Pranab's balm on P-notes soothes market nerves

Govt won?t tax holders of P-notes, but concerns remain over taxability of FIIs

In a relief to end-buyers of participatory notes, finance minister Pranab Mukherjee said today the government would not tax holders of the derivative products. The statement helped calm the nerves of anxious investors and triggered a market rally.

The Bombay Stock Exchange (BSE) benchmark, the Sensex, surged 345.59 points, or 2.03 per cent, to 17,404.20. At the National Stock Exchange (NSE). The 50-stock Nifty index jumped 2.25 per cent to 5,295.55. Foreign Institutional Investors (FIIs) bought shares worth Rs 962.65 crore today, provisional data on the BSE showed.

However, worries remain as Mukherjee also said the government would examine the tax liability of foreign institutional investors (FIIs) registered with market regulators to invest in India.”The tax authorities would examine the tax liabilities of the said FIIs. However, they would not go beyond the FIIs to check any further details about P-note holders. Accordingly, the question of tax liability of participatory note holders does not arise,” Mukherjee said.

This means the government will continue to look into the possible tax liability of FIIs.

P-notes are derivative products, sold by registered FIIs or their sub-accounts to their overseas clients, which attempt to mimic the performance of an underlying security.

The latest concerns over P-notes had revived memories of 2007 when the market regulator said it was unhappy with P-notes and proposed restrictions that included compulsory registration of funds investing through them. This, the regulator said, was being done to curb excessive market volatility. The market had crashed immediately after the announcement but settled down after Sebi put in place a mechanism for faster registration of FIIs.

It was in October 2007 that market regulator Sebi, under chairman M Damodaran, clamped down on the issue of these instruments. At that time, Sebi had asked FIIs and their sub-accounts not to issue or renew P-notes with the underlying as derivatives. Also, they were asked to unwind their positions within 18 months. The Sensex had fallen about 1,500 points, or nearly eight per cent, in just three days after Sebi’s decision on October 16, 2007. The ban was reversed by Sebi in 2008 during C B Bhave’s tenure.

Asia Securities Industry and Financial Markets Association (ASIFMA), which has FIIs like Goldman Sachs, Credit Suisse, Bank of America-Merrill Lynch and Morgan Stanley as its members, welcomed the FM’s statement, but said its concerns remained.

“The news about P-notes is positive. But, threats of taxation directly on FIIs could seriously disrupt the Indian capital markets,” ASIFMA CEO Nicholas de Boursac said in a statement.

PROBLEMATIC NOTES

OCT 16, 2007

* Sebi, under chairman M Damodaran, clamps down on P-note issuances

* FIIs and sub-accounts asked to unwind their positions within 18 months

* Sensex falls nearly 1,500 points, almost 8%, in just three days after Sebi’s decision

2008

* Step reversed by Sebi under chairman C B Bhave

THIS WEEK

* Monday Sensex drops 309 pts as fears on P-notes mount

* Tuesday FM clarifies GAAR meant to check tax avoidance through complicated structures, not directed at P-notes

* Wednesday FIIs seek clarity

* Thursday “As and when the position will be clarified, you will come to know,” says FM

* Friday FM says question of tax liability of P-note holders does not arise; Sensex surges 345 pts

The Hong Kong-based association had expressed concerns over norms related to the taxation of indirect transfers of assets and General Anti-Avoidance Rule (GAAR) in the Finance Bill in a strongly worded letter to Mukherjee on Wednesday.

Hong Kong-based CLSA stopped selling P-notes this week, warning that as the registered FII, it could be liable for taxes. It warned clients it would then consider passing any such costs to them.

“For CLSA or any other P-note issuer the tax liability must rest with the end ODI investor, the end beneficiary of the economic gain,” it said in an email to clients seen by news agency Reuters, referring to offshore derivative instruments.

ASIFMA said concerns outlined in its letter remained, that FIIs may be subjected to substantial levels of taxation as the new rules came into force. “We look forward to continued and constructive conversations to protect these foreign investment flows and will work to support the best interests of the Indian capital markets,” said de Boursac.

Experts say the government clarification on P-notes is helpful, but it still needs to clarify some issues.

“People wrongly assumed P-note holders will be taxed. The FM has now clarified they won’t and the market has rallied because of that,” said Saurabh Mukherjea, head of institutional equities at Ambit Capital. “There is no transfer of assets in a P-note, it’s just a contract. India doesn’t have the jurisdiction to tax contracts signed abroad between two foreign counterparties. However, from Monday onwards, FIIs that come from tax havens like Mauritius and Singapore but can’t show substance will get taxed. If they can show substance, they will be able to avail the treaty benefits,” he added.

According to Mukherjea, the government needs to articulate what exactly will be considered “substance” in a tax haven. “Our understanding is that if your pooling of funds is happening in a tax haven and senior investment personnel are located there, you can prove substance,” he said.

Uncertainty over FII taxability has been weighing on Indian shares since the Budget on March 16. “There is confusion about the FM’s statement. As far as taxability of P-note beneficiaries is concerned, it is now clarified they won’t be liable to pay tax,” said U R Bhat, managing director at Dalton Capital Advisors (India). “However, the larger issue of the tax status of FIIs who come through Mauritius — where the tax authorities are of the view the structure is without substance but used for tax avoidance — is still wide open and needs a definitive clarification soon,” he added.