A study on Qualified Foreign Investments (QFI): the system and its benefits to Foreign Nationals

FORMAT OF INDUSTRY ASSIGNMENT

 1 Title of the Industry Assignment2 Key Words3 Executive Summery4 Table of Contents5 Exhibits6 Figures7 Introduction8 Literature Review9 Analytical Interpretation on the topic ( your contribution )10 Suggestions11 Conclusion

Definitions

2.1 Authorised bank“Authorized Bank‟ means a bank including a co-operative bank (other than an authorized dealer) authorized by the Reserve Bank to maintain an account of a person resident outside India .

2.2 Authorized Dealer “Authorized Dealer” means a person authorized as an authorized dealer under sub-section (1) of section 10 of FEMA.

2.3 Authorized Person

“Authorized Person” means an authorized dealer, money changer, offshore banking unit or any other person for the time being authorized under Sub-section (a) of Section 10 of FEMA to deal in foreign exchange or foreign securities.

2.4 Capital

“Capital” means equity shares; fully, compulsorily & mandatorily convertible preference shares; fully, compulsorily & mandatorily convertible debentures. (*Note : Warrants and partly paid shares can be issued to person/ (s) resident outside India only after approval through the Government route).

2.5 Capital Account Transaction

“Capital account transaction” means a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India of persons resident outside India, and includes transactions referred to in sub-section (3) of section 6 of FEMA.

2.6 Company Controlled by Indian residents

A company is considered as “Controlled” by resident Indian citizens if the resident Indian citizens and Indian companies, which are owned and controlled by resident Indian citizens, have the power to appoint a majority of its directors in that company .

2.7 Depository Receipt

“Depository Receipt” (DR) means a negotiable security issued outside India by a Depository bank, on behalf of an Indian company, which represent the local Rupee denominated equity shares of the company held as deposit by a Custodian bank in India. DRs are traded on Stock Exchanges in the US, Singapore, Luxembourg, etc. DRs listed and traded in the US markets are known as American Depository Receipts (ADRs) and those listed and traded anywhere/elsewhere are known as Global Depository Receipts (GDRs).

2.8 OCB

“Erstwhile Overseas Corporate Body” (OCB) means a company, partnership firm, society and other corporate body owned directly or indirectly to the extent of at least sixty percent by non-resident Indian and includes overseas trust in which not less than sixty percent beneficial interest is held by non-resident Indian directly or indirectly but irrevocably and which was in existence on the date of commencement of the Foreign Exchange Management (Withdrawal of General Permission to Overseas Corporate Bodies (OCBs) ) Regulations, 2003 (the Regulations) and immediately prior to such commencement was eligible to undertake transactions pursuant to the general permission granted under the Regulations.

2.9 FDI “FDI” means investment by non-resident entity/person resident outside India in the capital of an Indian company under Schedule 1 of Foreign Exchange Management

(Transfer or Issue of Security by a Person Resident Outside India) Regulations 2000 (Original notification is available athttp://rbi.org.in/Scripts/BS_FemaNotifications.aspx?Id=174. Subsequent amendment notifications are available at http://rbi.org.in/Scripts/BS_FemaNotifications.aspx)

2.10 FEMA “FEMA” means the Foreign Exchange Management Act 1999 (42 of 1999) (http://finmin.nic.in/law/index.asp).

2.11 FIPB “FIPB” means the Foreign Investment Promotion Board constituted by the Government of India.

2.12 FII

“Foreign Institutional Investor”(FII) means an entity established or incorporated outside India which proposes to make investment in India and which is registered as a FII in accordance with the Securities and Exchange Board ofIndia (SEBI) (Foreign Institutional Investor) Regulations 1995.

2.13 Government Route

“Government route” means that investment in the capital of resident entities by non-resident entities can be made only with the prior approval of Government (FIPB, Department of Economic Affairs (DEA), Ministry of Finance or Department of Industrial Policy & Promotion, as the case may be).

2.14 Indian company “Indian Company” means a company incorporated in India under the Companies Act, 1956.

2.15 Investing Company“Investing Company” means an Indian Company holding only investments in other Indian company/ (ies), directly or indirectly, other than for trading of such holdings/securities.

