RBI’s recent clarifications to India’s foreign investment regime

Partner: Kosha Thaker, Senior Associate: Adit Munshi

On 20 January 2025, the Reserve Bank of India (RBI) issued an updated Master Direction on Foreign Investment in India (Master Direction). These updates provide much needed clarity on multiple long-standing issues under India’s foreign investment regime, particularly in relation to the structuring of downstream investments by foreign owned or controlled companies (FOCC). In addition, the updates outline compliances for acquisitions through rights issues and filing requirements for downstream investments. The updates also incorporate the amendments made to the Foreign Exchange Management (Non-Debt Instrument Rules), 2019 (NDI Rules) in August 2024 which facilitated cross border mergers and acquisitions (M&A) by permitting secondary share swap arrangements.

1. Downstream investments by FOCCs to be treated on par with foreign direct investments

Downstream investments by FOCCs have traditionally been subject to the same regulatory treatment as non-resident investments, requiring compliance with sectoral caps, pricing guidelines, and other conditions applicable to foreign direct investments. The guiding principle— “what cannot be done directly, shall not be done indirectly”—underscores the regulatory intent to place downstream investments on an equal footing with foreign direct investments. However, despite this principle, there remained uncertainty over whether FOCCs could structure downstream investments through share swaps or employ deferred consideration arrangements, even though these mechanisms are permitted in the context of foreign direct investments.

The ambiguity regarding deferred consideration arose after several FOCCs received notices from the RBI in 2023 for implementing tranche-based payment structures. This regulatory action prompted authorised dealer (AD) banks to adopt a conservative stance, holding that deferred consideration arrangements by FOCCs would require RBI approval.

Similarly, there was uncertainty around whether FOCCs could structure their investments through a share swap. In a meeting in January 2024, the RBI had reportedly informed AD banks that FOCC transactions involving share swaps would require its approval. This interpretation appears to have stemmed from Rule 23(4)(b) of the NDI Rules, which mandates that FOCCs must fund downstream investments either using funds brought in from abroad or internal accruals (i.e., profits transferred to reserve accounts after tax payments) and prohibits FOCCs from using funds borrowed in the domestic market to make downstream investments.

The conservative regulatory approach on both the above points represented a departure from the guiding principle otherwise applicable to FOCCs, effectively subjecting them to a stricter regulatory environment than the one applicable to foreign direct investments – i.e., even what could be done directly, could not be done indirectly. This was also at odds with the commercial realities of M&A transactions where share swaps and deferred payment structures— including post-closing price adjustments, holdbacks, escrows, milestone-based earnouts —are common mechanisms for risk allocation and deal structuring.

The Master Direction has now rectified this ambiguity by expressly clarifying that, based on the guiding principle of downstream investments, the arrangements available for foreign direct investments such as share swaps and deferred payment mechanisms are also available to FOCCs when making downstream investments. This is a welcome clarification and represents a consistent and logical application of the guiding principle.

It is important to note however, that the downstream investment must be structured to ensure it complies with the provisions of Rule 23 of the NDI Rules, including the restriction on using domestically borrowed funds.

2. Filing of Form DI for reclassified investments

The updated Master Direction now explicitly requires that a domestic entity that was initially classified as a resident but subsequently becomes foreign owned or controlled must report this reclassification to the RBI in Form DI within 30 days from the date of acquiring FOCC status. Certain AD banks were already following this process in practice.

The update facilitates greater transparency and accurate reporting of downstream investments. Entities undergoing such reclassification must proactively track changes in ownership and control to ensure timely compliance with this updated reporting mandate.

3. Acquisition of unsubscribed portion of a rights issue

The NDI Rules ordinarily require any issuance of shares to a non-resident to be priced at or above fair market value (FMV). However, these pricing guidelines are not applicable when a non-resident shareholder subscribes to its entitlement under a rights issue, in accordance with Section 62(1)(a)(i) of the Companies Act, 2013 (Companies Act). In such cases, the only key requirement is that such shares must not be priced lower than those offered to the resident shareholders.

The RBI has now clarified that in addition to entry route, sectoral caps and other attendant conditions under the NDI Rules, the pricing guidelines will need to be adhered to when a non-resident subscribes to shares under a rights issue in accordance with Section 62(1)(a)(iii) of the Companies Act (i.e., where the board of directors exercises its discretion to dispose of the unsubscribed portion of a rights issue in a manner not disadvantageous to the shareholders and the company).

It is important to note that, where a resident shareholder renounces its rights entitlement in favor of a non-resident in accordance with Section 62(1)(a)(ii) of the Companies Act, the NDI Rules require the shares to be priced at or above FMV. Considering this, certain AD banks were already taking the view that the exemption from the pricing guidelines would only apply to the extent of a non-resident shareholder subscribing to its proportionate entitlement in a rights issue.

The latest clarification appears to extend the same principle, requiring adherence to pricing guidelines in cases where unsubscribed shares are allotted at the discretion of the board.  

4. Foreign direct investment permitted to meet net-owned funds requirements

The RBI has clarified that Indian entities whose proposed activities are regulated by a financial sector regulator may receive foreign investment to comply with minimum net-owned funds (NOF) criteria prescribed by such regulators. Accordingly, entities proposing to engage in regulated financial activities have been granted general permission to bring in foreign investment, even in cases where such investment would typically require government approval, provided the investment is for the purpose of meeting NOF requirements. However, the updated Master Direction clarifies that such foreign investment must be exclusively used to meet NOF requirements and cannot be diverted for any other purposes or activities. Further, if the company fails to obtain the relevant license or registration from the regulator, the company must either repatriate the investment or must obtain applicable government approvals, if any, before deploying these funds.

Conclusion

The RBI’s clarifications enhance regulatory transparency and align foreign investment norms with market practices, while maintaining oversight. These updates, along with the government’s ongoing efforts to further ease the foreign exchange regime, are aimed at attracting foreign capital and streamlining India’s foreign investment framework. As regulatory refinements continue, these measures are expected to boost investor confidence and create a more favourable investment environment in India.

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