GAAR implementation raises P-noteholder concerns

Author: | Published: 1 Aug 2012
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After the Union Budget 2012/ 2013 was announced, the influx of foreign institutional investors (FIIs) showed a slowdown as Participatory Note (P-notes) holders were worried that they might be taxed once the general anti avoidance rules (GAAR) were implemented. The Government of India (GOI) later clarified that the income tax department will not go beyond FIIs to check further details of the P-noteholders and therefore P-noteholders will not be taxed under the GAAR regime.

The implementation of GAAR was postponed for a year and will not now come into effect until the fiscal year 2013/2014. Despite this, and the government assurances, there are remaining concerns on whether FIIs will be taxed in relation to their whole investment, including those with P-notes, and whether such tax liabilities will be passed on to P-noteholders.

An instrument of the State

In the Union Budget 2012/2013, it was proposed that GAAR would come into effect on April 1 2012 to counteract aggressive tax avoidance. GAAR is an instrument under the Direct Tax Code 2010 (DTC) to address issues relating to tax avoidance and evasion. Under the new regime, transactions will be taxed based on the substance, instead of form, of the transaction. The onus is on parties to prove they are using a specific structure for commercial purpose and not simply to avoid tax.

The tax authorities can question the claims of companies and FIIs, and even deny tax benefits in cases where companies fail to prove the commercial purpose in using a structure under concern. Under the DTC, the term 'tax benefit' has been defined to mean: a reduction, avoidance or deferral of tax; an increase in a refund of tax; a reduction, avoidance or deferral of tax that would be payable but for a tax treaty; an increase in a refund of tax as a result of a tax treaty; or a reduction in the entity's tax base, including an increase in loss, in the relevant financial year or any other financial year.

A large proportion of foreign investment in the Indian stock market comes through companies registered in Mauritius, and they are exempted from tax under a double taxation avoidance agreement between India and Mauritius. These companies only need to satisfy a minimal residency requirement in order to be able to register with the Mauritius Stock Exchange. When GAAR is eventually implemented, a tax residency certificate (TRC) might not be enough for investors to be exempt from tax liabilities. Parties without substantial proof of their presence in Mauritius will be subject to tax under the DTC.

A P-note is a form of offshore derivative instrument that is issued by FIIs to parties who do not invest in the Indian stock market directly. These FIIs, or their sub-accounts, are themselves registered with places that are enjoying tax benefits and in turn they offer their buyers anonymity. Prior to implementation of GAAR, P-notes have not been subject to capital gains tax. In February 2012, P-notes accounted for 16.4% of total FIIs, with most of them routed via Mauritius.

Juhi Singh, a partner at S&R Associates, says: "Investors use P-notes to invest in India because they do not want to disclose their information. Now, under the GAAR regime, the disclosure of information becomes mandatory. This is completely against their intention as they invest in India."

When GAAR is eventually implemented, parties without substantial proof of presence in Mauritius will be subject to tax under the DTC

Genuine investors

P-notes have been criticised by the tax authorities as dominant instruments for investors to avoid their tax liabilities. Thus, when implementation of GAAR was proposed, P-noteholders were worried that they would be specifically targeted by the tax department. And there is a good case to tax P-noteholders as they derive their value from an underlying Indian security, and their hedges are carried out by the counterparty FII residing in a jurisdiction with favourable tax treaties with India.

Concern escalated when, in the same Union Budget, it was proposed that, under the Income Tax Act, the ability to deduct tax in respect of payments made for the purchase of capital assets would now apply to all non-residents, irrespective of whether they have any presence in India. Under the new tax regime, P-notes could be subject to a short-term capital gains tax of 42% and a long-term capital gains tax of 21%.

Singh says: "The government has a strong intention to stop the proliferation of P-notes. P-noteholders are very worried as they have not yet fully understood from the regulator what will happen to them now and in the future."

There were 1,772 FIIs and 6,341 FII sub-accounts registered with Sebi as on March 16 2012. On April 15 2012, the number of FIIs reduced to 1,768 while sub-accounts slightly increased to 6,343.

The GOI later clarified in April 2012 that it would not treat P-noteholders in a blanket manner, and thus the identity of P-noteholders would not be traced. In one interview, the finance minister was quoted as saying that "the purpose of the Indian government is not to cause any harassment to genuine investors. Indian tax authorities will examine the tax liability of FIIs, they won't go beyond the FIIs to check further details of the P-noteholders and therefore there is no taxing of P-noteholders".

But the problem is whether the tax liability of FIIs will be taxed in relation to their whole portfolio of investments, including those with P-notes. The FIIs might then pass on the tax liabilities to the P-noteholders, which would mean that they would still be taxed as they would be traced by the FIIs with whom they are registered.

Due to a strong reaction among foreign investors, on May 7 2012 the GOI announced that implementation of GAAR would be postponed by one year and would come into effect in fiscal year 2013/14. This decision was widely welcomed by investors as it granted them more time to restructure their deals in order to comply with the new tax regime. But the question of whether P-notes will be affected by GAAR after its implementation still needs further clarification from the GOI. It is also unclear at this point whether GAAR will affect transactions prior to its date of implementation (see also 'Implications of GAAR beyond prospective' in the Taxation chapter).

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