FOREIGN INVESTMENT REGIME: NEW RULES

INTRODUCTION

The Foreign Exchange Management Act, 1999 (the FEMA) governs the law relating to foreign exchange in India. The Reserve Bank of India is the nodal authority for all matters concerning foreign exchange. Under section 6(2) of the FEMA, the RBI was the authority empowered to notify Regulations pertaining to capital account transactions. Pursuant to the same, the RBI had notified the Foreign Exchange Management (Transfer or Issue of any Security to a Person Resident Outside India) Regulations, 2017 (TISPRO Regulations) for foreign investment in Indian securities and the Foreign Exchange Management (Acquisition and Transfer of Immovable Property in India) Regulations, 2018 (Property Regulations) for foreign investment in Indian immovable property.

However, the Finance Act, 2015 amended FEMA to provide that the RBI would only be empowered to notify Regulations pertaining to Debt Instruments, whereas the Central Government would notify Rules pertaining to the limit and conditions for transactions involving Non-Debt Instruments. While moving the Finance Bill, 2015 the Finance Minister explained the rationale for the same. He stated that capital account controls were more a policy matter rather than a regulatory issue. Accordingly, the power to control capital flows on equity was transferred from the RBI to the Central Government. Hence, a distinction was drawn between Debt Instruments and Non-Debt Instruments. The power to determine what is debt and what is non-debt has also been given to the Central Government.

While this enabling amendment was made in 2015, the actual Rules for the same were only notified on 16^th October, 2019 and, thus, the transfer of power took place only recently. Let us analyse some key features of these new Rules.

DISTINCTION

The Department of Economic Affairs, Ministry of Finance is the authority within the Central Government which has been given the above responsibility. The Finance Ministry has, on 16^th October, 2019, determined certain instruments as Debt Instruments and certain others as Non-Debt Instruments as given in Table 1 below:

Table 1: Classification of Debt vs. Non-Debt Instruments

NOTIFICATION OF RULES AND REGULATIONS

Pursuant to this determination, the Finance Ministry on 17^th October, 2019 notified the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (the NDI Rules) and, correspondingly, the RBI has notified the Foreign Exchange Management (Debt Instruments) Regulations, 2019 (the Debt Regulations). The NDI Rules have superseded the erstwhile TISPRO Regulations and the Property Regulations which were issued by the RBI. While there are no changes in the NDI Rules as compared with the erstwhile Property Regulations, there are several changes in the NDI Rules as compared with the erstwhile TISPRO Regulations which are explained below. The RBI had also notified the Master Direction No. 11/2017-18 on Foreign Investment in India. This was issued pursuant to the TISPRO Regulations. However, section 47(3) of the FEMA states that all Regulations made by the RBI before 15^th October, 2019 shall continue to be valid until rescinded by the Central Government. Now that the TISPRO Regulations have been superseded by the NDI Rules, it stands to reason that this particular Master Direction would also no longer be valid. However, unlike the TISPRO Regulations, this Master Direction has not been expressly rescinded.

The TISPRO Regulations permitted an Indian entity to receive any foreign investment which was not in accordance with the Regulations provided that the RBI gave specific permission for the same. The NDI Rules also contain a similar provision for the RBI to give specific permission but it must do so after consultation with the Central Government. The powers of the RBI to specific pricing guidelines for transfer of shares between residents and persons resident outside India continue under the NDI Rules but they must be made in consultation with the Central Government.

Debt vs. Non-Debt definition: As compared to the TISPRO Regulations, the NDI Rules contain certain changes. Some of the key features of these Rules are explained here. One of the important definitions is the term ‘Non-Debt Instruments’ which has been defined in an exhaustive manner to mean the instruments listed in Table 1 above. Consequently, the term ‘Debt Instruments’ has been defined to mean all instruments other than Non-Debt Instruments.

Equity instruments: The term ‘capital instruments’ has been replaced with the term ‘equity instruments’. It means equity shares, compulsorily convertible debentures (CCDs), compulsorily convertible preference shares (CCPS) and warrants.

FDI: The distinction between foreign direct investment (FDI) and foreign portfolio investment has been continued from the TISPRO Regulations. Accordingly, any foreign investment through equity instruments of less than 10% of the post-issue paid-up capital of a listed company would always be foreign portfolio investment, whereas if it is 10% or more it would always be FDI. Any amount of foreign investment through equity instruments in an unlisted company would always be FDI.

Listed Indian company: The definition of the term ‘listed Indian company’ has undergone a sea change as compared to the TISPRO Regulations. Earlier, it was defined as an Indian company which had its capital instruments listed on a stock exchange in India and, thus, it was restricted only to equity shares which were listed.

