Background
The Ministry of Finance (“MoF”) and Reserve Bank of India (“RBI”) notified the new overseas investment (“OI”) regime on August 22, 2022 (“New Regime”).
The New Regime inter alia comprises the OI Rules, 2022[1] notified by the MoF (“Rules”), the OI Regulations, 2022[2] notified by the RBI and the Master Directions issued by the RBI to authorised persons. It supersedes FEMA 120[3] and the circulars and directions issued thereunder (“Old Regime”).
The segregation between ‘Rules’ and ‘Regulations’ has its genesis in the amendment made to FEMA vide the Finance Act, 2015. Pursuant to this amendment, the regulatory architecture under FEMA follows an interesting two-tier structure, where the power to frame rules for non-debt instruments vests with the MoF; and the power to frame regulations for debt-instruments vests with the RBI[4]. However, RBI has been empowered under Rule 3 to administer the rules framed by the MoF.
The New Regime can be broadly divided into three buckets i.e. equity, debt, and OI by resident individuals. In this blogpost, the authors discuss key implications from an equity perspective, and highlight aspects that need greater regulatory clarity.
Grandfathering of Existing Investments
Rule 6 clarifies that OI made in compliance with the Old Regime shall be deemed to be compliant with the New Regime. For OI that was not in compliance with the Old Regime, there is no deeming provision stating that such investments shall be compliant with the New Regime. In such situations, a compounding application may have to be filed with the RBI.
Key Changes and its Implications
“Foreign Entity”
“JV” and “WOS” has now been replaced with ‘Foreign Entity’ which inter alia means “an entity formed or registered or incorporated outside India..”[5] In a welcome move, the New Regime expands the meaning of ‘Foreign Entity’ and unlike the Draft Rules[6], ‘incorporation’ of a Foreign Entity is not a mandatory requirement. This is relevant for LLPs in jurisdictions like the United States, which are registered but not incorporated.
“Indian Entity”
“Indian Entity”[7] includes companies, body corporates, LLPs and interestingly, even partnership firms registered under the Indian Partnership Act, 1932 are covered.
“Control”
“Control” means the right to appoint majority of the directors or to control management or policy decisions exercisable by a person/ persons acting individually or in concert, directly or indirectly, including by virtue of shareholding or management rights or shareholders’ agreements/ voting agreements that entitle them to ten per cent or more of voting rights or in any other manner in the entity.[8]
As the Rules have introduced a new 10% voting rights test (“10% Test”), there is a material distinction between the tests for control under the Rules, and the applicable tests under Section 2(27) of the Companies Act, 2013 (“Companies Act”) and the takeover regulations. The 10% Test assumes relevance whilst determining whether the overseas entity would be regarded as a ‘subsidiary’ or a ‘step-down subsidiary’ (“SDS”).
Under the Rules, a subsidiary would be regarded as an entity, in which a foreign entity has control. By virtue of the 10% Test, a Foreign Entity may be regarded as a subsidiary/ SDS even when it does not meet the ‘subsidiary test’ under Section 2(87) of the Companies Act.
ODI vs OPI
In a welcome change, there is now a clear segregation between an overseas direct investment (ODI) and an Overseas Portfolio Investment (OPI). An ODI inter alia includes[9]:
- Acquisition of unlisted equity capital of a foreign entity; or
- Subscription as a part of MoA of a foreign entity; or
- Investment in 10% or more of the paid-up equity capital of a listed foreign entity; or
- Investment with control where investment is less than 10% of paid-up equity capital of the listed foreign entity.
OPI is defined as investments other than ODI, in foreign securities, but not in any unlisted debt instruments or any security issued by a person resident in India who is not in an IFSC.[10]
OI only in “bona fide business activities”
“Bona fide business activity” means any business activity permissible under any law in force in India and the host country.[11] Further, the three no-go areas for ODI are (i) real estate activity; (ii) gambling; and (iii) dealing with financial products linked to the Indian Rupee, without specific RBI approval.
