Controversial offshore derivative instruments (ODIs), commonly known as Participatory Notes (PNotes), are all set to regain their lost charm. Nearly four years after they were partially bannedby market regulator SEBI, PNotes will make a comeback in Indian stock market as Finance Minister Nirmala Sitharaman announced that the government will recognise “offshore derivative contracts” as valid.

According to experts, the statement means India was yet again allowing the full-fledgeduse of PNotes. The Budget documents further show that the reorganisation is subject to the instruments being issued via GIFT (Gujarat International Finance Tech-city); and the income distributed through PNotes to foreign players will be exempt. They also said this is a bigger move than double tax treaty exemption since it will allow FPIs to structure their taxes to virtually zero as GIFT City has no long- or short-term capital gains tax.

Foreign investors had patronised PNotes for 14 years between 2004 and 2018. At the peak, PNote-linked investments in India stood at around ₹4-lakh crore. But PNotes lost their charm after SEBI restricted its use and banned them completely in the derivatives segment.Currently, India is parched for foreign money in stock markets and allowing PNotes could act like steroids, experts say. On a net basis, the foreign portfolio investors (FPIs) sold Indian equities worth more than $20 billion in 2022. Tax arbitrage has forced FPIs to move to other jurisdictions.

Offshore havens

Originally, PNotes could be issued by foreign banks to clients anywhere in the world, guaranteeing them their equity holdings or derivative positions in India. But it was seen that majority of PNote-holders were from tax havens. Banks issuing PNotes were known to SEBI and the government, but the ultimate beneficiary of these instruments remained in the shadows, giving the holder a perfect cover from authorities. This obscure nature of PNotes facilitated round tripping of black money. But the instruments are making a come back with tighter norms, experts insist.

Gandhinagar-based GIFT, a International Finance Service Centre (IFSC), was created to compete with tax havens like Singapore, Mauritius and Dubai, which stole India’s equity market volumes.

“The Securities Contracts Regulation Act (SCRA) that governs stock markets in India, restricted GIFT-City domiciled bank branches from issuing PNotes. But it is a highly lucrative business to which SCRA was a roadblock. The proposed new changes will now enable banks to conduct the PNotes business. Significantly, the move will enable India to compete with Singapore and France,” said Suresh Swamy, Partner, Price Waterhouse & Co LLP.

According to him, PNotes will now have more checks and balances. “It is specified that the issuing entity has to be an FPI. Branches of foreign banks in IFSC should be able to obtain an FPI license for this business. Indian banks will not be allowed to issue PNotes. The Finance Bill also proposes exemption on income distributed on P-Notes to non-residents, which brings IFSC on par with leading overseas financial centres,” Swamy said.

PNotes could don a new avatar. “While PNote-holders will enjoy tax benefits and face enhanced reporting norms, it would be interesting to see how the government addresses the issue of identification of the ultimate beneficiary,” another expert said.

GIFT regulator

Sitharaman announced special powers to GIFT regulator IFSC Authority (IFSCA). “To enhance business activities in GIFT, the following measures will be taken: Delegating powers under the SEZ Act to IFSCA to avoid dual regulation, setting up a single-window IT system for registration and approval from IFSCA, SEZ authorities, GSTN, RBI, SEBI and IRDAI,” she said.

Effectively, IFSCA is likely to have powers to approve PNote-issuing FPI. “Any distributed income from ODIs entered into with an offshore banking unit is also proposed to be exempted subject to certain conditions,” Sitharaman said.

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