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Govt must clarify policy on P-note taxation
April, 06th 2012

The loss of the Vodafone tax case in the Supreme Court must have weighed on the mind of the Finance Minister when he fast-tracked the General Anti-Avoidance Rules (GAAR) originally part of the Direct Taxes Code in Budget 2012-13.

Though he had ring-fenced a repeat of Vodafone-type tax losses by amending Section 9 of the Income-Tax Act (and with retrospective effect too), GAAR was brought in as an additional measure to ensure that effectively all doors for tax evasion in the name of tax planning were closed.

A glance at the GAAR provisions was sufficient to raise concerns amongst the foreign institutional investors (FIIs) who effectively run the bourses in India that the one-time controversial participatory notes (P-notes) would be brought into the tax net.


GAAR can be invoked on any transaction that satisfies any of four tests the arrangement creates rights and obligations not normally created between parties dealing at arm's length, it results in misuse or abuse of provisions of tax laws, it lacks commercial substance or is deemed to lack commercial substance and is carried out in a manner normally not employed for bonafide purpose.

If one assumes that this was brought in 2007 and the acquisition of Hutch by Vodafone was on the table of the Assessing Officer, he would have wasted no time to refer the transaction under GAAR to the Commissioner.

An arrangement is said to lack commercial substance if, inter-alia, its substance differs materially from its form, it involves round-trip financing or an accommodating party (this must have got the FIIs worried) or it is a transaction conducted through one or more persons and disguises the value, location, source, ownership or control of the fund that is the subject matter of such transaction (this must have got the FIIs really jittery).


P-notes have been designed to ensure that anyone abroad can participate in the story of the Indian stock market through the back door. It soon became obvious that an entry through the back door would not involve detailed checks and balances.

Sensing this, FIIs came in hordes with the value of P-notes at one time reaching a high of Rs 1,48,000 crore. When the Securities and Exchange Board of India (SEBI) sensing that something was amiss closed the back door on October 16, 2007, the market tumbled. Though the door was re-opened in 2008, the allure was gone.

The new registration process for FIIs that SEBI formulated found quite a few takers. In the diaspora of international transactions, two significant players are the corporate world and the FIIs. These players can be segregated into two categories those who play by the book and those looking at the tax provisions with a microscope to identify tax minimising possibilities.

Those who play by the book invariably get a ruling from the Authority for Advance Rulings (AAR) on the tax impact of the transaction. The others remain mum till the taxman appears at their door.

There are quite a few similarities between Vodafone and a P-note beneficiary the beneficiary is located abroad, the underlying asset is in India and there is no clear provision in tax law about taxing transactions between the two.

The only difference could be the presence of a local facilitator in the case of the P-note beneficiary.

Adam Smith's canon of equity in tax laws would dictate that if the intention of the Government is to pursue Vodafone till all the tax due is in the treasury, P-notes should not be treated any differently. The intention seems unclear at present.


The Finance Minister may have secured temporary peace by stating that P-notes would not be subject to tax in India. Subtly, he has not said the same about taxing FIIs who are registered with SEBI but who operate out of tax havens such as Mauritius and the Isle of Man.

In case he does the same with the latter, GAAR provisions would remain on the statute book only in theory.

The dilemma that he is faced with is familiar in India he does not want to rock the boat of FIIs who are still interested in the India story by taxing them but at the same time, he wants his pound of flesh from those who indulge in round-tripping and circuit transfers.

History is evidence to the fact that the best decisions taken have been the toughest ones it is time the Finance Minister states unequivocally which side of the line he is toeing.

There could be some gyrations in the market but these would even out over time as tax benefits are not the only factor behind FIIs' investing in India.

Clarity in tax laws would assist them to work on their business model but it is unlikely they would flee the country, considering the limitations in their other options.

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