MAT row pushes FIIs towards P-note

FII's P-note holdings touch 7-year high at Rs 2.72 lakh crore

Foreign investors’ concerns about the minimum alternate tax (MAT) on direct investments into India have pushed up demand for participatory notes (P-notes).

According to data from the Securities and Exchange Board of India (Sebi), the total notional value of foreign portfolio investment in debt, equity and derivatives stands at a seven-year high of Rs 2.72 lakh crore as of March.

In the past two years, investments through P-notes have nearly doubled, from Rs 1.47 lakh crore in March 2013. Investments through P-notes stood at Rs 3.23 lakh crore in February 2008.

“Taxation on the MAT front has been one of the key reasons for investors choosing to invest through P-notes in the past year. But going forward, since it is not going to be levied, there would be no specific reason for investors to choose this particular route,” said Avinash Gupta, managing director, Alpen Capital.

P-notes or offshore derivative instruments can be used by foreign investors who have not registered with Sebi to invest in India. These are used primarily by high net worth individuals (HNIs), hedge funds and other foreign financial institutions, invest through registered foreign portfolio investors (FPIs).

FPIs incorporated as companies are liable to pay MAT. However, this is not applicable to investors coming through the P-notes. Just as other investors in India, FPIs pay no tax on long-term capital gains. Imposition of MAT will change this to a minimum tax of 18.5 per cent, which along with the surcharge would make the effective tax rate 20.01 per cent.

“If the investors come through the regular, direct route and agree to pay tax in India, then the effective tax rate for those entities will be 20 per cent. But if the investor comes through the P-note route, then he does not have to pay tax if the issuer can make sure the investors are entitled to the tax-treaties,” said Suresh Swamy, partner (financial services), PwC Tax and Regulatory Services.

Finance minister Arun Jaitley, in his Budget presentation in February, had said MAT would not be levied for investments from April. But reports suggest the government is looking at impose the tax retrospectively, and has already sent out notices to FPIs defaulting on such payment. This is expected to add Rs 40,000 crore to the government’s kitty.

Experts believe the fear and uncertainty surrounding the levying of MAT could have a negative impact on the investment sentiment on India. While India continues to remain an attractive destination for investment, such tax uncertainties could render the direct route of investments unpopular.

Sector analysts said the popularity of P-notes could go up further. “From a tax standpoint, investors will not have the comfort of coming through the direct route and would prefer to come in through P-notes,” said Swamy. “In the worst case, assuming half the FII funds (by value) are impacted by this case and going by the government’s estimated tax collection of Rs 40,000 crore, a four per cent impact could be felt on the NAVs (net asset values) of these funds, if the funds foot the tax bill,” said an ‘India Strategy’ report on MAT by foreign brokerage firm CLSA.

The report quoted Deloitte as saying only the investment entities incorporated as ‘companies’ will be impacted.