The Securities and Exchange Board of India (Sebi)'s recent action to tighten participatory note (P-note) norms, on a lighter note, is an extension of the Prime Minister's Swachh Bharat mission to the capital markets.
Over the years, offshore derivative instruments (ODIs), commonly known as P-notes, have become an important mode for accessing Indian markets. P-notes are instruments issued by foreign portfolio investors (FPIs) to foreign investors who wish to take exposure in underlying Indian securities but without registering themselves with Sebi.
Prominent ODI issuers have set up bases in countries such as Mauritius and Singapore, as India's treaty with these countries offered capital gains tax exemption.
Amid concerns of possible misuse of ODI structures for routing illicit money into India, Sebi recently tightened the Know Your Customer (KYC) norms, issuance/subscription and reporting norms for ODIs. Clearly, the cost and effort to comply with these norms will increase manifold.
Sebi's press release was silent on the transitional provisions. Presumably, the regulation, as and when amended, will provide an appropriate grandfathering of existing ODI.
Interestingly, the new ODI norms have been introduced at a time when India has also renegotiated its tax treaty with Mauritius. India will have the right to tax capital gains arising from transfer of shares of an Indian company from FY17. Capital gains on investments in shares made before April 1, 2017, however, might continue to be tax exempt, regardless of when they are sold.
There is no doubt that these developments will affect the P-note issuers. The cost of tax will have to be factored in in the P-note arrangements. This would make such arrangements not only costly but also less lucrative for investors, as their returns will be curtailed by the tax component.
ODI issuers will also have to deal with the practical challenge of allocation of tax cost. Long-term capital gains (shares held for one year or more) on sale of listed shares in the hand of the shareholder is not chargeable to tax in India. The ODI issuer could hold the underlying security for more than one year. However, P-note holders might not necessarily have open positions for the corresponding period. They might actually move in and out of the security more frequently. What further complicates the matter for a P-note issuer is that the Indian law mandates computing tax on FIFO basis.
Also, consider what may happen to P-notes issued during the interim period of April 1, 2017, to March 31, 2019. If a P-note holder unwinds within 12 months in that period, there will be a tax cost of 7.5 per cent of the gains. However, if he unwinds after March 31, 2019, but within 12 months of subscription, his tax cost will be 15 per cent of the gains. P-note issuers might, therefore, want to factor in the appropriate short-term capital gains tax before passing on the gains to the holder.
They will face a huge challenge to make sure that they are not out-of-pocket yet remain competitive in the market. Another option, but not such an easy one, for such issuers may be to look for other treaties that provide for complete capital gains exemption.
In a nutshell, P-notes might eventually lose their sheen as it becomes more costly and onerous to comply with new regulations. Smaller subscribers wanting to limit their exposure to India could continue with P-notes, but other players seeking greater exposure to Indian markets may prefer to register directly with India. And that is what Sebi ultimately wants.
Over the years, offshore derivative instruments (ODIs), commonly known as P-notes, have become an important mode for accessing Indian markets. P-notes are instruments issued by foreign portfolio investors (FPIs) to foreign investors who wish to take exposure in underlying Indian securities but without registering themselves with Sebi.
Prominent ODI issuers have set up bases in countries such as Mauritius and Singapore, as India's treaty with these countries offered capital gains tax exemption.
Amid concerns of possible misuse of ODI structures for routing illicit money into India, Sebi recently tightened the Know Your Customer (KYC) norms, issuance/subscription and reporting norms for ODIs. Clearly, the cost and effort to comply with these norms will increase manifold.
Sebi's press release was silent on the transitional provisions. Presumably, the regulation, as and when amended, will provide an appropriate grandfathering of existing ODI.
Interestingly, the new ODI norms have been introduced at a time when India has also renegotiated its tax treaty with Mauritius. India will have the right to tax capital gains arising from transfer of shares of an Indian company from FY17. Capital gains on investments in shares made before April 1, 2017, however, might continue to be tax exempt, regardless of when they are sold.
There is no doubt that these developments will affect the P-note issuers. The cost of tax will have to be factored in in the P-note arrangements. This would make such arrangements not only costly but also less lucrative for investors, as their returns will be curtailed by the tax component.
ODI issuers will also have to deal with the practical challenge of allocation of tax cost. Long-term capital gains (shares held for one year or more) on sale of listed shares in the hand of the shareholder is not chargeable to tax in India. The ODI issuer could hold the underlying security for more than one year. However, P-note holders might not necessarily have open positions for the corresponding period. They might actually move in and out of the security more frequently. What further complicates the matter for a P-note issuer is that the Indian law mandates computing tax on FIFO basis.
Also, consider what may happen to P-notes issued during the interim period of April 1, 2017, to March 31, 2019. If a P-note holder unwinds within 12 months in that period, there will be a tax cost of 7.5 per cent of the gains. However, if he unwinds after March 31, 2019, but within 12 months of subscription, his tax cost will be 15 per cent of the gains. P-note issuers might, therefore, want to factor in the appropriate short-term capital gains tax before passing on the gains to the holder.
They will face a huge challenge to make sure that they are not out-of-pocket yet remain competitive in the market. Another option, but not such an easy one, for such issuers may be to look for other treaties that provide for complete capital gains exemption.
In a nutshell, P-notes might eventually lose their sheen as it becomes more costly and onerous to comply with new regulations. Smaller subscribers wanting to limit their exposure to India could continue with P-notes, but other players seeking greater exposure to Indian markets may prefer to register directly with India. And that is what Sebi ultimately wants.
The author is partner, tax (financial services), PwC India. Contributions from Siddharth Ajmera, associate director; and Ketki Shah, associate