Downstream investments by FOCCs: Practical challenges and conundrums

• Introduction

  The Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules)¹ were notified on 17 October 2019 by the Ministry of Finance (Department of Economic Affairs) to primarily regulate direct foreign investments by persons resident outside India into Indian entity (FDI). The NDI Rules also provide the regulatory framework governing indirect foreign investment² into an Indian entity, which is conventionally termed downstream investment (Downstream Investment).³ Downstream Investments have been regularly utilised as a route by Indian entity with foreign investment to invest into and acquire other Indian entity, allowing consolidation within a sector, diversification of the portfolios of such Indian entity, and providing associated and related products in conjunction with their primary offerings.

  Where such FDI funded Indian entity are not owned⁴ and controlled⁵ by persons resident in India and are instead owned and controlled by persons resident outside India (FOCC), the central government seeks to regulate Downstream Investments by such FOCCs under the well-established legal principle of 'what cannot be done directly, must also not be done indirectly'.⁶ This principle forms the basis of Rule 23(1) of the NDI Rules which provides that an “Indian entity which has received indirect foreign investment shall comply with the entry route, sectoral caps, pricing guidelines and other attendant conditions as applicable for foreign investment”. The intent to treat FOCCs at par with persons resident outside India was to prevent foreign investors from putting in place workarounds to avoid the (Indian) exchange control regulations by investing through Indian entity owned and controlled by them.

  Unfortunately, the NDI Rules do not provide for a comprehensive code on all regulatory aspects concerning investments by FOCCs. Given regulatory ambiguity, the industry has to rely on informal guidance received from authorised dealer banks (AD Banks) on transactions, which, in turn, has evolved through their discussions with the Reserve Bank of India (RBI).

  This article seeks to delve into certain key practical issues, arising out of the inadequacy of/ambiguity in the provisions in the NDI Rules, which have resulted in difficulties in structuring cash and share swap transactions, while also providing insights on the views being adopted by the industry in conjunction with AD Banks in this regard.

• Key issues in downstream investments by FOCCs

  Unfortunately, the NDI Rules do not provide for a comprehensive code on all regulatory aspects concerning investments by FOCCs. The industry has to rely on informal guidance received from authorised dealer banks.

  • Determining pricing of equity instruments

    The general pricing guidelines, outlined in Rule 21 of the NDI Rules, broadly provide that a transfer of equity securities from a person resident outside India to a person resident in India shall be undertaken at a ‘ceiling’ price of the fair market value of such equity securities (FMV), whereas a transfer of equity securities from a person resident in India to a person resident outside India shall be undertaken at a ‘floor’ price of the FMV. Additionally, certain transactions are required to be reported to the prescribed regulatory authorities through prescribed form filings as outlined in the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019.

    With respect to FOCCs, Rule 23(5) of the NDI Rules provides for compliance requirements relating to transactions involving the transfer of equity instruments of an Indian entity by an FOCC as under.

    • FOCC to a person resident outside India will be subject to reporting requirements.
    • FOCC to a person resident in India will be subject to pricing guidelines.
    • FOCC to another FOCC; neither pricing guidelines nor reporting requirements will be applicable.

    This would indicate that while evaluating a transaction where equity instruments are being transferred by an FOCC, the intent of the NDI Rules read with the Master Direction on Foreign Investment in India (Master Direction)⁷ is: (a) to treat FOCCs at par with persons resident outside India, while determining the applicability of pricing guidelines, and (b) to treat FOCCs at par with persons resident in India, while determining the applicability of reporting requirements (Assumed Residency Principle).

    Notably, the NDI Rules and the Master Direction do not provide for the applicable compliance requirements where an FOCC is the transferee (and not the transferor) of equity instruments of an Indian entity. In the absence of regulatory guidance in this regard and given the broad principle outlined in Rule 21 of the NDI Rules mentioned above, a reasonable argument could be made to apply the Assumed Residency Principle and conclude that pricing guidelines are not applicable in respect of transfer of equity instruments of an Indian entity from a person resident outside India to an FOCC.⁸

    However, the industry practice (developed through informal guidance received by the AD Banks from the RBI) has been migrating towards taking the view that the parties involved in such a transfer (i.e., transfer of equity instruments of an Indian entity from a person resident outside India to an FOCC) are required to adhere to pricing guidelines. This conundrum may create issues from a structuring perspective, and it would be prudent to consult with the AD Bank tasked with processing the relevant transaction to ensure that the views have not further evolved through subsequent discussions with the RBI.

    Another concern also arises when the subject transaction involves an FOCC simultaneously purchasing equity instruments of an Indian entity from both persons resident in India as well as persons resident outside India, which is fairly ubiquitous in 100% acquisitions by way of share transfers. Given the above, and as has also been seen in the past, the AD Banks have required that pricing guidelines be adhered to while (a) undertaking the transfer from a person resident in India to an FOCC (where the FMV will be the lowest permissible price), and also while (b) undertaking the transfer from a person resident outside India to an FOCC (where the FMV will be the highest permissible price). This often results in parties having to undertake the entire transaction at exactly the FMV, which is often not the price previously arrived at through commercial negotiations.

  • The absence of adequate regulatory clarity has resulted in placing reliance on the informal guidance provided by AD Banks to structure transactions. Issuance of appropriate clarifications and a comprehensive framework for FOCCs is the need of the hour.

