MAY 17, 2014

By TIOL Edit Team

THE Committee to Review the FCCBs and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993 has turned the focus on unfinished agenda for reforming the securities markets for attracting foreign investment through all channels.

Though the committee chaired by M.S. Sahoo, Secretary, Institute of Company Secretaries of India (ICSI), has focused on depository receipts (DRs), it has called for a comprehensive review of the entire framework of governing capital controls and foreign investment. It believes that DR reforms as a stand-alone initiative would not yield full benefits.

It has thus proposed that the review should include External Commercial Borrowings (ECBs) and Foreign Currency Convertible Bonds (FCCBs); direct listing of Indian companies abroad; dual listing of Indian companies; Foreign Institutional Investment (FII)-Foreign Direct Investment (FDI) regime; residence-based taxation vis-a-vis source based taxation; and relationship between authorities in India and in foreign jurisdictions.

The Committee wants global integration of Indian capital markets to a new high, an idea that is loaded with significant benefits and risks.

Sahoo Committee's report, coupled with the reported suggestions made by the Committee for rationalizing the definition of FDI and FII head by Economic Affairs Secretary Arvind Mayaram, constitute an important policy agenda on which the incoming Government would have to take a careful call to give a big boost to the economic growth.

It is difficult to draw clear picture of the foreign investment-related securities reforms as the UPA Government has not made public Mayaram Committee report. The Outgoing Government put the Sahoo Committee report in public domain on 13th May though it was submitted on 26th November 2013. This shows the UPA lacked the political will or clarity to take the economy forward.

Market reforms are one area where UPA talked big but delivered little and that too belatedly. The need for reforms in the entire domain of securities market is urgent against the backdrop of periodic emergence of scams and compartmentalized regulation of different markets including commodities and their derivatives markets.

Securities and Exchange Board of India (SEBI) itself has been dealing with reforms in bits and pieces as evidenced from release of discussion papers and reports of SEBI-appointed committees. In this editorial, we would, however, focus on foreign investment-related securities reform.

Whatever be the intensity of securities reforms under the new Government, the guiding principle should be creation of a level-playing field taxation of both domestic investments and foreign inflows.

As put by Sahoo Committee, "The taxation regime should be neutral between domestic investors in securities and foreign investors in securities or DRs on securities. The issue of DRs should not inconvenience or adversely affect the interests of existing holders of securities."

It has pointed out that under the 1993 DRs scheme, taxation is "more than those applicable to domestic investors/domestic securities." It has thus proposed taxation should be "at par with domestic investors /domestic securities" under a new DR scheme that replace the existing one.

The Committee has rightly recommended that the tax treatment of DRs should be similar to that of the underlying securities. The conversion of a DR into the underlying securities and vice versa should not be taxable events. The trading of DRs outside India should not attract any tax in India. The tax treatment of transfer of securities by holders of such securities through a public tendering process to a foreign depository for issue of DRs should be aligned with that of transfer of shares on a stock exchange.

We endorse the Committee's stance that the Government should be agnostic if a firm uses DR route or FDI route to secure investment from overseas or if a foreign investor invests in the country/a firm through DR route or FII route as long as the total investment in Indian firms is within the permissible limits. Therefore, DRs should not suffer any additional restriction or enjoy any privilege compared to any other route of foreign investment.

The Committee has, however, contradicted itself on this while finalizing the draft Depository Receipts Scheme, 2013.

The Draft says: "The issue of DRs as such shall not require any approval under any law from any authority in India. However, the issue or transfer of permissible securities to a person resident outside India to form the underlying for DRs would require the approvals, if any, under the FEMA (Foreign Exchange Management Act)."

If no approval is required for DRs, then Foreign Direct Investment Policy and Foreign Investment Promotion Board (FIPB) would lose relevance. The companies would bypass FDI policy restrictions and FIPB approval mechanism by opting for DRs.

The approval authority for DRs should thus be FIPB and in the case of automatic approval of FDI, the DR issues should just be registered with Reserve Bank of India as is the case with proposals that do not require FIPB clearance.

DRs, which are negotiable foreign currency-denominated instruments, are issued in overseas capital markets to foreign investors. The DRs at present get converted into underlying equity shares at ratio or price determined by the markets.

The Committee has proposed that the underlying security for DRs should not be restricted to equity shares and should be extended to all forms of securities.

The committee has rightly recommended that DRs should be issued in a foreign jurisdiction which is a member of Financial Action Task Force (FATF) and the regulator of securities market of that jurisdiction is a member of International Organization of Securities Commissions (IOSCO).

This would help minimize the scope for money laundering and security frauds.

The Committee wants the Government to specify in the new scheme its intention to crack down on prospective manipulators of the capital markets.

It has thus aptly proposed that "the use of DRs or market of DRs to abuse the Indian market for underlying securities shall be considered as abuse of the Indian securities market and should be dealt accordingly. The abuse for this purpose would mean insider trading, fraudulent and unfair trade practices and takeover irregularities to the extent applicable to permissible securities."

The liberalization of access to foreign capital by Indian corporate sector should, however, have built-in safeguards against flow of hot money. There should be subtle bias for durable FDI especially the one that facilitates inflow of technology and innovations. Put simply, FDI by foreign companies should get some preferential treatment over foreign portfolio investment.