Foreign investment in India is governed by a combination of the prevailing foreign investment policy of the government of India, the Foreign Exchange Management Act, 1999, as amended (FEMA), and regulations and notifications issued by the Reserve Bank of India (RBI), under the FEMA.
The Foreign Investment Policy was first announced by the government in 1991 in a document called the Industrial Policy Statement. The Industrial Policy Statement set out the broad parameters for foreign investment in India, listing the industrial sectors that would be open to foreign investment and the percentage of foreign investment permitted in certain sectors.
Since 1991, the government has made changes in the Foreign Investment Policy from time to time. A number of these changes have been to add to the list of industries in which foreign investment is permitted or to increase the percentage of foreign investment permitted in such industries. Changes in the Foreign Investment Policy have been announced either through Press Notes published by the Secretariat of Industrial Assistance, a division of the Ministry of Commerce and Industry (SIA), or circulars, notifications or amendments issued by the Ministry in charge of the relevant industry.
Under the Foreign Investment Policy, foreign direct investment (FDI) in certain sectors may be made under the automatic route where no prior approval of any regulatory authority is required, and in certain other sectors, with the prior approval of the Foreign Investment Promotion Board (FIPB). There are certain specified sectors in which FDI is not permitted, such as multi-brand retail, atomic energy and betting and gambling.
There has been some ambiguity in the provisions of the Foreign Investment Policy in relation to issues arising out of transactions where the foreign investor invests in an Indian company and such Indian company subsequently invests into another Indian company or where the foreign investor invests in an Indian company that already has investments in another Indian company.
The government has recently issued certain guidelines for calculation of foreign investment in Indian companies, transfer of ownership or control of Indian companies and downstream investments by Indian companies that have foreign investment. These guidelines are expected to have a significant impact on the structuring of in-bound foreign investment transactions in India. These guidelines are in the form of the following Press Notes:
Press Note 2 (2009 Series) dated February 13 2009, which relates to guidelines for the calculation of total foreign investment, i.e. direct and indirect foreign investment in Indian companies;
Press Note 3 (2009 Series) dated February 13 2009, which relates to guidelines for transfer of ownership or control of Indian companies in sectors with specified limits on foreign investment from resident Indian citizens to non-resident entities; and
Press Note 4 (2009 Series) dated February 25 2009, which relates to guidelines on downstream investments by Indian companies that have foreign investment.
Press Note 2 of 2009
Press Note 2 of 2009 provides guidelines for the calculation of aggregate foreign investment (i.e. direct and indirect foreign investment) in an Indian company. The government has introduced this method of calculation with the stated objective of achieving uniformity and consistency in the method for calculating foreign investment. These guidelines apply across different sectors, subject to certain exceptions where the foreign investment is governed specifically by a statute or statutory rules, such as insurance and banking.
Press Note 2 of 2009 specifies that in relation to an investment by an Indian company in another Indian company, if (a) the investing Indian company is owned and controlled by resident Indian citizens, and (b) foreign entities do not own or control the investing Indian company, then the foreign investment in the investing Indian company will not be considered for calculation of the foreign investment in the investee Indian company. However, if the requirements under (a) and (b) above are not satisfied, then the entire investment of the investing Indian company in the investee Indian company will be considered foreign investment.
Pursuant to Press Note 2 of 2009, an investing company shall be considered (i) owned by resident Indian citizens or foreign entities if more than 50% of its equity interest is beneficially owned by resident Indian citizens or foreign entities, as the case may be, and (ii) controlled by resident Indian citizens or foreign entities if the resident Indian citizens or foreign entities, as the case may be, have the power to appoint a majority of its directors.
As an exception to the general rule set forth above, Press Note 2 of 2009 provides that if the investee Indian company is a wholly-owned subsidiary of the investing Indian company, then the foreign investment in the investee Indian company will be the same as the foreign investment in the investing Indian company.
The following illustration explains certain aspects of the calculation of foreign investment based on the above rules:
Company A, an Indian company, which has foreign investment, has invested in Company B, another Indian company.