The NDI Rules amended this definition to read as an Indian company which has its equity or Debt Instruments listed on a stock exchange in India. This amendment has created several unresolved issues. For example, under the SEBI (Issue and Listing of Debt Security) Regulations, 2008 a private limited company can also list its non-convertible debentures on a recognised stock exchange in India. Now, as per the amended definition under the NDI Rules, such a private company would also have to be treated as a listed Indian company. Accordingly, any foreign investment in such a private company, through equity instruments of less than 10% of the share capital, would now be treated as foreign portfolio investment. Secondly, Rule 21 specifies the pricing guidelines and states that the price of equity instruments issued by a listed Indian company to a person resident outside India would be as per the SEBI Guidelines. Thirdly, in case of a transfer of shares in such a company from a resident to a person resident outside India would have to be as per the SEBI Guidelines. There are no SEBI Guidelines for pricing of unlisted equity shares in case of a company whose debentures are listed. Hence, the Rules require adherence to SEBI pricing Guidelines when, in fact, there are none for private companies whose debt alone is listed! It is submitted that the NDI Rules should be amended to revert to the original position.

Rule 19 of the NDI Rules provides that in case of the merger / demerger of two or more Indian companies, where any of them is a company listed on a stock exchange, the scheme shall be in compliance with the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015. Here Rule 19 does not use the defined phrase of ‘listed Indian company’. Further, while the aforesaid SEBI Regulations apply both to listed equity shares and listed debt, the provisions in Regulation 37 relating to scheme of arrangement apply only to companies which have listed their equity shares. Hence, it stands to reason that this particular provision of Rule 19 only covers companies whose equity shares are listed on a stock exchange.

Separate schedules: Similar to the TISPRO Regulations, the NDI Rules classify the different types of foreign investment which an Indian entity can receive into different schedules. Schedule I deals with FDI in an Indian company; schedule II deals with investment by a Foreign Portfolio Investor; schedule III deals with repatriable investment by NRIs; schedule IV deals with non-repatriable investment by NRIs and other related entities; schedule V deals with investment by other non-resident investors, such as sovereign wealth funds, pension funds, etc.; schedule VI deals with investment in an LLP; schedule VII deals with investment by a Foreign Venture Capital investor; schedule VIII deals with investment in an investment vehicle; schedule IX deals with investment in Foreign Depository Receipts; and schedule X deals with investment in Indian Depository Receipts.

Mutual funds > 50% in equity: One major amendment introduced by the NDI Rules was to classify a mutual fund which invested more than 50% in equity as an investment vehicle along with an REIT, AIF and an InVIT. The implication of this seemingly small amendment is drastic. It would mean that any mutual fund which is owned and / or controlled by non-residents and if it has invested more than 50% in equity, then any investment made by such a fund would be treated as indirect FDI. Thus, any investment by such a fund (even though it is not a strategic investment but a mere portfolio investment) would have to comply with pricing guidelines, reporting, sectoral caps and conditions, etc., specified for indirect FDI. Further, several sectors would be out of bounds for such a fund which are currently off limits for FDI. This move created turmoil within the mutual fund industry since several funds are owned and / or controlled by foreign companies. It also led to a bias against such funds and in favour of purely domestic funds. The SEBI took up this issue with the Finance Ministry and, accordingly, the NDI Rules have been amended on 5^th December, 2019 with retrospective effect to drop such mutual funds which invest more than 50% in equity from the definition of investment vehicle. Accordingly, any investment by such mutual funds would no longer be classified as indirect FDI.

Sectoral caps: The NDI Rules amended the definition of sectoral caps to provide the maximum repatriable investment in equity and Debt Instruments by a person resident outside India. Thus, compared to the TISPRO Regulations, Debt Instruments were also added in the definition of sectoral caps. This definition again created an ambiguity since it was not possible to consider debt investment while reckoning the sectoral caps. Accordingly, the NDI Rules have been amended on 5^th December, 2019 with retrospective effect to drop Debt Instruments from the definition of sectoral caps and revert to the earlier definition.

Pricing of convertible instruments: Unlike the TISPRO Regulations, the NDI Rules did not provide flexibility in determining the issue price of CCDs and CCPS. Now, the NDI Rules have been amended on 5^th December, 2019 with retrospective effect to provide that the price of such convertibles can either be determined upfront or a conversion formula should be determined at the time of their issue. The conversion price should be ≥ the fair market value as at the date of issue of the convertible instruments.

FPI: The NDI Rules have substantially amended the provisions relating to investments by SEBI Registered Foreign Portfolio Investors or FPIs:

(a) Under the TISPRO Regulations, maximum aggregate FPI investment was 24%. This limit could be increased to the sectoral caps by passing a special resolution. Thus, a company in the software sector which has no sectoral caps could increase the FPI limit to 100%.

(b) The NDI Rules now provide that with effect from 1st April, 2020 the FPI limit for all companies shall be the sectoral caps applicable to a company irrespective of whether or not it has increased the limit by passing a special resolution. The only exception is a company operating in a sector where FDI is prohibited – in which case the FPI limit would be capped @ 24%. This is a new feature which was not found in the TISPRO regime. Thus, in the case of a listed company operating in the casino / gambling sector (where FDI is taboo) the FPI limits would be 24%! This is a unique provision since FDI and FPI are and always were separate ways of investing in a company. Now, FPI would be limited in a company simply because it is ineligible to receive FDI.

