A Short Analysis On A Recent Restriction Issued By The Reserve Bank Of India Under The FAQs Relating To Overseas Direct Investment Regulations.

 

21 November, 2019

 

 

The Recent Change and its Impact 

 

The Reasons for Round-Tripping Practice 

 

The practice of investing back into India through a foreign holding company is known as ‘round-tripping’. Historically, Indian Parties have taken advantage of friendly tax treaties with the countries where such holding companies are set up, to invest monies back into India. However, the RBI has traditionally frowned upon round-tripping practices because not only it encourages tax avoidance but also it is used as a route to launder black money. In May, 2019 the Reserve Bank of India (“RBI”) updated its FAQs1 on Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004, as amended from time to time (“ODI Regulations”), expressly clarifying that a foreign joint venture (“JV”) and/or wholly owned subsidiary (“WOS”) cannot be used by Indian Parties (as defined under the ODI Regulations means and includes, corporate entities incorporated in India making investment in overseas JV and/or WOS) to make investments back into India. This FAQ under the ODI Regulations was further amended on 19 September, 2019 to clarify that Indian Party who needs an exemption from the above restriction can approach the RBI for specific approval. 

 

Therefore, to monitor round-tripping practices by such Indian Parties, the said FAQ contemplates a twofold ban on Indian Party seeking to use automatic route for investments under the ODI Regulations viz., (i) Indian Party is not permitted to set up a subsidiary in India through its overseas JV and/or WOS, and (ii) Indian Party is barred from acquiring a WOS or invest in a JV that already has investment in India (“Restricted Activities”). 

 

What does the RBI Indicate and Gap in the ODI Regulations – Reasons for Proliferation of Round-Tripping Practices 

 

Although, the RBI implies that a restriction against round-tripping practice has always been inherent under the ODI Regulations, it may be noted that there is no express language in the said Regulations to prohibit such practice. 

 

In terms of the ODI Regulations, an Indian Party has certain event based2 obligations to file Form ODI and also an annual obligation to file an Annual Performance Report (“APR”) with respect to each overseas JV and/or WOS. Filing of From ODI by Indian Party does not apply to cases where the overseas JV and/or WOS diversifies its activities, including setting up of a step down subsidiary (“SDS”) or altering the shareholding pattern in the overseas entity (“Diversification”). Therefore, when an overseas JV and/or WOS set up by an Indian Party made investment back into India, no Form ODI was required to be filed. 

 

Regulation 13 of the ODI Regulations, which permits an Indian Party to set up a SDS through overseas JV and/or WOS, does not expressly preclude setting up such SDS in India. In the event of 

 

Diversification, as per Regulation 13 an Indian Party has to report the same to the RBI within 30 (thirty) days, it is observed that the said reporting obligation is rarely complied by Indian Parties. Indian Parties have typically included the details of such Diversification only in the annual APR. 

 

The form for filing of APR has sections relating to the aggregate details of capital structure, net loss/profit of and repatriation by the foreign holding company and also provides for reporting of investment in WOS or JV SDS of the foreign holding company3, which by definition under ODI Regulations only includes foreign entities. An Indian SDS set up by such foreign holding company would not strictly be a WOS and/or JV of the first level WOS and/or JV set up by the Indian Party. Further, APR has no specific place to report a foreign holding company’s expansion into India. 

 

Thus, it can be seen that neither did the ODI Regulations nor the Forms under the said Regulations provided for a definite provision to detect round-tripping practices. Such gap in the compliance obligation of an Indian Party has been used as a route to avoid scrutiny of the RBI to invest monies back into India through a foreign holding company. 

 

Going forward, an Indian Party is required to take prior approval of the RBI, if it desires to undertake the Restricted Activities. Consequently, is it possible that an Indian Party who has already undertaken Restricted Activities will now need to obtain post facto approval from the RBI to continue the Restricted Activities, or is it likely that such an Indian Party will be held in violation of FEMA regulations and will be required to apply for compounding of contravention in terms of provisions under Foreign Exchange Management Act, 1999, read with Foreign Exchange (Compounding Proceedings) Rules, 2000, as amended from time to time. 

 

The Grey Zone 

 

Although the RBI has updated its FAQs under the ODI Regulations, there are many queries that still needs to be clarified, illustratively: 

 

• The restriction speaks of the ban only with respect to ‘Indian Parties’ which by definition excludes resident individuals. Since, in terms of Regulation 20A of the ODI Regulations resident individuals are permitted to invest in JV and/or WOS, it is not clear if the RBI exempts JV and/or WOS set up by resident individuals from the application of the new FAQ. 
• The restriction does not set out a specific threshold on the equity holding of the Indian Party in the overseas JV to fall under the said restriction relating to incorporation of Indian SDS through such JV. This could be a problem where the Indian Party is merely a minority shareholder in the overseas JV and the majority promoter of the JV being a non-resident decides to invest back in India through such JV, under automatic route. 

 

It would be helpful, in terms of certainty if a specific circular/notification addressing these issues can be brought by the RBI. 

 

For further information, please contact:

 

Dipankar Bandyopadhyay, Partner, VERUS Advocates

dipankar.bandyopadhyay@verus.net.in

 

1 https://www.rbi.org.in/scripts/FS_FAQs.aspx?Id=32&fn=5

2 In terms of the ODI Regulations, the Indian Party is required to file Form ODI in the event when the Indian Party desires to undertake, inter alia, events set forth: direct investment in JV and/or WOS, issuance of guarantee, including personal guarantee and bank guarantees in favour of JV and/or WOS, issuance of corporate guarantee on behalf of its first level step down operating subsidiary set up by their JV and/or WOS under automatic route. 

3 The requirement of this reporting is under Section VI of the APR.