INTRODUCTION
Over the last decade, numerous Indian corporates, entities and HNIs have invested in foreign countries in various ways / assets and expanded their business operations in offshore jurisdictions.
Overseas investments by persons resident in India are also important drivers of foreign trade and technology transfer thus boosting domestic employment, investment and growth. Therefore, as a part of the efforts to liberalize, simplify and promote ease of doing business, on 22nd August, 2022, the Government of India issued the Foreign Exchange Management (Overseas Investment) Rules, 2022 (“ODI Rules”), Foreign Exchange Management (Overseas Investment) Regulations, 2022 (“ODI Regulations”) and the Foreign Exchange Management (Overseas Investment) Directions, 2022 (“ODI Directions”). The ODI Rules, ODI Regulations and the ODI Directions are hereinafter collectively referred to as “ODI Framework” for the purpose of this Update.
The ODI Framework supersedes the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004 and the Foreign Exchange Management (Acquisition and Transfer of Immovable Property Outside India) Regulations, 2015.
Part I of this Research Update expounds on some of the important changes made by the ODI Framework and key takeaways out of the same.
CONCEPT OF “JV” OR “WOS” REPLACED BY “FOREIGN ENTITY” AND “STRATEGIC SECTOR”
Under the old ODI regime, Indian parties could set up the Joint Venture (“JV”)/Wholly Owned Subsidiary (“WOS”) abroad and could extend loan or a guarantee to or on behalf thereof. The ODI framework replaces the terms ‘Joint Venture’ and ‘Wholly Owned Subsidiary’ with the term ‘foreign entity’ (i.e. an entity formed or registered or incorporated outside India, including International Financial Service Centre that has limited liability). IFSCs have been expressly recognised as a ‘foreign entity’.
Limited liability’ would mean a structure such as a limited liability company, limited liability partnership, etc. where the liability of the person resident in India is clear and limited.
A foreign entity may be an investment fund / vehicle, regulated by the financial sector regulator of the host jurisdiction and set up as a trust outside India, in which case the liability of the person resident in India shall be clear and limited not exceeding the interest or contribution in the fund. Further, the trustee of such fund shall be a person resident outside India.
Investment made in foreign entities engaged in Strategic Sector (including start-ups) – Exception to limited liability feature – Investments made in foreign entity whose core activity is in the strategic sector are not required to have ‘limited liability’. Strategic Sector includes energy and natural resources sectors such as oil, gas, coal, mineral ores, submarine cable system and start-ups and any other sector or sub-sector as deemed necessary by the Central Government. ODI in start-ups will be permitted only out of the internal accruals of the Indian entity or its group/associate companies in India and in case of a resident individual, from its own funds.
This exception to the requirement of ‘limited liability’ for investment in strategic sector shows the intention of the government to promote overseas investment in these specific sectors. The term “strategic sector” has been defined by way of an inclusive definition and includes start-ups. Therefore, Overseas investment can be made in start-ups even when the liability of the Indian investor therein is unlimited. A clarification would be required from the regulators on meaning of the term “start-up” for the purpose of overseas investment as not all foreign jurisdictions would describe the said term.
CONCEPT OF SUBSIDIARY, STEP-DOWN SUBSIDIARY AND CONTROL
‘Subsidiary’ or ‘Step-Down Subsidiary’ of a foreign entity means an entity in which the foreign entity has control.
The term ‘Control’ has been defined to mean the right to appoint majority of the directors or to control management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders’ agreements or voting agreements that entitle them to 10% or more of voting rights or in any other manner in the entity. On analysis, the following features of the definition are discernible and the following situations would lead to the presumption that there exists control with a person:
i. The foreign entity has the right to appoint majority of the directors; or
ii. The foreign entity has the right to control management or policy decisions. This right can be exercised by the foreign entity individually “or in concert with” other persons. The term “in concert with” is not defined under the ODI Framework. Assistance can however be taken from the definition given under SEBI Take Over Code which states to the effect that persons who, with a common objective or purpose of acquisition of shares or voting rights in, or exercising control over a company, pursuant to an agreement or understanding, formal or informal, directly or indirectly co-operate for acquisition of shares or voting rights in, or exercise of control over the company shall be considered to persons who are acting in concert;
iii. The aforesaid control can be direct or indirect;
iv. Control may be exercised by virtue of:-
- shareholding, or
- management rights, or
- shareholders agreement, or
- voting agreement that entitle them to 10% or more of voting rights or in any other manner in the entity.
- or in any other manner.
The placement of the phrase “10% or more of the voting rights” and “in any other manner” may lead to ambiguity in interpretation and divergent views. There can be a scenario where the foreign entity may have the right to appoint majority of directors or control management or policy decisions, directly or indirectly, individually or in control by virtue of management rights or shareholders agreement or in any other manner, even when such foreign entity holds less then 10% of the voting rights. Such a scenario may still lead to an inference that the foreign entity is “controlling” the other entity and accordingly such other entity is a subsidiary or step-down subsidiary of such foreign entity even when it is holding less than 10% of the voting rights of the other entity. This interpretation finds support from Note to Direction 20 of the ODI Master Directions which states that subsidiary shall have the meaning as provided in the OI Rules i.e. an entity in which the foreign entity has control (which includes a stake of 10% or more in an entity as per the OI Rules). The word “includes” signifies that control can be exercised by ways / modes other than by virtue of holding 10% voting rights also.