The Rules are silent on the test to be applied for determining whether a business activity is ‘permissible’ in India. In India, certain business activities like multi brand retail, online gaming or sale of liquor may be legal only in certain States, and it is unclear whether OI can be made in such sectors.
Calculation of Total Financial Commitment Limit (“TFC Limit”)
Whilst the TFC Limit has been retained at 400% of net worth, the definition of ‘net worth’[12] has been aligned with Section 2(57) of the Companies Act and now includes security premium account, thereby potentially increasing the headroom available to the Indian Entity. However, the Indian Entity can no longer utilise the net worth of its subsidiary/ holding company, which could impact large conglomerates where subsidiaries are used to structure OI.
The Rules provide that the TFC Limit should be determined at the time of undertaking the financial commitment.[13] Whilst the same wording was not present in the Old Regime, a conjoint reading of the Rules and the FEMA Master Directions on Reporting[14] suggests that the earlier ODIs would have to be computed at the old rate mentioned in the Form FC and the new ODIs would be worked out using the current exchange rate. However, RBI needs to clarify this aspect in the FAQs.
It is also pertinent to note that the TFC Limit only includes ODIs, and a separate limit of 50% of net worth has been provided for OPIs. It will be helpful for RBI to clarify whether the additional 50% limit for OPIs is available only for Indian listed companies and not for unlisted Indian companies or resident individuals – and whether for unlisted Indian entities/ resident individuals, the 50% limit will get subsumed within the 400% limit?
Further, as a non-controlling investment of less than 10% in a listed foreign entity is treated as an OPI, it may not fall within the TFC Limit of 400% of net worth.
NOC Requirement
An NOC requirement[15] for making financial commitment has been introduced for any person resident in India who:
- Has an NPA account; or
- Is classified as a wilful defaulter; or
- Is under investigation by a financial service regulator or by investigative agencies in India, viz, CBI/ED/SFIO.
There is also a deemed approval provision if the agency fails to furnish the certificate within 60 days. However, as investigative agencies are more prosecution-focused and are not used to giving NOCs for ODI, this may delay the NOC-process. If queries are raised by any investigative agencies before the 60th day, it is unlikely that AD Bank will treat it as the case of ‘deemed approval’.
Pricing Guidelines
The pricing for OI should be on an arm’s length basis, based on valuation undertaken as per any internationally accepted pricing methodology[16]. The AD banks are responsible for ensuring compliance with arm’s length pricing requirements. It will be interesting to see the guidelines that may be framed by AD Banks in relation to arm’s length pricing; and whether AD banks will insist on a valuation certificate from an investment banker or a chartered accountant before certifying compliance.
ODI in Financial Services Activity
An Indian entity not engaged in financial services activity can now make ODI in a foreign entity engaged in financial services activity, except banking and insurance, provided certain conditions are met.[17] One of the conditions is that the Indian entity has net profits during the preceding three financial years; and the Covid-19 period i.e., FY 2020-21 and FY 2021-22 can be excluded while determining profitability.
Further, ‘financial services activity’ has been defined as an activity, which if carried out by an entity in India, requires registration with or is regulated by a financial services regulator in India.[18]
Round Tripping (ODI-FDI Structures)
While the Old Regime did not explicitly mention round tripping in the text of the law, FAQ No.64 of RBI’s ODI FAQs effectively enacted substantive law by mandating prior RBI approval for round-tripping transactions (ODI-FDI structures).
Under the New Regime, ODI-FDI structures shall be permitted subject to compliance with the layering restrictions set out under Rule 19(3), which provides that “no person resident in India shall make financial commitment in a foreign entity that has invested or invests into India, at the time of making such financial commitment or at any time thereafter, either directly or indirectly, resulting in a structure with more than two layers of subsidiaries.”[19] A plain reading of the Rules suggests that for computing the number of layers of ‘subsidiaries’, a foreign entity will be regarded as a ‘subsidiary’ even if the 10% test is independently met.
