On August 22, 2022, the Department of Economic Affairs, Ministry of Finance issued the Foreign Exchange Management (Overseas Investment) Rules, 2022 (OI Rules) in supersession of the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004 (Erstwhile FEMA 120) and the Foreign Exchange Management (Acquisition and Transfer of Immovable Property Outside India) Regulations, 2015, which governed investments outside India by persons resident in India for almost two decades. Further, the Reserve Bank of India (RBI) has also notified the Foreign Exchange Management (Overseas Investment) Regulations, 2022 (OI Regulations) and the Foreign Exchange Management (Overseas Investment) Directions, 2022 (OI Directions) in this regard. We understand that these changes have been made to ease the regulatory compliances involved in offshore investments.

In this context, we have analysed some of the key changes introduced to the regulatory regime governing overseas direct investment by way of notification of the OI Rules, OI Regulations and OI Directions (collectively referred as “OI Laws”).

  1. ‘Overseas Direct Investment’ v. ‘Overseas Portfolio Investment’

Overseas Direct Investment (ODI) has been defined under the OI Rules to mean “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 ten per cent, or more of the paid-up equity capital of a listed foreign entity or investment with control where investment is less than ten per cent. of the paid-up equity capital of a listed foreign entity.” On the other hand, Overseas Portfolio Investment (OPI) has been defined to mean investment in foreign securities that does not constitute ODI. It also does not include investment in any unlisted debt instruments or any security issued by a person resident in India who is not in an International Financial Services Centre (IFSC). Determination of an investment as ODI or OPI is relevant as the compliances in terms of filing, sale, permissibility, manner of investments etc. are determined accordingly (as indicated in the points mentioned below) – the compliances involved for ODI are extensive and more stringent.

Basis the aforementioned definition, any equity investment made by a person resident in India (even 1 share) in an unlisted foreign entity shall be considered to be ODI (subject to a few exceptions mentioned below). Offshore equity investment in a listed foreign entity shall be considered as OPI if its below 10% and there is no control (subject to certain exceptions such as investment less than 10% and without control in unlisted entities through ESOP, sweat equity, minimum qualification shares).

The current ODI construct corresponds to the definition of ‘direct investment’ under the erstwhile regime. Further, the erstwhile regime did not define portfolio investment. Indian listed companies were (and continue to be) permitted to invest up to 50 per cent of their net worth in shares of an overseas listed company as a portfolio investment. Similarly, under the liberalised remittance scheme (LRS), in addition to the direct investment route for resident individual, resident individuals were permitted to invest in shares of both listed / unlisted companies. In practice, if resident individuals invested in offshore entities (listed or unlisted) below 10% (in some cases, a lower threshold was prescribed by the authorised dealer bank (AD Bank)) such that they did not have any negotiated rights or control over the offshore entity, then the same was considered as a portfolio investment by resident individuals and not direct investment.

However, under the OI Laws, it now appears that OPI as a construct is limited only to listed foreign entities as mentioned above.

  1. Manner of making offshore investments

Per Rule 9(1) of the OI Rules, investment outside India shall be made by persons resident in India only in a ‘bona fide’ business, directly or through a step down subsidiary or special purpose vehicle. However,  OI Laws do not clarify if more than 2 layers of special purpose vehicles can be engaged for purposes of making offshore investments, a point that has been contentious, and in practice, not permitted by AD banks especially if the 2 layers of SPVs are consecutive in the chain of subsidiaries. However, paragraph 20 (2) of OI Directions state “it is provided that no further layer of subsidiary or subsidiaries shall be added to any structure existing with two or more layers of subsidiaries post notification of the OI Rules/Regulations.” While this is stated in context of ‘round tripping’, it is unclear if this is applicable to every offshore structure or not.

Separately, bona fide has been defined to mean “any business activity permissible under any law in force in India and the host country, as the case maybe”. This appears to mean that if any activity is not permissible in India but permissible in the host country, the same may not be considered as “bona fide” business – thereby impacting the ability of some Indian entrepreneurs to conduct business offshore in cases where the business is facing regulatory uncertainty in India or is not permissible under Indian laws

  1. Offshore investment in start up

Rule 19(2) of the OI Rules states that ODI in start-ups recognised under the laws of the host country or host jurisdiction as the case may be, shall be made by an Indian entity only from the internal accruals whether from the Indian entity or group or associate companies in India and in case of resident individuals, from own funds of such an individual. Therefore, borrowing for purposes of ODI in start-ups offshore is not permitted. What is not clear is the scope of “start-up” – what if the host country does not have laws in place to specifically register / recognise start-ups? Will every new foreign entity set up be considered as a ‘start-up’? If the Indian entity / resident individual does not seek registration / recognition as a start-up in the host jurisdiction, how will compliance with this provision be undertaken?