However, if such foreign entity merely has the right to exercise 10% or more of the voting rights of the entity but even after such holding, if the foreign entity cannot control management or policy decisions or have the right to appoint majority of directors then it will not be considered to be controlling such other entity. Here, the phrase “in any other manner” is also important because the right to control management or policy decisions or have the right to appoint majority of directors can arise even when the foreign entity holds less than 10% of the voting rights in the other entity.
Further the structure of such subsidiary or step-down subsidiary should also fulfil the structural pre-requisites of a foreign entity i.e. it should have limited liability. However, the subsidiary/step-down subsidiary can have unlimited liability if it is engaged in activities which are covered under strategic sector.
BONA FIDE BUSINESS ACTIVITY
According to the ODI Framework, investment in a foreign entity shall be permitted only if its carries on bona fide business activity. Bonafide business activity means any business activity permissible under “any law in force in India” as well as the host country / jurisdiction. It is important to note that the activity must not only be permitted in the host country but also in India. Activities like gaming not permitted across PAN India. Certain states like Assam, Sikkim, Nagaland, Odisha, Telangana, and Andhra Pradesh have prohibited the same. Hence, if an ODI investment originates from such state, then a question may arise whether such ODI investment will be considered to be a bona fide business activity.
ROUND TRIPPING / LAYERS OF SUBSIDIARIES
As per the ODI Framework, no person resident in India shall make any financial commitment by a in a foreign entity that has directly or indirectly invested or invests into India at the time of making such financial commitment (or at any time thereafter), resulting in a structure with more than two layers of subsidiaries. Therefore, if an Indian entity invests in a foreign entity and the foreign entity invests back (directly or indirectly) into an Indian entity, then such an investment shall be restricted to two layers.
It is important to note that firstly the aforesaid restriction is applicable only when investment is routed back to India. If the investment is not made in India then there is no restriction on the layers of subsidiaries. Secondly, it appears that, – if the investment (round tripped) in India is made through a multi layered structure other than subsidiaries, then such an investment is permitted.
However, the aforesaid restriction does not apply to companies mentioned under Rule 2 (2) of the Companies (Restriction on Number of Layers) Rules, 2017, i.e. (i) banking company (ii) systemically important NBFC (iii) insurance company and (iv) government company.
In so far as ODI by individuals is concerned, resident individuals cannot make or hold ODI in foreign entities that has subsidiary or step-down subsidiary, even if the individual has control in the foreign entity. However, ODI by way of inheritance, acquisition of sweat equity shares, qualification shares for holding management post in a foreign entity and acquisition of shares or interest under ESOP or Employees Benefits Scheme is permitted even where the foreign entities have a subsidiary or a foreign subsidiary. Resident individuals are also prohibited from making ODI in foreign entities in IFSC if that foreign entity has any subsidiary or step-down subsidiary outside IFSC.
CONCEPTS OF ODI, OPI, FINANCIAL COMMMITMENT AND OI
The ODI Framework has defined ODI and OPI.
‘ODI’ is defined as –
- investment by way of acquisition of unlisted equity capital of a foreign entity; or
- subscription as a part of the memorandum of association of a foreign entity; or
- investment in 10% or more of the paid-up equity capital of a listed foreign entity or
- investment with control where investment is less than 10% of the paid-up equity capital of a listed foreign entity;
Where an investment by a person resident in India in the equity capital of a forei photo emailgn entity is classified as ODI, such investment shall continue to be treated as ODI even if the investment falls to a level below 10% of the paid-up equity capital or such person loses control in the foreign entity.
‘OPI’ is defined as – investment, other than ODI, in foreign securities, but not in any unlisted debt instruments or any security issued by a person resident in India who is not in an IFSC.
OPI by a person resident in India in the equity capital of a listed entity, even after its delisting shall continue to be treated as OPI until any further investment is made in the entity.
‘Financial Commitment’ has been defined to mean the aggregate amount of investment made by a person resident in India by way of overseas direct investment (ODI), debt other than OPI in a foreign entity or entities in which the ODI is made and shall include the non fund-based facilities extended by such person to or on behalf of such foreign entity or entities
‘Overseas Investment’ means financial commitment and Overseas Portfolio Investment (OPI) by a person resident in India.
Financial commitment of an Indian entity under ODI in all Foreign entities taken together cannot exceed 400% of such Indian entity’s net worth as on the date of the last audited balance sheet. Investment as OPI by an Indian entity cannot exceed 50% of its net worth as on the date of its last audited balance sheet.
The Financial Commitment excludes capitalization of retained earnings for determining such limit but shall include:
- utilization of the amount raised by the issue of American Depository Receipts or Global Depositary Receipts and stock-swap of such receipts; and
- utilization of the proceeds from External Commercial Borrowings to the extent the corresponding pledge or creation of charge on assets to raise such borrowings has not already been reckoned towards the above limit
TO BE CONTINUED IN PART II OF THIS RESEARCH SERIES