RBI’s Endeavor to Regulate Grey Areas: FOCCs’ Overhaul in Consonance with FDI

[Kartik Mehta and Pranav Jain are fourth-year B.A.,LL.B(Hons.) students at HNLU, Raipur]

The Reserve Bank of India (RBI) on 20 January 2025 released the updated master directions for foreign direct investment (FDI) in India, leading to a significant overhaul in the framework for investment through foreign-owned and controlled companies (FOCCs). In summary, a foreign investor can invest in an Indian company or a limited liability partnership (collectively an “Indian entity”) by acquiring equity instruments (like compulsorily convertible debentures, compulsorily convertible preference shares and share warrants) either directly or indirectly through another Indian entity. When FDI occurs indirectly through an intermediary Indian entity, such investment is referred to as downstream investment, and such intermediary is referred as FOCC. According to the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules), FOCC is an Indian entity that has received foreign investment and is not controlled or owned by a person resident in India (PRI) but by a person resident outside India (PROI). Whenever a PROI invests in an Indian entity through an intermediary in an equity instrument, the downstream investment regime kicks in. Such acquisitions of equity instruments of an Indian entity are regulated by the Foreign Exchange Management Act, 1999 (FEMA) and the NDI Rules. This post delves into the implications of the newly introduced RBI master directions for downstream investments being made through FOCCs while also highlighting the existing lacunae acting as an impediment to an effective regulatory framework.

Deciphering Downstream Investment

Through the foreign investment policy, the Central Government aims to regulate downstream investments to ensure that “what cannot be done directly must also not be done indirectly“. For instance, XYZ Ltd., a foreign company, seeks to enter the Indian market to capitalise on the booming online betting sector (a prohibited sector under Schedule 1 of NDI rules for foreign investment). Instead of investing directly, it acquires a controlling stake in ABC Pvt. Ltd. (an Indian company operating in the same space). Such an acquisition would violate India’s FDI Policy and as a result ABC Pvt Ltd. is termed as an FOCC and needs to comply with the FOCC regime.

Rule 23 of the NDI Rules prescribes certain requirements to be complied with in case of a downstream investment in terms of entry route, sectoral caps and pricing guidelines amongst others. However, FOCCs being domiciled in India also become subject to other regulations as applicable to residents. This dual classification of FOCCs, where they are treated as residents for certain regulatory purposes while simultaneously being regarded as non-residents for others, creates significant regulatory hurdles.

Clarifications on the Ambiguity: A Step in the Right Direction

Allowing the 18–25 rule for deferred payments

Rule 9(6) of the NDI Rules provide that the transfer of equity instruments between a PRI and PROI can be permitted to defer up to 25% of the total consideration for a period not exceeding 18 months from the execution of the transfer agreement (18–25 rule). However, since FOCCs were not explicitly covered under this rule, uncertainty persisted regarding their ability to utilise deferred consideration structures, leading to differing interpretations in practice. In September 2023, the RBI issued notices to FOCCs for the violation of FDI norms in terms of deferred payments on the downstream investment in other Indian companies. This led to FOCCs taking an extremely conservative view, inferring that no deferred payments can be allowed. A regulatory paradox existed wherein indirect foreign investments by FOCCs faced stricter compliance requirements than direct foreign investments by non-residents.

Subjecting FOCCs to complete prohibition on deferred payments neither aligned with the intent of preventing circumvention of the rules nor had any commercial practicality. It prevented the use of all forms of deferred consideration, including post-closing price adjustments, holdback escrows, and earnouts alike commonly utilised in M&A deals. The master directions have brought much-needed clarity while allowing the 18–25 rule to be applicable, aligning with the policy and commercial practicalities alike. While being a welcome step, the directions do not categorically delineate the extent to which the framework for direct investments will apply to downstream investment, which may warrant further RBI interference at a later stage.

Flexibility in equity swaps

A conjoint reading of Rule 6(a), Rule 9 read with Schedule I of the NDI Rules provides that an Indian company can be involved in share swaps, whereby equity instruments can be issued to a PROI in exchange for equity instruments of another Indian company under the automatic route. Further, Rule 23 of the NDI Rules provides that certain requirements are to be complied with in the case of a downstream investment in terms of entry route, sectoral guidelines and pricing guidelines amongst others, implying that FOCCs are to be treated as PROI. This would imply that similar to FDI, share swaps would be allowed in the case of downstream investments alike.

However, sub-rule 4(b) of Rule 23 entangled the situation while providing for the use of funds from abroad or retained earnings only, prohibiting any use of funds from the domestic market for downstream investment. This led to the inference that consideration is required to be paid in cash only. Based on this interpretation of the sub-rule and RBI’s questioning of swap transactions, authorised dealer banks started following a narrow approach, allowing share swaps to fall under the government approval route compulsorily payable fully through cash. 

Clearing the ambiguity surrounding the same, the new directions now expressly affirm that downstream investments by FOCCs can utilise the same investment arrangements available for direct investment in downstream investment alike. By bridging the regulatory gap between direct investment and downstream investments, this update enhances investment flexibility while maintaining compliance with existing norms.

Room for Further Clarification

While the master directions have certainly provided clarity to the ambiguities surrounding share swap and deferred payment, issues surrounding pricing norms and reporting mandates warrant further clarification. Under Rule 21 of the NDI Rules, the transfer of equity securities from a PROI to a PRI is considered at the highest price of fair market value (FMV). In contrast, the same transaction from PRI to PROI would be taken into account at the lowest price of FMV.

*Table 1 : Pricing and Reporting Compliances in Transfer of Equity Instruments.

It provides unequivocal guidance on the transfer of equity instruments by an FOCC to either a PROI or a PRI, stipulating distinct compliance requirements for each scenario.

1. Transfer to PROI: The transaction is subject to reporting requirements such as Form FC-TRS but does not need to comply with pricing guidelines.
2. Transfer to PRI: The transaction must comply with pricing guidelines, meaning that the consideration paid cannot exceed the FMV. However, reporting requirements do not apply.

The FDI framework does not provide clarity on transactions where an FOCC is the recipient of a transfer from PROI or PRI alike. It creates a grey area with no clear guidance whatsoever in the case of PROI being the transferor; it is uncertainas to whether only reporting requirements apply or if the pricing guidelines mandate adherence to FMV.  In the case of PRI, the applicability of reporting requirements lies in limbo as to whether the price per equity instrument must meet or exceed the FMV under-pricing guidelines.

Conclusion

The newly introduced master directions are a significant step towards a much more efficient FOCC regime. It not only clears the air in terms of prevailing ambiguities but also aligns the framework for downstream investment with the broader FDI rules. The clarification in terms of share swap transactions and applicability of the 18–25 rule for deferred payment for downstream investments would allow acquisitions without RBI approval. However, ambiguity still persists with regards to the pricing and reporting guidelines particularly transactions involving FOCCs on the receiving end. Such ambiguities can pose significant challenges for foreign investors while navigating the regulatory framework. Consequently, further RBI clarifications on the same would act in coalescence with these master directions to ensure investor confidence and deal with the ever evolving investment landscape.

– Kartik Mehta & Pranav Jain