2.16 Non-Resident Entity “Non resident entity” means a person resident outside India as defined under FEMA.

2.17 NRI“Non Resident Indian” (NRI) means an individual resident outside India who is a citizen of India or is a person of Indian origin.

2.18 Company owned by Indian Resident

A company is considered as ‘Owned’ by resident Indian citizens if more than 50% of the capital in it is beneficially owned by resident Indian citizens and / or Indian companies, which are ultimately owned and controlled by resident Indian citizens;

2.19 Portfolio Investment Scheme

“Portfolio Investment Scheme” means the Portfolio Investment Scheme referred to in Schedules 2 & 3 of FEM (Transfer or Issue of Security by a Person Resident Outside India) Regulations 2000.

2.20 QFI

“A Qualified Foreign Investor (QFI)” means a non-resident investor (other than SEBI registered FII and SEBI registered FVCI) who meets the KYC requirements of SEBI for the purpose of making investments in accordance with the regulations/orders/circulars of RBI/SEBI.

2.21 RBI “RBI” means the Reserve Bank of India established under the Reserve Bank of India Act, 1934.

2.22 SEBI“SEBI” means the Securities and Exchange Board of India established under the Securities and Exchange Board of India Act, 1992.

2.23 Assets Under Management

Assets under management (AUM) denotes the market value of all the funds being managed by a financial institution (a mutual fund, hedge fund, private equity firm, venture capital firm, or brokerage house) on behalf of its clients, investors,

partners, depositors, etc.

3.Exhibits

Exhibit 3.1 – Capital Control in India

Exhibit 3.2 - FII flows ,circa 2002-2010

Exhibit 3.3-Representation of the proposed QFI framework

4.FiguresFigure 4.1 World Governance Indicators for developing nations

Figure 4.2 Current account flows to GDP (Capital account integration)

Figure 4.3 Average assets under management

Figure 4.4- Category wise growth in assets under Management

Figure 4.5- Investors in the equity and non-equity categories

5.Background of the Issue in study.5.1 A snapshot of the Indian economy

1.India is ranked 132nd out of 183 economies in Doing Business 2012, recording an increase of 7 points compared to last year. This increase reflects large improvements in the Paying Taxes, Resolving Insolvency, and Getting Electricity indicators.

2. According to the latest Enterprise Surveys (2006), Electricity, Tax Rates and Corruption represent the top 3 obstacles to running a business in India.

3. India’s restrictions on foreign equity ownership are greater than the average of the countries covered by the Investing Across Sectors indicators in the South Asia region and of the BRIC (Brazil, Russian Federation, India, and China) countries. India imposes restrictions on foreign equity ownership in many sectors, and in particular in the service industries.

4. India’s economic freedom score is 54.6, making its economy the 123rd freest in the 2012 Index. Its score is unchanged from last year, with an improvement in labor freedom offset by declining scores in five other areas including business freedom, freedom from corruption, government spending,and monetary freedom. India is ranked 25th out of 41 countries in the Asia–Pacific region, and its overall score is below the world average.

In 2010, a report by the world bank on the Indian Business environment, that talked about “Investing across borders”, read:

“India’s restirction on foreign equitty ownership are above the average of the countries covered by the investing across sectors indicators in the south Asia region and of the BRIC countries. India imposes restrictions on foreign equity ownership in many sectors, and in particular in the service industries. Sectors such as railway freight trasportation and foresttry are dominated by public monopolies and are clsoed to foreign equity participation. With the exception of certain activites specified by law, foregin ownership in the agriculture sector is also not allowed. Gorreign ownership of pulishing companies aren newspapers is limited to a maximum of 26%. In the financial services sector, foreign capital participation in local banks is limited to 87% and in insurance companies to 265. Furthermore , oerign ownership in the telecomunications sector is limited to a less than 75% stake.”

In other words, by the end of 2010 , by global parameters, the Indian outlook was starting to dwindle; while internally, the economy was doing fairly well, there was little scope for those outside the system to contribute to it. Conseqently, the spectrum of the indian financial sector remained limited; and this starting leading to stagnation.

