Correcting tax and disclosure anomalies
Loose disclosure norms for money from abroad have serious implications for systemic risk
It is high time for Indian authorities and regulators to: (a) make participatory notes, or P-notes, marketed by foreign institutional investors (FIIs) transparent; (b) revise double taxation avoidance agreements (DTAAs) to increase applicable tax rates for foreign investments; and (c) review and abrogate most of our bilateral investment promotion and protection agreements (BIPAs). India's long-term interest in enhancing stable foreign exchange inflows should not continue to depend on P-notes and DTAAs, which facilitate anonymity and tax evasion. This article discusses the systemic financial sector risk consequences of inadequate disclosure requirements and disproportionately low taxes on investments from foreign jurisdictions, as well as the urgent need to make the changes demanded by national interest.
Even as this article argues in favour of tightening disclosure norms for P-notes, we need to hasten cautiously. Any precipitate move would be counterproductive. To illustrate the difficulties we may encounter, the clock needs to be turned back to October 16, 2007, when the Securities and Exchange Board of India (Sebi) announced poorly articulated restrictions in the use of P-notes. On October 17, 2007, stock market indices dropped by about 10 per cent and trading had to be suspended. Fearing large foreign exchange outflows, the finance ministry pushed Sebi to clarify that P-notes would be allowed as before.
What are P-notes? These are leveraged instruments involving Indian equity, debt or derivatives issued by FIIs to individuals and institutions not registered with Sebi. It is claimed by proponents of P-notes that such tailor-made securities make it attractive for high-net-worth individuals and hedge funds to invest in India. In practice, it is a channel for investing anonymously in Indian securities at negligible rates of taxation. Even for regular investments in India, as distinct from P-notes, FIIs route inflows through tax havens with which India has DTAAs. The only acceptable logic for allowing P-notes and DTAAs, as these stand now, is that these channels facilitate incremental foreign exchange inflows. On the downside, allowing such investments probably encourages capital flight from India and consequent round-tripping.
Going forward, Sebi, with the finance ministry's support, should insist on making public precise information on the extent of leverage, types of derivatives used, and gross, net and mark-to-market credit exposures embedded in P-notes. Sebi sources indicate that the total nominal principal P-note volumes are about 15 per cent of the stock of FII investments. However, losses on leveraged P-note trades could be disproportionately large, resulting in the rushed sale of high volumes of underlying securities driven by stop-loss limits or margin requirements.
In June 2013, a Sebi committee on "Rationalisation of Investment Routes and Monitoring of Foreign Portfolio Investments" recommended steps to reduce risks stemming from P-note trading. Subsequently, the denial of P-note trading rights to high-risk non-institutional participants, according to this committee's suggestions (Sebi's press release number 56/2013 dated June 12, 2013), was rendered ineffective by Sebi's decision at the end of April 2014, which grandfathered existing P-note investors.
India's DTAAs with 85 countries are meant to ensure that foreign investors do not pay taxes both at home and in India. In practice, these DTAAs have been used to evade taxes since the foreign jurisdictions through which most foreign exchange inflows are received are tax havens. A cursory examination of the negligible-to-low rates of taxation in Mauritius, Cyprus and Singapore explains the high volumes of foreign direct investment (FDI) and portfolio investments received through these countries. It follows that our DTAAs with tax havens need to be revised in such a manner that taxes levied are comparable to those in countries with which India is competing for foreign exchange inflows.
India has BIPAs with 72 countries and these bilateral agreements are meant to protect foreign investors from unilateral action by India. The core argument in favour of BIPAs is that foreign investors are prepared to accept project, market and exchange rate risks but not unilateral Indian government action - for example, nationalisation of assets or additional restrictions on foreign exchange repatriation. In practice, BIPA obligations have often not been thought through and resulted from the desire to show substance in summit meetings by signing bilateral agreements. This is evident from the fact that some BIPA partner countries are proceeding to take India to international arbitration on tax issues. It would be prudent to mutually agree to terminate most BIPAs, since these have not helped to avert legal disputes.
If our newly elected government takes a disciplined approach to containing the revenue and fiscal deficits and improves the prerequisites to boost manufacturing, we can expect sustained and sizeable foreign exchange inflows. Of course, India would continue to be exposed to the risk of prolonged conflict in the Gulf and West Asia, which could lead to higher oil prices, lower Indian stock valuations, capital outflows and rupee depreciation. Higher oil prices and capital outflows can be provisioned for by reducing subsidies on fuel and fertiliser and by raising our foreign exchange reserves respectively. As regards a lower rupee, this would help improve our trade balances. Additionally, the interest cost of mopping up surplus rupees, as we raise our foreign exchange reserves, would be reduced by buoyant tax revenues due to higher earnings of our export-oriented businesses. This would provide us with the elbow room to make P-note trading transparent and for DTAAs to be renegotiated. Even without these imperatives, India needs to increase its foreign exchange reserves and the Reserve Bank of India needs to co-ordinate its efforts with those of the central government to this end without triggering inflationary pressures.
To summarise, we need to assess just how vulnerable India is to substantial foreign exchange outflows if it changes P-note trading norms, amends DTAAs and drops most BIPAs. If India wishes to be attractive for higher-risk projects - including longer-gestation investments in manufacturing, among other reforms - we need to reduce the effective rates of corporate taxes to the levels of our principal competitors. The bottom line is that we should make our investment norms uniform for domestic and foreign investors and make the so-called fully automatic FDI route genuinely so by listening to suggestions from external sources. It is widely believed outside India that the only way to do any type of business in India is to have a reliable local partner to get through the jungle of government and regulatory hurdles and rent seekers. Another benchmark for how effective our reforms have been in attracting foreign investment would be that this perceived requirement of a local partner is no longer viewed as a prerequisite for doing business with and in India.
