritius, Jersey, the Cayman Islands, or the British Virgin Islands, SEBI may examine the entity further by looking beyond the technical home country of the applicant (the tax haven) and also examine the individual applicants true home country, the jurisdiction of that home country, the regulator in the home country, and its ultimate registration/regulation.

For example, an application by a Mauritius-registered entity whose ultimate owner is a U.S. hedge fund manager will result in the investigation not only of the Mauritius entity and its principals, but also of the U.S.- based hedge fund manager, the fitness of the manager, the U.S. regime under which it is regulated, the U.S. regulator (the SEC), and the suitability of its regulation with regard to that hedge fund.

Specific Regulations under Which the Applicant Operates

After the SEBI is satisfied with the regulator, it then examines the specific regulations that the applicant is subject to and whether the regulations are adequate according to the standards of the SEBI. The specific regulations are particularly relevant to hedge funds, especially those in the United States. While the U.S. Securities and Exchange Commission (SEC) is a highly regarded regulator, U.S. hedge funds come under greater scrutiny by the SEBI because of:

(1) the one-year regulation requirement for eligibility, and

(2) the nature of specific regulation in the United States regulating hedge funds.

As of the date of this writing, the regulation of U.S. hedge funds is an issue fraught with confusion and uncertainty. In 2005, the U.S. SEC passed a rule requiring hedge funds with assets in excess of US$30 million to register with the SEC as investment advisers and submit to occasional inspections of their books and records. This rule went into effect in February 2006, at which time many hedge funds complied and registered. However, the rule was challenged in court and voided by a U.S. Court of Appeals in July 2006. At the time of this writing, the SEC was still deciding whether to appeal the recent ruling, seek legislation reinstating it, or pursue some other course of action. Thus, hedge fund applicants for FII registration face two questions:

1. Are they registered with any entity? If not, their eligibility becomes problematic.

2. Does SEBI regard the regulation under which the hedge funds are registered as in providing adequate oversight to the standard that SEBI is seeking?

Prior to the voidance of the registration requirement, SEBI had not yet reached a conclusion regarding the nature of the recent U.S. hedge fund regulation and whether it is simply an informative process or a more rigorous oversight of hedge fund operations. Up to May 2006, SEBI had not acted favorably on any U.S. hedge fund applications while it continued to review the nature of the regulation and whether SEBI considers it adequate for participation in Indias financial markets. With the recent court ruling voiding the registration requirement altogether, SEBI approval will remain problematic.

In addition to the difficulties in meeting the FII registration eligibility requirements for hedge fund applications in India, U.S. hedge funds also receive greater scrutiny from SEBI because of two other concerns:

(1) a concern for mass movements of funds out of the market, and

(2) the origination of investor money.

Mass Movement of Funds

The potential for the mass movement of funds out of the marketwhich could cause a short period of concentrated selling beyond what the domestic market can easily or comfortably absorbremains a concern throughout the developing market, and India is no exception. Indian regulators have been concerned about the possibility of a mass foreign investor exodus from the market that would overwhelm the buying power of domestic investors, thus leading to a sharp correction in the market. Recent and expected future growth of domestic investor demand has mitigated some of these concerns.

However, these concerns have not disappeared, and SEBI remains consciousand waryof the issue. Thus, the nature of a particular applicants investment strategy and style will be scrutinized to determine the quality of the FIIs contribution to the market.

In the minds of some observers in Southeast Asia, including government bureaucrats and politicians such as former Malaysian Prime Minister Mahathir, the Asian economic crisis in the late 1990s was caused by hedge funds and the havoc that their fast trading can cause, particularly when operating under a herd mentality. As SEBI is concerned about maintaining the quality of FII flows, it seeks to approve only investors it considers responsible and beneficial to Indias capital markets. The regulators are proud to note that every year from FY1993 until FY2006 (ending March 31, 2006) there have been net positive flows from FIIs into India, with the only exception being 1999, when net outflows totaled a mere US$166 million. For 2007, (encompassing the steep market corrections in AprilJune 2006 and February 2007) net equity investment flows were up US$5.73 billion and net FII investment in debt was up $1.27 billion, resulting in a net positive investment flow of almost US$7.0 billion for FY2007.

Source of Funds

The Indian government remains vigilant about knowing the source of funds coming into its markets. This vigilance includes, but extends beyond, global money laundering concerns from illegal sources of money. Of particular concern to India is what is known as round-tripping. Round-tripping concerns the return of money to India in respectable form from money that originally left India illegally. This might be money earned in the underground market or money for which taxes were never paid.

India has currency controls for citizens on the ability to move money outside of the country. The government wants to stop the illegal outflows and wants to ensure that money coming back into India is not illegally exported money. Thus, investments in India by nonresident Indians, persons of Indian origin, and overseas-controlled businesses (known as Overseas Corporate Bodies) are monitored closely and fall under rules that are different

Overseas Corporate Bodies (OCBs) are defined as entities that are predominantly (at least 60 percent) owned, directly or indirectly, by individuals of Indian nationality or origin resident outside India, and include overseas companies, partnership firms,societies, and other corporate entities from other foreign investors. This issue may impact hedge fund applicants because of their perceived lack of transparency as to the identity of underlying investors, and whether too large a block of a fund might in reality be round-tripping money returning to India.

Growing Acceptance of Hedge Funds

In the spring of 2007, the Chairman of SEBI, M. Damodaran, appeared to soften his stance regarding hedge fund registration in the Indian markets. A proposal is under consideration to permit the registration of any foreign entity which agrees to make certain disclosures about their operations. This shift from a previously harder line, rejecting attempts by hedge funds to register, is thought to be a result of the widely accepted reality that hedge funds are already participating in the Indian markets in a significant way, but doing so under the radar, without disclosure to the regulators. In 2006, approximately 30 percent of the estimated US$200 billion in FII activity was in the form of participatory notes, and a significant percentage of that activity is thought to be hedge fund driven. As such, SEBI has apparently decided that it is better to have the hedge funds operate as registered entities in an open, transparent, and direct way, with full disclosure, rather than through the hidden, indirect route behind off-shore participatory notes. In response to critics expressing concern about the feared destabilizing effect that hedge funds can impose on a stock market, the SEBI Chairman noted that since the hedge funds are in the market already, albeit hidden, their ability to destabilize will only be reduced by registration. Time will tell how this proposal to be more inclusive of hedge funds will develop, but the trend is definitely positive for hedge fund acceptance.

FINANCIAL INSTRUMENTS AVAILABLE TO FIIS

Foreign investors registered with SEBI can invest in the following financial instruments:

_ Securities in the primary and secondary markets, including shares, debentures, and warrants of companies, unlisted, listed, or to be listed, on a recognized stock exchange in India

_ Units of mutual funds

_ Dated government securities

_ Derivatives traded on a recognized stock exchange and subject to operational guidelines as specified by the SEBI, the RBI, and other various regulatory authorities

_ Commercial paper

The following are the main financial products/instruments traded in the secondary market:

Equity:

_ Equity shares

_ Rights issues and rights shares