Pause before P-Notes

The post-budget uncertainty over taxation of participatory notes (P-Notes) remains unresolved. In the past few days the market may have breathed a bit easier after the Finance Minister told the media that there could be no question of tax liability in India for the P-Note holder. However, the implications of the budget proposals are far-reaching and greater clarity is required.

An offshore contract

P-Notes are ‘offshore derivative instruments' that signify a contractual arrangement executed outside India between the P-Note holder and the FII issuing it.

They are meant for investors looking for exposure to the Indian capital market. The FII is contractually obliged to provide a return that is linked to the performance of the specified security.

This financial instrument is especially useful for a significant number of investors who are not registered as FIIs with the Securities and Exchange Board of India; it gives them access to such superior returns that these Indian securities may generate.

Typically, the P-Note holder has no ownership rights in the specified security. Though the performance of the P-Note is linked to the performance of the specified security, the FII issuing it is not obliged to hold the security.

Where the FII holds the security, it is on its own account and in accordance with its risk-taking ability. Further, in some cases the return to the P-Note holder is net of taxes incurred, if any, by the FII from hedging .

Taxing assets in India

The understanding all along has been that as a foreign asset, the gains on transfer of P-Notes are not liable to be taxed in India. However, now an uncertainty has arisen due to the proposed amendments to the Income-tax Act, 1961 (Act) on two counts.

First, in an attempt to amend the Act retrospectively to tax Vodafone-like transactions, certain amendments have been proposed to significantly widen the ‘source' rule. These inter alia include amendment of section 9 of the Act, deeming any asset or capital asset that forms a share or interest in a company or entity incorporated outside India, as Indian if the share or interest derives its value substantially from the assets located in India. This raises worry as the return on P-Notes is linked to the performance of specified Indian securities, which are assets located in India and taxable here.

‘Impermissible avoidance'

The second area of worry is the introduction of the General Anti-Avoidance Rule (GAAR), which empowers the tax officer to declare as “impermissible avoidance arrangement” any arrangement whose main purpose is to obtain tax benefit and inter alia lacking in commercial substance. The P-Note holder may be affected, especially where the hedging entity of the issuing FII is located in a jurisdiction that has a favourable tax treaty with India for capital gains. GAAR proposes to override the tax treaties India has entered into with other sovereign nations. The proposed provisions are widely worded and onerous.

Further, the onus is on the taxpayer to prove that the provisions do not apply. This leaves the application of GAAR to the judgment of the tax officers. Further, the applicability would be determined only at the assessment stage, which typically creates a time lag. This results in uncertainty over the tax position for these instruments.

Wary foreign funds

Such uncertainties in tax positions could deter FIIs from issuing P-Notes and even lead to the unwinding of existing issuances, which could adversely impact foreign capital inflow to the Indian capital market.

It is worth noting that P-Notes are not unique to India and are prevalent in economies where direct access to the market is restricted; for instance, the Qualified Foreign Institutional Investor (QFII) regime in China, the Foreign Institutional Investor (FINI) regime in Taiwan, and the Investor Identification regime in Korea. Even as emerging market economies are vying for a share of the same pie, clarity and certainty on the issue of P-Note taxation will go a long way in reassuring the FII community and prevent an exodus of foreign capital from India.

(The author is Tax Partner and National Director — Financial Services, Ernst & Young.)

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