The Foreign Exchange Management Act (FEMA) was enacted in 1999 by the Parliament to facilitate external trade payments and regulate foreign exchange transactions. It replaced the FERA Act of 1973 as a part of India’s financial sector reform. The FEMA Act broadly divided foreign exchange transactions into two parts- current account transactions and capital account transactions. The regulatory framework between the central government and the Reserve Bank of India (RBI) was also created through the FEMA Act.
In this post, I will critically analyze the recent amendments to the FEMA Act and the rules and regulations issued by the RBI and central government, and how these changes affect the regulatory structure of FEMA. The author argues that despite the structural changes brought by the enactment of the Finance Act, 2015 and the amendments to the FEMA and the subsequent rules and regulations issued by the RBI and the central government there exist regulatory issues and clarity is needed on various interpretative issues.
THE BASIC FRAMEWORK OF THE FEMA ACT
The FEMA Act divides foreign exchange transactions into two broad categories- capital account transactions and current account transactions. Section 5 of the FEMA regulates current account transactions and the proviso to the section allows the central government in consultation with the Reserve Bank of India (RBI) to impose reasonable restrictions on current account transactions. Similarly, Section 6 of the FEMA regulates capital account transactions. Subclause (2) of Section 6 allows the RBI in consultation with the central government to specify any class or classes of capital account transactions that are permissible and the limit to which the foreign exchange would be admissible.
Since the enactment of the FEMA in 1999 when it came to the oversight and regulation of foreign investments in India, there were regulatory overlaps. The Ministry of Finance, which is a part of the Central Government, was still responsible for formulating policies for foreign direct investment (“FDI”) in India, even if the Reserve Bank of India (“RBI”) was the regulatory agency responsible for developing the laws and guidelines relevant to the issuance or transfer of securities. When the RBI adopted the stated FDI policy into its present foreign exchange laws through master directives issued by it, the separation of powers became frequently unclear. However, there were several cases where the FDI policy was not properly integrated or applied to the foreign exchange regulations.
RESTRUCTURED FOREIGN EXCHANGE REGULATORY MECHANISM UNDER FEMA
India’s foreign exchange management regime. In 2019 the Ministry of Finance notified Sections 139, 143, and 144 of the Finance Act, 2015 which amended Sections 6, 46, and 47 of the FEMA. Post these amendments RBI now had the power to specify any class or classes of capital account transactions involving debt instruments and make regulations for the same as mandated by amended Section 6 read with amended Section 47 of the FEMA and the central government now had the power to prescribe any class or classes of capital account transactions not involving debt instruments and make rules for the same as mandated by amended Section 6 read with Section 46 of the FEMA.
In other words, the RBI now had the power to frame regulations for capital account transactions involving debt instruments and the central government had the power to make rules for foreign exchange transactions involving non-debt instruments. The changes were implemented by the introduction of the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (Non-debt Instruments Rules or NDI Rules) and the Foreign Exchange Management (Debt Instruments) Regulations, 2019 (Debt Instruments Regulations or DI Regulations). These replaced the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (TISPRO Regulations) as well as the Foreign Exchange Management (Acquisition of Transfer of Immovable Property in India) Regulations, 2018 (ATIP Regulations).
These legislations bring several important changes in terms of how the provisions of the FEMA Act will be enforced. This part of the paper will deal with some of these changes keeping in mind the basic research question of this paper which is an examination of the division of power between the RBI and the Central Government.
Changes in Definitions and introduction of new definitions
The NDI Rules and the DI regulations have both added new definitions for terms like debt instruments, non-debt instruments, and equity investments and modified definitions for terms like investment vehicle and hybrid securities. The introduction and modification of definitions under the erstwhile TISPRO regulations will be discussed in greater detail in the later part of this paper.
Changes related to Foreign Venture Capital Investors (“FVCIs”)
FVCIs had the option of investing in start-ups’ “securities” under TISPRO. Under TISPRO, the word “securities” was not defined. An FVCI may invest in “equity or equity linked instruments or debt instruments issued by an Indian “start-up,” regardless of the sector in which the start-up is engaged,” according to the new NDI Rules. In the NDI Rules, the term “equity or equity-linked instrument” or “debt instrument issued by an Indian start-up” is used instead of the word “securities” as it was in TISPRO. The NDI Rules have also added the phrase “irrespective of the sectors” as a new inclusion. This is a welcome change in terms of encouraging foreign investments in Indian startups and also aligns with the government’s policy of liberalizing and globalizing the financial sector.
Increased Government Control
One of the striking changes brought about by the Non-Debt Instruments Rules is the Central Government’s increased control over foreign investments. This is evident in the introduction of the phrases “and in consultation with the Central Government” in a number of provisions, including those pertaining to the approval of transfers not covered by general permission and the divestment of investments by Non-Resident Indians (“NRIs”) or Overseas Citizens of India (“OCIs”) in the event of a breach of the relevant limits or sectoral caps, and issuance of shares in case of swap of equity instruments. This virtually eliminates the RBI’s autonomy and discretionary powers, and it raises the question of how much longer the approval process will become since the existing process was cumbersome and time taking.
