A Regulatory Conundrum on The Dual Treatment of Foreign-Owned Or Controlled Companies under Foreign Exchange Management Act, 1999 (FEMA, 1999)
1. INTRODUCTION
Foreign Owned or Controlled Entities (“FOCC”) are Indian companies that have received foreign investment and are owned or controlled by a foreign entity. When FOCC acquires equity instruments of another Indian company or contributes towards the capital of another Indian entity, it becomes a downstream investment.
The Foreign Exchange Management Act, 1999, and rules and regulations made thereunder (“FEMA”), particularly Rule 23 of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“the Rules”) provide a regulatory framework for downstream investments. While the NDI Rules require certain conditions to be met for downstream investments, ambiguities continue to exist with regard to the treatment of FOCCs.
Rule 23(5) of the NDI Rules mandates the pricing guidelines and reporting requirements if FOCC is transferring capital instruments to an Indian resident. The said Rules are silent on the requirements to be followed if FOCC is the one purchasing equity instrument of an Indian entity. The presentation aims to explore the regulatory hurdles in downstream investments in India which ought to be addressed by the relevant authorities.
II. REGULATORY HURDLES
A. Regulatory Gaps in Pricing:
On a plain reading of Rule 23(5) of the NDI Rules, it can be interpreted that the FOCC is treated as a Non-Resident (“NR”) from a pricing perspective and an ‘Indian Resident’ from reporting perspective. Consequently, FOCC should be treated as an NR from a pricing perspective in case of purchase of equity instruments by it. It has been observed that in some cases Authorised Dealer (“AD”) banks have applied the pricing guidelines in a transaction between an NR and an FOCC. This is counter-intuitive as there is no outflow of domestic funds from the country in such transactions.
Secondly, the NDI Rules do not cover the pricing guidelines in case of simultaneous acquisition of shares of an Indian company by FOCC from a resident as well as an NR. Taking into account a combined reading of rules 21 and 23, the recent views adopted by AD Banks suggest that if the FOCC is acquiring shares simultaneously from NRs and residents, it should purchase shares from NRs at or below the Fair Market Value (“FMV”) but from residents at or above the FMV. This leads to the absurd situation where the FOCC is treated as a resident when buying from NR but as NR when buying from residents.
B. Regulatory Gaps in Filings:
Like the pricing issue, the NDI Rules do not specifically provide for filing requirements when FOCC acquires equity instruments from a resident or an NR. In addition to Form DI (used to report downstream investments), AD banks may also require the filing of Form FC-TRS in such cases. For transfers between FOCCs, as NDI Rules are silent, no reporting may be required although the acquiring FOCC may have to file Form DI.
C. Investment in Optionally Convertible Preference Shares (“OCPS”) or Optionally Convertible Debentures (“OCDs”)
OCPS or OCDs are instruments that provide flexibility to parties in structuring their transaction. The investor gets the flexibility to choose at a later point in time, whether to convert his investment into equity shares and participate in the profits and capital appreciation or redeem the instrument to protect the capital he has invested. In the absence of a definition of ‘capital instruments’ under the NDI Rules, capital instruments are assumed to have the same meaning as ‘equity instruments’ under the NDI Rules. The Reserve Bank of India (“RBI”) had explained in its frequently asked questions (“FAQs”) on 7 May 2018 that investment in an instrument other than a capital instrument would not be treated as a downstream investment. Therefore, investment by FOCCs in OCPS or OCDs would not be treated as a downstream investment. However, on their subsequent conversion to equity shares, it would be treated as a downstream investment.
D. Applicability of the term “other attendant conditions”
Downstream investment is obligated to comply with the designated entry route, sectoral caps, pricing guidelines, and additional conditions relevant to foreign investment. The term “other attendant conditions” refers to the generic conditions that are applicable in the context of foreign investment regulations. These conditions are in addition to the FDI-linked performance conditions as imposed on Foreign Direct Investment (“FDI”). Therefore, it is recommended that the scope of “other attendant conditions” be construed restrictively, to not render regulations governing downstream investments as burdensome as FDI.
III. CONCLUSION:
The regulatory landscape governing downstream investment primarily hinges on the treatment of investments originating from Foreign Owned and Controlled Companies (FOCCs) across various scenarios. Depending on specific circumstances, FOCCs may be classified as Non-Residents (NRs) in certain contexts, while in most cases, they are regarded as Indian residents as per the prevailing Rules. This nuanced differentiation significantly complicates transactions involving FOCCs, adding layers of complexity to the process.
The bifurcated treatment of FOCCs concerning pricing and reporting guidelines is deemed favorable, yet it underscores the necessity for uniformity in their treatment, especially regarding pricing regulations. Amidst the ambiguity surrounding FOCC investments in Optionally Convertible Debentures (OCDs) of domestic entities, it is recommended to consider such investments as downstream investments, particularly when these debt instruments are converted into equity capital. It is crucial to avoid burdening FOCC investments with all the stringent conditions applicable to Foreign Direct Investment (FDI) in the case of downstream investments. Hence, any constraints on FOCCs should be explicitly elucidated to ensure clarity and compliance.
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