Introduction
India has a capital control regime, which regulates foreign equity and debt investments into India. The FDI Policy conditions are implemented through various legislations, which include the Foreign Exchange Management Act, 1999 (‘FEMA’) and subordinate rules made under it such as the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (‘NDI Rules’).
Foreign investors can enter the Indian market either directly through Foreign Direct Investment (‘FDI’) or indirectly. Indirect foreign investment refers to investments received by an Indian entity from: (a) another Indian company that has at least 50% FDI or is controlled by a foreign entity, or (b) an investment vehicle whose sponsor or manager is controlled by persons resident outside India (‘PROI’). An Indian entity which has received indirect foreign investment and is owned[1] and controlled[2] by PROI is called a foreign owned and/or controlled company (‘FOCC’). If an originally resident-controlled entity becomes PROI-controlled, its investments are treated as downstream investments from the date on which the entity becomes an FOCC.
It is pertinent to note that NDI Rules prescribe no proportionality in calculating the quantum of foreign investment. If the investing company is owned and controlled by PROI, the entire investment by such a company will be considered indirect foreign investment. Thus, if the investing company has 55% FDI, the downstream investment made by such a company in a downstream company will entirely be considered as indirect foreign investment, and the NDI Rules will apply to such an investment. However, an exception to this rule is that indirect foreign investment in wholly owned subsidiaries of operating-cum-investing / investing companies, will be limited to the foreign investment in the operating-cum-investing/ investing company.
Downstream investments have become popular as corporate structures with a resident entity provides certain benefits to both, operating companies and strategic/financial funds. For operating companies, FOCCs provide operational ease to foreign investors as FOCCs have similar operational flexibility to carry out business as that available to other Indian resident companies. In terms of funds, having a first-level FOCC vehicle in India helps funds consolidate the India- level investments in their portfolio and facilitate greater value creation for their stakeholders.
Currently, certain regulatory gaps persist in the treatment of FOCCs that come up often while structuring deals in the M&A sphere and which can complicate investment compliance for FOCCs. This article delves into these regulatory concerns and highlights the considerations that investors and investee companies should keep in mind while structuring M&A deals.
Reporting Requirements and Pricing Guidelines
Rule 23(5) of the NDI Rules makes it clear that FOCCs are treated as a ‘PROI’ from the perspective of applicability of pricing guidelines and an ‘Indian Resident’ from the reporting perspective. Notably, the NDI Rules have omitted from stating on the applicable compliance requirements where an FOCC is the transferee of equity instruments of an Indian entity.
In the absence of explicit regulatory guidance, industry practice (as informed by informal advice from Authorized Dealer Banks (‘AD Banks’)), suggests that transactions involving the transfer of equity instruments between PROIs and FOCCs must adhere to pricing guidelines. The current applicability of reporting and pricing requirements as typically advised by AD Banks are as follows:
BUYER | SELLER | REPORTING | PRICING |
FOCC | FOCC | Not applicable | Not applicable |
FOCC | PROI | Forms FC-TRS, DI and notifying Secretariat for Industrial Assistance, DPIIT | Applicable, price shall not exceed FMV. |
PROI | FOCC | Form FC-TRS | Not applicable, price can be commercially agreed. |
FOCC | Resident Indian entity | Form DI and notifying Secretariat for Industrial Assistance, DPIIT | Applicable, price shall not be less than FMV. |
Resident Indian entity | FOCC | Not applicable | Applicable, price shall not exceed FMV. |
A conundrum which arises is a situation wherein an FOCC is involved in a transaction in which it is purchasing equity instruments of a resident Indian entity from both, PROIs as well as resident Indian entities. Care should be exercised in drafting of definitive agreements so that the purchase price of equity instruments differs in accordance with the seller of the equity instruments and complies with the pricing guidelines. In case differential pricing is not practically possible, the transaction may need to be concluded at exactly the Fair Market Value (‘FMV’) instead of a commercially negotiated price, which may dissuade parties.
Investment in Optionally Convertible Preference Shares & Debentures.
