Downstream Investments by FOCCs – Resolving the Regulatory Conundrum

[Roshan Cyriac is a 4th-year B.A., LL.B. (Hons.) student at NALSAR University of Law, Hyderabad]

Foreign investors can invest in India directly through foreign direct investment (FDI) or through an entity owned and controlled by it (FOCC). An FOCC is a company incorporated in India but owned and controlled by a (non-resident) foreign company. When a non-resident transfers shares in Indian entities using its subsidiaries set up in India, the downstream investment regime steps in. The purpose of such investments is to attract lesser compliance as compared to FDI. The Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules) provide the regulatory framework for the same. FOCCs are subject to entry routes, sectoral caps, and pricing guidelines under the Foreign Exchange Management Act, 1999 (FEMA) when they undertake downstream investments, but regulatory lacuna due to drafting oversight has resulted in ambiguity. This post analyses regulatory gaps within the pricing guidelines, reporting requirements, investment in non-capital instruments, and deferred consideration arrangements contained in the NDI Rules and proposes solutions to reconcile the same.

Pricing Guidelines

Rule 23(5) of the NDI Rules specifies pricing and reporting requirements for downstream investments by FOCCs in three scenarios, namely, the transfer of Indian equity instruments:

(a) from an FOCC to a person resident outside India (PROI) where only reporting requirements apply,      

(b) from an FOCC to a person resident in India (Resident) where only pricing guidelines apply, and      

(c) from an FOCC to another FOCC where neither reporting requirements nor pricing guidelines apply.

It is pertinent to note that these requirements are prescribed only for the sale or transfer and not the purchase of equity instruments. From the above rule, it is evident that FOCCs are treated as Residents from the reporting perspective and PROIs from the pricing perspective. However, whether pricing norms apply to the transfer of Indian equity instruments from PROIs to FOCCs remains unsettled and ambiguity remains due to the lack of clarification by the Reserve Bank of India (RBI) and differing stances taken by authorised dealer banks (AD Banks).

Rule 21(2) of the NDI Rules prescribes that:

 (i) the transfer of shares from a non-resident to a resident should be made at a price that is not more than the fair market value (FMV); and    

 (ii) the transfer of shares from a resident to a non-resident should be made at a price that is not less than the FMV.

Rule 23(5) of the NDI Rules prescribes pricing guidelines only for the transfer of equity instruments by FOCCs to Residents and not for the transfer of shares by FOCCs to PROIs and pricing guidelines are exempted in the case of transfer of shares between two PROIs. This has led to a scenario where in the instance of an FOCC acquiring shares from Residents and Non-Residents simultaneously, it must purchase shares from Non-Residents at or below the FMV and from Residents at or above the FMV. This results in an unusual situation where FOCCs are treated as Residents when buying from Non-Residents and as Non-Residents when buying from Residents. The FOCC is thus forced to adopt marginal differential pricing or purchase all shares at the FMV in order to complete the transaction. However, the contractually agreed price is usually higher than the FMV from a deal perspective and hence the shares cannot be purchased at a lesser amount at FMV.

The rationale for applying pricing guidelines in the case of a transfer of shares from a PROI to an FOCC is that the payment in foreign exchange is made by the FOCC to the PROI and this amount should not be above the FMV since FOCCs are treated as Residents by virtue of being a company incorporated in India. To resolve this issue, it is proposed that FOCCs must be treated as PROI for the purpose of pricing, and pricing guidelines must be applied for any transaction involving the purchase or sale of equity instruments in Indian companies because FOCCs are owned or controlled by foreign entities. This is in alignment with the intent of FEMA, which is to ensure maximum inflow of foreign exchange while limiting its outflow. Rule 23(5) of the NDI Rules must be amended accordingly to add that pricing guidelines would apply in case of a transfer or purchase of equity instruments from an FOCC to a PROI.

Reporting Requirements

Rule 23(5) of the NDI Rules prescribes reporting requirements only in the case of transfer of Indian equity instruments from FOCCs to PROIs. The Rules are silent on the reporting requirements in the case of transfer from a PROI to an FOCC as well as the purchase of equity instruments to and from FOCCs and PROIs. Regulation 11 of the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019 (Reporting Regulations) prescribe the filing of Form DI and notifying the Secretariat for Industrial Assistance of the Department for Promotion of Industry and Internal Trade (DPIIT). However, the Reporting Regulations do not specify reporting requirements in the case of transfer of Indian equity instruments from PROIs to FOCCs and AD Banks have differing views on the same. The Reporting Regulations are also silent on reporting requirements in the case transfer of Indian equity instruments between (to and from) two FOCCs. It is evident from the aforementioned rules and regulations that FOCCs are treated as Residents for reporting purposes.

