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Abstract
This article analyses the applicability of
the Comprehensive Economic Co-operation Agreement
signed between Singapore and India against the
backdrop of the current regulatory regime for
hedge funds in India. It examines in particular
the benefits of listing hedge funds on the Singapore
Exchange.
1. Introduction
The Comprehensive Economic Co-operation Agreement
("CECA") between Singapore and India
is the first of its kind that India has signed
with any country as well as the first that Singapore
has signed with a developing country. CECA integrates
agreements on trade in goods and services, investment
protection and promotion and economic cooperation
in fields like education, intellectual property,
science and technology.
2. Benefits under CECA
2.1 Capital Gains Exemption
The understanding reached on CECA has also resulted
in an improvement to the Double Taxation Avoidance
Agreement between Singapore and India. The Protocol
gives Singapore residents a status comparable
to that given to residents of Mauritius ie whereby
capital gains may be remitted from India free
of Indian withholding tax. However, for Singapore
residents to qualify for the capital gains exemption,
a resident must not be a shell/conduit company
with nil/negligible operations or with no real
and continuous business activity carried on in
Singapore. A company has been given a broad definition
and could include other entities such as funds.
A Singapore tax resident is deemed not
to be a shell/conduit company if:
i. it is listed on the Singapore Exchange ("SGX");
or
ii. has an annual operating expenditure of at
least SGD 200,000 or Rs. 5,000,000 in the last
24 months preceding the capital gains.
A separate condition is that a Singapore resident
may not be permitted to claim the benefit of the
exemption where the affairs of the resident are
primarily arranged to take advantage of the capital
gains exemption. However this condition is explained
to cover cases of legal entities not having bona
fide business activities. The phrase "arranged
with the primary purpose to take advantage of
the benefits in Article 1" has not been defined.
It remains to be seen whether Indian tax authorities
come out with guidance notes to clarify its application.
The concession granted to Singapore, with reference
to capital gains exemption, will remain valid
so long as the same treatment is available under
the India-Mauritius DTAA. While critics of CECA
feel that the limits on the Singapore treaty make
it less efficient than the Indo-Mauritius DTAA,
it should be noted those limits on CECA were inserted
to stem abuse of the kind seen in the case of
the India-Mauritius DTAA where mail-box companies
were established. India is under tremendous pressure
to review the capital gains exemption terms it
has with Mauritius. Accordingly, it might be a
short-term strategy to use Mauritius for new investments.
2.2 Increase in permissible investment limits
of equities and instruments listed on SGX
CECA provides two primary benefits in relation
to SGX-listed instruments (including hedge funds):
i. Securities and Exchange Board of India ("SEBI")
regulated funds managed by asset management companies
("AMCs"), owned or controlled by India
or Singapore juridical persons and intermediaries,
may offer SGX-listed mutual funds and CIS (including
hedge funds) to Indian investors without the limitation
that the company in which investments are made
should have a stake in an Indian company; and
ii. AMCs established in India, which are owned
or controlled by Singapore or India juridical
persons, may invest an additional US$250 million
in SGX-listed equities and instruments above the
usual ceiling of US$1 billion that Indian AMCs
may invest abroad.
2.3 Listing of hedge funds in Singapore
In light of the CECA benefits, hedge funds may
consider an SGX listing both:
i. to qualify for exemption from Indian tax on
capital gains made by the hedge fund; and
ii. as an avenue for tapping Indian investor demand
for hedge funds.
Hedge funds would generally be regarded as collective
investment schemes ("CIS") in Singapore.
The Monetary Authority of Singapore ("MAS")
has essentially gone the way of most regulators
in allowing hedge funds to remain largely self-regulated
unless they are to be offered to the public. Where
CIS are to be offered to the public or any section
of the public, they would have to be "authorised"
if constituted in Singapore or "recognised"
if constituted outside Singapore. There is also
an abridged procedure for restricted recognition
where the CIS are only to be offered to sophisticated
investors.
