On An Unreasonable Note

The SIT on black money has asked that the ultimate beneficiary owner of every participatory note (PN) be traced. This revives an old, misplaced mistrust from nearly a decade ago. PNs help India better integrate into the global financial system. When India fixes its financial systems to become more competitive, these very PN customers will bring their business onshore.

PNs are one way for international investors to put their money in Indian assets today. When they want to invest in an Indian company, they buy a contract from financial firms in their country. In turn, these firms may choose to invest in the Indian asset by buying a PN from a Sebi-registered foreign portfolio investor (FPI), a “PN-seller”. Many times, one firm comes to buy a contract from the PN-seller and, at the same time, another comes to sell it. The PN-seller makes money by charging fees to both. No back-to-back transaction takes place in India. The PN-seller is “running a book”. Sometimes he sells 100 to one person and buys 80 from another. This leaves an imbalance of 20. This net imbalance shows up as a trade in India when the FPI sells the security. These are reported as PN trades to Sebi. The PN-seller is continuously changing its position in India, generating PN trades. These activities are good for India because they connect it with the world of global finance.

PNs are a reflection of the global investment community’s interest in Indian assets. But why does the international financial investor buy a PN instead of investing directly? As with everything in finance, this is about getting the lowest price.There are several problems with Indian policy due to which directly trading in India results in a higher price.

Trades on Indian exchanges are charged securities transaction tax (STT), a policy mistake. There is no such cost for the global investor when buying from a foreign financial firm. PN-sellers are domiciled in places like London and Singapore, where tax policy is sensible and transactions are not taxed. Since the PN-seller only sends its net imbalance as trades to India, the burden of the STT is lower.

The taxation of non-residents, other than from Mauritius and Singapore, is another policy mistake. Some foreign investors bring their money into India through Mauritius or Singapore to achieve residence-based taxation. Others take their business to PN-sellers domiciled in places where financial activities of non-residents are tax exempt and who have worked out Mauritius/ Singapore vehicles to do trades in India. The PN business is helping India earn revenues by avoiding the consequences(result,परिणाम) of our flawed(imperfect,दोषरहित) approach to taxation of non-residents. India has also made policy mistakes on capital controls. For example, it makes it difficult to take a position on currency futures in excess of $15 million. PN-sellers are domiciled in places where financial regulation does not do this.

The SIT wants to know the ultimate beneficiary of a PN transaction. This is inadvisable. First, because PNs are a reflection of a net position between all buyers and sellers, it’s impossible to pinpoint the ultimate beneficiary owner. Second, the regulator has the ability to trace the ownership chain only after an investigation starts. This suffices(be enough,काफी होना) for regulators in 33 of the Financial Action Task Force-signatory countries. Third, if a person in India buys a derivative in India and sells it to an investor in London, India does not have the right to ask about the London investor except in the context of an investigation. Strong-arm tactics and unreasonable information requests will drive up the cost of doing business.

If we want better knowledge about the beneficiary owner, we would do well to reform tax policy, capital controls and financial regulation to bring the business directly to India. This would be more effective in strengthening regulatory control, without destroying much-needed global flows into India.