Some foreign institutional investors (FIIs) are miffed by the exemption granted to participatory notes (P-notes) from the provisions of the General Anti-Avoidance Rules (GAAR) announced recently.
While FIIs and their sub-accounts investing in India through Mauritius and other tax havens may face the risk of being denied tax treaty benefits, if the offshore entity does not satisfy the “economic substance” test, P-note investors, who invest in the Indian markets through these FIIs, will be exempt without facing any such test.
P-notes are derivative instruments issued against an underlying security (shares or derivatives). These are issued by FIIs registered in India to overseas clients who may not be eligible to invest in the markets here. The holder of P-notes gains from the capital appreciation in the underlying shares.
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Smaller FIIs, which do not issue or buy P-notes, say the GAAR exemption is not in line with the regulatory and government policy, which have discouraged the use of P-notes over the years and is unfair to genuine investors who have played by the rules.
“What we learned quite quickly about the application of GAAR is that P-notes will not be subject to GAAR. We are FIIs and our investments are made by directly buying shares in the Indian markets. We have never used P-notes. For the last eight years, we have read that P-notes are undesirable; that P-notes are a conduit for black money and P-notes obscure the true beneficial ownership of Indian shares. Instead of using GAAR to help solve the P-note problems, it almost immediately clarified that P-notes would not be impacted. I believe this is a huge inconsistency and frankly, unfair to those of us who have taken the time and incurred the costs to be registered FIIs,” Seth R Freeman, chief executive officer, EM Capital Management, a California-based FII, said in an email response to queries on GAAR by Business Standard.
At least 1765 FIIs are registered with Sebi. Of these only a handful of big bracket firms dominate the P-note business. P-notes themselves accounted for only eight per cent of total assets held by FIIs as of April.
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Investors point out to prior government statements against P-notes, including putting new P-notes on hold a few years ago. In 2007, the Securities and Exchange Board of India (Sebi)had put restrictions on the use of P-notes for buying securities. However, these conditions were lifted in 2009. As late as May 2012, a white paper on black money prepared by the finance ministry said that P-notes could be conduits for illegal money. “Concerns have been raised that some of the money coming into the market via P-notes could be unaccounted wealth, camouflaged under the guise of FII investment,” the white paper said.
Sebi even tightened the norms for reporting by FIIs handling P-notes after the report. “To investors, policy inconsistency is as bad as vague announcements and flip-flopping,” Freeman added.
P-notes are used by relatively larger investors because the brokers require relatively large-value orders to cover the compliance and manpower costs that go with these. P-note investors are ready to pay these higher transaction costs as they avoid the costs and risks of being directly regulated by Sebi. This also helps them in quick entry and exits.
A senior official with another FII, who did not wish to be named, said registration with Sebi and regular reporting to them means FII investments should have higher status than P-note investors.
“Unlike P-note investors, FIIs have committed to being regulated by Indian authorities, obtain a PAN card and report under India’s tax regime. FIIs have an ongoing regulatory relationship with Indian authorities. With this high level of transparency and compliance it seems logical that registered FIIs and their sub-accounts would be the first named investor group to be immune from GAAR. Giving immunity to P-note investors must make all foreign investors question remaining a registered FII. Regulatory and GAAR-related tax risks and overheads are all lower being a P-note investor,” he added.
Added U R Bhat of Dalton Capital, “The actual P-note investor has nothing to do with India. The Indian tax department cannot tax him. The government will catch hold of people who it can. By saying we will not tax P-notes, the government is trying to make a virtue out of its inability.”