How hiccups in P-note GIFT plan could impact wide-scale adoption

Use of the instrument has been falling over time

A budget boost to the issuance of specialised instruments for foreign investors issued from the International Financial Services Centre (IFSC) faces some snags that may affect wide-scale adoption.

The budget proposed to give a tax exemption on income from participatory notes (P-notes) that were issued from international financial services centres such as the Gujarat International Finance Tec-City International Financial Services Centre (GIFT IFSC) at Gandhinagar. Foreign investors use this instrument to invest in Indian markets even without direct registration.

“Taking forward our efforts to further promote the IFSC, I hereby propose to provide that income of a non-resident from offshore derivative instruments, or over the counter derivatives issued by an offshore banking unit, income from royalty and interest on account of lease of ship and income received from portfolio management services in IFSC shall be exempt from tax,”  said finance minister Nirmala Sitharaman in her budget speech on Tuesday.

The finance bill had the additional details.

“It is proposed to amend the said clause so as to provide that exemption under the said clause (4E) shall also be applicable to the income accrued or arisen to, or received by a non-resident as a result of transfer of offshore derivative instruments or over-the-counter derivatives entered into with an Offshore Banking Unit of an International Financial Services Centre,” said the relevant portion in the finance bill.

The budget move sought to bring parity to IFSC because foreign investors enjoy similar exemption when subscribing to P-notes issued by broker dealers abroad.

“However the route could have limited use because the instruments can be issued only by Indian banks and foreign banks operating in India and registered as IBUs (IFSC Banking Unit)...Non-bank broker dealers cannot avail this benefit. Also, the bank will continue to pay capital gains tax on gains from the sale of underlying Indian shares,” pointed out Rajesh H Gandhi, partner at Deloitte Haskins & Sells.

Use of P-notes has been falling over time. The latest data shows that the share of these instruments is at a record low. It accounted for 1.81 per cent of total foreign investor assets under custody, according to data from the Securities and Exchange Board of India. The classification of this share has varied with time, with instruments like hybrid securities only accounted for in the last two years. However, it can be considered broadly indicative of the popularity of the instrument. It had accounted for more than a third of foreign investments in 2007 before the global financial crisis (see chart 1).

The regulator since clamped down on its use. It was seen to be a potentially problematic conduit for anonymous capital flows.

While the share has declined over time, there is still significant holding through the instrument. The total value of equity holdings was Rs 84,948 crore as of December 2021. Debt and hybrid holdings were worth Rs 10,322 crore and Rs 231 crore respectively (see chart 2).

Holdings of both debt and equity assets have risen since January. While equity holdings are up 9.3 per cent since then, debt holdings are up 57 per cent on a smaller base. Hybrid holdings have declined.