Taxing P-Notes? Not just yet

The finance ministry has decided to keep the issue of taxing participatory notes (P-Notes) on the back burner to encourage foreign inflows.

These views follow a renewed effort by the Central Board of Direct Taxes to seek a clarification on the taxation of the P-Notes. Sources said the clarification was sought since it was noticed that the issuance of these notes had gone up, following buoyancy in the equity market.

"Even if the notes issued this year could not be taxed in this assessment year, the issuers could be taxed for the P-Notes issued last year, since the issuers in India remain more or less the same," said a source. The Income Tax Department had already sought data from the Securities and Exchange Board of India (Sebi) to this effect.

CBDT had proposed that the government should clarify that the original holder of P-Notes and not the issuer of these should bear the incidence of tax.

According to sources, in most cases, the P-Notes are issued from tax haven countries with whom India has a double tax avoidance agreement, or DTAA. By these DTAAs, the capital gains arising out of such instruments should be taxed either in India or the other tax haven country, where the capital gains tax is zero.

A tax haven is a country or territory where certain taxes are levied at a low rate or not at all. A P-Note is an offshore derivative instrument issued by investors based overseas but who want to have exposure in Indian markets. These investors derive their value from an underlying financial instrument, such as an equity share.

Taking advantage of DTAA, investors in countries where the capital gains tax is not exempt prefer to route the investment through tax haven countries, where capital gains is exempt, they added.

The I-T department, during its investigations, has found that the original holders of these P-Notes belong to countries where there is no DTAA, or capital gains tax is not exempt. Therefore, the department had urged the ministry to clarify that the original holder of P-Notes to whom the income is accruing should be taxed and not the issuer, which is usually a foreign institutional investor, bank or mutual fund based in a tax haven.

The CBDT had first suggested a clamp on P-Notes through possible taxation of such instruments in December last year. This year again, official sources said, the board renewed its effort by suggesting this specific measure.

Sources added that the Indian tax jurisdiction on foreign countries, which is in dispute in various cases, including the Hutch Vodafone one, is another reason which has delayed a decision. The government wanted to wait till a final decision was made, they added.