A number of short-term investors such as hedge funds that gain exposure to Indian securities through participatory notes (P-notes) have temporarily exited the Indian market to avoid potential future tax liability that India’s proposed tax rules might cause to their portfolios. 

Some foreign institutional investors (FIIs) that issue these P-notes have made similar decisions. One example is CLSA’s move in March to hold back on adding new long positions for their P-note business due to fears that the proposed general anti-avoidance rules (Gaar) would compound potential tax liabilities for the firm.

Traditionally, regulators such as the Securities and Exchange Board of India (Sebi) have always preferred foreign investors in Indian stocks and fixed income to register with them as an FII, rather than taking the P-note route, say industry players. From a regulatory perspective, the ultimate identity of these P-note holders and the source of their money that ultimately gets invested in the Indian onshore market are opaque to them.

But the proposed Gaar has effectively put the Indian tax authority and the finance minister in a bind. Gaar seeks to impose a 15% capital gains tax on investment gains made within a 12-month period, if a transaction is deemed an “impermissible tax avoidance arrangement” lacking commercial substance.

Foreign investors had feared the government would use Gaar as a tool to clamp down on P-notes; while the proposed Gaar and indirect transfer rule – another anti-tax abuse rule proposed as part of the Finance Bill for 2012-2013 – have seemingly reduced FII activity on both the National Stock Exchange and the Bombay Stock Exchange in April and May.

According to data provided by investment bank UBS, average trading volume by FIIs in Indian cash equities between April 1 and May 21 fell 23% from the three-month period average between January and March this year. Foreign investor activity in derivatives – whose flow was mainly seen in index options, single-stock futures and index futures tracking the Nifty – was down 9% over the same period.

“In the derivative space, foreigners have always been more active in index options, single-stock futures and index futures as a means to hedge their positions, or as a result of running various index arbitrage books,” says David Rabinowitz, head of direct execution for Asian equities at UBS based in Hong Kong. 

As the cash market is still dominated by domestic retail flow, which accounted for 58.5% as at April, Rabinowitz says one should look more closely at foreign investors’ open interest levels within the derivatives market to understand FIIs' level of participation.

FII trading volume in the single-stock futures market, for example, was down by 36% in April and May compared to the first quarter of 2012, and that decline exceeded the 26% decline in the broader single-stock futures market. As a result, says Rabinowitz, one may assume that foreigners have indeed stepped back, due above all to the possible implications of the proposed tax rules.

In an attempt to further assure the market that P-note holders would not be targeted by the tax rules, finance minister Pranab Mukherjee told India's parliament in May that tax will be levied only at the FII level under the proposed Gaar. He also deferred the implementation of Gaar by one year to financial year 2013-2014, so that both investors and the tax administrators would have more time to prepare.

Still, those assurances and amendments have yet to yield the desired result. “We know of a number of our clients that were not prepared to carry the risks of future tax consequences on their portfolio, and that there are many other emerging markets where they could get the incremental alpha without the need to run the risk of future tax liability,” says Rabinowitz.

Other industry players say this exit from the Indian market is relevant particularly in the hedge fund space; and the flows related with the P-note customers, as they are more inclined to sell-off in a timely manner.

According to Sebi data, in March the total notional value of P-notes issued on equities and debt was at Rs115,332 Crores ($21.11 billion), or 10.4% of all FII assets under custody.

These hedge fund managers’ concerns are validated by tax advisers and lawyers, who say asset managers that use P-notes will likely end up shouldering the related cost passed down by the dealers who issue the instruments.

“If an FII that issues the P-note has an underlying Indian position, the FII would pay that tax when they exit that position,” says Gautam Mehra, executive director of tax and regulatory services at PwC in Mumbai. "They would pass the 15% capital gains tax back to the P-note holder if the Gaar is invoked on the FIIs."

This means that if the P-note issuer passes the related gains from the underlying Indian equity performance to the asset manager, that gain could be net of the Indian tax levied on the FII issuer.