Tax authorities have indicated that income from trading in participatory notes, better known as PNs, should be taxed in India. Though issue and trade of PNs take place on foreign shores by entities not based in India, the income-tax department has raised a query on its taxability.

PNs are offshore derivative instruments issued by FIIs registered in India to overseas investors with no direct access to the domestic stock market.

Tax experts say this is similar to the departments stance in the Vodafone case. It had issued a show-cause notice to Vodafone, Netherlands, which acquired Hutch-Essar from Hong Kongs Hutchison.

Though the deal was sealed abroad by two overseas parties, the I-T departments rationale is that tax is payable in India as the underlying asset is in the country. It has applied the same thinking to PNs toothough they are offshore derivatives sold outside the country, the underlying assets are stocks of companies in India, traded on Indian stock exchanges.

At one stage, PNs contributed about one-third of the FII trading volumes. But volumes have dramatically dropped since November when Sebi banned issuing PNs to unregulated foreign entities and checked proprietary accounts of FIIs. It also put an immediate stop on PNs where the underlying was local stock derivatives. FIIs get I-T notices

However, if the tax department does indeed make a claim on the profits earned in earlier years, the amount could be significant. A few weeks ago, the department had sent notices to select FIIs, seeking details of their PN profits. Most FIIs operate out of Mauritius and pay no capital gains tax in India, thanks to the India-Mauritius tax treaty. The question that has cropped up is whether the treatys benefits should be extended to PN trades. The IT department recently collected the PN deal details from Sebi and custodians, and chances are that the non-Mauritius entities will come under greater scrutiny. Before the recent Sebi clampdown on PNs, FIIs issued these derivatives to hedge funds, and as per the agreement, the income earned by FIIs from transaction in Indian shares was passed on to the hedge funds after retaining commission by FIIs. The tax authorities possibly view that FIIs should withhold the tax amount while passing on the gains to PN holders. Some sections are of the view that the tax department can move on the proposal only after the court gives its ruling on the Vodafone case.