Rewinding back to 1991. The times were as bad as they could be; the economy was in doldrums; the balance of payments crisis was at its peak and India did not even have enough forex to probably support its imports for more than 15 days. Those were the times that had called for desperate measures; and that was the time which marked India’s foray into the global financial market. From then, the economy opened up, albeit at a snail’s pace, to foreign investments; FDI’s; capital inflows; a free-er currency; and thus, in a nut shell, propped up all the macroeconomic factors needed to propel a country to positive growth, keeping inflation in control and unemployment at bay. However, given that India has a behemoth population and conceded that the political and social conditions in India were NOT conducive to blazing growth, the growth story of India has, time and again, been spersed with joblessness, slow growth, high inflation, unstable governments, fluctuating

rupee, poor manufacturing figures, and red taping. This has meant that not all policies or economic measures have been able to spread their wings properly; and intuitively, on the flip side, it suggests that India is yet to reach full potential, and is not even half way through. Or, in other words, times call for even a bigger slew of measures and more defiant, cognitive steps to freeing up the economy.

5.2 The entry of the Qualified Foreign Investors

The year 2011 was not a great year for the Indian economy. The year started with robust projections of 8.5% growth in GDP, however by year end the figure has been revised to 7%. To make matters worse, political disunity and slow decision making (if any) over crucial issue of FDI and a depreciating rupee has ensured the year ended in economic gloom.

However, on January 1, 2012 the central government took an important decision of allowing QFIs to invest directly in Indian stocks- a decision that had the potential to directly impact the quality of foreign investments in India and ensure stability in Indian markets. The first day of this year-January 1, 2012 should probably be declare, in line with existing traditions, as QFI Day in our country. It is the day when Ministry of Finance (hereinafter referred to as Ministry) vide its press note, permitted QFIs to invest directly in Indian Equities Market.

Prior to this circular QFIs were allowed to invest in India but only in the Mutual Fund segment ;Having received the licence to invest directly into equities market now meant that QFIs can themselves select the scripts they wish to invest in, unlike investing in Mutual Funds, where the fund chooses the scripts in which the money is to be invested.But Before we delve into the regulatory framework and implications involved in this system,there is an interesting episode behind having this new class of investors. Since the 1991 liberalization policy, various modes of investments were made available to the foreigners. These included the foreign direct investment (FDI), foreign institutional investment (FII), non-resident Indian (NRI) investment, overseas corporate body (OCB) investments and later the foreign venture capital investments (FVCI).Having these number of class of investors led to overlapping of regulatory regime governing them. Further, the availability of multiple routes caused uncertainties to foreign investors when it came to opting for the appropriate investment route to adopt in order to invest in India. To address these issues, the Working Group on Foreign Investments in India published a report on 30 July, 2010. Inter alia, the report recommended consolidating the above mentioned group of investors into one class that shall be called- QFIs.

Interestingly, what actually was done is that QFIs were introduced in addition to the existing class of investors. Thus inspite of acting on the recommendation to consolidate them, the Ministry went on to introduce an additional route to invest in the country. Thus this marked the opening of QFIs in the country.The prime reasons to add another class of investors as stated by the Ministry were:-

a) To widen the class of investors,

b) Attract more foreign funds,

c) To reduce market volatility and,

d) To deepen Indian Capital Market.

It should be remembered that prior to this only FIIs/sub accounts and NRIs were permitted to invest in Indian Equity directly.

5.3 QFI-Understanding the system.(Exhibit 3.1)

As per the initial circulars, a QFI meant any person that

• Is not a Resident of India or not a SEBI(Securities Board Of India) registered Foreign Institutional Investor (FII)/Sub Account /Foreign Venture Capital Investor(FVCI);

• Is a resident of a country other than India, which is a member of Financial Action Task Force (FATF) or a member of a group which is a member of FATF and is signatory to International Organization of Securities Commission’s (‘IOSCOs’) Multilateral Memorandum of Understanding or a signatory of a bilateral MOU with SEBI.

