Recalibrating India’s Downstream Investment Regime Under Updated Directions
1. Understanding Downstream Investments
Foreign investors can invest in India directly through Foreign Direct Investment (FDI) or via a foreign-owned and/or controlled company (FOCC). An FOCC is an Indian-incorporated entity in which non-residents hold over 50% shares or exercise control through the appointment of majority directors or by influencing strategic decisions. When a non-resident transfers shares in Indian companies via its subsidiaries established in India, the downstream investment regime steps in. The purpose of such investments is to attract less compliance as compared to FDI.
The guiding principle of the downstream investment in India has been that “what cannot be done directly, shall not be done indirectly“. This ensures that foreign investors cannot circumvent sectoral restrictions and other conditions under the FDI regime by routing their investments through an FOCC. Accordingly, similar to FDI norms, downstream investments must also comply with the entry routes, sectoral limits, pricing caps, and related conditions specified in the Foreign Exchange Management Act, 1999 (FEMA) and the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules).
Although Rule 23(1) of the NDI Rules seeks to treat FOCCS equally with persons resident outside India (PROI), there have still been ambiguities regarding certain aspects, such as share swap arrangements or deferred consideration payment structures. As a result, the industry often relies on informal guidance received from authorised dealer banks (AD Banks) on such transactions.
The Reserve Bank of India (RBI) on 20 January 2025, released an updated Master Direction on Foreign Investment in India (Master Direction) aimed at clarifying various grey areas, particularly for FOCCs pursuing downstream investments. The updated Master Direction seeks to resolve uncertainties, harmonise the regulatory framework and streamline compliance requirements for FOCCs wishing to acquire stakes in domestic business.
2. Key Updates Regarding Downstream Investments
a. Share Swaps move from Ambiguity to Recognition
Indian companies are allowed to issue equity instruments to PROIs in exchange for equity instruments of another Indian company under the automatic route as per Rule 6(a), Rule 9, read
with Schedule I of the NDI Rules. However, Rule 23(4) led AD banks to adopt a restrictive interpretation for downstream investment. As a result, companies typically either avoid downstream investments or go under the approval route. This resulted in an absurd situation wherein FOCCs were facing more limitations in downstream investment as compared to companies undertaking direct foreign investments.
The recent clarification, under Rule 9-A, allows for FOCCs to transfer equity instruments of an Indian company through swap transactions, subject to other applicable conditions. Clearing the ambiguity, the Master Direction affirms that downstream investments by FOCCs may employ similar investment structures available for direct investment routes.
Any acquisition by way of share swap must adhere to sectoral limits, valuation report, pricing regulations, and reporting requirements, with compliance with overseas direct investment (ODI) guidelines applicable to the acquisition of shares from foreign companies. Prior government approval is necessary if the Indian investee company functions in a restricted FDI sector or as mandated by regulation.
Since this is a recent clarification, its practical implementation in easing the transfer of shares is uncertain and remains to be seen. The extent of discretion available to AD banks in vetting these transactions could lead to inconsistent execution.
b. Investment Limits on Deferred Consideration and the FOCC Dilemma
Rule 9(6) of the NDI Rules permits deferred consideration in FDI transactions, allowing up to 25% of the consideration to be deferred for a maximum of 18 months. These deferments are typically used for post-closing adjustments, escrows, or earnouts in mergers and acquisitions (M&A) deals, subject to adherence to pricing guidelines.
However, since FOCCs were not specifically included under this provision, it has led to conservative market interpretation. This uncertainty deepened in 2023 when the RBI issued notices to several FOCCs that had undertaken deferred payment arrangements. Consequently, this led to an anomalous situation where indirect foreign investments faced stricter regulatory standards than FDI.
To address this, Paragraph 9 of the Master Direction clarified that FOCCs can utilise deferred consideration for equity transfers. This update broadens the structuring of transactions involving FOCCs, aligning with the policy and commercial practicalities alike. That said, the clarification lays down that the downstream transaction must not evade the NDI Rules, including the restriction on using borrowed funds. Although this clarification provides greater flexibility to FOCCs in structuring downstream investment, they do not explicitly state whether all procedural relaxations for FDI will apply uniformly to downstream investments, which allows for potential interpretational differences by AD banks.
c. Facilitating Compliance for Minimum Net Owned Fund (NOF) Criteria
The Master Direction provides explicit clarification that Indian entities regulated by financial sector authorities may receive foreign investment solely to meet the minimum NOF requirements, even in cases where such investment would typically require government approval. This aims to streamline a lengthy and cumbersome process of getting prior approval from the Department of Economic Affairs, Government of India, enabling companies to raise funds efficiently.
