P-note issuers seek indemnity from GAAR provisions

Issuers of participatory notes, or P-notes, are asking their holders to take responsibility for any liabilities if the taxman comes knocking.

They are trying to make use of indemnity certificates, by which the users of P-notes would have to pay any taxes arising out of their investments in India through the P-note structure, after finance minister increased the scope of the tax-authority’s powers which could allow them to examine such structures.

Participatory notes are offshore derivative instruments (ODIs) used by foreign investors not registered with the Securities and Exchange Board of India to take an indirect exposure to Indian equities. These instruments are issued by registered foreign institutional investors (FIIs) or their sub accounts.

The finance minister in the Budget gave tax authorities wide ranging powers to examine and tax, indirect transfers as well as tax-avoidance structures based in countries such as Mauritius with which India has a tax treaty. Foreign entities fear tax authorities may use these powers to go after P-notes.

Siddharth Shah, head- funds practice, at Nishith Desai Associates, said issuers of P-notes are indeed looking to make use of indemnity certificates to protect against such a liability.

“The issuers of ODIs, because of the uncertainty over taxes, would want to pass on tax risk to the holders of the P-Notes. They wish to get over the uncertainty by using indemnity certificates,” he said.

Suresh V Swamy, executive director, tax & regulatory services at PricewaterhouseCoopers, said indemnities would be most effective if they are taken on by the parent company.

For example, consider a fund from a global asset management company which is the beneficiary of a P-note. If the fund is wound up, it would cease to have any assets, thus making it impossible to enforce the indemnity against any future tax demands. The indemnity would be much more effective if it was in the name of the parent.

“However, the parents don’t really want to issue an indemnity, so it becomes a difficult thing to use or enforce in the practical sense of the word,” he said.

The Asia Securities Industry and Financial Markets Association, a group which makes representations to various regulators and authorities on behalf of foreign institutions, wrote a letter to finance minister Pranab Mukherjee dated March 28.

It said GAAR (General Anti Avoidance Rule) provisions are very broadly worded and could be interpreted to tax FIIs which have assets under custody of more than Rs10 lakh crores (over $200 billion) or 17% of the capitalisation of India’s equity markets.

“If these tax uncertainties are not resolved quickly, we fear that FIIs will decide that the tax risks are unacceptable. These investors may then proceed to liquidate their India investments and such a disorderly dissolution of large positions held by these overseas investors could seriously disrupt the Indian capital markets,” said the letter reviewed by DNA.

The letter asked that indirect ownership of 10% or less of an Indian listed company should not be taxed under indirect transfer rules, in line with the Standing Committee’s recommendations that the indirect transfer rules should not apply to indirect ownership of “small shareholdings” of Indian companies.

Experts suggest that the tax on foreign institutions if interpreted as business income could run in excess of 42%, instead of the 15% under short-term capital gains. Shifting from Mauritius to Singapore, which was earlier seen as a way out of tax scrutiny, could also be taxed as it constitutes a transfer of assets.

“If GAAR provisions are invoked which disregards tax treaty, it’s up to the tax authorities to categorise the income as business income or as income from capital gains. In its current form, there are bound to be lots of challenges and representation from those affected. One needs to wait for detailed guidelines to understand the implications,” said C A Gupta, partner - direct tax at Deloitte Haskins & Sells.

The markets have shown a negative trend following the GAAR move in the Budget, amidst the uncertainty. The BSE’s Sensex, which is seen as a market barometer, has dropped 617.24 points or 3.49% since the provisions were announced. On Thursday, it closed at  17058.61.