The Securities and Exchange Board of India SEBI, in consultation with Government of India and Reserve Bank of India later decided to amend its earlier provisions with respect to Foreign Investor in mutual funds and equity share markets. As per the new definition,resident of a country that is a member of a group which is a member of FATF will also be eligible to be considered as QFI. Therefore, all the residents of the 6 member countries of the Gulf Cooperation Council and the 27 member countries of the European Commission would now be eligible to be considered as QFI.

For this purpose, the term “Person” has the same meaning under Section 2(31) of the Income Tax Act, 1961 (ITA) as well as the Foreign Exchange Management Act (FEMA) 1999. As per this definition, Individuals, Partnership Firms, Hindu undivided family, Companies, Trusts, Association of Persons and Body of Individuals fall within the purview of “Person”. Therefore, technically, any of these entities are entitled to invest as QFIs subject to fulfillment of other conditions.

Types of investments that can be made by QFI’s :

Equity shares Rupee denominated units of equity schemes of domestic Mutual Funds(MFs) Domestic Mutual fund debt schemes in infrastructure debt Debt securities

Qualified Foreign Investors (QFIs) in Listed equity share investments-The Foreign Investors who are Qualified i.e., the QFIs are allowed to purchase on repatriation basis equity shares of Indian companies’ subject the following terms and conditions:

a) QFIs shall be permitted to invest through SEBI registered Depository Participants (DPs) only in equity shares of listed Indian companies through recognized brokers on in equity shares of Indian companies which are offered to public and in India recognized stock exchanges in India in terms of the relevant and applicable SEBI guidelines/regulations.

b) QFIs shall also acquire equity shares by way of bonus shares, rights shares or equity shares on account of stock split / consolidation or equity shares on account of merger, demerger or any such corporate actions relating to investment limits.

Depository participants: (Exhibit 3.3)

A Depository Participant (DP) is basically an agent of the depository. They can be called as the intermediaries between the investors and the depository. The relationship between the depository and the depository participants DPs is governed by an agreement made between the two under the Depositories Act. In legal sense, a DP is an entity who is registered with SEBI and under the sub section 1A of Section 12 of the SEBI Act. These are the following parameters to be fulfilled by registered DP under SEBI for becoming a “Qualified Depositary Participant”:

DP should have a available means of Rs. 500 million or more It shall be either a clearing bank or clearing member of any of the clearing corporations It shall have appropriate arrangements for receipt and payment of money with a assigned

Authorised Dealer (AD) of Category – I bank It shall also demonstrate about the systems and procedures it has which have to be

complied with the FATF Standards, Prevention of Money Laundering Act (PMLA), other Rules and circulars issued from time to time by SEBI.

Also it shall obtain a prior approval from SEBI before the commencement of its activities relating to opening of dematerialized accounts by QFIs and shall ensure that QFIs meet all the requirements, as per the relevant rules and regulations issued by SEBI from time to time.

QFIs shall pay money through normal banking channel in any permitted currency (i.e.the currency which is freely convertible) directly to the single rupee pool bank account of the DP maintained with an Assigned Authroised Dealer of category – I bank. On receipt of instructions from QFI, DP shall carry out the transactions relating to purchase and sale of equity).

Sale of acquired equity shares by QFI :-

QFIs can sell their equity shares which are acquired by way of sale in the following ways: through recognized brokers on recognized stock exchanges in India; or In an open offer in accordance with the SEBI (Delisting of Securities) Guidelines, 2009; or In an open offer in accordance with the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011; or By the way of buyback of shares by a listed Indian company in accordance with the SEBI (Buyback) Regulations, 1998.

Tax implications:

At present, there are no specific provisions in the Indian Income Tax Act, 1971 relating to QFIs. The primary reason for this is that the Government has finalized its guidelines and also issued the SEBI circular only recently. It is likely that in the next Finance Act, there would be some amendments in the IT Act relating to QFIs. In the meantime, one would need to apply the normal provisions contained in the ITA to the income earned by QFIs from the investments made in Indian mutual funds and equities. while doing so, there is a need to check whether the QFI is entitled to the benefit of any Double Tax Avoidance Agreement (DTAA) signed by India with such country. If it is so then the QFI is entitled to take appeal to the provisions of the DTAA or the domestic law whichever is more beneficial. As per the Income Tax laws in india, the taxation of the income earned by a QFI is considered as Income from dividend declared by Indian companies.

