(A) BACKGROUND – FDI Regulations pre-October, 2019
Under the erstwhile FEMA regulations
governing Foreign Direct Investment into India (‘FDI’), i.e., FEM 20(R),
Foreign Exchange Management (Transfer of Issue of Security by a Person Resident
outside India) Regulations, 2017 (‘FDI Regulations’) dated 7th November, 2017,
the RBI had powers to govern FDI which included equity investments into India.
The above regulations were issued
after superseding the earlier regulation dealing with FDI, i.e., the Foreign
Exchange Management (Transfer or issue of Security by a Person Resident outside
India) Regulations, 2000 which were issued by RBI on 3rd May, 2000 (‘Old FDI
Regulations’).
Thus, under the FDI regulations, RBI
had powers to regulate FDI into India. At the same time, the Government of
India used to issue a consolidated FDI Policy which contained a broad policy
framework governing FDI into India. The last such consolidated FDI Policy (‘FDI
Policy’) was issued on 28th August, 2017 by the Department of
Industrial Policy and Promotion, Government of India. However, as only the RBI
had the powers to govern FDI, Para 1.1.2 of the FDI Policy stated that any
changes in it made by the Government of India will need to be notified by the
RBI as amendments to the FDI regulations. Further, it was specifically
clarified that if there was any conflict between changes made in the FDI Policy
through issuance of Press Notes / Press Releases and FDI Regulations, the FDI
Regulations issued by RBI will prevail. Further, the FDI Policy defined FDI in
Para 2.1.14 as under:
‘FDI’ means investment by
non-resident entity / person resident outside India in the capital of an Indian
company under Schedule I of Foreign Exchange Management (Transfer or Issue of
Security by a Person Resident Outside India) Regulations, 2000.
Schedule I of the Old FDI
Regulations dealt with investment by person resident outside India in the
equity / preference / convertible debentures / convertible preference shares of
an Indian company.
Hence, under the earlier FEMA regime
FDI was governed by the RBI through FDI Regulations and the policy framework
was given by the Government through issuance of an annual FDI Policy and
amendments by issuance of Press Notes / Press Circulars as and when required.
(B) BACKGROUND – FDI Regulations post-October, 2019
However, the above position
governing FDI was completely overhauled with effect from October, 2019. From 15th
October, 2019 the Government of India assumed power from the RBI to regulate
non-debt capital account transactions. Subsequently, vide 16th
October, 2019, the Central Government notified the following list of instruments
which would qualify as non-debt instruments:
List of instruments notified
as non-debt instruments
(a) all
investments in equity instruments in incorporated entities: public, private,
listed and unlisted;
(b) capital
participation in LLPs;
(c) all
instruments of investment recognised in the FDI Policy notified from time to
time;
(d) investment
in units of Alternative Investment Funds (AIFs), Real Estate Investment Trusts
(REITs) and Infrastructure Investment Trusts (InvIts);
(e) investment
in units of mutual funds or Exchange-Traded Funds (ETFs) which invest more than
fifty per cent in equity;
(f) junior-most
layer (i.e. equity tranche) of the securitisation structure;
(g) acquisition,
sale or dealing directly in immovable property;
(h) contribution
to trusts; and
(i) depository
receipts issued against equity instruments.
Thus, all investments in equity
shares, preference shares and convertible debentures and preference shares were
classified as non-debt and came to be regulated by the Central Government
instead of by the RBI.
Thereafter, on 17th
October, 2019 the Central Government issued the Foreign Exchange Management
(Non-Debt Instruments) Rules, 2019 (‘Non-Debt Rules’) for governing Non-Debt
transactions.
Hence, upon issuance of the above Non-Debt
Rules, the power to regulate FDI into India was taken over by the Central
Government from the RBI. Accordingly, the FDI Policy effectively became
redundant as it governed FDI as defined under the erstwhile FDI Regulations
which was superseded by the Non-Debt Regulations with effect from 17th
October, 2019.
(C) Amendments to FDI Policy by issuance of Press Note No. 3 (2020)
dated 17th April, 2020
The existing FDI Policy, vide
Para 3.1.1, provided that a non-resident entity could invest in India under the
automatic route subject to the FDI Policy. However, investments by an entity or
an individual based in Bangladesh and Pakistan was allowed only under the
Government route.
In view of the Covid pandemic, the
Government of India has amended the FDI Policy by issuing the above Press Note
No. 3 (2020) dated 17th April, 2020 under which the FDI Policy is
now amended to provide that if any investment is made by an entity, citizen or
beneficial owner who is a resident of a country with whom India shares its land
border, will be under the Government route. Further, any transfer of ownership
of existing or future FDI in an Indian entity to a person resident of the above
countries would also require Government approval.
