India: NRIs Cannot Hold Beneficial Interest In Foreign Portfolio Investors – New SEBI KYC Requirements

Last Updated: 13 June 2018
Article by Seema Jhingan, Dhruv Manchanda and Tanmay Mohanty

The Securities and Exchange Board of India's ("SEBI") recent circular dated April 10, 2018 (Ref No. CIR/IMD/FPIC/CIR/P/2018/64) ("2018 Circular") has shaken up the investment industry due to its wide ranging impact on the Non-Resident Indians ("NRIs"), the Foreign Portfolio Investors ("FPIs") and the resident Indian managers of funds. The Know Your Client ("KYC") requirements for FPIs have been made stringent by SEBI primarily to identify and verify the Beneficial Owner ("BO") of the FPIs to potentially curb the money-laundering and round tripping concerns.

SEBI vide its earlier circulars dated (i) September 5, 2012 (Ref. No. CIR/MIRSD/11/2012); and (ii) September 12, 2013 (Ref. No. CIR/MIRSD/07/2013) had prescribed the requisite documentation for fulfilling the KYC requirements of eligible foreign investors classified as category I, II and III investing under the Portfolio Investment Scheme route, which requirements were being followed for completing the KYC requirements for the FPIs. We herein below assess the impact of the 2018 Circular on NRIs and Indian residents.

NRIs cannot be the Beneficial Owners: NRIs have been investing capital in Indian companies through the foreign direct investment route which imposes lesser sector specific conditions on NRIs. However, increasingly, NRIs showed preference to invest through Category II FPIs due to the flexibility and ease of operation that it offered along with the option of investing (through the FPIs) in jurisdictions other than India. This flexibility has been severely impacted with the imposition of the recent restriction that NRIs or Overseas Citizens of India can no longer be the beneficial owners i.e., BOs of FPIs. The BO is a natural person who ultimately owns or controls the FPI and needs to be identified in compliance with Rule 9 of the Prevention of Money Laundering (Maintenance of Records) Rules, 2005 ("PMLA Rules").

In case of the FPI having a structure of a company or a trust, the BO is to be identified on controlling ownership interest (also termed as ownership or entitlement) and control basis. In case of the FPI having the structure of a partnership firm or unincorporated association of individuals, the BO is to be identified on ownership or entitlement basis. "Control" has been defined to include the right to appoint majority of the directors or to control the management or policy decisions including by virtue of their shareholding or management rights or shareholders agreements or voting agreements.

Materiality Threshold: The materiality threshold for identifying the BO of the FPI on controlling ownership interest (or ownership/entitlement) basis is 25% in case of a company and 15% in case of a trust, partnership firm and unincorporated association of individuals. Lower materiality threshold of 10% may be applied with respect to the FPIs coming from 'high risk jurisdictions', (as referred in SEBI master circular no. CIR/ISD/AML/2010).

Look through Principle: The materiality threshold, for the purposes of identifying the BO, is to be applied at the level of the FPI and at the next level, the look through principle is to be applied to identify the BO of the material shareholder/owner entity. Only the BO with holdings equal to and above the prescribed materiality thresholds in the FPI, need to be identified using the look through principle. Further, in case no material shareholder/owner entity is identified in the FPI using the materiality threshold criteria for controlling ownership interest basis and also on control basis, then the BO shall be the senior managing official of the FPI. The 2018 Circular has however clarified that if the FPI is a Category II investment manager of other FPIs and in a non-investing entity, then such FPI may be promoted by NRI or Overseas Citizens of India.

Compliance: FPIs which are not in compliance with the aforesaid restrictions have been given a period of 6 months to either change their ownership structure or to close their existing position in the Indian securities market. Needless to say, the 2018 Circular has created a lot of furore in the market with the NRIs now rushing to either divest their investments from the FPIs or seeking creative structures to ensure compliance.

Indian Residents cannot be the Beneficial Owners of FPI: The 2018 Circular has gone a step further and also restricted Indian residents to be BOs in FPIs. Many Indian residents and India based managers have set up funds outside India especially in jurisdictions such as Mauritius and Singapore to attract foreign funds to invest in India and other emerging markets. Generally, India based managers or residents, invest a small capital in FPIs but retain management control in such funds and these investments would now be impacted by the above norm.

Aggregation of Holding: The restrictions imposed by the 2018 Circular has been aggravated by the fact that aggregate NRI investments in the fund over the above prescribed threshold limits will also not be permitted. This would also affect the broad-based funds who have several NRI investors to leverage their interest in the Indian markets. Separately, NRIs who would want to continue with their investments in India would now need to distribute their investments through multiple FPIs, to restrict their investment in each FPI below the prescribed threshold limits and ensure compliance with the provisions of the SEBI rules and regulations introduced by the 2018 Circular.

Reportedly, over the last few days, the custodians, which are large multinational banks and arms of Indian financial services groups handling investments of foreign institutional investors and undertake KYC formalities for foreign funds investing in India, have been requested by SEBI to provide information concerning NRI linked funds in India, including the ways NRIs exercise control in FPIs in India and whether they have the power to appoint majority of the directors and enjoy majority voting rights or not.

A number of representations have been filed by several funds and groups managing the foreign funds requesting SEBI to reconsider and dilute the restrictions imposed by the 2018 Circular. However, it is yet to be seen if the restrictions imposed by the 2018 Circular would be diluted by SEBI or these restrictions would continue as they are and therefore challenge the accepted operating structures of several foreign funds which are either controlled or managed by Indian managers, NRIs and Overseas Citizen of India.

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