The new Overseas Investment (“OI”) framework, which comprises the Foreign Exchange Management (Overseas Investment) Rules, 2022 (“Rules”), the Foreign Exchange Management (Overseas Investment) Regulations, 2022 (“Regulations”) and the Foreign Exchange Management (Overseas Investment) Directions, 2022 (“Directions”), was conceived in an attempt to rationalize the erstwhile framework with the government’s larger “ease of doing business” objective. It was notified on August 22, 2022, almost a year after the release of the draft rules and regulations seeking stakeholder comments. The new OI framework, which has been in the pipeline for a significant period of time and highly anticipated by industry participants, has introduced several welcome changes across all forms of offshore investments.
The new framework has successfully addressed several key concerns that had continually been raised in the application of the erstwhile regime, not the least among which was the subjectivity involved in the determination of an investment as Overseas Direct Investment (“ODI”) or Overseas Portfolio Investment (“OPI”). Apart from explicitly setting out the categories of investments that may constitute ODI and OPI, the new regime also lays out what comprises debt and non-debt instruments for the purposes of OI. While the erstwhile regime simply required equity participation to satisfy eligibility to provide loans and non-fund based financial commitment, under the new OI framework, only Indian entities having control in a foreign entity are now eligible to invest in debt instruments or issue other non-fund based financial commitments such as pledges, guarantees, charge etc. towards the foreign entity. The control threshold (pegged to a 10% shareholding or management control) may operate as an impediment in cases of cross-border transactions where investors agree to provide financial support as a pre-requisite for their investments.
Another aspect of the new OI framework that requires clarification is OPI by an unlisted Indian entity. The new framework categorically provides for four ways in which OPI investment could be made by an unlisted Indian entity, which are: rights issues or bonus allotments, capitalization of dues, swap of securities, mergers, demergers and other forms of restructuring. While unlisted Indian entities were prohibited to make OPI earlier, it is unclear how such entities are to make the initial primary investment in the foreign entity in order to be eligible to make OPI in certain forms such as through rights issues and bonus allotments.
A key clarification ushered in through the new framework is the definition of bona fide business activity. While this inclusion is a welcome change, the definition does leave room open for further clarifications. The new OI framework defines bona fide business activity to mean an activity permissible under any law in force in India and the host country. This brings to question whether foreign investment in a purely holding company under the new regime could itself be a challenge. Clarity will be required to be sought on which activities would be considered bona fide. Consequently, whether an activity is permissible under Indian law raises the question of whether this is with reference to only central laws or even state laws. For instance, certain states like Gujarat, Bihar, Nagaland etc. prohibit the manufacture and sale of liquor; online gaming has been banned by states like Andhra Pradesh and Telangana which is permitted in other states of India. In such cases, it is unclear whether such activities would be considered permissible and consequently bona fide for investors from such states.
The liberalisation of the round tripping provision by bringing it under the ambit of the automatic route, subject to the Indian entity fulfilling certain transparency conditions, has been the highlight of the new regime and a promising move. The draft rules, however, contained a provision prohibiting investment in a foreign entity whose investments are designed for the purpose of tax evasion/tax avoidance, which has not found mention under the Rules. The new regime now permits financial commitment in a foreign entity that invests in India, if it does not result in a structure with more than two layers of subsidiaries. While the Directions clarify that the restriction on two layers of subsidiaries is a continuing obligation, it is yet unclear if structures beyond two layers would be prohibited entirely or would now require approval from the Reserve Bank of India (“RBI”) under Rule 9(2)(ii) of the Rules.
In the determination of the two layers, the question of whether the foreign entity or the subsidiary under the foreign entity would constitute the first layer has been an issue of contention in the market. However, the instructions for filling Form FC under the RBI Master Directions on Reporting do provide ample clarity stating that the level of subsidiary shall be calculated treating the foreign entity as the parent and the subsidiary directly under the foreign entity as the first level. This simplifies investments in foreign entities holding layered structures of subsidiaries.
Another provision to note is the restriction on resident individuals holding ODI in a foreign entity having a subsidiary or step-down subsidiary, where the resident individual has control in the foreign entity. This prohibition would significantly impact high net-worth individuals or founders desirous of setting up foreign holding structures for their Indian companies (for the purposes of attracting better investments or listing opportunities) as they would be prohibited from holding control in such holding structures. Considering the relaxation in the control threshold to now include holding even 10% of voting rights in a foreign entity, this restriction would be easily tripped up.
While the new regime has successfully simplified the earlier framework in many respects, there are several areas that still need explicit clarification from the RBI in the nature of explanatory amendments or FAQs. The introduction of new concepts such as “strategic sector”, investment in start-ups etc. may lead to further interpretative questions and it remains to be seen if the RBI will respond proactively to achieve the goal of integrating Indian businesses into the global market.
(By Anjali Menon, Partner; Alysha Razvi, Senior Associate, and Karishma Karthik, Associate, at Shardul Amarchand Mangaldas & Co)
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