Chapter 12: Foreign Portfolio Investors (FPI)

Foreign capital investment in Indian securities markets is governed by the Securities and Exchange Board of India (Foreign Portfolio Investors) Regulations, 2019, alongside the Foreign Exchange Management Act (FEMA), 1999, and RBI master directions.

A Foreign Portfolio Investor (FPI) is a person or entity resident outside India that invests in Indian securities (equity shares, corporate bonds, government securities, mutual fund units, REITs/InvITs) under the portfolio investment route.

Under the modern regulatory architecture, SEBI decentralized the registration and monitoring of foreign investors to Designated Depository Participants (DDPs):

• A Designated Depository Participant (DDP) is a qualified institutional custodian or depository participant approved by SEBI to process, register, and monitor foreign portfolio investors on behalf of the regulator.
• Single Window Onboarding: Foreign investors submit the Common Application Form (CAF) to a DDP. The DDP evaluates eligibility, conducts exhaustive Know Your Customer (KYC) and Anti-Money Laundering (AML) due diligence, grants the FPI registration certificate, facilitates allocation of the Permanent Account Number (PAN) through tax authorities, and opens foreign currency / demat accounts.

FPI ONBOARDING ARCHITECTURE VIA DDP

Under the SEBI FPI Regulations, 2019, foreign portfolio investors are streamlined into two risk-based categories:

To balance international capital inflows with national economic security, the Indian government and SEBI impose strict statutory investment boundaries:

1. Individual and Group Limits

• An individual FPI (including its investor group) can hold a maximum of below 10% of the total paid-up equity capital of a listed Indian company on a fully diluted basis.
• If an FPI's holding reaches or exceeds 10%, the foreign investor must either:
  • Divest the excess holding within five trading days; or
  • Have the entire investment re-classified as Foreign Direct Investment (FDI), subjecting the investor to sectoral FDI conditions and mandatory reporting.

2. Sectoral Aggregate Limits and Depository Monitoring

• Every Indian listed company is subject to a composite foreign investment sectoral cap (e.g., 20% in public sector banking, 49% in defense, 74% in private banking, 100% in information technology).
• Systemic Depository Monitoring:
  • Depositories (NSDL and CDSL) operate an integrated foreign investment monitoring system.
  • When aggregate foreign shareholding in a company reaches within 3% below the applicable sectoral cap (the "Red Flag Limit"), the depository system alerts stock exchanges and market participants.
  • When foreign holding breaches the red flag threshold, foreign investors are prohibited from purchasing further shares without prior approval, and stock exchanges restrict buy orders for FPIs.

Foreign Portfolio Investors are permitted to participate in Indian fixed-income markets through three specialized regulatory channels established by the RBI and SEBI:

+-----------------------------------------------------------------------------------+
|                        FPI DEBT INVESTMENT CHANNELS                               |
+-----------------------------------------------------------------------------------+
|                                                                                   |
|           +-----------------------+-----------------------+                       |
|           |                       |                       |                       |
|           v                       v                       v                       |
|  +-----------------+     +-----------------+     +-----------------+              |
|  | MEDIUM TERM     |     | VOLUNTARY       |     | FULLY           |              |
|  | FRAMEWORK (MTF) |     | RETENTION ROUTE |     | ACCESSIBLE ROUTE|              |
|  | - Annual quotas |     | (VRR)           |     | (FAR)           |              |
|  |   allocated by  |     | - Committed     |     | - Selected G-Sec|              |
|  |   RBI across    |     |   holding period|     |   benchmarks    |              |
|  |   G-Secs & NCDs |     |   (min 3 years) |     | - NO CEILING    |              |
|  | - Cap: 6% of    |     | - Exempt from   |     |   or investment |              |
|  |   outstanding   |     |   macro-prudent.|   |   caps for FPIs |              |
|  +-----------------+     +-----------------+     +-----------------+              |
+-----------------------------------------------------------------------------------+