Additionally, it has also been
provided that the above amendment in the FDI Policy will take effect from the
date of the FEMA notification.
Subsequently, the Government of
India has issued a notification dated 22nd April, 2020 (‘FEMA
Notification’) to amend Rule 6(a) of the Non-Debt Rules which deals with FDI
for giving effect to the above Press Note No. 3.
(D) Implication of above amendment to Non-Debt Rules
(i) Restrictions on investment from neighbouring countries
As on date, India shares its land
boundary with the following seven countries: Pakistan, Bangladesh, China,
Nepal, Myanmar, Bhutan and Afghanistan.
As per the pre-amended Rule 6(a) of
the Non-Debt Rules, a person resident outside India could make investment
subject to the terms and conditions specified in Schedule I which dealt with
FDI in Indian companies. However, there was a proviso which specified
that investment from the following persons / entities was under the Government
route:
- An entity incorporated in Bangladesh or
Pakistan;
- A person who is a citizen of Bangladesh or
Pakistan.
As per the amendment made on 22nd
April, 2020, the above provision has been amended to provide that investment
from the following persons / entities will be under the Government route:
- An entity incorporated in any of seven
neighbouring countries mentioned above;
- If the beneficial owner is situated in any
of the above seven neighbouring countries;
- The beneficial owner is a citizen of any of
the above seven neighbouring countries.
Further, transfer of ownership of
any existing or future FDI in an Indian entity to the above persons will also
be under the Government route.
Accordingly, for example, if earlier
a company based in China wanted to undertake FDI in any Indian company, the
same was allowed under the automatic route subject to sectoral caps, if any,
applicable to the industry in which the Indian company was operating. However,
post-22nd April, 2020 a Chinese company which has made investment in
an Indian company which is engaged in a sector where FDI is permissible up to
100% without any restrictions, would neither be allowed to undertake any fresh
investment in such Indian company nor acquire shares in any existing Indian
company under the FDI route without Government approval.
The above restriction has come in
the wake of news reports that the People’s Bank of China has acquired more than
1% stake in HDFC. The Government’s intention is to ensure that when the
valuation of Indian companies is low due to the impact of Covid-19, Indian
companies are not taken over by Chinese companies. However, the above
restriction is not directed only at China but covers investment from all the
seven countries mentioned above.
(ii) Meaning of beneficial ownership
It is interesting to note that the
term ‘beneficial owner’ has not been defined under FEMA. Rule 2(s) of the
Non-Debt Rules, 2019 while defining the term ‘foreign investment’ clarifies
that where, in respect of investment made by a person resident in India, if a
declaration is made under the Companies Act, 2013 that the beneficial interest
in the said investment is to be held outside India, such investment even though
made by a person resident in India, will be considered as foreign investment.
Thus, the Non-Debt Rules, 2019 refer to the provisions of the Companies Act,
2013 (‘Cos Act’) for determining whether a beneficial interest exists or not.
Section 89(10) of the Cos Act
defines beneficial interest in a share to include directly or indirectly,
through any contract, arrangement or otherwise, the right or entitlement of a
person alone or together with any other person to –
(a) exercise
or cause to be exercised any or all of the rights attached to such share;
(b) receive
or participate in any dividend or other distribution in respect of such share.
Hence,
based on the above provision of the Cos Act, it can be concluded that ‘beneficial
interest’ means a person who has the right to exercise all the rights attached
to the shares and also receive dividend in respect of such shares.
Further, section 90 of the Cos Act
read with Rule 2(e) of the Companies (Significant Beneficial Owners) Rules,
2018 specifies that if an individual, either directly or indirectly, is holding
10% or more of shares or voting rights in a company, such individual will be
considered to be a significant beneficial owner of shares and will be required
to report the same in the prescribed format.
Additionally, Rule 9(3) of the
Prevention of Money Laundering (Maintenance of Records) Rules, 2005 (‘PMLA Rule
9’) defines beneficial owner as a natural person holding in excess of the
following thresholds:
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Nature of entity
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Threshold limit
|
|
Company
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25% of shares or capital or profits
|
|
Partnership firm
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15% of capital or profits
|
|
Unincorporated body or body of individuals
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15% of property or capital or profits
|
|
Trust
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15% interest in trust
|
Further, the above-referred PMLA
Rule 9 also provides that in case any controlling interest in the form of
shares or interest in an Indian company is owned by any company listed in India
or overseas or through any subsidiaries of such listed company, it is not
necessary to identify the beneficial owner. Thus, in case of shares or
interest-held listed companies, beneficial ownership is not to be determined.
The above PMLA Rule 9 is followed by
SEBI for the purposes of determining beneficial ownership in any listed Indian
company.