Further, the rationale of limiting the source of funding for start-ups is not clear –at the least, Indian parties should be permitted to borrow to make ODI in such start ups after lapse of a certain period of time.

  1. Round tripping

While the term round tripping had not been defined under the erstwhile regime, conceptually it meant that a person resident in India cannot set up an offshore company if such offshore company then invests back into India. On account of concerns arising from ‘disguised FDI’, ‘tax evasion’ and money laundering, this concept was interpreted strictly to cover cases even when an Indian resident invests in an offshore company which may have an existing Indian subsidiary (see FAQ 64 in respect of Overseas Direct Investment on RBI’s website). However, under OI Laws, it appears that a round tripping structure is permissible on the condition that the number of layers of subsidiaries do not exceed 2 (two) layers.

Whilst this is a surprising and a welcome relaxation, we will await for clarification from the AD Bank / RBI in this regard in respect of any enhanced KYC that maybe required for such structures. Such enhanced KYC, in our view, is relevant and maybe expected in light of the inherent issues (as discussed above) that prevail in such a structure. Additionally, the term subsidiary has been defined to mean  an offshore entity held by the foreign entity over which the latter has control.  In such a situation, if the foreign entity does not have control of the investee company, it may not be considered as “subsidiary” and hence multiple investee companies of such nature maybe formed, which can certainly be an issue from a regulatory standpoint and not the intent of the regulator.

Separately, as mentioned in point 2 above, it appears that the restriction on having not more than 2 subsidiaries also applies to any other structure (whether or not the subsidiary is set up in India). If so, this will be in direct contradiction to the provision under Companies (Restriction on Number of Layers) Rules, 2017 which permits an Indian company from having more than two layers of subsidiaries in case of an offshore acquisition by an Indian entity wherein the offshore entity has multiple subsidiaries as per the laws of the host jurisdiction.

  1. Offshore investments by resident individuals

Subject to the limit of USD 250,000 under the LRS, a resident individual is permitted to undertake ODI if: (i) the foreign entity is an operating company not engaged in financial sector; and (ii) if the resident individual has control over the foreign entity, the latter does not have a step down subsidiary (except in case of issuance of shares through inheritance, sweat equity, ESOP or qualification shares in which case conditions under (i) and (ii) do not apply). Per paragraph 22(1) of the OI Directions, in the event a resident individual has made ODI without control in a foreign entity that subsequently acquires or sets-up a subsidiary/SDS, such resident individual shall not acquire control in such foreign entity. Control is defined as the ability to appoint majority of the directors on the board of a foreign entity or control the management or policy decisions of the foreign entity in any manner whatsoever including if the Indian entity / individual holds more than 10% voting power in the foreign entity.

This is in line with the provisions of erstwhile FEMA 120 wherein direct investment by resident individual in an offshore entity had to be such that the offshore entity does not have a step down subsidiary. In order to provide relaxation in cases of ODI where the resident individual does not have control, a carve out has been made to permit such foreign entity to have a step down subsidiary.

Reading these provisions with point 4 above, if a resident individual does not control the offshore entity, the offshore entity may have an Indian subsidiary as well provided there are not more than 2 layers of subsidiary. If the resident individual controls the offshore entity, then the permissibility of an Indian subsidiary as per point 4 above shall not be applicable to such ODI made by the resident individual.

  1. Gifting of foreign security by non-resident to resident

Under the Erstwhile FEMA 120, gift of foreign securities by non-resident to residents was permitted. However, paragraph 2(3) of Schedule III of OI Rules states that such gift is permissible if made in accordance with Foreign Contribution (Regulation) Act, 2010 (FCRA). This appears to mean that  a registration under the FCRA is required to obtain a gift, along with compliance of other applicable conditions. While it is not clear why FCRA has been included, consequent amendments to FCRA to clarify the scope of compliance required for gift of foreign securities would be welcomed.

  1. Net worth criteria

An Indian entity providing financial commitment to a foreign entity has to ensure that its cumulative financial commitment do not exceed 400% of its net worth. Under Erstwhile FEMA 120, ‘net worth’ was defined as paid up capital plus free reserves. However, the definition of net worth under OI Laws align it to Companies Act, 2013 to account for adjustment on account of accumulated losses (that is paid up capital + free reserves minus accumulated losses and other specified adjustments). This can reduce the headroom of networth now available for financial commitments.

Under Erstwhile FEMA 120, an Indian entity was allowed to utilise the net worth of the holding company or the subsidiary company to the extent such entity had not utilised its net worth for purposes of making financial commitment. Per paragraph 21(4)(e) of the OI Directions, this practise of utilisation of net worth of the holding company / subsidiary company shall be discontinued, thereby further tightening the headroom available for the Indian entity to undertake financial commitment.