1. Medium Term Framework (MTF): Traditional route where the RBI specifies quantitative limits on FPI investments in Central Government Securities, State Development Loans, and Corporate Bonds (pegged at approximately 6% of outstanding stock).
2. Voluntary Retention Route (VRR): Encourages long-term, stable foreign investments. FPIs commit to retaining at least 75% of their investment in India for a minimum period of three years, in return for exemption from macro-prudential concentration limits.
3. Fully Accessible Route (FAR): Introduced by the RBI to facilitate inclusion of Indian sovereign bonds into global benchmark bond indices (e.g., J.P. Morgan GBI-EM Index). All foreign investments in designated "specified securities" under FAR are completely free from quantitative caps or limits.

An Offshore Derivative Instrument (ODI), commonly known as a Participatory Note (P-Note), is an offshore derivative contract issued by an overseas registered FPI against underlying Indian securities:

• Regulatory Concern: Historically, ODIs were used by overseas investors who wished to gain exposure to Indian stocks without undergoing direct SEBI registration or disclosing their identities.
• Modern SEBI Restrictions on ODIs:
  • Only Category I FPIs are permitted to issue, subscribe to, or deal in ODIs.
  • ODIs cannot be issued to Resident Indians, Non-Resident Indians (NRIs), or entities that fail FATF AML standards.
  • The issuing FPI must conduct full "Look-Through" KYC to identify the natural person Ultimate Beneficial Owner (UBO) of the ODI subscriber.
  • FPIs must submit monthly detailed reporting of all ODI transactions and underlying portfolios to SEBI and the DDPs.

To prevent illicit round-tripping, corporate camouflage, and money laundering through foreign investment channels, SEBI and the Reserve Bank of India enforce stringent ownership identification norms:

UBO IDENTIFICATION THRESHOLDS UNDER PMLA

1. Mandatory UBO Look-Through Principle

• The Designated Depository Participant (DDP) must "look through" the corporate veil of intermediate holding companies, investment trusts, and general partners to identify the natural persons who ultimately exercise effective control or beneficial economic ownership.
• If no natural person meets the percentage threshold, the senior managing official (e.g., CEO, Managing Director) is identified as the beneficial owner.

2. Enhanced Disclosure Mandate for Concentrated FPI Holdings

In landmark regulatory reforms, SEBI mandated enhanced granular disclosures for foreign portfolio investors meeting specific risk triggers:

• Trigger 1: FPIs holding more than 50% of their total Indian equity Assets Under Management (AUM) in a single Indian corporate group; or
• Trigger 2: FPIs that, individually or along with their investor group, hold more than ₹25,000 Crore of Indian equity AUM.
• Compliance Requirement: FPIs breaching these thresholds must provide complete granular disclosures of all natural persons having any economic, voting, or ownership interest, down to the ultimate legal level, without applying any materiality thresholds. Failure to disclose within statutory cure periods results in mandatory liquidation of securities and cancellation of FPI registration.

Foreign Portfolio Investors operating in Indian capital markets are governed by the provisions of the Income-tax Act, 1961, read with applicable Double Taxation Avoidance Agreements (DTAAs):

• Capital Gains Classification: Under Section 2(14) of the Income-tax Act, any security held by an FPI is statutorily characterized as a Capital Asset, guaranteeing that all gains arising from the transfer of such securities are treated as capital gains rather than business profits.
• Short-Term Capital Gains (STCG): Gains realized from equity shares and equity-oriented mutual fund units held for 12 months or less (subject to Securities Transaction Tax - STT) are taxed under Section 111A at 20% (plus applicable surcharge and health/education cess).
• Long-Term Capital Gains (LTCG): Gains realized from listed equity shares held for more than 12 months are taxed under Section 112A at 12.5% on gains exceeding an annual exemption threshold of ₹1,25,000 (without indexation benefits).
• Tax Deduction at Source (TDS) and Custodian Role: Custodians acting as DDPs calculate tax liabilities on outbound remittances and withhold appropriate TDS under Section 195, ensuring statutory tax clearance before repatriating funds.