(c) In case the Indian company desires to reduce the FPI limit then it can peg it to 24% or 49% or 74% provided that it passes a special resolution to this effect before 31^st March, 2020. Thus, if an Indian company is wary of a hostile takeover through the FPI route, then it may reduce the FPI limit. Such a company which has reduced its FPI limit may once again increase it to 49%  or 74% or sectoral cap by passing another special resolution. However, once a company increases its FPI limit after first reducing it, then it cannot once again reduce the same.

(d) If an FPI were to inadvertently breach the limit applicable to a company, then it has five trading days to divest the excess shares, failing which its entire shareholding in that company would be classified as FDI.

(e) The Rules originally provided that FPIs could sell / gift shares only to certain non-residents. This provision has been amended with retrospective effect to provide that FPIs can sell in accordance with the terms and conditions provided by the SEBI Regulations. Thus, the original position prevalent under the TISPRO Regulations has been restored.

FVCI: Under the TISPRO Regulations, a SEBI registered Foreign Venture Capital Investor could invest in the securities of a start-up without any sectoral restrictions. As compared to the TISPRO Regulations, instead of the term ‘securities’, the NDI Rules provide a more detailed description permitting investment in the equity or equity-linked instruments or debt instruments issued by a start-up. However, if the investments are in equity instruments then the sectoral caps, entry routes and other conditions would apply.

Sectoral conditions: The NDI Rules have made certain changes in the sectoral conditions for certain sectors which are as follows:

(i)   Coal and lignite: 100% FDI through the automatic route is now allowed in sale of coal and coal mining activities, including associated processing infrastructure, subject to the provisions of the Mines and Minerals (Development and Regulation) Act, 1957 and the Coal Mines (Special Provisions) Act, 2015. This includes coal washery, crushing, coal handling and separation (magnetic and non-magnetic).

(ii)   Manufacturing: The 100% automatic route FDI is permissible in manufacturing. The definition of the term manufacturing has been amended to include contract manufacturing in India through a legally tenable contract, whether on principal-to-principal or principal-to-agent basis. In this respect, the Commerce Ministry has clarified that the principal entity which has outsourced manufacturing to a contractor would be eligible to sell its products so manufactured through wholesale, retail or e-commerce on the same footing as a self-manufacturer. Further, the onus of compliance with the conditions for FDI would remain with the manufacturing entity.

(iii) Broadcasting: A new entry has been added permitting FDI up to 26% on the Government approval route in uploading / streaming of news and current affairs through digital media.

(iv) E-commerce: Under the TISPRO Regulations, an e-commerce entity was defined to mean an Indian company or a foreign company covered under the Companies Act, 2013 or an office, branch or agency which is owned or controlled by a person resident outside India and which is conducting e-commerce activities. The NDI Rules have truncated the definition to only cover a company incorporated under the Companies Act, 1956 / 2013. Hence, going forward, branches of foreign companies would not be treated as an eligible e-commerce entity. Further, a new condition has been included that an e-commerce marketplace with FDI must obtain and maintain a report from its statutory auditor by the 30^th day of September every year for the preceding financial year confirming compliance with the FDI Guidelines.

(v) Single Brand Product Retail Trading (SBRT): The original NDI Rules contained some variations compared to the TISPRO Regulations which have now been rectified. However, even though 100% automatic route FDI continues to be allowed in SBRT, there are yet some changes compared to the TISPRO Regulations:

(1)     SBRT FDI > 51% requires that at least 30% of the value of the goods procured shall be locally sourced from India. The entity can set off this 30% requirement by sourcing goods from India for global operations. For this purpose, the phrase ‘sourcing of goods from India for global operations’ has been defined to mean the value of goods sourced from India for global operations for that single brand (in rupee terms) in a particular financial year directly by the entity undertaking SBRT or its group companies (whether resident or non-resident), or indirectly by them through a third party under a legally tenable agreement.

(2)     As before, an SBRT entity operating through brick and mortar stores can also undertake retail trading through e-commerce. However, it is now also possible to undertake retail trading through e-commerce prior to the opening of brick and mortar stores, provided that the entity opens brick and mortar stores within two years from the date of starting the online retail.

The power to govern the mode of payment and reporting of the non-debt instruments still vests with the RBI and, thus, the RBI has also notified the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019. These lay down the forms to be filed on receipt of various types of foreign investment, the manner of making payment by the foreign investors and the manner of remittance of the sale / maturity proceeds on sale of these foreign investments. These Regulations contain provisions which are the same as those contained in the earlier TISPRO Regulations.

DEBT REGULATIONS

Consequent to the notification of the Debt Rules, the RBI has notified the Foreign Exchange Management (Debt Instruments) Regulations, 2019. These regulate debt investment by a person resident outside India. For instance, the investment by FPIs in corporate bonds / non-convertible debentures is governed by these Regulations. One change in the debt regulations as compared to the TISPRO Regulations is that NRIs are no longer allowed to invest in money market mutual funds on a non-repatriation basis.

CONCLUSION

The FEMA Regulations have been totally revamped in the field of capital instruments. It remains to see whether the Government would amend more FEMA Regulations to transfer power from the RBI to itself. One only wishes that whichever authority is in charge, there is clarity and simplicity in the FEMA Regulations which would lead to a conducive investment climate.