Some Ambiguities in the Rules on Downstream Investments

[The following guest post is
contributed by Ajay G. Prasad, who
is a Senior Associate with Kochhar & Co, Bangalore. Views expressed in this
post are personal and do not reflect the views of the firm.]
Exchange control rules on downstream
investment form an important aspect to consider in M&A transactions. As per
the foreign direct investment policy (“FDI
Policy
”) of the Department of Industrial Policy & Promotion (the “DIPP”), the expression “downstream
investment” means indirect foreign investment by one Indian company into
another Indian company (either by way of purchase of shares or by way of fresh allotment
of shares).
Until Press notes 2, 3 and 4 were
issued by the DIPP in 2009, there was considerable ambiguity surrounding the treatment
of such indirect foreign investment. Although the issuance of these press notes
sought to clear the ambiguity, the DIPP unwittingly gave room for further
uncertainty by creating new classes of companies called “operating companies”, “investment
companies” and so on. As a result, stakeholders were required to apply the downstream
rules contained in these press notes after determining which category a given company
fell. This was a difficult exercise to undertake.
Fortunately, the DIPP did away with
most of these differentiations through the FDI policy released in April 2011. Ever
since, the downstream investment rules are being continuously pruned. Press
note 12 of 2015 read with the amendments to the FEMA (Transfer or Issue of Security
by a Person Resident Outside India) Regulations, 2000 (the “2016 FEMA Amendment”) dated 15 February
2016 has further liberalized these rules. But despite numerous attempts of the Government
and the Reserve Bank of India (RBI) to fine tune these rules, I submit that
some issues and ambiguities persist. I provide a few illustrations below.
Ambiguity in the expression “foreign investment” as appearing in
paragraph 3.10.3.1 of the FDI Policy
Chapter 3.10 of the FDI Policy
specifies that (for the purpose of that chapter) the expression “foreign
investment” would have the same meaning as in Paragraph 4.1. Paragraph 4.1 does
not contain a specific definition of foreign investment. It however specifies
that foreign investment into an Indian company comprises both direct foreign
investment (i.e. a non resident entity directly investing in an Indian entity) and
indirect foreign investment (i.e. one Indian company /LLP with foreign
investment investing in another Indian company/LLP). It goes on to state that for
the purpose of counting foreign investment in an Indian company/entity, all of
the direct foreign investment by a non-resident would be counted towards
foreign investment. As far as counting indirect foreign investment goes, the
same would be counted towards calculating foreign investment if the investing Indian
company/entity is either owned or controlled (or both) by non-residents.
Be that as it may, paragraph 3.10.3.1
of the FDI Policy specifies that foreign investment into an Indian company
engaged only in the activity of investing in the capital of other Indian
companies will require prior Government / Foreign Investment Promotion Board
approval, regardless of the amount or extent of foreign investment
(emphasis supplied). The ambiguity arises when one compares the aforesaid
language to the language and intent of paragraph 4.1 (which clearly mentions
that indirect foreign investment by Indian companies owned and controlled by
resident Indian citizens would not be counted towards foreign investment). What
then is the intent of using the expression “regardless of the amount or extent
of foreign investment”? Does it mean that only for the purpose of paragraph 3.10.3.1
even indirect foreign investment by companies which are owned and controlled by
Indian companies and / or Indian citizens would be counted towards foreign
investment? That should clearly not be the case (and presumably, the intent).
Therefore, a couple of possible
solutions could be to either amend the definition of the expression “foreign
investment” or delete the language  “regardless
of the amount or extent of foreign investment” (which was emphasized above).
No guidance around the meaning of the expression, “domestic market”
The downstream investment rules of
the FDI Policy specify that: (i) an Indian company undertaking downstream
investment would have to bring in requisite funds from abroad and not leverage
funds from the domestic market (emphasis supplied); (ii) this would
however not preclude downstream companies with operations from raising debt in
the domestic market; and (iii) downstream investment through internal accruals
are permitted. The 2016 FEMA Amendment defined the expression “internal
accruals” for the very first time in the context of these rules to mean profits
transferred to the reserve account after payment of taxes.
The expression “domestic market” used
in the rules has created some uncertainty as there is no regulatory guidance as
to what is the meaning of the same. This is particularly so in transactions
which involve one Indian company (say “X”, owned and controlled by
non-residents or owned or controlled by non-residents) lending to an Indian
subsidiary company (say “Y”) for the purpose of Y making investment in another
unrelated Indian company (say “Z”).
In this context, I have come across several
stakeholders who tend to concentrate only on the word “domestic” to the
exclusion of “market” and argue that investment by Y into Z is not permitted
under the automatic route (i.e. without Government / FIPB approval). Typically,
they interpret “domestic market” to mean “domestic source”. However, in my view
the intent of the policy is not to prohibit such downstream transactions; or
make them subject to the approval route. The intent is to regulate transactions
where Y, instead of obtaining a loan from its holding company X, raises funds
from a bank or a financial institution or a non-banking financial company to fund
the acquisition. As per Black’s Law Dictionary, “market” means: (i) place of
commercial activity in which goods, commodities, securities, service, etc. are
bought and sold; (ii) a public time and appointed place of buying and selling;
also purchase and sale. The rules also use the expression “raise debt”.
Typically, the word “raise” means raising a loan in the debt market or through
a bank or financial institution.
Based on the above, I submit that
from an exchange control law perspective, the intent is not to prohibit lending
by a holding company to a subsidiary company for making investments. The reason
X is lending to Y is on account of the relationship that they share. Hence, it
should be covered under the automatic route. In this connection, one needs to
also examine the legality of these transactions from an Indian Companies Act,
2013 perspective. That is a different topic and not part of the scope of this post.
Confusion around using the escrow mechanism
Exchange control laws permit parties
to an FDI transaction to set up an escrow account with an authorized dealer
bank wherein consideration payable on account of transactions may be deposited
in the escrow account for a period of six months. This is allowed under the
automatic route (i.e. without taking special RBI permission). In case the
parties intend that escrow to be operational beyond six months, they need to
obtain special RBI permission. Recently, some relaxations have been made
available in this respect. Where parties to a transaction so agree, an escrow
account, wherein not more than twenty five percent of the total consideration
is deposited, can be operational for a period up to eighteen months without
taking special RBI permission.
While the above rules seem clear enough,
when it comes to their application in a downstream investment scenario, things
get slightly muddied. The relevant language in the downstream investment
section of the FEMA Regulations specifies five [(a) to (e)] conditions, none
relating to opening an escrow account to undertake downstream investments. Therefore,
when it comes to opening an escrow account for downstream investment, one would
assume that parties are not required to comply with the rules relating to
escrow (even the recently released FEMA Deposit Regulations seems to suggest
the same).
However, some stakeholders (including
a few authorized dealer banks) have taken a view that since downstream
investment is indirect foreign investment, an escrow account for the purpose of
facilitating downstream transactions should also be subject to the same rules. As
there is no express regulatory guidance on this, most transactions are
structured after taking the inputs of the authorized dealer banks (who in turn
would have obtained some sort of comfort from the RBI after presenting all the
facts to the RBI, mostly on a no-names basis). In the absence of clear
regulatory guidance, the RBI’s approach may have been based on transaction-specific
facts (and slightly ad-hoc). In my view, having clarity on this issue would go
a long way in avoiding this case to case approach currently being adopted.
It is hoped that the new FDI policy
(scheduled to be released soon by the DIPP as per past precedents) would
address some of these issues.

– Ajay G. Prasad

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.

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