The use of the controversial offshore derivative instruments known as participatory notes (P-notes) in India's stock market is set to get a boost. This is after Finance Minister P Chidambaram on Monday specified that P-notes will be excluded from the General Anti-Avoidance Rules (GAAR), the implementation of which itself was postponed by two years.
GAAR, announced in Budget 2012-13, was perceived as a draconian law. It gave the taxman the much-needed alibi to target P-note investors and had spread a “reign of terror” among foreign institutional investors (FIIs). For many years, P-notes provided a perfect smokescreen to those who wanted to camouflage their identity. They were identified as an instrument to route black money and FIIs were worried the taxman would go behind them after GAAR was implemented.
Legal experts say the finance minister’s announcement that the tax authority will have to issue a show-cause notice to FIIs or companies before invoking GAAR provisions against them, has come as a major relief.
| ON A HIGH P-note investments in November rose to nine-month high | |||
| Total value of PNs (Rs lakh cr) | Total FII assets (Rs lakh cr) | PNs as % FII assets | |
| Jan - 12 | 1.51956 | 10.4313 | 14.6 |
| Feb - 12 | 1.83151 | 11.15648 | 16.4 |
| Mar - 12 | 1.65832 | 11.07399 | 15 |
| Apr -12 | 1.30012 | 10.93955 | 11.9 |
| May -12 | 1.28895 | 10.40547 | 12.4 |
| Jun - 12 | 1.29851 | 10.90359 | 11.9 |
| Jul - 12 | 1.29586 | 10.96492 | 11.8 |
| Aug-12 | 1.4171 | 11.13894 | 12.7 |
| Sep-12 | 1.466 | 12.19163 | 12 |
| Oct - 12 | 1.75829 | 12.219 | 14.4 |
| Nov - 12 | 1.77164 | 12.89612 | 13.7 |
| Source: Sebi: Note: Includes PNs on equity, debt and derivatives | |||
“Many foreign brokers issuing P-notes will increase their book size after the finance minister’s green signal. Though, I would restrict myself from saying that the finance minister has opened the flood gates for flow of foreign money via P-notes,” said Saurabh Mukherjea, head of institutional equities at Ambit Capital.
Added Nishith Desai, founder of Mumbai-based Nishith Desai Associates: “P-note structures are not aimed at tax avoidance, but essentially seek to provide an alternative means for exposure to Indian markets. Certainty on non-application of GAAR will definitely make P-notes more attractive to foreign investors. However, FIIs and sub-accounts of FIIs taking advantage of tax treaty benefits will be subject to the scrutiny of GAAR.”
Under GAAR, which intended to crack down on tax evasion, the onus earlier was perceived to be on companies to prove they were using a specific structure for commercial purposes and not to avoid tax. Taxmen could have questioned claims of companies and FIIs. This is not the case now, if a tax residency certificate was presented.
However, there is also a counter view. “Exemption of P-notes from tax will only create trouble as their use will rise. When you give concessions to an instrument, it becomes a preferred vehicle and regulators have often tried to discourage the use of P-notes,” said a senior Mumbai-based tax lawyer.
P-notes came under the lens of taxmen and the Securities and Exchange Board of India (Sebi) due to the difficulty faced in ascertaining the ultimate beneficiaries of these instruments. In 2007, it was discovered that 60 per cent of FII exposure to the Indian market was through P-notes after which former Sebi chairman M Damadoran banned these. P Chidambaram, the then finance minister, had advocated limiting the use of these instruments.
According to former finance minister Yashwant Sinha, any tax concession for P-notes will increase its use by FIIs and, thereby, encourage round-tripping (transactions in assets meant to avoid tax). Sinha said he was not against the use of P-notes, but Sebi is yet to devise a mechanism to track the ultimate beneficiaries of these instruments and black money holders continue to operate from behind a smokescreen. In such a scenario, if P-notes are exempt from tax, its use will go up and the finance minister cannot take credit for introducing an unadulterated GAAR, Sinha, a Bharatiya Janata Party leader, told Business Standard.
According to the latest data released by Sebi, the total value of P-note investments in Indian markets (equity, debt and derivatives) rose to Rs 1.77 lakh crore at end-November after falling to a near three-year low of Rs 1.28 crore in May. The November figure has reached the highest level since February, when the cumulative value of such investments stood at Rs 1.83 lakh crore. Short-selling through the use of P-notes was a major issue in the markets.