Limitations on QFIs-The QFI investments are subjected to certain limitations:

The investment by QFI would be subjected to an individual investment limit of 5% of the paid-up capital of the Indian company and aggregate investment limit of 10%.

QFI can open only one demat account with any one of the DPs. Selling and buying of equity shares is done only through that DP.

Coming to joint accounts, every holder shall individually meet the requirements prescribed specifically for QFIs.

QFIs investment will be taxed at the same rate as the Indian investors, which means Qualified DP deduct TDS at the short term rate for QFIs at the time of remittance of the sales

proceeds. QFIs are not eligible to subscribe to any Systematic Investments or Transfer or Withdrawal

plans.

They can subscribe to or redeem only to their units. Units held by QFIs by way of Usable Capital Receipts and Demat holding are neither

transferable nor tradable. QFIs are not allowed to do off shore transfers of securities. The investments bought cannot be pledged or placed in lien and they should be free from

encumbrances. QFIs cannot engage in activities like lending and borrowing of any kinds of funds or

securities.

6. Analytical interpretation of the situation: The Indian side and the Foreign National side

Any move that connects the country to the rest of the world always has two players to the game- the national economy, and the external investors/producers/economies, depending on the scale of the transaction. Relations with other economies result in the creation of current accounts and capital accounts; relations with producers result in exchange and transfer of technology; and the relation with the external investor, the most volatile of all, results in the creation or flight of capital, as the case may be. Simply speaking, for an emerging nation like India, with a burgeoning national economy and generally positive macro-economic indicators, internal investors form a major part of the present picture as the country has been slow in opening itself up in order to protect its fledgling economy from the vicissitudes of external trade and investment; But as was discussed previously, this stand has now evolved to include more of free trade and investment, which has been seen in the form of relaxing norms on FDI and FII flows.While FDI flows are of a slightly more permanent nature, depend mainly on trade terms, internal policies, political stability and offer long-term, stable gains to the investor and asset creation to the destination of investment (India, in this case),flow of capital is of a more transient nature and depends on more critical macro-factors like the interest rate, general market sentiments, and offers immediate, large scale returns to the investor, and capital inflows/ better nominal exchange rate to the investee. And this is where QFI, a slightly drilled down version on institutional investing that focuses mainly on the individual investing rather than on institutional investing, comes in . Just like institutional investing provides a fillip to the financial markets of a nation, and generally rallies market sentiments, Individual investing by high net-worth individuals also have the ability to boost stock prices, help in capital inflows, push up industrial capital, and thus increase production as well as growth. Having said that from the point of view of the nation, a lot can also be said about the unbound returns and advantages to the individual investor, given than any emerging nation is always grossly undervalued and has the ability to outperform any benchmark or any prediction that may be targeted. And this is what the following few pages will do- analyse this phenomenon of Qualified foreign investing from two perspectives, the nation and the investor, and thus try to reach a common ground that works best for both.

6.1 The Indian side

Foreign investment laws have been enacted in economies in transition in order to encourage and protect foreign investments. Some countries, such as Kazakhstan, Uzbekistan and Kyrgyzstan, have now adopted revised foreign investment laws that offer investors essential guarantees and protection. The Kyrgyz Republic’s new Law “On Foreign Investments” provides foreign investors with a just and equal legal regime, full and continuous protection, guarantees of nondiscrimination, protection against expropriation of foreign investments, and the right to freely dispose of their investments and of income from them, as well as compensation for losses to foreign investors in the event of armed conflict

