I wrote the following column in the Business Standard on February 23, 2009:
In a bold move, the government has opened up foreign investment in an unprecedented manner. The move legitimizes many a structure that would have hitherto been keeping even their authors shy.
The Cabinet Committee on Economic Affairs has taken a policy decision that any Indian company in which foreign ownership is not more than 50% of the equity stake and where foreigners do not have a right to appoint a majority of the directors on the board, could freely invest in other Indian companies. Such investments would not be regarded in any manner as a foreign investment even indirectly.
In a press note issued by the Department of Industrial Policy and Promotion (“DIPP”), the government has stated that unless an Indian company is “owned” (ownership of more than 50% equity) or “controlled” (power to appoint a majority of directors) by foreign investors, investments by it into other Indian companies would not be regarded as foreign investment at all. The investment by such an Indian company – one over that a foreign neither “owns” nor “controls” would be regarded as an investment by an Indian company.
The term “control” has been defined purely as the ability to appoint a majority of the directors – a statutory right that would flow in India from owning at least one share more than 50% of the equity of a company – the DIPP’s definition of “owned” picks exactly the same thing.
Therefore, in a company in which foreign investment is regulated by way of sectoral caps, a foreign investor could take a direct equity stake to the fullest extent of the permitted sectoral cap, and the balance beneficial interest could be taken through one or more Indian companies where the foreign investor holds not more than 50% equity.
There is a flip side to this approach. Even if multiple unrelated foreign investors
cumulatively hold more than 50% in an Indian company, the Indian company would be treated as a foreign investor.
Therefore, any investment by such Indian company into the equity of another Indian company would be treated entirely as a foreign investment, rather than as a proportionate investment. For example, if foreign holding in an Indian company is 51% and that company invests 26% in another Indian company, the foreign investment in the second company would not be regarded as 51% of 26% i.e. a bit more than 13%, but would be regarded as a foreign investment of 26%.
Such an approach poses several challenges. While this may be a legitimate way to deal with a single foreign investor who owns a majority in Indian company and uses its Indian subsidiary to make further investments, there are a number of board-driven Indian institutional companies that have attracted foreign investment, and would get similarly treated.
For instance the new approach of the government will not differentiate between a Hindustan Unilever Ltd. and say, an ICICI Ltd. The former is clearly a subsidiary of
a foreign company while the latter is an Indian company that has majority ownership in foreign hands, and therefore, technically, entailing the power to appoint a majority of the board of directors being vested in foreign hands.
There is one other major anomaly with the DIPP’s latest approach. In treating the entire holding by an Indian company owned or controlled by foreign investors, an exception has been made for investment in wholly owned subsidiaries. The foreign equity stake in a wholly owned subsidiary would be regarded as a mirror image of level of foreign equity shareholding in the parent.
Therefore, if a 51% foreign-owned Indian company invests in 100% of another Indian company’s equity, the foreign holding in the latter would be regarded as 51%. However, if the 51% foreign-owned Indian company were to give 5% in its subsidiary to another Indian investor, and holds 95%, the foreign investment in the subsidiary would be regarded as 95%. Surely, this is a clear disincentive for foreign investors to share their holdings with other Indian investors.
Clearly, all of this would be relevant only in the case of sectors where foreign holding is regulated. There is yet another self-inflicted problem that the DIPP needs to resolve. Last year, in a first, the DIPP started objecting to Indian companies having foreign investment acting as “operating-cum-holding companies” i.e. as companies that have legitimate foreign investment, their making investments in other Indian companies has been regarded as being per se illegitimate.
Nobody has challenged this stance in a court of law so far. With the notification of the new dispensation, the DIPP ought to hasten to clarify that henceforth, having brought clarity to the meaning of the term “foreign owned Indian company”, such a stance will not be taken by the government.
Predictability is the hallmark of good investment law. However, precision continues to be elusive.