Budget impact: FPIs may look at P-notes for making investments in India

P-Notes. Illustration: binay sinha
Foreign portfolio investors (FPIs) may look at participatory notes (p-notes) for making fresh investments in India, to sidestep the additional surcharge levied in the Budget.

The Centre ruled out a rollback of the “super-rich” tax on FPIs, organised as trusts or association of persons, last week. This could affect 40-50 per cent of FPIs. Of those likely to be impacted by the surcharge, 10-15 per cent may route their new investments through p-notes, said experts.

P-notes are issued by foreign institutions that are typically companies. This is one way to plan around the surcharge hike, as the underlying is a corporate structure,” said Girish Vanvari, founder of Transaction Square.

P-notes are issued by registered FPIs to overseas investors who wish to invest in India without registering themselves directly with the Securities and Exchange Board of India. Regulatory changes have made this route unpopular among investors over the last two years, with their overall share as a percentage of assets under custody (AUC) of FPIs declining to under 2.5 per cent, from close to 50 per cent a decade ago.

Prominent P-note issuers include JPMorgan, Citi, Morgan Stanley, Deutsche Bank and Goldman Sachs.

Investment through P-notes does not amount to direct ownership of equity, which could deter a few investors from choosing this route.

“It’s a limitation, and majority of the collective investment funds — such as pension funds and mutual funds — will be in favour of direct investment rather than entrusting money to another entity,” said Vanvari.

Investors will have to incur additional costs by way of fees to the issuing entity. Further, existing norms do not allow category-3 FPIs to take this route.

“There are restrictions that will limit the flexibility for trusts to use the P-note route. For instance, the issuing FPI entity cannot invest in naked derivatives. So, this route is ruled out for FPIs focusing more on investing in derivatives,” said Punit Shah, partner, Dhruva Advisors.

A substantial number of FPIs, therefore, may route fresh investments through corporate structures in countries such as Mauritius, Singapore and France, to bypass the additional surcharge.

Such arrangements, however, could come under the ambit of the domestic general anti-avoidance rules (GAAR), unlike those made through P-notes.

The effective long-term capital gains tax rate for FPIs operating as trusts and earning Rs 2-5 crore has risen from 11.96 per cent to 13 per cent. For those earning over Rs 5 crore, it has risen to 14.25 per cent.

For short-term capital gains, the effective tax rate has risen from 17.94 per cent to 19.5 per cent for those earning Rs 2- 5 crore, and to 21.37 per cent for those earning over Rs 5 crore.

The effective tax rate on short-term gains from unlisted securities and derivatives will be 39 per cent for the Rs 2-5 crore bracket, and 42.74 per cent for the above Rs 5 crore bracket.

Globally, most MFs and pension funds are organised as non-corporate vehicles (specifically trusts) as they represent interests of small investors and invest for the long term. 

According to experts, there is no ground to tax FPIs organised in different legal forms in their home country, on a differential basis.

“Increasing the surcharge on non-corporate FPIs will hurt the FPI funds set up as trusts and inadvertently discriminate against some jurisdictions over others for the same activity,” said Asia Securities Industry & Financial Markets Association, an industry body for FPIs.

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