Changes regarding the acquisition of immovable property
The combining of laws relating to the acquisition or transfer of immovable property, which was formerly covered under the ATIP Regulations, with provisions relating to foreign investment is one of the most drastic changes brought about by these Non-Debt Instrument Rules. While the rules regarding the purchase or transfer of real estate by a person residing outside of India have not changed significantly, such a transaction would now be seen as a non-debt investment.
The clarity in Debt Instrument Regulations
The rules governing investments in debt, non-convertible debentures, security receipts, and other government securities by FPIs, NRIs, OCIs, foreign central banks, and multilateral development banks, among others, have been shifted from the TISPRO Regulations to the Debt Regulations.
The Regulations now go a step further and permit an authorized dealer to allow remittances, both inward and outward, related to permitted derivatives transactions. Previously, the TISPRO Regulations only allowed an authorized dealer to allow the remittance of sale proceeds of a security (net of applicable taxes) to the seller of shares resident outside India.
CRITICAL ANALYSIS OF THE CHANGES IN THE FEMA ACT
There are interpretative issues however even in these rules and regulations. Firstly, neither the FEMA nor the Finance Act of 2015 contains a definition of debt instruments or non-debt instruments. The Debt Instrument Regulations and Non-Debt Instrument Rules both contain definitions of the term ‘debt instruments’ but both the legislations define the term very differently. The Non-Debt Instruments Rules define debt instruments as all those instruments other than the non-debt instruments defined in clause 2 (a) of these rules. The Debt Instruments Regulations define debt instruments as those which are listed in Schedule I of the Regulations. Schedule I of the Regulations have different instruments for different classes of overseas investors [FPI, NRI’S (both on repatriation and non-repatriation basis and Foreign Central Banks or a Multilateral Development Bank]. It is clearly visible that the instruments which are classified as debt instruments for the purposes of Non-Debt Instrument Rules need not be considered debt instruments for the purposes of Debt Instrument Regulations. The problem this dichotomy creates is that which instruments are referred to as ‘debt instruments’ in Sections 2A, 6, and 46 of the FEMA 1999 is left open to interpretation. The Foreign Exchange Management (Overseas Investment) Rules, 2022 (‘ODI Rules’) seem to address this issue as these specifically list the instruments which shall be considered as debt instruments and non-debt instruments for the purposes of the sub-section (7) to Section 6 of the FEMA Act, 1999. As per the ODI Rules Government bonds, corporate bonds, all tranches of securitisation structure which are not equity tranche, borrowings by firms through loans and depository receipts whose underlying securities are debt securities are considered as debt instruments while all investments in equity in incorporated entities (public, private, listed and unlisted), capital participation in Limited Liability Partnerships, all instruments of investment as recognised in the Foreign Direct Investment policy from time to time, investment in units of Alternative Investment Funds and Real Estate Investment Trust and Infrastructure Investment Trusts, investment in units of mutual funds and Exchange-Traded Fund which invest more than fifty percent in equity, the junior-most layer (i.e., equity tranche) of securitisation structure, acquisition, sale or dealing directly in immovable property, contribution to trusts; and depository receipts issued against equity instruments are considered as non-debt instruments. The Foreign Exchange Management (Overseas Investment) Regulations, 2022 (‘ODI Regulations’) which were subsequently issued by the RBI also accept the definition in the ODI Rules. These new set of legislations seem to solve the problem from a practical standpoint as the latest definition should be referred to by the practitioners, businesses, and policy analysts dealing with FEMA but the interpretative issue highlighted in this paper still remains as the ODI Rules and ODI Regulations do not repeal or suppress the NDI Rules or DI Regulations. This creates a regulatory issue as well because the governing powers of the RBI and central government post the foreign exchange regime overhaul has been bifurcated on the very basis of debt instruments and non-debt instruments and an ambiguity regarding the classification of these instruments is likely to cause regulatory issues in future.
There is a similar ambiguity that arises in the way the term ‘hybrid securities’ has been defined in the Non-Debt Instrument Rules. The rules define hybrid securities as hybrid instruments such as optionally or partially convertible preference shares or debentures and other such instruments as specified by the Central Government from time to time, which can be issued by an Indian company or trust to a person resident outside India. Not only is the definition itself ambiguous it also appears from a bare reading of the definition that it is a sub-category of debt instruments, but the term has not been referred to anywhere in the Non-Debt Instrument Rules and the Debt Instrument Regulations as well do not include any mention of the term hybrid securities. This raises questions regarding how hybrid securities will be treated and makes one wonder on the very fact that why the term has been defined in the first place the government’s proposal in this regard becomes further unclear as under the erstwhile TISPORO Regulations they were regulated as external commercial borrowings and classified as ‘debt instruments The Compulsory Convertible Debentures (CCD’S) which are a form of hybrid securities are listed as equity under the FDI Policy and therefore can be construed as non-debt instruments however, similar clarity cannot be said to exist for other forms of hybrid instruments and there structurization and regulation, therefore, remain ambiguous.
There exist certain drafting errors as well in these new sets of rules and regulations. For example, in the NDI Rules the term ‘equity instruments’ resembles the meaning assigned to the term ‘capital instruments’ in the erstwhile TISPRO regulations. However, in various provisions in the NDI rules like the definition of downstream investment and the conditionalities for investment in some sectors the term ‘capital instruments’ is still used and the same has not been defined under the NDI rules. Although it is not very difficult to decipher that this is a mere drafting error for clarity an official acknowledgement of the same would be better.
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