P-notes and pain points

By Anuj SahRohan Singh

  • 28 Jul 2015

With the recent publication of the special investigation team’s recommendations, participatory notes (“P-Notes”) are in the limelight once again. Pursuant to hearings in cases relating to black money, the Supreme Court had directed the government to constitute a special investigation team (“SIT”) to suggest measures to address the issue of black money. Media reports indicate that one of the recommendations of the SIT is that SEBI should take further action to identify the real owners/ beneficiaries of P-Notes and put in place restrictions on the transfer of P-Notes. Indian stock markets fell substantially in response to SIT recommendations, however, such sharp market reaction to news on P-Notes is not new , evidencing that any proposed additional regulation of P-Notes has a substantial impact on stock investments. 

P-Notes provide a channel for foreign investors which are not already registered as a foreign portfolio investor (“FPI”) with the Securities and Exchange Board of India (“SEBI”) to participate in Indian stock markets by subscribing to P-Notes issued by FIIs. The use of P-Notes gained prevalence in the 1990’s, as a manner of foreign investment into India on account of 2 primary reasons, first, the simplified procedure of investment through FPIs  where the actual P-Note holder had minimal disclosure requirements, and secondly, the advantage of the capital gains exemptions under the double taxation avoidance agreement between Mauritius and India. Evidence of the popularity of P-Notes could be seen as early as 2007, when SEBI mentioned in a discussion paper that the use of P-Notes increased from 20% of assets under custody of FPIs (erstwhile foreign institutional investors)/ sub-accounts (“AUC”) in March 2004 to 51.6% of AUC in August 2007. As of the end of October 2014, investments through P-Notes had climbed to an almost 7-year high of more than INR 2.65 Lakh Crore.

Regulation of P-Notes


Historically, the main regulatory and security concerns with the use of P-Notes have been two-fold: (i) notwithstanding the tightening of regulations prohibiting erstwhile foreign institutional investors and sub-accounts from acting for subscribers to offshore derivative instruments (“ODIs”) which were not registered with the relevant regulatory bodies in their home jurisdiction and which had not complied with extant Know-Your-Customer requirements, P-Notes could be used for funding criminal syndicates, including terrorists; and (ii) P-Notes could be used by Indian tax evaders to launder black money offshore by pumping it back into Indian securities. The need for addressing these concerns in a more comprehensive manner have long been felt. However, given the mammoth size of investments which come through this route, SEBI has been cautious in imposing additional restrictions as any move against P-Notes could potentially dry up liquidity in Indian stock markets and adversely affect, amongst other aspects, market valuations of Indian companies. On 24 November 2014, SEBI published a circular pursuant to which additional restrictions were imposed on the issuance of ODIs/ P-Notes to ensure greater clarity and better beneficiary identification. These restrictions, made by way of clarifications on the applicability of certain provisions of the FPI Regulations, provided that: 

(i)ODIs could not be issued to a subscriber which has an ‘opaque structure’ (either structured as a protected cell company, segregated cell company or equivalent where the details of the ultimate beneficial owners are inaccessible or where the beneficial owners are ring fenced from each other or from ring fenced with regard to enforcement). 

(ii)ODIs could not be issued to subscribers who did not meet the eligibility criteria prescribed under Regulation 4 of the FPI Regulations. 


(iii)Investment restrictions imposed on FPIs under Regulation 21(7) of the FPI Regulations would apply to ODI subscribers as well. 

(iv)FPIs were mandated to set up systems to ensure compliance with the Circular for fresh ODIs and existing ODI positions were grandfather until the expiry of such ODI contracts, after which no roll-over or extension on same terms was permitted.

Looking into the crystal ball


As on date, the clarion call is for clear and cogent guidance from the Ministry of Finance, SEBI and the RBI in order to provide predictability of regulatory action and afford stability to the P-Notes regime.  The SIT recommendations in respect of P-Notes have been issued with the principal objective of reducing avenues of black money laundering. While these recommendations are significant, and their implementation is essential, the manner in which regulatory measures are implemented would have an appreciable impact on Indian stock markets.  

In any event, we expect further checks and conditions to be imposed in the long term, geared towards ultimate beneficiary identification in order to increase transparency and reduce the likelihood of abuse of the P-Notes regime. This, in our view, would go a long way towards addressing the concerns raised by the SIT. However, given that the SIT’s pronouncements are only recommendations, unregistered foreign investors (such as hedge funds) and FPIs will need to adopt a ‘wait and watch approach’ for the time being as the government will consult the Ministry of Finance, SEBI and the RBI.

Anuj Sah is an Associate Partner and Rohan Singh is an Associate at Khaitan & Co. Views are theirs


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