P-Notes on a rough pitch

The post-Budget uncertainty surrounding taxation of P-Notes has impacted sentiments with many large investors seeking clarity on the issue. A conference call organised by the Edelweiss Research team with ALMT Legal indicated that transactions of FIIs routing money through tax havens like Mauritius (with or without P-Notes), which lack commercial substance, will be liable to tax in India under GAAR from April 1. The taxation rates are 15 per cent on short-term gains and NIL on long-term gains, subject to payment of Securities Transaction Tax. Since tax will be imposed on FIIs, Edelweiss analysts expect its impact to be passed on the ultimate beneficiary (P-Note holder).

Among options to escape imposition of GAAR could be migrating operations to Singapore, since the Singapore treaty requires an FII to have a full-fledged commercial establishment. For bank-FIIs which already have significant operations in Singapore, it will be relatively easier to justify commercial substance vis-à-vis non-bank FIIs, which do not have significant operations there.

Further, the probability of direct taxation of gains arising out of P-Note transactions under Section 9 amendments (foreign transactions like Vodafone) looks remote, since P-Notes are contractual in nature and do not constitute any transfer of shares/interest in any entity registered outside India. Since Section 9 is not applicable, the question of retrospective taxation is also ruled out.

To understand the impact of tax on P-Notes, consider this example. A P-Note holder, based out of the US, enters into a contract to invest through a P-Note issuer (based out of a tax haven, say Mauritius, in Indian equities (Transaction A). The P-Note issuer trades in Indian equities on behalf of the P-Note holder and derives gain (Transaction B).

Transaction B will be taxed in India in accordance with the provisions of GAAR applicable from April 1. The tax burden will, however, be passed on by the P-Note issuer to the P-Note holder. For Transaction A, P-Notes are offshore instruments which constitute a contract and not a share or interest. If P-Notes do not pass any rights for voting or dividend to the holder, then a good case can be made that P-Notes will not be taxed by invoking Section 9, which deals with income deemed to be accrued in India, since the nature of transaction is a contract and does not deal with transfer of shares involved in the transaction.