Participatory Notes

Stricter compliance may eventually make P-Notes unviable…

Regulating Participatory Notes (P-Notes) is nothing new. Back in 2007, an attempt by the Finance Ministry to curb P-Notes resulted in the indices touching the lower circuit. Later in 2012, the markets were spooked by the likely introduction of GAAR and again resulted in large-scale value destruction. Not surprisingly, SEBI is treading a lot more cautiously on the P-Notes front. Here are the key issues to understand…

The lure of P-Notes…

 The biggest lure of P-Notes has been its simplicity. Let us say, an endowment fund in the US wants to invest in India without the regulatory hassles. They can approach a large Foreign Portfolio Investor (FPI) like Credit Suisse, Morgan Stanley or Goldman Sachs who will help them to participate in Indian markets through P-Notes. So, the endowment fund does not need to register with SEBI and go through the legal and compliance process in India. The same will be done by the FPI on behalf of the endowment fund. This was a preferred vehicle for many global investors.

Taxation and end-beneficiary…

Recently, SEBI has announced 2 key changes which could have serious ramifications for the issue of P-Notes in Indian markets. Firstly, there is the issue of taxation of capital gains. As per the amended DTAA with Mauritius, India will get the privilege of taxing capital gains of FIIs from Mauritius effective April 2017. Capital gains complicates the issue of P-Notes as the FPIs will now have to pay tax on capital gains which will have to be charged to the end investors. This will reduce the effective returns on P-Notes and reduce their sheen. Secondly, SEBI also stipulates that FPIs be aware of the final beneficiary. Normally, FPIs are aware of their immediate P-Note client which is regulated by their onshore regulator. Now SEBI is insisting that FPIs maintain an audit trail of subsequent owners of the P-Note and also take the responsibility of reporting any suspicious transactions that they come across.

Where do P-Notes go from here?

It needs to be remembered that P-Notes as a percentage of total FPI inflows have fallen from 50% in 2007 to just about 10% currently. Imposition of capital gains tax and end-beneficiary compliance will further reduce the attractiveness of P-Notes. Since the year 2014, SEBI has substantially relaxed the process of FPI registration, which will be another disincentive for global investors to adopt the P-Note route. The regulator has long been skeptical of P-Notes due to their potential for misuse in round tripping of funds. As FPI registration becomes simpler and more transparent, global investors may not see any advantage in the P-Note route. It would be better to let it fade away naturally as they become increasingly unviable. ©

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