While the Rules recognise that many ODI-FDI Structures are pursuant to legitimate commercial reasons, the layering restrictions raise more questions than they answer. First, regulatory clarity is awaited on how to compute the number of layers.
Second, whilst the exemption provided under the Companies (Restriction on Number of Layers) Rules, 2017 (“Layering Rules”), for banking companies, NBFCs, insurance companies etc. has been replicated, the exemption for one layer of WOS, as provided in the Layering Rules, has not been mirrored.
Third, whilst the Layering Rules provides an exemption for acquisition of an overseas company that has more than two subsidiary layers as per the laws of the foreign jurisdiction, a similar exemption has not been provided in Rule 19(3); and it appears that even acquisition of an existing structure may require compliance with Rule 19(3). However, this aspect needs to be clarified by the RBI.
Further, the RBI needs to clarify that when the ODI turns back into India as FDI under Rule 19(3), will it be seen as pure FDI from the compliance/ FOCC/ disinvestment perspective or will it be seen as an IOCC under the consolidated FDI Policy and the NDI Rules, 2019.
For ODI-FDI Structures where it is not commercially feasible to comply with the layering restrictions (such as ODI-FDI structures in the infrastructure space), parties can approach the RBI for prior approval based on sound commercial justifications.
It is interesting to note that the Draft Rules had provided that ODI-FDI structures would be permitted subject to the ascertainment that the transaction was not designed for the purpose of tax avoidance/ tax evasion. This requirement has been omitted from the Rules.
Conclusion
Whilst the New Regime has its set of positive changes that may facilitate OIs, there are a few areas where regulatory clarity is awaited. Unfortunately, regulators have not followed the Sodhi Committee’s recommendation that all complex rules/ regulations should have specific ‘legislative notes’ that clarify the regulatory intent; and reduce scope for divergent interpretations.[20]
There is also a larger concern relating to whether RBI should at all be regulating the number of layers – given that no other advanced jurisdiction (except Israel) has similar layering restrictions – and Section 129 of the Companies Act mandates consolidation of accounts between the holding company and all its domestic/ overseas subsidiaries. Logically, substantive law should not be enacted through FAQs. Instead of issuing FAQs, it may be advisable for the RBI and the MoF to iron out the creases through suitable amendments to the rules/ regulations.
There are many bright spots in the new architecture. Global economic meltdown due to inflation and war, may present good opportunities for Indian parties to acquire strategic assets at an attractive valuation. It is expected that the RBI may soon come out with a slew of FAQs to clarify their position on all the contentious issues.
[1] Foreign Exchange Management (Overseas Investment) Rules, 2022.
[2] Foreign Exchange Management (Overseas Investment) Regulations, 2022.
[3] Foreign Exchange Management (Transfer or Issue of any Foreign Security) Regulations, 2004.
[4] Section 6(2A) read with Section 46 of FEMA inter alia provides that the power to frame rules in relation to non-debt instruments vests with the Central Government. Further, as per Section 6(2)(a) read with Section 47, the power to frame regulations in relation to debt instruments vests with the RBI.
[5] Rule 2(1)(h).
[6] Draft Foreign Exchange Management (Non-debt Instruments – Overseas Investment) Rules, 2021, issued for public consultation on August 9, 2021.
[7] Rule 2(1)(j).
[9] Rule 2(1)(q).
[10] Rule 2(1)(s).
[11] Explanation to Rule 9(1).
[12] Rule 2(1)(p).
[13] Para 3 of Schedule I.
[14] Part VIII, FEMA Master Direction on Reporting, FED Master Direction No.18/2015-16, updated as on August 22, 2022.
[15] Rule 10.
[16] Rule 16.
[18] Explanation to Schedule 1, Para 3(2).
[19] Rule 19(3).
[20] Report of the High-Level Committee to review the SEBI (Prohibition of Insider Trading) Regulations, 1992, Chaired by Justice N.K. Sodhi, December 7, 2013.