or other such circumstances. Consequently, efforts in these countries to improve legislation on foreign investments are oriented toward the creation of an overall legal system that is consistent with international standards and that incorporates elements regulating domestic investments as well. Transition economies have also concluded numerous international agreements on investment protection. Most of the elements of these agreements are reflected in their foreign investment laws. Nevertheless, these international agreements on investment protection take precedence over the countries’ national foreign investment laws, since guarantees and concessions for investors, in keeping with national legislation, can be rescinded by the enactment of a different law, while guarantees and concessions established by an international treaty cannot be altered or rescinded by a host country unilaterally. Therefore, economies in transition need to be more active in signing international treaties on investment protection and in harmonizing their own foreign investment laws with such treaties. The OECD countries recently signed a multilateral agreement on investments that contains strict criteria as regards liberalizing investment and investor-protection regimes and includes effective dispute resolution procedures and many key elements of international treaties and agreements on investment activity that are already in effect. The treaty is open for signing by all interested countries, including transition economies. Since the world community is moving in the direction of recognizing international standards and criteria to govern foreign-investment regimes, it is extremely important that economies in transition have the same base elements in their foreign investment legislation.However, One of the causes of the low level of foreign participation in privatization is the fact that transition economies have insufficient expertise in attracting foreign investors. As a result of these countries’ inexperience and a lack of assistance in searching for foreign investors, the task of finding qualified foreign buyers for enterprises has proved to be a serious problem. In addition, existing restrictions on DFIs(direct foreign investments), and a lack of information about enterprises being offered for sale have had a negative effect. For this reason, as they continue to implement privatization, economies in transition need to do a better job of marketing, identifying potential foreign investors and providing them with complete information about investment opportunities.Putting the above into perspective, the decision to allow QFIs to directly invest in Indian stocks holds a lot of promise for the Indian industry, especially as Indian companies are increasingly getting global. For instance, infrastructure major L&T is investing heavily in gulf, so an investor in Gulf States would be more aware of L&T and will invest in it. If we consider IT major Infosys, an investor in US can now directly invest in it- so the investor must be aware of the company’s strengths and long term growth prospects and hence will most likely be for medium to long term, thus ensuring stability for the company. However for this scheme of things to be successful, there needs to be wider participation of state owned banks and also forging partnerships with entities like Abu Dhabi Commercial Bank which are better equipped to handle the KYC norms for local investors.This seems to be the right way forward now, because having toyed around with FDI and FII, this is another major aspect that has been wanting attention for sometime now. By allowing foreign investors, with a large individual disposable income, to invest into the country, the regulator is not only ensuring a back-up supply of capital, but also letting the stock market adjust to more informed ways of performance, given that foreign investors are naturally

better disposed to information and technology; and after the initial hiccup of a new market, can use it to significantly get better gains out of an investment. Further, this has a positive spiralling effect, because as investors invest, confidence grows; and as confidence grows, the market burgeons , sends out positive signals, and thus attracts even more investment, private, institutional or otherwise. The third, slightly compounded effect that QFI’s may have is reducing the effect of hot-money flow through institutional investors, and the hammering it produces on the Indian currency. By allowing QFI’s, a greater leeway is made for capital inflows; and the inflows will now not just consist of institutional investments, but private investment as well; and thus when sentiments turn rough, the flight of capital will not be as pronounced, given than foreign individual investors tend to wait and watch more and are less sensitive to fluctuations. This will provide a buffer for the rupee, and thus absorb a bit of the shock that negative sentiments can produce,and consequently, will help shore up the rupee in rough weather by adding to the forex reserves in the country.

6.2 The Foreign national side.As much as we may talk about the Indian side of it, the truth remains that foreign investors need to be given a reason to invest in this country; and they need to be convinced of the ‘go-to’ potential of the Indian economy as a source of stable, persistent and continued returns.

Exhibit 3.2 depicts the flow of FII into India, with a reference to the 2008 crisis, when it was at its lowest. Now while 2008 was a year of lows with the stock markets round the world tumbling and gains crashing, India continued to be steady. Growth was positive, and infact continued to reach new highs; thus at a time when global markets were burning, India continued to prosper and provide returns to anyone who put faith in its economy. This is perhaps the strongest indicator of why a foreign national should invest in India. With a robust economy , large population, strong technology base that is growing, minor hiccups cannot really derail its progress. Admittedly, currency fluctuations have dogged the country in recent times; but even these are temporary, and it is very such investments that will help the country tide over such factors and provide better ROI to the prospective investor.

Figure 4.1, which shows global