(i) If Company A has (a) foreign investment of less than 50%, and (b) a resident Indian citizen (or an Indian company which is owned and controlled by resident Indian citizens) controls it, Company B will be considered to have no indirect foreign investment.
(ii) If Company A has foreign investment of 75%, and:
(a) invests 26% in Company B, then the foreign investment in Company B will be 26%;
(b) invests 80% in Company B, then the foreign investment in Company B will be 80%.
(iii) If Company A is controlled by a foreign entity, and:
(a) invests 26% in Company B, then the foreign investment in Company B will be 26%;
(b) invests 80% in Company B, then the foreign investment in Company B will be 80%.
(iv) If Company A has foreign investment of 75% and invests 100% in Company B (i.e. Company B is a wholly-owned subsidiary), then the foreign investment in Company B will be 75%.
Press Note 2 of 2009 sets forth a broad definition of foreign investment which includes investment by foreign institutional investors (FIIs) and non-resident Indians, and foreign investment in the form of American depositary receipts, global depositary receipts, foreign currency convertible bonds, convertible preference shares and convertible debentures.
In addition to the general rules, Press Note 2 of 2009 also provides specific conditions for foreign investment in certain sectors. In certain media businesses (such as FM radio, print media, news and current affairs television channels) and in the defence sector, where the foreign investment cap is "less than 49%", the relevant Indian company is required to be owned and controlled by resident Indian citizens and Indian companies owned and controlled by resident Indian citizens. Further, the largest Indian shareholder is required to hold at least a 51% equity interest in the Indian company, excluding any equity interest held by public sector banks and public financial institutions.
Press Note 2 of 2009 specifies that in sectors where the approval of the government is required for any foreign investment, if there is an agreement among shareholders of the relevant Indian company which has 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, such agreement will need to be provided to the approving authority. The approving authority will consider such agreement in making a determination regarding ownership and control of the Indian company.
Key concerns
Some preliminary issues that arise from Press Note 2 of 2009 are set forth below.
Definition of foreign investment
Under the Foreign Investment Policy, certain sectors, such as Direct-to-Home (DTH) broadcasting, have sub-limits for investments by FIIs within the overall foreign direct investment limit. Arguably, in view of the broad definition of foreign investment under Press Note 2 of 2009, such sub-limits are no longer relevant.
In addition, foreign institutional investors were earlier permitted to invest on the secondary market in certain sectors where FDI is prohibited, such as multi-brand retail. One possible interpretation of Press Note 2 of 2009 is that such investments will no longer be permitted as they will constitute FDI. Further, if FII investments are included in the definition of FDI, certain prominent Indian banks, such as ICICI Bank and HDFC Bank, would be deemed to be foreign-owned and therefore downstream investments by such banks would constitute foreign investment.
Beneficial ownership
The ownership test refers to the term beneficial ownership. However, Press Note 2 of 2009 does not provide any definition or guidance in respect of the meaning of this term. The [Indian] Companies Act, 1956, as amended, requires the filing of a declaration of any beneficial interest in the shares of an Indian company. In the absence of such declaration of beneficial interest, it is unclear that being named as a shareholder in an Indian company's statutory records is sufficient for a person to have beneficial ownership in respect of the relevant shares for the purpose of Press Note 2 of 2009.
Control
There may be circumstances in which neither resident Indian citizens nor foreign entities have control over an Indian company as such term is defined in Press Note 2 of 2009. For example, a listed company has a requirement to appoint a minimum number of independent directors and neither resident Indian citizens nor foreign entities will have the right to appoint a majority of the directors. In such a case, since resident Indian citizens may not have ownership and control over the Indian company in terms of Press Note 2 of 2009, there is an argument that the entire investment by such an Indian company in another Indian company will be considered foreign investment. This may be an unintended result of the rules set forth in Press Note 2 of 2009.
