India: New paradigm for foreign investors

Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 In focus Treasury Research Group October 30, 2006 For private circulation For only private circulation only India: New paradigm for foreign investors P-notes as a percentage of assets under custody (AUC) of FPIs have fallen significantly since 2007 (%) 60 50 40 30 20 10 0 Notional value of P-notes as % of asset under custody(auc) of FPIs May 20, 2016 Samir Tripathi samir.tripathi@icicibank.com +91-22-4008-7233 Niharika Tripathi niharika.tripathi@icicibank.com +91-22-4008-6943 Sumeet Agarwal sumeet.agrawal@icicibank.com +91-22-4008-7213 Please see important disclaimer at the end of this report Clarifications from Ministry of Finance suggest the exemption of fixed asset instruments from the scope of the amended Mauritius tax treaty. Entities will be eligible for tax credit in their respective countries. Additionally, SEBI tightened the regulations regarding the issuance of participatory notes (P-notes). While the regulation may increase the transaction cost, both steps are in the right direction from a healthier market development perspective. Government amends Mauritius tax treaty India and Mauritius signed, on May 10 th, a protocol for amendment of the Double Taxation Avoidance Agreement (DTAA). The amendment will allow India to tax capital gains made by a Mauritius based company for sale of shares acquired in India after April 1 st, 2017. The new structure will be adopted in a staggered manner, with capital gains being taxed at 50% of India s tax rate for shares purchased from April 1 st, 2017 to March 31 st, 2019. Full tax rate will be implemented for shares purchased post March 31 st, 2019. Clarifications from Ministry of Finance (MoF) Further clarifications from Minister of State for Finance, Jayant Sinha, and other MoF officials suggests: a) The reform is applicable to only shares. All fixed asset instruments as well as derivative products are exempt from the scope of capital gains tax. b) The Limitation of Benefits (LoB) clause will allow only those Mauritius based companies to benefit from the tax treaty that have an annual operational expenditure greater that INR 27 lakhs. c) Capital gains on sale or transfer of shares purchased till March 31 st, 2017 will be grandfathered and will continue to enjoy benefits of the tax treaty. d) Companies/individuals will pay a tax on capital gains in India but will be eligible to avail tax credit on ST capital gains in their respective country. e) A Working Group, including custodians, tax experts etc., will be set up to assess compliance issues and processes. SEBI tightens P-note norms Capital market regulator Securities and Exchange Board of India (SEBI) has tightened the regulations regarding the issuance of participatory notes (P-notes). The key measures taken by the policy makers include:- The P-note issuer will be required to follow the Know your customer (KYC) or Anti-money laundering rules (AML) norms of the Indian jurisdiction as against the earlier norm of following only the KYC/AML norms of the foreign investor s home jurisdiction. It has also increased the frequency of reporting by P-note issuers. In order to tighten the offshore derivative instruments (ODIs) and have more control over the issuance and transfers of ODIs, the ODI subscribers will have to seek prior permission of the original ODI issuer for further issuance/transfer of ODIs. (Further details inside) Impact of new measures The measures aim to bring in more transparency and curb any misuse of the investment route used by foreign investors not registered in India. The move to amend the DTAA is in line with a more equitable treatment of tax and avoidance of treaty exploitation. Given the easing of entry-related norms for foreign investors and stricter norms for ODI issuance, the notional value of ODIs to the assets under custody of FPIs has declined from a peak of 55.7% in June 2007 to 10% recently. While the tighter P-note regulation is likely to increase the transaction cost for P-note investors, it is a step in the right direction from a healthier market development perspective.

India has amended the India-Mauritius tax treaty Background In Focus Mauritius, contributing 20% of total FII outstanding (equity) in India, is the 2 nd largest source of FII funds India outstanding FII (equity) - Countrywise (Top 10) Equity (% of total equity) US 6,598.8 34.1 Mauritius 3,910.2 20.2 Singapore 1,593.6 8.2 Luxembourg 1,505.4 7.8 UK 1,006.1 5.2 Norway 398.4 2.1 UAE 602.9 3.1 Ireland* 521.2 2.7 Netherlands 413.9 2.1 Canada 488.5 2.5 Others 2,333.4 12.0 Total 19, 372. 3 100. 0 Mauritius and Singapore have contributed ~50% of the FDI inflows to India since 2000 Foreign Direct Investment inflows into India (2000-2015) (% of total Mauritius 4651.6 32.7 Singapore 2383.5 16.7 United Kingdom 1129.3 7.9 Japan 1003.8 7.0 US 899.8 6.3 Netherlands 911.8 6.4 Cyprus 419.5 2.9 Germany 435.5 3.1 France 249.6 1.8 UAE 177.2 1.2 Total 14240. 7 100. 0 Source: DIPP, ICICI Bank Research India and Mauritius signed, on May 10 th, a protocol for amendment of the Double Taxation Avoidance Agreement (DTAA). The amendment will allow India to tax capital gains made by a Mauritius based company for sale of shares acquired in India after April 1 st, 2017. The new structure will be adopted in a staggered manner, with capital gains being taxed at 50% of India s tax rate for shares purchased from April 1st, 2017 to March 31 st, 2019. Full tax rate will be implemented for shares purchased post March 31 st, 2019. Fixed asset instruments outside the purview of the new tax In a conference call with the Minister of State for Finance, Jayant Sinha, further clarity on the new tax reform was received. Key points include: Scope: The reform is applicable to only shares. All fixed asset instruments as well as derivative products are exempt from the scope of capital gains tax. On Limitation of Benefits (LoB) clause and grandfathering clause: The limitation of benefits clause will allow only those Mauritius based companies to benefit from the tax treaty that have an annual operation expenditure greater that INR 27 lakhs. Further, capital gains on sale or transfer of shares purchased till March 31 st, 2017 will be grandfathered and will continue to enjoy benefits of the tax treaty. On existing tax exempt companies: Tax exempt companies such as provident funds and sovereign wealth funds will be liable to pay the tax. On tax credit: Companies/individuals will pay a tax on capital gains in India but will be eligible to avail tax credit on ST capital gains in their respective countries. On Compliance: A Working Group, including custodians, tax experts etc., will be set up to assess compliance issues and processes. Amendment is in line with goal of checking tax evasion The move to amend the DTAA is in line with the objective to increasing transparency and a more equitable treatment of tax. Given that the Singapore-India tax treaty is coterminous with the Mauritius treaty, it is likely that the capital gains tax provision will be extended to Singapore as well. The Government is currently in talks to introduce similar reforms with respect to Singapore and Cyprus. The Government aims to introduce General Anti- Avoidance Rules (GAAR) next year to check broader issue of tax evasion. Impact analysis Mauritius and Singapore are amongst the top three countries contributing to India s FII and FDI. Prior to the above mentioned treaty change, coupled with the fact that Mauritius did not levy any capital gains tax, led to a situation where the capital gains arising from the sale or transfer of shares purchased in India to be subject to a nil tax liability. This has been rectified now. The amended tax treaty will thus allow for more a fair and equitable tax collection. Further, the amended tax reform will allow the check of treaty exploitation, such as routing funds to avail benefits of double non-taxation. In the short run, the grandfathering clause will provide some support to investors. Meanwhile, in the long run, improved tax clarity and steps to check tax evasion is likely to prove to be key positive for the economy. 2

Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 In Focus SEBI tightens P-note norms P-notes as a percentage of assets under custody (AUC) of FPIs have fallen significantly since 2007 (%) 60 50 40 30 20 10 0 Notional value of P-notes as % of asset under custody(auc) of FPIs Capital market regulator Securities and Exchange Board of India (SEBI) has tightened the regulations regarding the issuance of participatory notes (Pnotes). The key measures taken by the policy makers includes:- The P-note issuer will be required to follow the Know your customer (KYC) or Anti-money laundering rules (AML) norms of the Indian jurisdiction as against the earlier norm of following only the KYC/AML norms of the foreign investor s home jurisdiction. It has also increased the frequency of reporting by P-note issuers. In order to tighten the offshore derivative instruments (ODIs) and have more control over the issuance and transfers of ODIs, the ODI subscribers will have to seek prior permission of the original ODI issuer for further issuance/transfer of ODIs. In the monthly reports on ODIs all the intermediate transfers during the month would also be required to be reported. Earlier the monthly report contained only details of holders of ODI, and the transaction details were made available to SEBI on demand. KYC review to be done on the basis of risk criteria as determined by the ODI issuers, as follows: i. At the time of on-boarding and once every three years for low risk clients ii. At the time of on-boarding and every year for all other clients Suspicious Transactions: ODI Issuers shall be required to file suspicious transaction reports with the Indian FIU, if any, in relation to the ODIs issued by it. Periodic Operational evaluation: ODI Issuers shall be required to put in place necessary systems and carry out a periodical review and evaluation of its controls, systems and procedures with respect to the ODIs. The measures aim to bring in more transparency and curb any misuse of the investment route used by foreign investors not registered in India. While the tighter regulation is likely to increase the transaction cost for P- note investors, it is a step in the right direction from a healthier market development perspective. Further, given the easing of entry-related norms for foreign investors and stricter norms for ODI issuance, the notional value of ODIs to the assets under custody of FPIs has declined from a peak of 55.7% in June 2007 to 10% recently. 3

In Focus 1. Outstanding FII in India APPENDIX India outstanding FII - Countrywise (Top 10) Equity Debt Total Apr-14 Apr-15 Apr-16 Apr-14 Apr-15 Apr-16 Apr-14 Apr-15 Apr-16 US 4,775 6,533 6,599 106 421 461 4,881 6,954 7,060 Mauritius 3,287 4,574 3,910 220 740 521 3,507 5,314 4,431 Singapore 1,148 1,720 1,594 661 1,102 1,004 1,809 2,822 2,598 Luxembourg 1,183 1,682 1,505 75 320 445 1,258 2,003 1,950 UK 827 994 1,006 9 15 20 836 1,009 1,026 Norway 323 407 398 160 231 244 484 638 642 UAE 503 615 603 0 7 6 503 622 609 Ireland* -- 436 521 -- 27 41 -- 463 563 Netherlands 316 376 414 38 90 115 354 466 529 Canada 324 438 489 3 13 27 327 451 516 Others 1,848 2,362 2,333 260 450 557 2,107 2,812 2,890 Total 14,535 20,138 19,372 1,531 3,415 3,441 16,066 23,554 22,813 *Ireland was not in the top 10 countries of FII in India in 2014 2. FDI inflow into India: Country wise (2000-Dec 2015) Amount of Foreign Direct Investment Inflows (2000-2015) (% of total Mauritius 4651.6 32.7 Singapore 2383.5 16.7 United Kingdom 1129.3 7.9 Japan 1003.8 7.0 US 899.8 6.3 Netherlands 911.8 6.4 Cyprus 419.5 2.9 Germany 435.5 3.1 France 249.6 1.8 UAE 177.2 1.2 Total 14240. 7 Source: DIPP, ICICI Bank Research 4

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