The fact that P-note (participatory notes) issuances have risen over the past several months is well known. What may not be so widely known is that the issuances have increased partly because many FIIs, already registered with Sebi, are using this route to avoid tax uncertainty and a multitude of compliance issues, say market experts.

The value of P-notes on equity and debt, excluding derivatives, has increased by 48% to Rs 1.02 lakh crore in December 2012, Sebi data shows. Meanwhile, FII registrations have declined to 1,755 by the end of the previous year from 1,767 as on 2011-end. "The rise in P-note issuances is being partly attributed to the fact that some FIIs, despite being registered with Sebi, have been investing in the Indian stock markets through this route to avoid the uncertainty over taxation of their income. Their taxation status would be finally determined only after several years when their tax returns come up for scrutiny," said UR Bhat, MD, Dalton Capital Advisors.

What's more, these FIIs have opted for the P-note route despite roundtrip brokerage being as high as 100 basis points (1 percentage point) against the normal 30 bps (0.3%) if a registered FII conducts a trade through another broker. These investors are willing to shell out higher transaction fees to primarily avoid the uncertainty pertaining to taxation of their income after three years and other compliances like filing I-T returns, etc.

On the other hand, a P-note issuer has to file tax returns and every remittance made out of India has to be audited by a chartered accountant. Further, it has to employ a compliance officer to interface with Sebi, besides paying custodian charges when it trades in India, said two investment advisors who closely deal with FIIs. They requested anonymity as they are not allowed to speak with the press.

P-notes are instruments used by foreign funds and investors who are not registered with Sebi but are interested in taking exposure in Indian securities.

"Since P-notes are denominated in foreign currency, the need to hedge currency risk is removed and though transaction costs (brokerage) are high, FIIs consider them a better alternative than having to incur administrative costs (custodian charges, filing returns,etc) on a continuous basis," said a senior EdelweissBSE 1.36 % official.

In an attempt to calm the frayed nerves of overseas investors and attract foreign inflows, finance minister P Chidambaram deferred controversial anti-avoidance tax laws, or GAAR, by two years to April 2016 and kept investors in P-notes outside its tax ambit. The fate of FIIs' income will be decided three years from now as the FM clarified that GAAR provisions will override the double-taxation avoidance agreement (DTAA) benefits if the arrangements were intended solely to evade taxes.