Disproportionate rights
Although the ownership and control tests specify rules for determining ownership and control of an Indian company, the reference in Press Note 2 of 2009 to the approving authority's review of shareholders' agreements to determine, among other things, whether it creates voting rights disproportionate to shareholding, suggests that the approving authority may also consider other factors in addition to the ownership and control tests. If a foreign investor holds up to a 49% equity interest in an Indian company, presumably such foreign investor will have certain rights in relation to the business and operations of that Indian company, such as veto rights over certain key matters, representation on the board of directors and transfer restrictions on the majority shareholder. Also, the rights of shareholders under a shareholders' agreement will be a function of the dynamics of a particular transaction and, to an extent, a matter of negotiation. The approving authority may determine in a specific case that a particular shareholder has disproportionate rights and actually controls the Indian company. Such determinations may lead to case-specific and sector-specific distortions, a lack of consistency and potentially the same issues that Press Note 2 of 2009 is intended to eliminate.
Grandfather clause
Press Note 2 of 2009 provides that any foreign investment already made in accordance with the guidelines in existence prior to the issuance of Press Note 2 of 2009 will not need to conform to the guidelines contained in Press Note 2 of 2009. There may however be instances where an existing investment structure is modified (for example, through an enhancement of existing foreign investment). In such a situation, presumably since the calculation of foreign investment cannot be made both under the old guidelines and the new rules, the existing investment may need to be restructured to conform to the new rules.
Implications for certain restricted sectors
Foreign direct investment is currently prohibited in certain sectors such as multi-brand retail. Given the size of the Indian consumer market, strategic investors and private equity funds have been keen to invest in such sectors. Pursuant to Press Note 2 of 2009, it is arguably possible for foreign investors to indirectly invest in such sectors through an investing Indian company provided that such investing Indian company is owned and controlled by resident Indian citizens and is an operating company.
In certain sensitive sectors, there are guidelines or licenses issued by the relevant Ministry that also define and regulate foreign investment. It is unclear whether these guidelines will be superseded or amended pursuant to the new Press Notes.
Press Note 3 of 2009
Press Note 3 of 2009 provides guidelines for the transfer of ownership or control of Indian companies from resident Indian citizens to foreign entities. These guidelines are applicable in relation to foreign investments in Indian companies operating in sectors with foreign investment caps, such as defence production, air transport services, ground handling services, asset reconstruction companies, private sector banking, broadcasting, commodity exchanges, credit information companies, insurance, print media, telecommunications and satellites. Press Note 3 of 2009 does not apply to sectors and activities in which there are no foreign investment caps, such as where 100% foreign investment is permitted under the automatic route.
Pursuant to Press Note 3 of 2009, prior approval of the government or FIPB will be required for the following transactions in sectors that have foreign investments caps:
1) the establishment of an Indian company with foreign investment if that Indian company will be owned by a foreign entity;
2) the establishment of an Indian company with foreign investment if that Indian company will be controlled by a foreign entity;
3) the transfer of control of an existing Indian company, currently owned or controlled by resident Indian citizens or Indian companies that are owned or controlled by resident Indian citizens, to a foreign entity as a consequence of a transfer of shares to such a foreign entity; and
4) the transfer of the ownership of an existing Indian Company, currently owned or controlled by resident Indian citizens and Indian companies that are owned or controlled by resident Indian citizens, to a foreign entity as a consequence of a transfer of shares to such a foreign entity.
Press Note 4 of 2009
Press Note 4 of 2009 issued by the government provides guidelines relating to downstream investments by Indian companies that have foreign investment, in other words Indian companies that have foreign investment and are investing in other Indian companies. These guidelines need to be read in conjunction with the guidelines for calculating foreign investment under Press Note 2 of 2009.
Pursuant to a strict construction adopted by the regulator in respect of the earlier downstream investment regulations set forth in Press Note No. 3 (1997 Series) dated January 17 1997 and Press Note No. 9 (1999 Series) dated April 12 1999, any foreign investment in an Indian company that had downstream investments in other Indian companies required prior FIPB approval. This approval requirement considerably increased the timelines for completion of several transactions in India that had a foreign element.