Hedge funds can seek a primary or secondary listing
on the SGX. Like the MAS, the SGX has also taken
a reasonably flexible approach to regulating listed
hedge funds, allowing listed hedge funds leeway
in how they manage their assets, whilst mandating
standards that ensure that investors in listed
hedge funds are made fully aware of the risk of
losing all or part of their investment, and setting
disclosure standards that are capable of fully
and frankly informing investors of a listed hedge
fund's investment performance and management standards.
The SGX's regulatory regime for hedge funds is
comparable to that of the Irish Stock Exchange
which currently attracts several hedge fund listings.
The SGX in comparison places minimal investment
restrictions on hedge funds.
3. The Indian regulatory framework regarding
hedge funds
3.1 SEBI (FII Regulations), 1995
Hitherto, there have been many pitfalls in the
mode of operation of hedge funds in India. For
instance, hedge funds generally do not approach
SEBI for registration as FIIs under the SEBI (FII
Regulations), 1995 ("Regulations") as
they are unlikely to satisfy the eligibility criteria.
The reason for this is that the eligibility requirements
for FII applicants which SEBI takes into consideration
are:
i. Applicant's track record2, professional
competence, financial soundness, experience, general
reputation of fairness and integrity;
ii. Whether the applicant is registered or regulated
by an appropriate Foreign Regulatory Authority
in the same capacity in which the application
is filed by SEBI;
iii. Whether the applicant is a fit and proper
person.
However hedge funds can enter the Indian market
through the FII sponsored sub-account route. Under
the Regulations, foreign corporates, foreign individuals,
proprietary fund of FIIs and institutions or funds
or portfolios established outside India, whether
incorporated or not, can get registered as sub-accounts.
The FII is required to apply on behalf of the
sub-account with both signing the application
form. The validity of the sub-account registration
is thus co-terminous with the FII registration
under which it is registered. However, it should
be noted that SEBI has in the past withheld approval
of sub-account applicants having characteristics
similar to a hedge fund According to SEBI figures,
on the basis of market value, the hedge funds
account for about five per cent of the market
value of the total assets held by the FIIs in
India.
3.2 Participatory Notes
Under the current regime, hedge funds operate
either through the sub-account route or through
the more popular Participatory Notes ("P-Note")
route. P-Notes are offshore derivative instruments
in the form of contract notes issued by registered
FIIs against underlying securities to overseas
investors. The reason for the popularity of P-Notes
is that it allows for foreign funds to flow in
without the identity of the actual overseas investor
being disclosed to SEBI. The way P-Notes function
is quite simple: the investors place their order
through brokerage houses that enjoy FII status.
The brokerage houses then repatriate the dividends
and capital gains back to these entities. The
broker executes the trade on its proprietary trading
account thereby keeping the investor's name anonymous.
The reason given by the foreign hedge funds for
use of P-Notes in India is threefold. First, there
is the problem of regulatory delay since it is
highly probable that a new fund will not get registration
as an FII and, even if it could, it will take
at least 4 weeks to obtain such registration.
This lag time is very inefficient for investment
in capital markets which react on a daily basis.
It is simpler therefore, to sign a P-Note contract
despite the fact that it is more expensive from
a trading point of view and very illiquid. The
second reason for opting for P-Notes is the freedom
and flexibility to trade in a few stocks rather
than be obliged to comply with the SEBI-imposed
requirement to invest in a broad market of 30-40
different stocks. The final factor for opting
for P-Notes is the disclosure regime as P-Notes
are only monitored by SEBI on an extremely limited
basis:
i. FIIs/sub-accounts which issue/renew/cancel/redeem
P-Notes are required to report to SEBI on a monthly
basis;
ii. FII/sub-accounts merely investing or subscribing
to the P-Notes/Access Products/Offshore Derivative
Instruments or any other such type of instruments/securities
with underlying Indian market securities are required
to report on a quarterly basis;
iii. FIIs/sub-accounts who do not issue P-Notes
but have trades or hold Indian securities during
the reporting quarter require to submit 'nil'
undertaking on a quarterly basis;
iv. FIIs/sub-accounts who do not issue P-Notes
and do not have trades or hold Indian securities
during the reporting quarter are not required
to make any report for that particular quarter.
