The controversy explained

What is a P-Note?
Global investors who do not qualify or are not registered as foreign institutional investors (FIIs) with the Securities and Exchange Board of India (Sebi) rely on the Participatory Notes (P-Notes) route to invest in Indian capital markets. P-Notes are a form of Offshore Derivative Instruments (ODI) issued by FIIs. Those who have applied for registration as an FII and don’t want to wait also choose this route.

A P-Note is a contract between a registered FII and an unregistered foreign investor, wherein the former says that on behalf of the buyer/seller, specific securities are purchased/sold at the mentioned price and quantity. For a buyer or P-Note holder, this is an unsecured contract which involves counter-party risk, as the underlying security is held by the FII in its own name. This is a contractual arrangement and the FII need not actually buy or sell that security. However, in that case, the risk remains with the FII.

Which securities can be bought through P-Notes?
Any listed securities, debt, derivative contracts like futures and options, securities of unlisted firms which are planning to get listed, including shares of companies floating IPOs, can be bought.

Why should there be a problem for tax authorities regarding taxing P-Notes?
There was apprehension on whether P-Note holders could be taxed twice, first, by Indian authorities as they (FIIs) buy and sell Indian securities and again by P-Note holders’ home tax authorities. The fears emanated from the thought that if anti-avoidance measures were invoked and the treaty benefits denied to PN-issuing FIIs, they would have to pass on the liability to the holder. Though the finance minister has tried to allay concerns by clarifying that tax authorities will tax FIIs and not P-Note holders, a consensus view can only emerge once the Budget proposals are formalised. The formal language of the law, however, is expected only in May, effective however, from April 1, 2012.

Other unanswered questions are what happens when there is a loss on the books of the FIIs relating to transactions on behalf of P-Note holders or if P-Note holders are taxed directly by Indian tax authorities (which should not be P-Note issuing FII’s headache), how will they be allowed to offset the loss?
However, what still stymies the comfort is that the FM had said, “The IT Department would examine the tax liability of FIIs”. Which means, while the ODI holder may not be taxed, there could be some burden imposed on the counterparty FII. In case of the FII issuing the P-Notes, the main concern that arises is whether the GAAR provisions can be used to deny treaty benefits to the FII in respect of the underlying hedge on purchase/disposition of Indian securities.

What is the current status about writing fresh P-Notes?
According to a note from Nishith Desai and Associates, most FIIs have restricted their ODI issuances. They seem to be taking the stance that contractually, the risks (including that of any taxes) should lie with the P-Note holder. A combined reading of the FM’s statements and the proposals under the GAAR lead to a perception (albeit not a consensus view) that while indirect transfers / redemptions of P-Notes may not be taxed in India, GAAR provisions could challenge the FII structure in the ODI mechanism. Under such circumstances till the Budget is approved and clarity obtained, most FIIs could limit the issuance of ODI.