  1. Pricing guidelines

Rule 16 of the OI Rules states that in case of any issuance or transfer of equity capital, the price for the same shall be subject to the price arrived on an arm’s length basis. Under the Erstwhile FEMA 120, only a valuation report was required though in practice, AD banks did not allow for sale of shares at a price less than that mentioned in the valuation report (which was as per Regulation 16 (iii) of Erstwhile ODI Regulations) or acquisition of shares at a price significantly more than that mentioned in the valuation report (a reflection of which was mentioned in the Draft Rules as well).

Rule 16 of OI Rules requires that the consideration for undertaking the transaction be subject to the price determined on an arm’s length basis. AD banks have been given the discretion in terms of formulating a policy internally to determine the documents required to ensure compliance with this condition which may include asking for a valuation done on the basis of internationally accepted pricing methodology. Whilst the aforementioned practice is not explicitly codified, we would expect the AD banks to continue the aforementioned practice going forward as well.

  1. Deferred Consideration

Previously, deferred consideration was not permitted in case of offshore investments by AD banks. OI Laws now permit deferred consideration if the period and amount for the same is specified upfront. This is certainly a welcome move as it provides flexibility to parties to structure payouts and related commercials in outbound M&A.

  1. Other Financial Commitment

An Indian entity can provide non fund based assistance and debt to its foreign entity provided that it has undertaken ODI in respect of such foreign entity (same as the Erstwhile FEMA 120). However, an additional criteria has been prescribed under OI Laws to state that prior to providing such non fund based assistance or loan, the Indian entity should be in control of the foreign entity (see paragraph 5 above for definition of ‘control’). This additional requirement is simply to ensure bona fide transactions are undertaken involving non fund based financial commitments.

Separately, as also provided under Erstwhile FEMA 120, resident individuals cannot undertake financial commitment by way of debt in respect of the foreign entity in which it has made ODI.

  1. Transfer Related

General permission is given to transfer instruments obtained in accordance with OI Laws (whether ODI or OPI) by way of sale to a person resident in India or outside India. In case of sale of instruments obtained through ODI, the following conditions need to be fulfilled:

  • The transferor shall stay invested for atleast 1 year (similar to the condition mentioned under the Erstwhile FEMA 120)
  • The transferor shall not have outstanding dues from the foreign entity in its capacity as an investor (such as dividends etc.). In case of any outstanding dues not connected with the transferor being an investor (such as export dues), the same can remain outstanding as per applicable laws and does not need to be cleared for the transferor to sell its shares (a significant relaxation from the condition under the Erstwhile FEMA 120 which required all outstanding dues to be closed).

Other conditions specified under the Erstwhile FEMA 120 in terms of manner of sale in case of listed company shares etc. have been done away with. Further, relaxations in respect of restructuring of the balance sheet of the offshore entity have also been provided under the OI Laws.

  1. Investment in Financial Sector

Under the erstwhile regime, entity not engaged in the financial sector in India was not allowed to invest offshore in the financial sector. Now this has been relaxed and except for certain sectors like banking and insurance, entities not engaged in the financial services sector in India may also be able to invest offshore in the financial sector, subject to fulfilment of certain conditionalities.

  1. Pledge of shares

Under the erstwhile regime, pledge of shares by Indian company held in the offshore entity / step down subsidiary was permissible subject to compliance with conditions including those set forth in A.P. Dir circular no. 54 dated December 29, 2014. The conditions mentioned therein inter alia include seeking no objection certificate from the AD Bank; a certificate from the Statutory Auditors’ of the Indian party, to the effect that the loan / facility availed by the offshore entity has not been utilized for direct or indirect investments in India etc. As per the OI Directions, this circular is now repealed. Accordingly, it would be relevant to see if any new conditionalities are further notified to be applicable to a pledge of shares held in the foreign entity.

Whilst the spirit and objective behind the overhaul in the regulatory regime governing overseas investment is laudable, the manner in which the OI Laws are implemented will be critical. Basis the OI Directions, we note that a significant amount of discretion is provided to authorised dealer banks to provide for manner of compliance with these provisions. Certain clarifications in respect of KYC required for the ‘round tripping’ structure, scope of start-ups, applicability of the two layer rule to any other structure, scope of FCRA applicability to gift of shares should be forthcoming at the earliest. Overall, it cannot be denied that there has been an ease in the applicable regulations – practical difficulties arising from the erstwhile regime have been recognised and significant relaxations have been provided in the new regime. What is instrumental is that the OPI route is extremely limited in its application and scope and accordingly, the new regime requires the Indian entity to comply with the net worth requirement and the other conditionalities applicable to an ODI investment – this indirectly tightens and limits the overall outflow of the outbound investments compared to the old regime.

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