Direct and Indirect Foreign Investment: Is There Clarity Now?

Last week, we had blogged about new guidelines that were announced on indirect foreign investments, wherein some questions were raised regarding the scope of these guidelines. However, since then, the Government has issued two Press Notes on February 13, 2009 that contain detailed provisions for implementation of the new guidelines. Press Note 2 of 2009 deals with calculation of total foreign investment in Indian companies, and Press Note 3 of 2009 relates to transfer of ownership or control of Indian companies in sectors with caps from resident Indian citizens to non-resident entities.

In the post below, Rajvendra Sarswat, an associate with an Indian law firm, discusses the implications of these new guidelines and raises some further questions for consideration.

The Ministry of Commerce and Industry has recently issued guidelines for calculation of total foreign investment, i.e., direct and indirect foreign investment in Indian companies. The basic object of the guidelines is to provide clarity by segregating the direct and indirect foreign investment in India. It is to bring clarity, uniformity, consistency and homogeneity into the exact methodology of calculation across sectors/activities for all direct and indirect foreign investment in Indian companies. It is stated that investment in Indian companies can be made both by non-resident as well as resident Indian entities. Any non-resident investment in an Indian company is direct foreign investment. Investment by resident Indian entities could again comprise of both resident and non-resident investment. Thus, such an Indian company would have indirect foreign investment if the Indian investing company has foreign investment in it. The indirect investment can also be a cascading investment i.e. through multi-layered structure.

The method of calculation of total foreign investment in an Indian company including indirect foreign investment through other Indian companies has been detailed either in sectoral regulations contained in various press notes or in rules and regulations under specific statutes. Essentially, the present FDI guidelines provide for three different regimes for calculation of indirect foreign equity. This includes the following:

· Telecom/Broadcasting: Proportionate method is used in Telecom/ Broadcasting sectors through Press Note 5 of 2005, Press Note 1(2006) and Press Note 3(2007);
· Insurance: Outlined in IRDA regulations (IRDA (Registration of Indian Insurance Companies) Regulations, 2000); and
· Other: In all other sectors, for an investing company in the infrastructure / service sector attracting equity caps, indirect equity is calculated as was set out in Press Note 2 of 2000: According to this, foreign investment in an investing company will not be set off against this cap where the foreign equity in the investing company does not exceed 49% and the management of the investing company is with Indian owners. Hence, for any downstream investment, FIPB approval is required by investing companies.

The new guidelines for calculation of foreign investment, direct and indirect, in an Indian company take into account two factors. For direct foreign investment, all investment directly by a non-resident entity into the Indian company would be counted towards foreign investment. For indirect foreign investment, the foreign investment through the investing Indian company would not be considered for calculation of the indirect foreign investment in case of Indian companies which are ‘owned and controlled’ by resident Indian citizens and/or Indian Companies (which are in turn owned and controlled by resident Indian citizens). Hence, the condition to be satisfied is that the Indian company should be owned and controlled by Indian residents; in other words, both the ownership and control conditions are to be satisfied. For the purpose of the explanation, ownership and control by Indian residents has been defined: if more than 50% of the equity interest in an Indian company is beneficially owned by resident Indian citizens and Indian companies, which are owned and controlled ultimately by resident Indian citizens; and, if the resident Indian citizens and Indian companies, which are owned and controlled by resident Indian citizens, have the power to appoint a majority of its directors.

Hence, in a case where the investing company is owned or controlled by ‘non resident entities’, the entire investment by the investing company into the subject Indian company would be considered as indirect foreign investment, and shall be regarded as foreign investment. First, there could be confusion as to the resultant position where the shareholding pattern is 50-50%. Second, if there is a shareholders agreement inter-se between the existing/proposed shareholder which provides for veto power or which reclassify the ‘control’ within the company. In such case, though the Guidelines provides that in any sector/activity, where Government approval is required for foreign investment and in cases where there are any inter-se agreements between/amongst share-holders which have an effect on the appointment of the Board of Directors or on the exercise of voting rights or of creating voting rights disproportionate to shareholding or any incidental matter thereof, such agreements will have to be brought to the notice of the approving authority. The approving authority will consider for determining ownership and control such inter-se agreements when considering the case for granting approval for foreign investment. Although there is some ambiguity in interpretation, it is likely that where both ownership and control cannot be demonstrated to be in the hands of the Indian owners, the investment by the Indian investing company would be treated as indirect foreign investment.

Interestingly, an exception is provided which states that the indirect foreign investment in only the 100% owned subsidiaries of operating-cum-investing/investing companies will be limited to any foreign investment in the operating-cum-investing/ investing company. The Department clarified this by saying that since the downstream investment of a 100% owned subsidiary of the holding company is akin to investment made by the holding company, the downstream investment should be a mirror image of the holding company.

In explanation to the same, the department provided the following example. It provides that, where Company A is a wholly owned subsidiary of Company B (i.e. Company B owns 100% shares of Company A), and if foreign investment in the holding Company B is 75%, then only 75% would be treated as indirect foreign equity and the balance 25% would be treated as resident held equity. The indirect foreign equity in Company A would be computed in the ratio of 75: 25 in the total investment of Company B in Company A.

The complete details about the foreign investment including ownership details etc. in Indian company and information about the control of the company would be furnished by the Company to the Government of India at the time of seeking approval.

As per the Guidelines, in certain sectors (such as the information & broadcasting and the defence sectors) the equity held by the largest Indian shareholder would have to be at least 51% of the total equity, excluding the equity held by Public Sector Banks and Public Financial Institutions, as defined in Section 4A of the Companies Act, 1956. Hence, though the object of the Guidelines is to simply the process of calculation or computation, in my view it is still left open with confusion and possible multiple interpretations.

– Rajvendra Sarswat

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

1 comment

  • It is clear from the opening portion of Clause 5.2.2 of Press Note 2 that if the investing Indian company is a 50:50 JV with equal ownership and control, any downstream investment by such company will be considered to be foreign investment as the investing company is neither ‘owned and controlled’ by a resident Indian citizen nor is it owned or controlled by a non-resident entity.

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