Govt may tax FIIs; relief for P-notes holders

Finance Minister Pranab Mukherjee gestures during a news conference in New Delhi May 27, 2009.

NEW DELHI (Reuters) - Finance Minister Pranab Mukherjee said on Friday India will look into the possible tax liability of foreign institutional investors, raising the prospect that brokerages and other financial firms with registered licences in India could be liable to pay taxes.

The Indian stock market has been roiled this week by investor anxiety over the prospect that foreign investors would be subject to new taxes following a proposal included in the recent budget. Investors have been clamoring for clarity over the new proposals.

On Friday, Mukherjee said the government was not targeting the end-buyers of participatory notes, or P-notes, the derivative products that had first sparked anxiety about foreign investments.

However, the government would examine the tax liability of foreign institutional investors (FIIs), which are registered with market regulators to invest in India.

"The Indian tax authorities would examine the tax liabilities of the said FIIs. However, the Indian tax authorities would not go beyond the FIIs to check any further details about P-note holders," Mukherjee said.

"Accordingly, question for liability in tax of the participatory note holders does not arise," he said.

The comments are unlikely to soothe concerns about the broader tax standing of overseas investors.

Investor worries center on two provisions announced this month. The first gives India power to retroactively tax the indirect transfer of assets, while the second provision targets tax evaders via the proposed General Anti-Avoidance Rule (GAAR).

Registered FIIs such as foreign brokerages often sell products such as participatory notes or exchange traded funds to investors, who may not be registered with the government because they are not directly buying an Indian security.

P-notes, for example, are derivative products sold to overseas investors that mimic the performance of an underlying Indian security. The brokerage buys the security and then sells the derivative tracking it to the investor.

"So far, the legal interpretation is FIIs look taxable. More detailed clarification would have to come from government and IT (income tax) department," said Krishna Kumar Karwa, managing director of Emkay Global Financial Services.

Hong Kong-based CLSA stopped selling P-notes this week, warning that as the registered FII, it could be liable for taxes, and warning clients it would then consider passing any such costs to them.

"For CLSA or any other P-note issuer the tax liability must rest with the end ODI investor, the end beneficiary of the economic gain," it said in an email to clients seen by Reuters, referring to offshore derivative instruments.

Brokerages and institutional investors have called on the finance minister to further clarify its stance.

A strategist at a domestic brokerage said that, should India tax FIIs, it would leave it to those institutions selling the products and their clients to deal with who would pay taxes.

Foreign investors in India have turned net sellers this week, which analysts believe is due to the uncertainty about taxation, with net sales of around 11 billion rupees in the week to Thursday, according to provisional stock exchange data.

(Additional reporting by Abhishek Vishnoi and Rafael Nam in MUMBAI; Editing by Tony Munroe)