Hitches in the new P-Note regime

University and pension funds could be affected

There are still a few grey areas in the new regime on participatory notes (p-notes), through which foreign investors hold about Rs 2 lakh crore in Indian securities.

A lack of clarity over issuance to entities such as pension funds and university endowment plans might keep them from accessing this route, despite being considered a relatively stable pool of capital unlike the ‘hot money’ that hedge funds bring. There are also ambiguities related to foreign investor caps and their applicability to p-note holders, say experts.

A p-note, also called an offshore derivative instrument (ODI), allows a foreign investor to invest in Indian markets even without registering with the stock market regulator. In December, such p-notes account for Rs 2.36 lakh crore or 10.5 per cent of the total foreign investor assets under custody, show regulatory data. The Securities and Exchange Board of India (Sebi) had come out with a circular on the p-note regime in November 2014.

Rajesh Gandhi, partner (tax) at Deloitte Haskins & Sells, said the problem would apply to category-II foreign portfolio investors, a definition that includes university and pension funds. “Sebi requires p-note holders to be regulated by the capital market regulator in all situations under category-II. This creates problems for entities such as pension funds. Let’s say a pension fund is not regulated by the capital market regulator, but regulated by other regulator such as the Department of Labour in its home country. In such a case, while such pension fund can register as a FPI (foreign portfolio investment), it cannot register as a p-note holder. This would also apply to university funds and seems to be an anomaly,” said Gandhi.

According to Suresh Swamy, partner, financial services - tax and regulatory services at PricewaterhouseCoopers, the requirement of pension fund to be regulated by the securities market regulator is an anomaly. “A clarification from Sebi that it will look at the relevant regulator and not necessarily the securities market regulator in case of pension funds/university funds will greatly help in this case,” said Swamy. He added the problem would apply to any new pension funds or university funds who seek to apply for FPI registration. The older ones would be exempted, but new ones would have to satisfy the condition for being appropriately regulated by a securities market regulator.

The majority of the p-note holdings are in the form of equity, accounting for Rs 1.64 lakh crore, according to December 2014 regulatory data. Another Rs 25,810 crore was invested in debt, while the remainder of holdings consisted of derivatives.

The regulator also clarified that if two or more p-note holders had a common beneficial owner, their positions would be considered together, rather than separately.

Issuers might not be in a position to keep track of such holdings, experts say. “Sebi wants FPIs who issue p-notes to have the necessary systems to keep a track of the total investment. However, it is unclear how this could be enforced, since most issuers don't have systems to monitor the total investments of p-note holders,” said Gandhi.

Russell Gaitonde, partner, BMR & Associates, said the regulator only clarified on an existing position and that issuers and holders would have to work out a framework of declarations to ensure that limits were not breached.

“It is not a change in the regulator’s position. Issuers and ODI holders will have to ensure that at no point in time are they breaching the investment limits for FIIs (foreign institutional investors) that have been stipulated in the FII Regulations,” he said.