The popularity of the controversial offshore derivative instruments known as participatory notes, or P-notes, may not fade away just yet. If fact, the use of this instrument is set to rise from current levels after finance minister Pranab Mukherjee on Friday said these would not be taxed in India.
Although the statement was to clear the air on the General Anti Avoidance Rule (GAAR) to be implemented from April, it will encourag foreign investors to use P-notes to invest in India, as it may prove more tax-efficient, say experts.
Foreign institutional investors (FIIs) were worried P-notes would be targeted by taxmen, post-implementation of GAAR, as these instruments have been under the scanner for long due to their opaque nature. Under GAAR, which intends to crack down on tax evasion, the onus is on companies to prove they are using a specific structure for commercial purposes and not to avoid tax. Taxmen can question claims of companies and FIIs. This was not the case till now if a tax residency certificate was presented.
According to former finance minister Yashwant Sinha, any tax concession for P-notes will increase its use by FIIs and thereby encourage round-tripping (transactions in assets meant to avoid tax).
“The FM is running with the hare and hunting with the hounds,” said Sinha. “On the one hand, he (FM) talks about crackdown on black money and on the other, he says that P-notes would be exempt from tax. This is very unfortunate.”
Currently, FII exposure to stock markets through P-notes stood at Rs 1,83,151 crore or 16.4 per cent of the total assets of Rs 11.15 lakh crore under management in February. This leaves ample room to issue more P-notes.
Experts say that along with hedge funds, major pension funds and mutual funds from foreign countries will resort to P-notes as it may prove tax-efficient. While there is no long-term tax on capital gains from trading in equities, the short-term tax is 15 per cent (if shares are sold in less than a year).
Tax lawyer Anil Harish, a partner with Mumbai-based D M Harish & Co. said, “Exemption of P-notes from tax will only create trouble as their use will rise. When you give concessions to an instrument, it becomes a preferred vehicle and regulators have often tried to discourage the use of P-notes.”
P-notes came under the lens of taxmen and the Securities and Exchange Board of India (Sebi) due to the difficulty in ascertaining the ultimate beneficiaries of these instruments. In 2007, it was discovered that 60 per cent of FII exposure to the Indian market was through P-notes. To limit their use, former Sebi chairman C B Bhave had put a cap on its issuance by FIIs. Sebi had stipulated that FIIs could issue P-notes for only up to 40 per cent of their entire assets under management.
“I’m not against the use of P-notes, but Sebi is yet to devise a mechanism to track the ultimate beneficiaries of these instruments and black money holders continue to operate from behind a smoke-screen. In such a scenario, if P-notes are exempt from tax its use will go up and the FM cannot take credit for introducing an unadulterated GAAR,” said Sinha, a leader of the opposition party, BJP.
According to Saurabh Mukherjee, head of institutional equities at Ambit Capital, the premiums charged on P-notes will go up in the coming days as FIIs step up the use of this instrument. Large players issuing P-notes include Morgan Stanley, Merrill Lynch, Citigroup, Goldman Sachs and CLSA.