The stated guiding principle of Press Note 4 of 2009 is that downstream investments by Indian companies owned or controlled by foreign entities should follow the same rules as those applicable to direct foreign investment. In respect of downstream investments by Indian companies that are not owned or controlled by foreign entities, there would not be any restrictions.
For the purpose of downstream investments, Press Note 4 of 2009 classifies Indian companies into: (i) operating companies, (ii) operating-and-investing companies, and (iii) investing companies. In connection with foreign investment in these categories of Indian companies, Press Note 4 of 2009 provides that:
1) Operating company: Foreign investment in an operating company will need to comply with the terms and conditions for foreign investment in the relevant sector(s) in which that company operates;
2) Operating-and-investing company: Foreign investment in such a company will need to comply with the terms and conditions for foreign investment in the relevant sector(s) in which that company operates. Further, the investee Indian companies into which downstream investments are made by that company will need to comply with the terms and conditions for foreign investment in the relevant sectors in which the investee Indian companies operate; and
3) Investing company: An investing company has been defined under Press Note 4 of 2009 as an Indian company holding only direct or indirect investments in other Indian companies other than for trading of such holdings. Any foreign investment in such a company will require the prior approval of the FIPB.
Press Note 4 of 2009 further provides that foreign investment in an Indian company that does not have (a) any operations, or (b) any downstream investments, will require the prior approval of the FIPB.
Under Press Note 4 of 2009, an investing company is required to bring funds from outside India for the purposes of downstream investments into other Indian companies, and not leverage funds from the Indian debt or equity markets for such investments. This essentially means that the only source of funds for downstream investments by an investing company will be the proceeds of equity issuances since current regulations that govern external commercial borrowings restrict the use of such borrowings for the purchase of shares.
Operating-and-investing companies and investing companies are also required to notify the FIPB, the SIA and the Department of Industrial Policy & Promotion at the Ministry of Commerce and Industry of any downstream investment within 30 days of such investment. Further, any issue or transfer of shares of an Indian company in the context of a downstream investment is required to be in accordance with applicable pricing guidelines for issue or transfer of shares to foreign investors under the FEMA.
A literal construction of Press Note 4 of 2009 suggests that any foreign investment in an investing company will require the prior approval of the FIPB. However, there may be an argument that since Press Note 4 of 2009 sets forth guidelines for downstream investment by Indian companies that are owned or controlled by non-resident entities, foreign investment in an investing company will require prior FIPB approval only if there is, or such investment will result in, ownership or control by non-resident entities.
The definitions of 'investing company' and 'operating company' can lead to ambiguities in interpretation.
Although not clear under Press Note 4 of 2009, the requirement to bring funds from outside India may also apply to operating-and-investing companies.
Uncertainties remain
Press Notes 2, 3 and 4 of 2009 provide greater flexibility and headroom to foreign investors for structuring investments in India in certain sectors. However, these Press Notes introduce certain new concepts that will be tested over a period of time and likely require further clarification from the regulator.
There are reports that certain departments within the government and the RBI are seeking changes to these Press Notes to provide greater clarity on the definition of foreign investment, prohibit indirect foreign investment in sectors such as multi-band retail and other prohibited sectors and broaden the definition of control. It is unclear whether (and when) any changes will be made to these Press Notes.
| Author biography |
Rajat Sethi
S&R Associates
Rajat Sethi's practice at S&R Associates focuses on advising public and private companies in a variety of corporate transactions including acquisitions, joint ventures, venture capital and private equity financings, regulatory and corporate compliance matters. He has advised Indian and foreign clients on several major transactions.
S&R Associates
S&R Associates was established in 2005. The firm provides legal services in the areas of mergers and acquisitions, securities laws, financings, foreign direct investment, regulatory matters, general corporate counseling and arbitration and litigation.
S&R Associates has five partners and 25 lawyers. Its offices are located at New Delhi, India.
64, Okhla Industrial Estate Phase III
New Delhi 110 020, India
Tel: +91.11.4069.8000
Fax: +91.11.4069.8001
E-mail: rsethi@snrlaw.in |