NDI Rules state that downstream investment can be done through investment by an FOCC in the ‘capital instruments’ of an Indian company.[3] It is pertinent to note that the NDI Rules do not define ‘capital instruments’ however, it does define ‘equity instruments’ to mean equity shares, convertible debentures, preference shares and share warrants issued by an Indian company.[4] Optionally convertible preference shares (‘OCPSs’) and optionally convertible debentures (‘OCDs’) are categorized as ‘hybrid securities’ and not included in the definition of equity instruments.[5] It can be
interpreted that ‘capital instruments’ cover those instruments as specified under the definition of the term ‘equity instruments’.
The question arises whether investments by FOCCs in OCPSs and OCDs should be considered downstream investments. Under the current framework, the RBI may not recognize OCPSs and OCDs as downstream investments unless these are duly converted into equity instruments.
Deferred Consideration Arrangements
Purchase consideration holdbacks and escrows are essential protective measures for buyers in M&A transactions. NDI Rules permit deferred payment arrangements in cross-border share purchase transactions, i.e., between a resident Indian company and a PROI.[6] This is a common practice in both, pure domestic and pure FDI transactions, allowing non-resident buyers to defer up to 25% of the sale consideration for up to 18 months.
However, NDI Rules are silent on this aspect concerning FOCCs and in the absence of formal guidance, AD Banks have taken differing views on this matter, with most AD Banks not permitting deferred consideration arrangements in downstream investments. Further, practical challenges may arise in completing form filings for transactions with an element of deferred consideration as Form DI (used to report downstream investments) has no place to disclose the amount of deferred consideration amount. However, due to there being some room for interpretation, if FOCCs are considered Indian residents then in cases of transfer from a PROI to an FOCC (and vice versa), deferred consideration arrangements should be permitted as it is essentially a transaction between a resident Indian company and a PROI. In light of this, certain AD Banks also take a view that deferred consideration may be possible, provided the amount paid upfront is above the fair market value derived in terms of the pricing guidelines.
Sale for non-cash consideration
Investments in the share capital of a company can be made either in cash or by way of a non-cash consideration. Non-cash consideration would typically involve consideration such as shares or other securities (share swap arrangement), intellectual property and other intangible assets such as goodwill, any movable or immovable asset, services etc.
The NDI Rules contemplate that FOCC can make further downstream investment in an Indian entity only by way of: (a) funds brought from abroad (not borrowed domestically); and (b) internal accruals (i.e., amount transferred to reserve account post-tax).[7] This restriction has been interpreted to imply that consideration in case of downstream investments should be discharged solely in cash. Most AD Banks are taking a conservative view that an FOCC undertaking downstream investment through consideration other than cash would fall under the government approval route and thus would require prior approval of the RBI.
Such a restriction is problematic in cases involving business/asset transfer transactions as the consideration for business transfers often is through issuance of shares.
Conclusion
Downstream Investment is an attractive option for foreign investors due to operational ease available to FOCCs. However, the regulatory framework governing downstream investments in India is complex and poses certain interpretational issues. The lack of clear framework has led to differential treatment of FOCCs based on the informal guidance provided by AD Banks which may lead to unintentional non-compliance. Necessary clarifications need to be issued with regards to the treatment of FOCCs for pricing and reporting purposes. Addressing these issues will help India continue to attract foreign investment while maintaining a robust and transparent regulatory framework.
Written By Nidhi Arora (Partner) and Shagun Taparia (Associate)
[1] Explanation to Rule 23 of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (‘NDI Rules’).
(a) “ownership of an Indian company” shall mean beneficial holding of more than fifty percent of the equity instruments of such company and “ownership of an LLP” shall mean contribution of more than fifty percent in its capital and having majority profit share.
[2] Explanation to Rule 23 of the NDI Rules.
(d) “control” shall mean the right to appoint majority of the directors or to control the management or policy decisions including by virtue of their shareholding or management rights or shareholders agreement or voting agreement and for the purpose of LLP, “control” shall mean the right to appoint majority of the designated partners, where such designated partners, with specific exclusion to others, have control over all the policies of an LLP.
[3] Explanation (g), Rule 23, NDI Rules.
[4] Rule 2(k), NDI Rules.
[5] Rule 2(x), NDI Rules.
[6] Rule 9(6), NDI Rules.
[7] Rule 23(4)(b), NDI Rules.