03/08/2015
While Indians will face the consequences of a draconian law, ‘foreign money’ gets to hide as faceless Participatory Notes
In 2007, Prof R Vaidyanathan (of IIM Bengaluru) wrote in The Hindu Business Line that Participatory Notes (PNs) had “created a storm in the stock market, with SEBI (Securities and Exchange Board of India) coming out with a draft for discussion on how to regulate them, the Reserve Bank of India (RBI) suggesting that they be phased out, and the finance minister assuring that the government is not going to phase them out.”
Prof Vaidyanathan, who is working on a book on Black Money & Tax Havens and India’s Wealth Abroad—and is a member of several committees of the capital market regulator—has been strongly in favour of phasing out these faceless investment instruments.
PNs are offshore derivative instruments issued by foreign institutional investors (FIIs) or their associates against underlying Indian securities. They are issued to investors who are either not qualified to invest in the Indian market or not registered with the regulators. By their very nature, PNs camouflage the beneficial ownership and the fact that they are quickly and easily transferable makes it almost impossible to track true ownership.
Eight years after Prof Vaidyanathan’s article was published, it was déjà vuagain. At the end of July 2015, a Supreme Court-monitored special investigation team (SIT) on black money caused another flutter by asking the capital market regulator to put in place regulation to pinpoint ‘final beneficial owners’ of PNs, right down to the individuals, or promoters and directors of companies that held the PNs.
This was just a part of a slew of instructions to the market regulator to step up action and prosecution against those who use equity investment to manipulate prices and evade taxes. The SIT noted that SEBI has an effective market monitoring mechanism that can red-flag unusual market movement both in terms of price and trading volumes. It asked that this information should be shared with the tax authorities as well as the Financial Intelligence Unit (FIU) in the finance ministry. A part of these instructions was to ensure better transparency in FII investment through PNs with a serious attempt to track beneficial ownership.
Predictably, the SIT report led to sharp dip in stock prices. Immediately, in a replay of 2007, the SEBI chairman, UK Sinha, rushed to clarify that “neither the Special Investigation Team (SIT) on black money nor the government has suggested closing the P-Note route and it was a business requirement for a certain class of foreign investors.” If that were not enough, the finance ministry also rushed into needless damage control and assured investors that there will be no hasty decision on PNs based on the SIT report. Was this necessary?
A lot has changed in the developed world since 2007. There is a serious crackdown on tax evasion as well as market manipulation. But things remain absolutely the same in India, as far as foreign portfolio investment is concerned. We have the finance minister rushing out to appease foreign investors at the first sign of market turmoil. And, we continue to have bankers and lawyers making the same tired arguments about how large foreign funds would not invest in India if they were asked to be transparent about beneficial ownership.
In fact, all the evidence points to the contrary. Speaking at a Moneylife Foundation event on 29th July, Prof Vaidyanathan pointed out that increased longevity in the developed world has meant that giant pension funds are under pressure to locate markets, like India, which give them a return of over 4% after factoring in various risks.
Consequently, clean institutional money is more likely to fall in line with domestic regulations, since they have nothing to hide. This is already happening. In 2007, nearly half the portfolio investment into India was from non-transparent PNs. Today, PNs are estimated to account for merely 11.5% of the total assets held by foreign portfolio investors. This would mean that institutional investors, convinced about the India story, probably, have their core holding through direct investments. The gradual tightening of disclosure rules over the past years would also have nudged them to register with SEBI.
Instead of rushing to reassure FIIs that PNs will be allowed to continue, the finance minister ought to have announced a deadline for phasing out these non-transparent investments or to force full disclosure of beneficial ownership.
Prof Vaidyanathan correctly says that PNs are ‘a slap on the face of every citizen who is an investor’ who has to comply with tedious know your customer (KYC) requirements to buy even a single share. But a foreign investor can invest millions of dollars though faceless PNs. These double standards become even more of an insult in the context of the draconian Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015 that has been passed by the Bharatiya Janata Party (BJP)-led government.
The Act specifically focuses on ‘undisclosed foreign income and assets’ which cover everything—from immovable property to jewellery, bullion, shares (including ESOPs), archaeological collections and artwork. The government has also notified the rules for calculating overseas income and assets and has given people a small window until 30th September, to declare such assets and pay up a penalty, if they wish to avoid proceedings under the Act.
Does this mean that the Act will only harass Indians who are not wealthy enough to route their funds through layers of numbered accounts and international banks? And, that it will assume that all foreign portfolio investment is clean and opts only for the PN route for ease of transaction?
This would suggest that our government is hypocritical in ignoring the massive crackdown by the United States on the biggest names in global banking. The Wall Street Journalwrites that “the biggest global banks have paid more than $60 billion in penalties over the past two years to resolve allegations of wrongdoing.”
Additionally, Germany, France, Australia and Britain as well as the G-20 countries have taken stringent measures to crackdown on tax havens. In 2009, the US Internal Revenue Service (IRS) and the Department of Justice (DOJ) broke through the famed Swiss bank secrecy laws. UBS, a top Swiss bank, revealed the names of account-holders in an issue that remains controversial with new disclosures about the Bank’s contributions to the Clinton Foundation. In 2014, Citigroup negotiated a $7-billion settlement with the US DOJ over dubious mortgage securities transactions. JP Morgan Chase had earlier entered a $13-billion settlement and Bank of America has since paid up almost $17 billion after pleading guilty to a series of violations.
Elsewhere, Deutsche Bank, the largest German Bank, has coughed up $2.5 billion in penalties after admitting to rigging the London Inter-Bank Offered Rates (LIBOR). In the US, five big banks have paid up $5.6 billion after pleading guilty to criminal charges for manipulating the foreign currency markets. These include Barclays, UBS, Royal Bank of Scotland, Citigroup and JP Morgan Chase.
Is our government naïve enough to believe that non-transparent PNs are only being used as a business necessity by large portfolio investors? Or are our political leaders continuing to protect the super-rich who are behind the round-tripping of funds through the capital market?
According to Prof Vaidyanathan, unaccounted Indian money abroad is anywhere between $500 billion to $1.5 trillion. This is not going to come back, if the government dithers over uniform applicability and strict enforcement of the black money legislation.
(Sucheta Dalal is the managing editor of Moneylife. She was awarded the Padma Shri in 2006 for her outstanding contribution to journalism. She can be reached atsucheta@moneylife.in)
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