P-note investors may shift to derivatives

treaties.

“This has created a potential arbitrage for those investing in equity versus those investing through derivatives as the former’s short-term capital gains will be subject to tax at the rate of 7.5 per cent during the transition period of next two years and at the rate of 15 per cent after that,” said Siddharth Shah, partner, Khaitan & Co.

Hedge funds are the most likely category to make the switch to derivatives, believe experts. Many hedge funds, which are regarded as Category-III foreign portfolio investors (FPIs), are set up in Cayman Islands, which has no tax treaty with India.

“For derivative trades, short-term capital gains’ tax under Indian law is 30 per cent if they invest directly from Cayman. These funds are likely to continue to invest in derivatives through P-notes in view of lower tax costs that Pnotes offer,” said Suresh Swamy, partner, financial services, PwC India. While investors can look forward to tax arbitrage, General AntiAvoidance Rules (GAAR), which came into effect from April 1, will continue to govern tax treaties. To that extent, if the issuer is unable to show sufficient commercial substance in Mauritius, Cyprus or Singapore, its taxability could shift to India. “In this case, they could end up paying 30 per cent tax even for their income through F&Os,” observed Shah. In December last year, the market regulator relaxed the combined F&O position limit of stock brokers, FPIs, and mutual funds in equity derivatives to 20 per cent of the applicable market-wide position limit. This is expected to boost FPI participation in derivatives, including participation through P-notes.

The share of P-notes as a percentage of overall FPIs in Indian markets has declined to under seven per cent from over 50 per cent about a decade ago.

P-notes are issued by registered FPIs to overseas investors that want to invest in Indian stock markets without registering directly with the regulator.

The regulator is said to be looking at further tightening of norms for P-notes to address concerns by Special Investigation Team on black (unaccounted) money.