It is pertinent to note that these funds must be used strictly for meeting NOF norms and cannot be redirected for any other purposes. If the entity fails to obtain the requisite license or registration, the investment must either be repatriated or be deployed only after securing the necessary approvals. This not only facilitates smoother regulatory approvals [such as Non-Banking Financial Company (NBFCs) fulfilling the ₹10 crore NOF requirement for RBI registration] but also ensures that the route is not exploited to circumvent the FDI framework.
d. Share-based Employee Benefits (SBEBs) clarify Employee Stock Option Plan (ESOPs) and sweat equity shares
The definition for ESOPs and sweat equity shares has now been aligned with the Companies Act 2013 and Securities and Exchange Board of India (SEBI) regulations, thereby eliminating previous regulatory ambiguities. SBEBs include equity granted to employees or directors of an Indian company’s holding company, joint venture, or wholly owned foreign subsidiary who reside outside India.
Such issuance must comply with the entity’s SBEB scheme, sectoral caps under the NDI Rules and, where required, prior government approval (particularly for citizens of Bangladesh or Pakistan). Notably, Master Direction mandates that the percentage of foreign investment arising from such grants must be calculated upfront, on a fully diluted basis, at the time of issuance, rather than upon exercise. This upfront calculation, which includes all outstanding options and convertible instruments, is designed to ensure compliance with applicable sectoral caps and reduce inadvertent regulatory breaches by Indian entities issuing such benefits.
e. Acquisition of Unsubscribed Portion of a Rights Issue
Traditionally, rights issues allowed non-resident shareholders to subscribe to their proportionate entitlement at prices no lower than those offered to resident shareholders, exempting such transactions from fair market value (FMV) pricing requirements. However, the new guidelines specify that when the board of directors disposes of the unsubscribed shares (either at its discretion or following a renouncement by a resident shareholder), these shares must be issued at FMV determined using internationally accepted valuation methodologies. This valuation must be certified by a qualified professional, such as a Chartered Accountant, Merchant Banker registered with SEBI, or a practicing Cost Accountant for an unlisted company, ensuring adherence to Rule 7A of the NDI Rules.
Additionally, the Master Directions confirm that all such issuances to non-residents must comply with entry route restrictions, sectoral caps, investment limits, and other conditions under the NDI Rules. By reinforcing the necessity of adhering to arm’s length pricing and sectoral rules for unsubscribed shares allotted at the board’s discretion (per Section 62(1)(a)(iii) of the Companies Act), these updates provide assurance both to companies and investors that the disposal of unsubscribed rights issue shares will not disadvantage any shareholder and the company. This update provides regulatory certainty where AD banks already had the view pricing guidelines exemption.
3. Conclusion
While the Master Direction have strengthened the regulatory framework governing downstream investments by FOCCs and aligned them with the direct FDI regime, the reforms remain incomplete. While NDI Rules provide clarity on downstream transfers where an FOCC acts as the transferor, there remains a conspicuous gap in the regime when an FOCC is the transferee of equity instruments. It is unclear whether such transactions will be limited to reporting requirements alone or whether pricing guidelines also apply. In practice, these transactions are vetted on a case-by-case basis by AD banks, often leading to inconsistent outcomes.
Further, the near-parity between downstream investment and direct FDI aims to prevent circumvention of sectoral caps and entry routes. The only residual differences lie in structural complexity and compliance layering, as downstream investments require additional filings and carry monitoring challenges around indirect use of borrowed funds. Thus, while direct FDI remains the simpler route, downstream investment has effectively become a parallel mechanism that is no longer a loophole but a regulated extension of foreign investment. A unified, codified FDI framework along with binding operational FAQs and harmonised compliance systems across RBI, Department for Promotion of Industry and Internal Trade (DPIIT), and Ministry of Corporate Affairs (MCA), would significantly enhance predictability. The consolidated FDI Policy would reduce reliance on bank-level interpretations and provide the predictability required for cross-border M&A transactions.
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Author: Ishita Gupta, Third Year B.A. LL.B. (Hons.) Student, Chanakya National Law University, Patna
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