3.3 SEBI Task Force Report
With a soaring market, healthy foreign exchange
reserves, and stronger institutional framework
in the capital markets (as compared with the rest
of Asia), India has finally taken a more favourable
view towards hedge funds. The biggest reason for
such a mindset shift is that hedge funds are becoming
the favoured investment vehicle for serious investors
in the US and the single largest source money
from foreign institutional investors. Hedge funds
have been collecting more money than mutual funds
reflecting that more investible funds are being
channelled through them. This has finally galvanised
India's market regulator, SEBI, to come out with
a draft report on 24 May 2005 ("Report")
for a proposed regulatory framework for registration
of hedge funds in India.
The Report, while identifying the lack of a definition
of hedge funds under any law, has pointed out
that these could loosely be termed as unregistered
private investment partnerships, funds or pools
that may invest and trade in different markets
and are not subject to any regulatory requirement
in their home country.
The Report is a consequence of SEBI trying to
find a workable solution to the problem at hand
and allowing hedge funds to register directly
with it instead of through the P-Note route. At
the end of March 2004, total investment by hedge
funds in offshore derivative instruments (participatory
notes) against Indian equity was Rs 8,050 crores.
The key recommendations of the Report include:
i. The investment advisor to the hedge funds
should be regulated investment advisors "under
the relevant Investor Advisor Act or the fund
should be registered under the Collective Investment
Fund Regulations or Investment Companies Act;
ii. The fund should be broad-based, that is, it
should invest in a basket of 30-40 stocks. The
rationale behind this recommendation is that hedge
funds seeking absolute returns usually invest
in a few stocks while the Regulations require
a more broad-based investment philosophy;
iii. The fund manager or investment advisor must
have a minimum three-year track record in managing
funds with an investment strategy that is similar
to that of the applicant fund. The rationale for
this is to keep the Indian markets insulated from
the trial and errors of new entrants and encourage
well managed funds;
iv. At least 20% of the corpus of the hedge fund,
seeking to register in India as an FII, should
have been contributed by pension funds, university
funds, charitable trusts, endowments, banks and
insurance companies. The presence of institutional
investors in the fund is expected to ensure better
governance on the part of the fund manager and
fund administrators. The rationale behind this
recommendation is that institutional investors
may help fund managers to take a long term perspective
of the market;
The Report, while recommending that hedge funds
be afforded a limited opportunity to invest in
the Indian equity markets, also recommends that
they should still not be allowed to invest in
commodity and currency markets in India. The Report
has also proposed an additional limitation on
hedge funds by recommending that they will not
be allowed to engage in the short-selling strategy
in the Indian stock markets. According to the
recommendation, all transactions must have a delivery
dimension.
There is no indication at this stage as to when
the proposals, made in the Report, will be implemented.
Footnotes
1 The author heads the
South Asia practice at Rajah & Tann. The author
would like to acknowledge the contributions of
Nisha Kaur Uberoi and Abhishek Singh.
2 It is necessary for the applicant
to have at least a one year track record.
Disclaimer: The information
contained in this article is correct to the best
of our knowledge and belief at the time of writing.
The contents of the above are intended to provide
a general guide to the subject matter and should
not be treated as a substitute for specific professional
advice for any particular course of action as
the information above may not necessarily suit
your specific business and operational requirements.
It is to your advantage to seek legal advice for
your specific situation. In this regard, you may
call the lawyer you normally deal with in Rajah
& Tann or e-mail the Knowledge & Risk
Management Group at .
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