About 30 foreign institutional investors (FIIs) are under the scanner of the income-tax department, which is exploring the possibility of claiming tax on income generated from trading of participatory notes, better known as P-Notes (PNs).

ABN Amro, Barclays Bank, CLSA Merchant Bank, Calyon, Citicorp Investment Bank, JPMorgan Securities, Goldman Sachs, Morgan Stanley, ICICI International, UBS and Deutsche International Trust Corporation are among those who have received notices from the income-tax department. These banking groups have been asked to provide details of their P-Note dealings.

PNs are offshore derivative instruments issued by FIIs registered in India to overseas investors, who have no direct access to the Indian stock market. At one point, PNs accounted for a third of the FII trading volumes in India.

However, business in participatory notes has dropped significantly since capital market regulator Sebi banned the issuance of PNs to unregulated foreign entities in November last year.

The tax authorities possibly feel that FIIs should withhold the tax amount while passing on the gains to PN holders. Most FIIs operating in India are registered in Mauritius with which India has a Double Taxation Avoidance Agreement (DTAA). Hence, these capital gains are not taxed in India. The question raised by tax authorities is: why should the tax exemption provided under the DTAA between India and Mauritius be extended to PNs?

The notices sent to FIIs may be seen in the context of the ones sent to Vodafone on its $11-billion acquisition of Hong Kong-based Hutchisons stake in Indian telecom major Hutch-Essar. In the Vodafone deal, though the transaction took place outside India between two overseas parties, the income-tax department thought it reasonable to claim tax on the deal.

The department feels it has the right to raise tax on the profit generated in India. The issue is currently pending before the Bombay High Court. The tax department has also sent notices to a few more companies on their cross-border acquisitions. An amendment in the last Budget seems to have emboldened tax authorities to claim tax on cross-border acquisitions.