Foreign portfolio investment inflows through participatory notes (P-Notes) in March rose to the highest level in four months before a new rule aimed at curbing tax avoidance took effect on 1 April.
Inflows via P-Notes rose to Rs1.78 trillion in March from Rs1.70 trillion in February. It was at Rs1.75 trillion in January and Rs1.57 trillion in December. As a percentage of total inflows from foreign portfolio investors (FPIs), it, however, was unchanged from February’s 6.6%.
P-Notes are offshore derivative instruments (ODIs) that are issued by registered FPIs to other overseas entities that are looking to invest in Indian markets without getting registered directly.
The flows via the controversial P-Note route have been reducing because of stricter regulations by Securities and Exchange Board of India (Sebi) and renegotiated tax treaties, and was expected to remain weak in 2017.
“It was expected that some of the P-Note subscribers would stock up their position to enable grandfathering under GAAR provisions,” said Suresh Swamy, a partner at PwC in India.
Grandfathering refers to the application of old rules on transactions concluded before a new rule is effective—in this case, 1 April.
After GAAR, foreign investors would need to prove that a structure is not aimed at evading taxes, as GAAR gives the tax department powers to scrutinize transactions that are structured in such a way as to deliberately avoid paying tax. Failure to establish that a transaction was not structured to evade taxes means investors will have to cough up 15% tax on equities and 30% on equity derivatives. Investing via P-Notes results in a lower tax liability of 7.5-8%.
GAAR is ensuring that P-Notes remain relevant, when they had been steadily losing ground owing to strengthened regulatory requirements, but also making newer jurisdictions seem more attractive.
In 2016, the tax treaty between India and Mauritius was renegotiated, under which India will get to tax capital gains on investments made through the island republic—a move aimed at curbing tax evasion, round-tripping and other treaty abuses. Similarly, in December 2016, the tax treaty between India and Singapore, another tax haven, was renegotiated.
With the Mauritius and Singapore routes no longer advantageous, foreign investors are looking to invest in India through Sweden, France, South Korea, Spain and the Netherlands, where existing treaties still allow them certain benefits.
“As we move forward and adapt to GAAR and renegotiated treaties there may be increased interest towards the P-Note route owing to the lower tax liability. More so, jurisdictions which still enjoy treaty benefits and hold some substance may become the routes through which majority of foreign money may find its way in India,” said Swamy.
According to Sebi data, 37 FPIs have outstanding ODI positions, out of which 66% of flows came to India via Singapore and Mauritius as of December-end.