Finance minister Pranab Mukherjee made a pragmatic call in exempting participatory notes (P-notes) from taxes, after fears arose that the introduction of anti-avoidance rules would cause foreign institutional investors (FIIs) to go into sell mode. At a time when external accounts are stressed, the government would rather not cope with a large foreign exchange outflow. This is not the first compromise on P-notes. In 2007, when phasing them out was proposed, the government ultimately caved in — again under threat of a mass FII exodus. However, dealing with P-notes should be about more than expediency. At least two P-note-related issues are central to notions of sovereignty. The first is, of course, a country’s right to impose taxes. This right need not, of course, be always exercised.
The other issue is, however, even more important. Every government has both the right and, to an extent, the obligation to know the identity of major economic actors. The very structure of P-notes is designed to negate assertion of that right. The instrument is designed specifically to maintain the holder’s anonymity. The rationale is as follows. An overseas entity cannot transact in Indian securities without registering at the Securities and Exchange Board of India (Sebi), thus revealing its identity. However, many hedge funds and private individuals wish to participate anonymously. So a registered FII buys Indian securities (rupee equity, bonds, or derivatives based on rupee assets) and creates a derivative called a P-note, based on those underlying instruments. P-notes are traded by anonymous entities, with all capital gains (or losses), interest, dividends and so on passing to the anonymous holder. FIIs report only net P-note exposure, so trade volume, cross-hedging, offsets and so on are all opaque to observers. There have been credible assertions made, thus, that P-notes are employed for round-tripping hawala money back into India. They are also a convenient route for laundering funds from other dubious sources. While the instrument exists in its current form, the authorities can only hope that FIIs maintain high due diligence standards.
In 2007, when Sebi had proposed P-notes be phased out, over half of FII rupee assets were held under such instruments. That proportion has declined. At end-February 2012, Sebi estimates, cumulative P-note exposure amounted to $36.6 billion, roughly 16.5 per cent of all FII assets. Between January and March 2012, FIIs pumped over $9 billion into Indian equities, along with $4 billion in debt. But only about $900 million of that is via P-notes. Until this fiscal, there was no tax advantage to prefer P-notes to the normal FII route. The sole advantage was anonymity. Now, with the introduction of the General Anti-Avoidance Rules, P-notes may also become more tax-efficient. This would be a policy absurdity — tax arbitrage under the new regime would promote more opacity! Surely other means can be devised to assure hedge funds and individuals of anonymity in transactions, while allowing Sebi, the Reserve Bank of India and the Indian tax authorities to trace them if required. So long as this wide open gateway to the financial markets exists, all the government’s pious assurances of tightening the tax regime and taking steps against laundering will ring hollow.