    Investment against swap of shares

    Rule 6 of the NDI Rules read with Schedule I allows an Indian company, under the automatic route, to issue equity instruments to a person resident outside India for non-cash consideration such as against:

    • share swaps, or
    • import of capital goods or machinery/equipment, or
    • pre-operative/pre-incorporation expenses.⁹

    Therefore, assuming that FOCCs are to be treated as persons resident outside India (based on the principle outlined in Rule 23(1)), a reasonable argument could be made that FOCCs would be permitted under the automatic route to make investments into an Indian entity against a swap of shares. In fact, this was historically considered permissible, under the automatic route. Recently, however, in light of the RBI actively questioning certain swap transactions, certain AD Banks have taken the conservative view that an FOCC undertaking downstream investment via the swap route would fall under the government approval route.

    This view appears to emanate from the language in Rule 23(4)(b) of the NDI Rules which states that “for the purpose of downstream investment, the Indian entity making the downstream investment shall bring in requisite funds from abroad and not use funds borrowed in the domestic markets and the downstream investments may be made through internal accruals and for this purpose, internal accruals shall mean profits transferred to reserve account after payment of taxes”,¹⁰ which is taken to imply that consideration is required to be solely in cash. Given that this rule has not been amended or modified before a more conservative view being taken, i.e., that government approval is required, there seems to have been a change in practice without there being a change in legal position.

    Separately, certain AD Banks are of the view, taken on a case-to-case basis, that while a transaction that is a ‘pure swap’ (i.e., that the entire consideration is sought to be discharged in the form of securities) would fall under the government approval route, a transaction where the consideration is payable partly in cash and partly as securities could fall under the automatic route.

    Given that there continues to be ambiguity and lack of consensus among AD Banks on this approval requirement, it would be prudent to consult with the AD Bank tasked with processing the relevant transaction to structure the transaction to avoid any last-minute regulatory hurdles.

• Conclusion

  The present legal framework for regulating FOCCs poses various interpretational issues as highlighted above. The absence of adequate regulatory clarity on these aspects has resulted in necessarily placing reliance on the informal guidance provided by AD Banks, on a case-to-case basis, to structure transactions. Issuance of appropriate clarifications by the regulators and providing a coherent and unambiguous framework for FOCCs would go a long way in allowing for strategic planning, structuring, and execution of transactions. Some of these issues are being taken up with the RBI by various stakeholders, and suitable clarifications are awaited.

^[1] In supersession of the Foreign Exchange Management (Transfer of Issue of Security by a Person Resident outside India) Regulations, 2017 and the Foreign Exchange Management (Acquisition and Transfer of Immovable Property in India) Regulations, 2018.
^[2] Explanation to Rule 23 of the NDI Rules:
(i) “indirect foreign investment” means downstream investment received by an Indian entity from:
(A) another Indian entity (IE) which has received foreign investment and (i) the IE is not owned and not controlled by resident Indian citizens or (ii) is owned or controlled by persons resident outside India or
(B) an investment vehicle whose sponsor or manager or investment manager (i) is not owned and not controlled by resident Indian citizens or (ii) is owned or controlled by persons resident outside India
Provided that no person resident in India other than an Indian entity can receive Indirect Foreign Investment
^[3] Explanation to Rule 23 of the NDI Rules:
(g) “downstream investment” shall mean investment made by an Indian entity which has total foreign investment in it, or an Investment Vehicle in the capital instruments or the capital, as the case may be, of another Indian entity
^[4] Explanation to Rule 23 of the NDI Rules:
(a) “ownership of an Indian company” shall mean beneficial holding of more than fifty percent of the equity instruments of such company and “ownership of an LLP” shall mean contribution of more than fifty percent in its capital and having majority profit share
^[5] Explanation to Rule 23 of the NDI Rules:
(d) “control” shall mean the right to appoint majority of the directors or to control the management or policy decisions including by virtue of their shareholding or management rights or shareholders agreement or voting agreement and for the purpose of LLP, “control” shall mean the right to appoint majority of the designated partners, where such designated partners, with specific exclusion to others, have control over all the policies of an LLP
^[6] Reserve Bank of India - Master Directions (rbi.org.in) last accessed at 5:36 pm IST on 14 March 2024.
^[7] Reserve Bank of India - Master Directions (rbi.org.in) last accessed at 5:36 pm IST on 14 March 2024.
^[8] In the past, discussions held during AD Bank conferences clarified that pricing guidelines will not be applicable in case of a transfer between an FOCC to a person resident outside India. A reasonable argument could be made, by extension of the principle in the aforementioned clarification, that pricing guidelines ought to not be applicable for transfer of equity instruments of an Indian entity from a person resident outside India to an FOCC.
^[9] Para 1 (d) of Schedule I to the NDI Rules.
(d) An Indian company may issue, subject to compliance with the conditions prescribed by the Central Government and/or the Reserve Bank from time to time, equity instruments to a person resident outside India, if the Indian investee company is engaged in an automatic route sector, against:
(i) swap of equity instruments or
(ii) import of capital goods or machinery or equipment (excluding second-hand machinery) or
(iii) pre-operative or pre-incorporation expenses (including payments of rent etc.)
Provided that the Government approval shall be obtained if the Indian investee company is engaged in a sector under Government route and the applications for approval shall be made in the manner prescribed by the Central Government from time to time.
^[10] Rule 23(4)(b) of the NDI Rules.

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