What are participatory notes?

FM's clarification today has helped assuage a sense of nervousness prevailing among the Foreign institutional investors (FIIs) regarding the taxation of Participatory notes (P-note).

The recent Budget proposals under General Anti-avoidance rules (GAAR)  were interpreted to mean that the income on P-note is taxable with retrospective effect in  India as the income arises due to the sale of an underlying asset, which has its presence in India.

A primer on P-notes:

What are participatory notes?
Participatory notes are offshore derivative instruments issued by foreign institutional investors with Indian shares as underlying to other overseas investors 

Why are they used?
These instruments aid investors who do not want to register with Sebi and reveal their identities to take positions in the Indian market.

How much of foreign investments come through this route?
At its peak, P-note investing accounted for a third of FII trading volumes in India, But Sebi clamped down in 2007 forcing many investors to wind down their positions. Though rules have since been relaxed, share of P-notes has hovered aroun 10-15% of the total FII holdings in India.