Participatory note paradox

Written by Sunil Gidwani | Sunil Gidwani | Updated: Jun 1 2008, 05:34am hrs
Over the last 6 months, Participatory notes (P notes) have taken a fair share of media space. Initially, it was the Sebi clampdown and recently it is the tax issue. P-note seems to start sounding like a problematic note rather than a participatory note.

What exactly are p-notes and why so much of fuss P-notes are essentially offshore derivative instruments (ODIs), issued to overseas investors by registered foreign institutional investors (FII). These instruments derive their value from the ownership of underlying shares in an Indian company. ODIs include P-notes, equity linked notes, capped return notes, participatory return notes, invest notes, etc. In the Indian context, P-notes and ODIs are used interchangeably.

It is a convenient, though expensive, route for foreign investors to take exposure to Indian securities without taking the trouble of registering with the market regulators. In some cases these investors may be forced to take this route as Indian regulators may not grant registration, though the investor may be willing to register (eg Hedge funds are not granted FII registration as they are not regulated in their home country). In such cases, the registered FII act as an exchange since it executes trade and uses its internal account to settle this.

Sebi, however, requires the FII to ensure that there is no further downstream issue or transfer of any P-notes to any person other than a regulated entity. FIIs are also required to file monthly reports with Sebi, which provides the details of the name and type of investor to whom P-notes have been issued.

It seems that Sebi is not very happy about P-notes because it does not have any system to know who owns the underlying securities and that it is concerned that non-resident Indians may be using the P-note route and round tripping investments into India. Sebi also fears that hedge funds acting through the P-notes route may cause economic volatility in Indias exchanges. In view of the above apprehensions, there was a major clampdown of the P-notes in October 2007. The recent media reports suggest that Sebi is reviewing its stand on P-notes and is considering relaxing the issuance of P-Notes.

The dust has hardly settled and when things are appearing to be returning to normal, the income tax department proposes to generate a storm by taxing P-note holders. There are various variants to a P-note, but the most common ones are a funded acquisition of P-Notes backed by underlying Indian securities and total return swaps, where an overseas investor enters into a swap agreement with the FII. The FII invests in Indian securities and issues P-notes to it. On redemption/maturity, the FII passes on the gains to the investor. As the FII holds securities, it may be subject to pay tax in India on any gain derived from such a transaction. However, FIIs registered in a tax-favourable jurisdiction, for eg: Mauritius, are not taxable in India in view of the India Mauritius tax treaty. As the FII discloses the gain in its return of income and validly claims the exemption, the gains should be considered as reported to the tax authorities in India and hence should not be considered again in the hands of the overseas investor.

One should also not raise the issue in such a case that the FII is not the beneficial owner of the share, since CBDT vide its circular issued in context of Mauritius entities has clarified that a TRC is a valid proof of residency as well as beneficial ownership.

However, in some of the offshore merger and acquisition deals, the tax authorities have taken a view that even if transaction has taken place outside India between two overseas investors, tax is payable in India as it amounts to transfer of controlling interest of an underlying asset situated in India. The matter is pending before appellate authorities/courts for adjudication. Apparently, applying the same analogy, tax authorities have started to examine whether P-notes can be taxable in India and whether FIIs should withhold tax while passing on the gain to P-note holders.

The tax implications of gains made on P-note trades would have to be carefully considered in the light of Indian domestic law and the tax treaty, which India has with the country of residence of P-note holders. The implications could vary significantly depending on the exact structure and cash flows of each P-note transaction and one cannot really apply one general principle of taxation to all the P-note transactions. For example, a funded transaction would stand on a different footing as compared to a non-funded one. Similarly, a P Note may be an uncovered one i.e. the issuer may not always hold underlying Indian securities. Such cases would have to be viewed differently as compared to the covered P-notes. Also, a situation where an issuer FII actually sells the underlying securities is very different from where it does not sell its securities in order to pay the P-note holder.

The approach adopted by the tax department would have a long-term impact on Indias ability to attract foreign capital. Tax authorities should therefore go slow on this issue. In the mean time investors may be advised to exercise caution in their dealings.

The author is executive director, PricewaterhouseCoopers