Hence, we have a situation where the
Cos Act determines a significant beneficial owner as a natural person holding
10% or more directly or indirectly in the share capital, whereas SEBI, for the
purposes of a listed company, considers a threshold of shareholding exceeding
25% to determine beneficial ownership.
Additionally, the OECD Beneficial
Ownership Implementation Toolkit, March, 2019 states that beneficial owners are
always natural persons who ultimately own or control a legal entity or
arrangement, such as a company, a trust, a foundation, etc. Accordingly, where
an individual through one or more different companies controls the investment,
all intermediate controlling companies will be ignored and the individual would
be considered to be the beneficial owner of the ultimate investment.
However, in the absence of any
clarity given under the FEMA notification or by the Press Note regarding the
percentage beyond which an individual would be considered to be having
beneficial interest in the investment, one may take a conservative view of
considering shareholding of 10% or more as beneficial interest for the purposes
of FEMA. The same is explained by the example below:
Example
An Indian company is engaged in the
IT sector in which 100% FDI is permitted under the automatic route having the
following shareholding pattern:
In the above fact pattern, where the
Chinese Co. or a Chinese individual are holding 10% or more beneficial interest
either directly or indirectly through one or more entities in an Indian
company, the same will be covered under the restriction imposed by the FEMA
notification. Accordingly, any future investment of the Mauritius Co. into the
Indian Co. will be subject to Government approval.
Further, any change in shareholding
at any level which will transfer beneficial interest from a non-Chinese company
/ individual to a Chinese company or Chinese individual, will also be subject
to Government approval.
(iii) Meaning of FDI
Rule 6(a) of the Non-Debt Rules
provides that a person resident outside India can make investment subject to
the terms and conditions specified in Schedule I which deals with FDI in Indian
companies. FDI is defined to include the following investments:
- Investment in capital instruments of an
unlisted Indian company; and
- Investment amounting to 10% or more of
fully diluted paid-up capital of a listed Indian company.
Capital instruments means equity
shares, fully, compulsorily and mandatorily convertible debentures, fully,
compulsorily and mandatorily convertible preference shares and share warrants.
As per the amendment made on 22nd
April, 2020 the above Rule 6(a) has been amended to provide that
investment from entities or a beneficial owner located in the above seven
neighbouring countries will be under the automatic route.
Any investment of less than 10% in a
listed Indian company is considered as Foreign Portfolio Investment and is
covered by Schedule II of the Non-Debt Rules.
Further, the following schedules of Non-Debt
Rules cover different types of investments into India:
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Schedule reference
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Nature of investment
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Schedule II
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Investment by Foreign Portfolio Investment
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Schedule III
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Investment by NRIs or OCIs on repatriation basis
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Schedule IV
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Investment by NRIs or OCIs on
non-repatriation basis
|
|
Schedule V
|
Investment by other non-resident investors like sovereign
wealth funds, pension funds, foreign central banks, etc.
|
|
Schedule VI
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Investment in LLPs
|
|
Schedule VII
|
Investment by Foreign Venture Capital investors
|
|
Schedule VIII
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Investment in an Indian investment vehicle
|
|
Schedule IX
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Investment in depository receipts
|
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Schedule X
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Issue of Indian depository receipts
|
As the amendment is made only in
Rule 6(a) which deals with FDI in India covered under Schedule I, investment
covered by the above-mentioned Schedules II to X (excluding investment in LLP
covered by Schedule VI) will not be subject to the above restrictions placed on
investors from China and other neighbouring countries.
For example, any investment of less
than 10% in a listed Indian company will be considered to be Foreign Portfolio
Investment and, accordingly, will not be subject to the above restrictions
placed on investors from China and other neighbouring countries.
With regard to investment in LLPs,
the same is covered by Schedule VI of the Non-Debt Rules. Clause (a) of
Schedule VI provides that a person resident outside India, not being Foreign
Portfolio Investor (FPI) or Foreign Venture Capital Investor (FVCI), can
contribute to the capital of an LLP which is operating in sectors wherein FDI
up to 100% is permitted under the automatic route and there are no FDI-linked
performance conditions.
Accordingly, post-22nd April,
2020, as FDI by person / entities based in neighbouring countries will fall
under the approval route they will not be eligible to make investment in any
LLP, irrespective of the sector in which it operates. Thus, persons / entities
based in neighbouring countries will neither be able to undertake fresh
investment in an existing LLP where they are already holding partner’s share,
or incorporate new LLPs or buy stakes in any existing LLP even under the
Government route.
Thus, unlike investment in companies
which will be allowed with the prior approval of the Government, investment in
LLPs will no longer be permissible either under the automatic route or the
approval route irrespective of the business of the LLP. Similarly, a company
having FDI with investors who belong to the neighbouring countries will not be
allowed to be converted into an LLP.
