P-note holders not liable to pay tax in India: FM

Written by fe Bureau | New Delhi/Mumbai | Updated: Mar 31 2012, 08:33am hrs
Page1Finance minister Pranab Mukherjee shakes hands with World Bank president Robert Zoellick at a meeting in New Delhi on Friday
Finance minister Pranab Mukherjee on Friday ruled out any potential tax liability in the country for foreign investors who use the participatory note (P-note) route to access Indian stocks and said that a clarification to this effect would be issued soon. His statement perked up the market but, according to many analysts, only reinforced the belief that he intends to nullify, in most cases, the tax advantage for investors coming through tax havens like Mauritius.

After two days of decline, the Sensex shot up 345.59 points on the last trading day of the quarter to end at 17,404.20.

The Indian tax authorities would examine the tax liability of the (foreign) institutional investors (using the tax haven route). However, the tax authorities would not go beyond the FIIs to check any further detail about the participatory notes holders, Mukherjee said. Accordingly, the question of liability for tax in India of (P-note holders) would not arise, he said. The minister, however, iterated that the income tax department would examine the tax liability of the FIIs.

From April 1, the General Anti-Avoidance Rule (GAAR) that is based on the substance over form doctrine will take effect. It will allow Indian tax authorities to go behind the legal structures created by foreign investors to invest in India despite the protective tax treaties and check if these lacked commercial substance. If the arrangement is found to be merely to camouflage the real purpose and avoid tax on capital gains, the investor could practically be deprived of the treaty benefit.

A sixth of all outstanding FII investment in Indian stocks are through the P-note route. Nine out of every 10 FIIs investing in India come in through one or the other tax haven and about half of the total FII investments is routed through Mauritius. FIIs have assets under ownership of more than R10 lakh crore or 17% of the capitalisation of Indias equity markets.

P-notes are issued by foreign portfolio investors registered with market regulator Sebi or by their sub-accounts, to investors overseas. The identities of the P-note holders are not revealed.

In the Budget, Mukherjee proposed GAAR in order to counter aggressive tax avoidance schemes, while ensuring that it is used only in appropriate cases, by enabling a review by a GAAR panel.

Over the past few days, the market had come to think that the GAAR could lead to harassment of foreign investors in India, especially because of the likely subjective element in its implementation. Friday's clarification by the FM hardly helps in removing the investors' fears. The fact remains that GAAR will allow the tax authorities to ask the investor to explain the rationale behind his Mauritius residency, said PwC's tax partner Rahul Garg.

UR Bhat, managing director, Dalton Capital Advisors (India), echoed this view. There are two components to the P-note debate. One is the P-note issuer who is an FII and the second is the ultimate beneficiary who uses this mode to route his investments. The ultimate beneficiary, it has now been clarified, is exempt. However, many FIIs whether P-note issuers or otherwise still suffer from huge uncertainties about their Indian tax status.

According to Rahul Bhasin, managing partner at Baring Private Equity Partners, which manges $1.3 billion in funds to invest in India, the features of the GAAR regime are opaque and they could impinge on the economics of all institutional foreign capital.

What is particularly worrisome about GAAR from the investors' perspective is that it practically puts the onus on the investor registered in a tax haven say, Mauritius to prove that the relevant arrangement is not merely aimed at obtaining a tax benefit. Also, the tax benefit in this case is defined rather widely to mean those as a result of tax treaty. The current norm that the treaty (which allows more benign tax treatment) will override the domestic law might get diluted with the invocation of GAAR.

While investors are jittery over how the Indian GAAR will pan out, the government has reiterated that it won't lead to harassment of genuine investors, a statement that doesn't mean much as in most cases the tax authorities could practically question the need for routing investments through tax havens citing the commercial substance doctrine.

GAAR gives the taxman the discretion to tax if he feels that the investment is routed through a Mauritius structure that has no substance and exists only to avoid paying tax. This is indeed the larger problem since it affects more than half the FII investments in India, whereas P-note holders account for just about a tenth of FII investments, said Bhat.

CII president B Muthuraman told FE: "FII investments have already slowed down and this is a bad thing (for the Indian economy). He said the industry had met the finance minister on this and the minister had agreed to have a re-look at some of the GAAR features. We are hopeful that the government will make the right decision," he said.

"On the face of it, GAAR looks very depressing, said R Shankar Raman, chief financial officer at Larsen & Toubro, India's largest engineering company. "Anything which is very subjective and not objective will not be looked at very positively."

Apart from GAAR, the proposal in the Finance Bill, 2012, to retrospectively amend the Income Tax Act to bring under the tax ambit offshore transactions that involve sale of underlying assets in India is also seen as a discomfiting feature by foreign investors. Goldman Sachs CEO Lloyd Blankfein on Thursday said called the retrospective amendment "unbelievable" and unfair and said that it would hurt India's image as a country where rule of law prevailed. There is, of course, a contrarian view that it is the prerogative of sovereign governments to change tax laws even retrospectively if need be. As tax systems are in a flux globally, such measures might be required, it is felt.