Asset managers who invest into India via P-notes have been warned they may face costs passed down by issuing dealers, despite recent assurances from finance minister Pranab Mukherjee.

Many managers gain exposure to Indian equities through participatory notes, issued by financial institutional investors (FIIs), such as investment banks and brokerages incorporated in Mauritius, to mirror the performance of underlying securities.

Under the Direct Tax Avoidance Agreement (DTAA) that India signed with Mauritius (and 81 other countries), any capital gains or dividends that investors collect from investing in Indian securities will not be subject to short-term capital gains tax, which currently stands at 15%.

At the same time, an FII which obtains gains from back-to-back hedges on underlying securities in the P-note it has issued, is also not subject to capital gains tax.

However, in response to the proposed General Anti-Avoidance Rule (GAAR), the implementation of which has been deferred until fiscal 2013, concerns have been raised about potential tax liability for P-notes. 

In an attempt to allay these fears, finance minister Pranab Mukherjee told India's parliament on May 7 that P-note holders would not be taxed under GAAR. “Tax will be levied only at the FII level, subject to treaty benefits,” he said.

But Gautam Mehra, executive director of tax and regulatory services at PwC in Mumbai, notes that a lot of the P-note holders are short-term players, such as hedge funds.

“If an FII that issues the P-note has an underlying Indian position, the FII would pay that tax when they exit that position," he says. "They would then pass the 15% capital gains tax back to the P-note holder [via net returns] if the GAAR is invoked on FIIs."

The market is eagerly awaiting updated guidance from the government on GAAR implementation. On the taxability of P-notes, Mehra says the government is set to issue a separate clarification, although a timeline has not yet been laid out.

According to the Securities and Exchange Board of India, in March the total notional value of P-notes issued on equities and debt stood at $21.1 billion, or 10.4% of all FII assets under custody.

But P-notes are not the only instrument that could be affected by the GAAR proposals. Under the indirect transfer of assets rule, which will become effective this financial year if the latest finance bill becomes law, the redemption of fund units could be liable for multiple taxations on profits.

That rule would see Indian authorities imposing tax on capital gains arising from the transfer of shares or interest in an offshore company if they derive substantial value from assets located in India. It is proposed that this rule be applied retroactively to April 1, 1962.

It is understood that, on redemption, the government may levy tax based on the indirect transfer rule, leaving FIIs to withhold tax prior to remitting money to investors.

Karthik Kumar, counsel at Jones Day in Singapore, says as the finance bill stands India’s indirect transfer rule is very broad in its application. Hence the market is awaiting guidelines to clarify the tax authority’s position on cross-border portfolio investments in Indian securities.

“There has not been clarification on what constitutes ‘substantial value’," he points out. "The question people are asking is, 'If you hold an instrument that holds just 5% of a company that ultimately derives its assets in India, would that 5% be considered substantial value?' Or whether it should be up to at least 50% interest in the Indian company, a threshold that would be in alignment with the OECD Model Tax Convention?" 

The convention allows indirect tax to be levied on the sale of an offshore holding firm’s shares only when those shares derive over 50% of their value from real estate assets in that jurisdiction.