The government has embarked on a major overhaul of its foreign investment policy matrix to remove inconsistencies that lead to regulatory arbitrage. The Prime Minister?s Office has directed the finance ministry, RBI and markets regulator Sebi to iron out their differences to integrate the legal and regulatory regimes for foreign capital inflows.

All legal, regulatory and taxation regimes with respect to foreign investments are under review. One objective of the exercise is to disallow foreign investors from evading rules by pitting one regulator against one another.

For its part, the finance ministry has just set up a 16-member working group to review the existing policy of foreign capital flows other than foreign direct investment. According to a senior government official, the group, headed by UTI-AMC CMD UK Sinha, has been entrusted with the task of removing ?specific bottlenecks? to foreign investment and defining a consensual and uniform policy regime for the country. The idea is to create an efficient policy regime for capital flows free from constraints, but not prone to easy abuse.

According to the terms of reference given to the group, it would ?identify the challenges in meeting the financial needs of the Indian economy through foreign investment?, without potentially disrupting the stability of the financial system. It would also critically look at arrangements relating to use of participatory notes (PNs) by foreign investors and suggest if any change in policy is required from a know-your-customer point of view. Significantly, the group would also examine the rationale for taxing transactions with levies like the securities transactions tax and stamp duty.

Policies related to various kinds of capital flows have been formulated over different periods of time in the last many years.

Most policy action was in response to the demands of expediency, rather than the outcome of deliberate evaluations or futuristic assumptions of regulatory needs. So, many policies have come to exist with very little interconnectedness, and also with regulators being smugly incognisant of the parts of the policy matrix they are not directly answerable for. This has created a regulatory arbitrage opportunity, which some foreign investors could be taking advantage of.

For example, foreign venture capital investors registered with Sebi are eligible for a more benevolent tax treatment than FIIs. It is feared that many FIIs are using the FVCI route to avail of tax benefits. An FVCI can invest up to one third of total capital in the stocks of listed companies, which negates the very purpose of their role as investors in new ventures.

RBI had repeatedly expressed reservations over the liberal policy regime for FVCIs especially with regard to investments in real estate. The central bank?s wariness about FVCIs is evident from the fact that there are 25 FVCI applications approved by Sebi, which the former is yet to clear.

According to the official, the objective of the current exercise is to try and ?remove these policy inconsistencies, if not contradictions.? The finance ministry has been flagging these issues in the high-level coordination committee on capital markets over the last few months, not always to find full support from the RBI and Sebi which are also represented in the committee.

Capital market transactions are subject to securities transaction tax and also a 10% short-term capital gains tax. However, there is no long-term capital gains tax on securities. There is policy debate as to whether the STT should be continued and whether ordinary income and capital gains need to be taxed at different rates. The direct taxes code unveiled by the finance ministry recently also envisages doing away with STT and taxing all capital gains at the same rate as ordinary income. Also, conveyance of debt is subject to stamp duty, with state-level rate variations. The working group would review levy of STT and stamp duty to rationalize the taxation of transactions.

The review of the way PNs are being used by portfolio investors, according to sources, is to ensure that appropriate KYC norms are in place to trace the investor. This, however, is unlikely to lead to any fresh restrictions on PNs, which are derivative instruments with the stocks or futures as underlying.

?There are foreign investments that flow in through circuitous ways. We can?t, therefore, afford to neglect the importance of KYC norms,? said PwC executive director Rahul Garg.

The working group comprises KP Krishnan, Govid Mohan and Arvind Modi, all joint secretaries in the ministry, economist Ajay Shah and National Stock Exchange managing director Ravi Narain.