Over the last financial year, India has witnessed several changes in the taxation regime for investments – from changes to the bilateral tax treaties that India had with countries like Mauritius, Singapore; to the General Anti-Avoidance Rules (GAAR) being effective from April 1, 2017.
These changes have also impacted several investors who had exposure to Indian securities through Offshore Derivative Instruments (ODI) commonly known as participatory notes (P-Notes). P-Notes are derivative instruments issued by Foreign Portfolio Investors (FPIs) which provide an opportunity for overseas investors to invest in the Indian capital markets, without being regulated directly by Securities and Exchange Board of India (SEBI). P-Notes are have been the preferred corridor for foreign investments due to advantages like:
- Simplified investment route with minimal administration and compliance requirements,
- Capital gains tax exemption under certain treaties,
- No registration with the Indian regulator/tax authorities.
Dwindling Investments Via ODIs
The total value of P-Notes as a percentage of assets under custody by all FPIs was on an upward trend from the year 2003 to 2007. The highest share was 55 percent in the year 2007. Amidst concerns over possible misuse of the ODI investment route for round-tripping and money laundering, SEBI has frequently tightened regulations relating to the issuance of ODIs. This is also evident from the recent SEBI board meeting on April 26, 2017, where it reiterated the fact that that resident and non-resident Indians can neither subscribe to ODIs nor can entities beneficially owned by them do so. A specific change in the FPI regulations will be made to this effect. The Special Investigation Team (SIT) constituted by the government is providing many recommendations to tighten the rules around the issuance of ODIs. Some of the stringent measures undertaken by the SEBI include:
- Identification of beneficial owners,
- Prior permission for transferring of ODIs,
- Reporting of complete transfer trails of ODIs.
The P-Note exposure has consistently declined from the 2007 level and is currently at 6.6 percent of the assets under custody for FPIs.
Direct Investment Versus Investments Via P-Notes
The government has been keen to have investors invest directly rather than through structures where the details of the end-investor or beneficial owner could not be identified. The government has also been taking steps to simplify the registration processes, tax regime for FPIs to encourage direct investments.
Tax certainty is critical for investment funds. Past controversies – on the applicability of MAT provisions, the impact of overseas transfer provisions, reassessment notices – have kept investors wary of direct investments in India.
GAAR and overseas transfer related tax provisions should not apply to the overseas investors investing via P-Notes.
Though GAAR provisions may apply to P-Note issuers, investors may decide in favour of investing indirectly through P-Notes by paying a marginal cost to the P-Note issuer, after weighing the pros and cons, just to avoid any unforeseen tax controversy in India.
ODI Issuers' Business Nuances
A majority of P-Note issuers hedged their positions through favourable tax treaties until those treaties were renegotiated. With the treaty changes, India gets the right to tax capital gains on shares, which were earlier exempt. This results in P-Note issuers facing a lot of challenges ascertaining the exact tax cost attributable to each investor. The primary challenge is that of tax computation on first in first out basis to be followed at P-Note issuer level. Other challenges include different tax rates for short term and long term capital gains, allocation of benefits due to losses amongst the investors, and the risk of currency fluctuation.
Since the large issuers have a presence in several parts of the world, some of them may consider hedging their positions through some European countries that continue to provide capital gains exemption on shares.
Dilemma Faced By Investors
Product offerings are not standard amongst issuers. Based on their cost composition, there are various deals being offered to lure investors.
Some issuers may offer to pass on the full tax benefit to their investors whereas others may want to apply a fee to recover the taxes calculated - at a flat rate for long term/short term capital gains on shares. A few may offer no tax for transactions in derivatives, while others may provide a benefit of carry-forward loss for a certain period. In cases where capital gains tax has been paid in the early part of the year and then investor makes losses towards the later part of the year, there would be discussions on whether or not one should allow a carry-back of losses (within the same year or over different years). A few P-Note issuers may look to clean up their books and insist that shares acquired prior to April 1, 2017 - grandfathered stock - be disposed-off within a specified period of time.
None of these may be directly comparable resulting in a dilemma for the investor.
No tax liability on investment by way of P-Notes on futures and options still remains the biggest factor which may influence investors to go for the P-Note route and not direct investment. To summarise, factors which need to be considered are:
- Tax recovery rate for P-Notes on equity (short term and long term), futures, options, debt;
- Set-off of losses in the same year;
- Carry-forward of losses to future years;
- The quantum of long term holding (more than 12 months and therefore tax-free) and otherwise.
Last but not the least, all issuers are revisiting the tax indemnity clauses in such arrangements. Although investors have been specifically excluded from the GAAR, it is likely that if the issuer does not satisfy the GAAR requirement and taxes are payable in India, the same will be passed on to the investor. This could be one situation where a tax indemnity will play a critical role for the issuers to ensure that they are not out-of-pocket.
As India is one of the fastest growing economies in the world which still has enormous growth potential, foreign investors are keen to continue their bet on the Indian markets. Taking into account the changing environment, one would need to wait and watch for the trend in investor preference: whether to invest through P-Notes or start direct investing through the FPI route.
Bhavin Shah is Partner & Tax Leader - Financial Services; and Sneha is Associate Director at PwC.
The views expressed here are those of the authors' and do not necessarily represent the views of Bloomberg Quint or its editorial team.
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