Even as this article argues in favour of tightening disclosure norms for P-notes, we need to hasten cautiously. Any precipitate move would be counterproductive. To illustrate the difficulties we may encounter, the clock needs to be turned back to October 16, 2007, when the Securities and Exchange Board of India (Sebi) announced poorly articulated restrictions in the use of P-notes. On October 17, 2007, stock market indices dropped by about 10 per cent and trading had to be suspended. Fearing large foreign exchange outflows, the finance ministry pushed Sebi to clarify that P-notes would be allowed as before.
What are P-notes? These are leveraged instruments involving Indian equity, debt or derivatives issued by FIIs to individuals and institutions not registered with Sebi. It is claimed by proponents of P-notes that such tailor-made securities make it attractive for high-net-worth individuals and hedge funds to invest in India. In practice, it is a channel for investing anonymously in Indian securities at negligible rates of taxation. Even for regular investments in India, as distinct from P-notes, FIIs route inflows through tax havens with which India has DTAAs. The only acceptable logic for allowing P-notes and DTAAs, as these stand now, is that these channels facilitate incremental foreign exchange inflows. On the downside, allowing such investments probably encourages capital flight from India and consequent round-tripping.
Going forward, Sebi, with the finance ministry's support, should insist on making public precise information on the extent of leverage, types of derivatives used, and gross, net and mark-to-market credit exposures embedded in P-notes. Sebi sources indicate that the total nominal principal P-note volumes are about 15 per cent of the stock of FII investments. However, losses on leveraged P-note trades could be disproportionately large, resulting in the rushed sale of high volumes of underlying securities driven by stop-loss limits or margin requirements.
In June 2013, a Sebi committee on "Rationalisation of Investment Routes and Monitoring of Foreign Portfolio Investments" recommended steps to reduce risks stemming from P-note trading. Subsequently, the denial of P-note trading rights to high-risk non-institutional participants, according to this committee's suggestions (Sebi's press release number 56/2013 dated June 12, 2013), was rendered ineffective by Sebi's decision at the end of April 2014, which grandfathered existing P-note investors.
India's DTAAs with 85 countries are meant to ensure that foreign investors do not pay taxes both at home and in India. In practice, these DTAAs have been used to evade taxes since the foreign jurisdictions through which most foreign exchange inflows are received are tax havens. A cursory examination of the negligible-to-low rates of taxation in Mauritius, Cyprus and Singapore explains the high volumes of foreign direct investment (FDI) and portfolio investments received through these countries. It follows that our DTAAs with tax havens need to be revised in such a manner that taxes levied are comparable to those in countries with which India is competing for foreign exchange inflows.
India has BIPAs with 72 countries and these bilateral agreements are meant to protect foreign investors from unilateral action by India. The core argument in favour of BIPAs is that foreign investors are prepared to accept project, market and exchange rate risks but not unilateral Indian government action - for example, nationalisation of assets or additional restrictions on foreign exchange repatriation. In practice, BIPA obligations have often not been thought through and resulted from the desire to show substance in summit meetings by signing bilateral agreements. This is evident from the fact that some BIPA partner countries are proceeding to take India to international arbitration on tax issues. It would be prudent to mutually agree to terminate most BIPAs, since these have not helped to avert legal disputes.
If our newly elected government takes a disciplined approach to containing the revenue and fiscal deficits and improves the prerequisites to boost manufacturing, we can expect sustained and sizeable foreign exchange inflows. Of course, India would continue to be exposed to the risk of prolonged conflict in the Gulf and West Asia, which could lead to higher oil prices, lower Indian stock valuations, capital outflows and rupee depreciation. Higher oil prices and capital outflows can be provisioned for by reducing subsidies on fuel and fertiliser and by raising our foreign exchange reserves respectively. As regards a lower rupee, this would help improve our trade balances. Additionally, the interest cost of mopping up surplus rupees, as we raise our foreign exchange reserves, would be reduced by buoyant tax revenues due to higher earnings of our export-oriented businesses. This would provide us with the elbow room to make P-note trading transparent and for DTAAs to be renegotiated. Even without these imperatives, India needs to increase its foreign exchange reserves and the Reserve Bank of India needs to co-ordinate its efforts with those of the central government to this end without triggering inflationary pressures.
To summarise, we need to assess just how vulnerable India is to substantial foreign exchange outflows if it changes P-note trading norms, amends DTAAs and drops most BIPAs. If India wishes to be attractive for higher-risk projects - including longer-gestation investments in manufacturing, among other reforms - we need to reduce the effective rates of corporate taxes to the levels of our principal competitors. The bottom line is that we should make our investment norms uniform for domestic and foreign investors and make the so-called fully automatic FDI route genuinely so by listening to suggestions from external sources. It is widely believed outside India that the only way to do any type of business in India is to have a reliable local partner to get through the jungle of government and regulatory hurdles and rent seekers. Another benchmark for how effective our reforms have been in attracting foreign investment would be that this perceived requirement of a local partner is no longer viewed as a prerequisite for doing business with and in India.
The writer, earlier finance professional in the World Bank Treasury and the finance ministry and also India's high commissioner to the UK, is currently RBI chair professor in Icrier.