Meaning of transfer of
existing or future FDI
The amended provision says
Government approval is required before transfer of existing or future FDI in an
Indian entity to persons / entities based in the neighbouring countries. Hence,
transfer of existing FDI in an Indian entity as well as transfer of any FDI
which is made in future to persons / entities based in the neighbouring
countries will require Government approval.
Restriction
on issuance of shares against pre-incorporation expenses
Under the existing provisions, a WOS
set up by a non-resident entity operating in a sector where 100% FDI is
permitted under the automatic route, is permitted to issue shares against
pre-incorporation expenses incurred by its parent entity subject to certain
limits.
Going forward, as investment by
neighbouring countries will now fall under the Government route, a WOS set up
by a parent entity which is based in the neighbouring countries will not be
permitted to issue shares against pre-incorporation expenses incurred by the
parent entity.
Convertible instruments
FDI includes equity shares, fully,
compulsorily and mandatorily convertible debentures, fully, compulsorily and
mandatorily convertible preference shares, and share warrants. Accordingly, any
issuance or transfer of convertible instruments to persons / entities of
neighbouring countries will now be subject to Government approval irrespective
of the fact that convertible instruments have not yet been converted into equity.
However, determining beneficial
ownership in case of convertible instruments will be challenging. The case may
be more complicated where overseas investors in an Indian company have issued
optionally convertible instruments.
In this regard, one may place
reliance on the definition of FDI under Rule 2(r) which requires FDI to be
computed based on the post-issue paid-up equity capital of an Indian company on
fully diluted basis. Hence, a similar analogy could also be applied for
computing beneficial ownership of residents / entities of neighbouring
countries on the assumption that the entire convertible instruments have been
converted into equity.
(iv) Indirect foreign investment – Downstream
investment
Indirect foreign investment is
defined to mean downstream investment received by an Indian entity from:
(a) another
Indian entity (IE) which has received foreign investment and (i) the IE is not
owned and not controlled by resident Indian citizens or (ii) is owned or
controlled by persons resident outside India; or
(b) an
investment vehicle whose sponsor or manager or investment manager (i) is not
owned and not controlled by resident Indian citizens or (ii) is owned or
controlled by persons resident outside India.
The above amendment will also affect
downstream investment made by an existing Indian company which is owned or
controlled by persons resident outside India. Hence, if persons / entities of
neighbouring countries have beneficial interest in such an Indian company which
is owned or controlled by persons resident outside India, any downstream
investment made by such a company would also be under Government route.
The above can be illustrated as
follows:
Thus, in the instant case, as Indian Co. is owned or
controlled by persons resident outside India, any investment made by Indian Co.
will be considered to be downstream investment and will be required to comply
with the applicable sectoral caps. Hence, if persons / entities of neighbouring
countries hold beneficial interest in Indian Co., any subsequent investment
made by Indian Co. will require Government approval. Further, any downstream
investment made by WOS would also need prior Government approval.
Additionally, downstream investment by an LLP which is owned
or controlled by persons resident outside India and having beneficial ownership
of persons / residents of neighbouring countries will not be allowed in any
Indian company, irrespective of the sector.
(v) Effective date of changes made in FDI Policy
It is interesting to note that the Government had decided to
make changes in the FDI Policy by issuing a Press Note. Further, the Press Note
has itself stated that the above changes will come into effect from the date of
issuance of the relevant notification under FEMA. The relevant FEMA
Notification has been issued on 22nd April, 2020 and hence the above
changes will be effective from that date.
(vi) Status of FDI from Hong Kong
Hong Kong is one of the major contributors to FDI in India.
As per Government of India records, FDI from Hong Kong is almost double that
from China and hence it is essential to evaluate whether Hong Kong will be
considered separate from China to determine whether it will be covered under
the new restrictions imposed by Press Note No. 3. It is interesting to note
that Hong Kong is governed separately as Hong Kong Special Administrative
Region of China but it forms part of China. However, for the purpose of
reporting FDI, Hong Kong is classified as a separate country by the Government
of India. Similarly, the Indian Government has entered into a separate tax
treaty with Hong Kong in addition to China for avoidance of double taxation.
Additionally, Hong Kong has separately signed the Multilateral Convention in
addition to China as part of OECD’s BEPS Action Plans.
Based on the above, it appears that the Government is taking
the view that Hong Kong is separate from China; and if such is indeed the case,
then it is possible to take the view that the above restrictions imposed by Press
Note No. 3 will not affect FDI from Hong Kong and the same should be covered
under the automatic route as hitherto applicable. However, it is advisable that
the Government issue an appropriate clarification on the same.
SUMMARY
Based on the above discussions, the amendment in
the FDI regime by putting investment from neighbouring countries under the
Government route has given rise to several issues. It is expected that the
Government will quickly issue necessary clarifications in this regard.
