Participatory notes dying slow death as government refuses to relent on GAAR

Written by Sunny Verma | Bijay Shankar Patel | New Delhi | Updated: May 3 2012, 08:31am hrs
Most FIIs have stopped selling the offshore derivative instruments after GAAR was announced in Budget

Participatory notes are set to die a slow death with the government refusing to relent on its proposals to tax them. Finance ministry has told foreign institutional investors (FIIs), which sell P-notes to their overseas clients, that any short-term gains on these instruments would be taxed in India.

Officials said FIIs have been advised to pass on the post-tax gains to their P-notes clients. This means that tax impact will have to be ultimately borne by the P-note holder. Finance minister Pranab Mukherjee is expected to clarify on this on May 7 when he replies to the Budget debate in Parliament.

This, industry sources said, could mark an end to the issuance of P-notes. Most FIIs have already stopped selling P-notes, also known as offshore derivative instruments (ODIs), after the General Anti-avoidance Rules (GAAR) were announced in the Budget. P-notes are derivatives products issued to overseas investors who cannot directly invest in Indian stocks. These have stocks as their underlying. FIIs sell ODIs to overseas clients to enable them have an indirect exposure in the Indian stocks.

The government last year liberalised rules for investment in the Indian equities market by permitting a new class of investors qualified foreign investors (QFIs) to invest in India. QFIs comprise foreign individuals, foreign pension funds and foreign trusts, and can invest directly in stocks and mutual funds.

Officials note that ODIs would over time give way to QFIs. For ODIs, the finance ministry would clarify that the obligation to deduct tax, at the time of the holder redeeming the ODI, will be on the FII. In their presentations to the finance ministry, FIIs said such a proposal would kill the ODI product.

FIIs such as CLSA have stopped issuing fresh ODIs to their clients. FIIs such as CLSA, JPMorgan and Morgan Stanley have met finance ministry officials several times in the past month to present their views on GAAR.

To ease concerns of FIIs, the finance minister said last month that ODI holders will not be required to pay taxes in India, and that the income-tax department would examine the tax liability of the FIIs, virtually putting the onus of tax deduction on the FIIs.