Majority of hedge funds junk participatory notes for direct FPI route

In July last year, Sebi issued a circular banning p-note holders from taking naked exposure to the derivatives market

The majority of hedge funds which came in through the participatory notes (p-notes) route have opted to register themselves directly as foreign portfolio investors (FPIs).

According to latest Sebi data, the notional value of p-note exposure to derivatives has dipped 91 per cent to Rs 50.72 billion as of November 2017, from Rs 557.8 billion in January.

In July last year, the Securities and Exchange Board of India (Sebi) had issued a circular banning p-note holders from taking naked exposure to the derivatives market. It said all existing positions would have to be squared off by the end of 2020 or date of maturity of the instrument, whichever was earlier.

According to experts, hedge funds with reasonable India exposure had started the process of (direct) registration within a few weeks of the Sebi circular. While the majority of hedge funds are going this way, a few have exited the market, given their insignificant dealings in Indian derivatives relative to their overall operations.

“With the enhanced level of regulatory restrictions and KYC (know your customer) requirements by the Sebi as also amendments in tax treaties, several foreign investors have discontinued their investments in the Indian capital markets through the p-notes route. In most cases, these investors have chosen to register themselves with the custodians as FPIs and make direct investments in India,” said Punit Shah, partner, Dhruva Advisors.

“The recently amended tax treaties continue to offer tax exemptions in respect of capital gains on F&O trading. Accordingly, these new FPIs which are registered in these jurisdictions would need to comply with the GAAR (General anti-avoidance rule), MLI (multilateral instruments) and POEM (Place Of Effective Management) regulations to avail the tax benefits,” he said.

The circular permitted hedging on the same stock on a one-to-one basis. This significantly reduces the possibility of using p-notes for taking derivative positions in India, particularly short positions. Therefore, many funds would prefer to invest directly into India through the FPI route, experts said.
 

For issuance of new p-notes with derivatives as the underlying product, a certificate has to be issued by the compliance officer (or equivalent) of the FPI. This must certify that the derivatives position, on which the p-note is being issued, is only for hedging the equity shares held by it, on a one-to-one basis. The said certificate is to be sent with the monthly p-notes report.

Experts say it would be easier for hedge funds based in European jurisdictions to register their own FPIs for derivative trades in India. This is because most European countries have tax treaties which exempt such entities from Indian tax on gains they make by trading in Indian derivative instruments. For hedge funds based in places such as Hong Kong or the Cayman Islands, the gains on Indian derivatives will be subjected to tax at 30-plus per cent. These will need to review the commercial viability of investing in Indian derivatives vis-a-vis the net returns from other jurisdictions.

“Direct registration for FPIs has become a lot smoother as the licence regime has eased out. The taxation regime for foreign investors has been clarified, incentivising direct investments rather than a p-note route,” said the senior official of an accounting firm, on condition of anonymity.

The share of p-notes as a percentage of overall FPIs in Indian markets has declined to four per cent, from over 50 per cent about a decade earlier.