It is proposed that FOCCs must alternatively be treated as PROIs for reporting purposes as well, considering that they are owned and controlled by foreign entities. This would remedy the inconsistent treatment that is meted out to them. Moreover, transactions undertaken by FOCCs may involve not only the inflow and outflow of foreign exchange but also possibly a change in control of an Indian company to a foreign entity and hence are liable to be reported. This is pertinent in the wake of national security concerns arising from opportunistic takeovers and takeovers by Chinese companies which led the government to issue Press Note 3 of 2020. Thus, Rule 23(5) must consequently be amended so that reporting requirements are applied for the transfer of Indian equity instruments from PROIs to FOCCs as well, keeping in mind that FEMA intends to regulate the movement of foreign exchange in the country. Similarly, reporting requirements must be prescribed for the transfer of Indian equity instruments from FOCCs to Residents and vice versa. A combination of Form DI, FC-GPR, FC-TRS, or DPIIT intimation may be prescribed as required. However, in the case of transfer between two FOCCs, there would be no inflow or outflow of foreign exchange nor a change in control of the Indian company, and hence reporting requirements need not be applied as is already stipulated in rule 23(5)(c) of the NDI Rules.

Investment in Non-Capital Instruments

Rule 23 of the NDI Rules defines downstream investment as an investment by an FOCC in “capital instruments” of an Indian company. However, the NDI Rules do not define the term “capital instruments”. The term was defined in the erstwhile TISPRO Regulations as equity shares, debentures, preference shares, and share warrants issued by an Indian company and included optionally convertible preference shares (OCPSs) and optionally convertible debentures (OCDs). The RBI has clarified in its FAQs that investments by FOCCs in non-capital instruments would not be treated as downstream investments and, hence, it could be understood that FDI conditions would not apply. However, the FAQs do not have a binding effect since the RBI website has a disclaimer that in case of any inconsistency between FAQs and notification/master directions/circular(s), latter shall prevail. Not considering investments through OCPSs and OCDs as downstream investments lead to a situation in which they are not scrutinised by the regulatory authorities, enabling the parties to such investments to circumvent the requirements of the NDI Rules, such as entry routes, sectoral caps, pricing guidelines, and other attendant conditions.

To resolve this inconsistency, the definitions clause of the NDI Rules must be amended to replace the term equity instruments with the term capital instruments to remedy the drafting oversight and the meaning must remain the same to include OCPS and OCDs. In the current framework, the RBI may not consider OCPSs and OCDs as downstream investments at the time investment is made; upon conversion to equity instruments, it becomes a downstream investment, and pricing guidelines and reporting requirements would apply at the time of conversion and not before conversion. This leads to a situation where the FOCC would not know the number of equity shares it will receive upon subscription and this reduces the attractiveness of OCPS and OCDs. The RBI thus needs to clarify that subscription to OCPS and OCDs constitutes downstream investment and prescribe the same in the NDI Rules.

Deferred Consideration Arrangements

Rule 9(6) of the NDI Rules permits deferred payment arrangements in cross-border share purchase transactions, i.e., between a Resident and a PROI. However, an FOCC is treated as a Resident as it is incorporated in India and deferred consideration arrangements between an FOCC and a Resident are not expressly permitted. The Form DI that is used to report downstream investments has no field to disclose the deferred consideration amount and, consequently, the RBI has rejected the reporting of downstream investments with the element of deferred consideration. This leads to a situation where FOCCs are regulated at a higher threshold than foreign entities. To remedy this, Form DI must be amended to include a field for deferred consideration amount to facilitate reporting and subsequent approval.

Non-Cash Consideration and Other Attendant Conditions

Rule 23(4)(b) of the NDI Rules permits the use of only funds received from abroad or internal accruals for making downstream investments. Internal accruals mean profits transferred to the reserve account after payment of taxes. This rule, for instance, prevents the FOCC from borrowing funds in India to make leveraged buyouts. However, taking into account that FDI conditions, including other attendant conditions, apply to downstream investments as well and that FDI by a PROI is permitted for non-cash consideration only in specific cases such as share swap and import of capital goods as prescribed in the NDI Rules, it can be understood that downstream investment for non-cash consideration is allowed in such cases and the RBI must therefore provide a clarification on the same lines.

Rule 23(1) of the NDI Rules prescribes that downstream investments must adhere to entry routes, sectoral caps, pricing guidelines, and other attendant conditions as applicable for foreign investment. The expression “other attendant conditions” has not been defined, and hence its scope can be construed broadly, leading to additional compliances for FOCCs bringing them on par with FDI, which can disincentivize the setting up of FOCCs. It is proposed that the rule must be construed restrictively to minimise compliance requirements on FOCCs.

Conclusion

Downstream investments provide an attractive option for non-residents to invest in Indian equity. However, the NDI Rules must be amended to harmonise regulatory protection and economic growth. FOCCs must be treated as non-residents in the context of both pricing guidelines and reporting requirements because despite being entities incorporated in India, they are owned and controlled by foreign entities, and such investments into India merit greater scrutiny. Thus, both the purchase and sale of Indian capital instruments must be subject to pricing guidelines and reporting requirements under the NDI Rules. Additionally, the drafting oversight reflected in the terms “equity instruments” and “other attendant conditions” must be remedied as recommended above. Moreover, OCPSs and OCDs must be considered as downstream investments for effective regulation, and deferred payment consideration and non-cash consideration must be permitted to bolster investment into the country.

– Roshan Cyriac