[The following guest post is contributed by Ajay G. Prasad, who is a Senior Associate with Kochhar & Co, Bangalore. Views expressed in this post are personal and do not reflect the views of the firm.]
Exchange control rules on downstream investment form an important aspect to consider in M&A transactions. As per the foreign direct investment policy (“FDI Policy”) of the Department of Industrial Policy & Promotion (the “DIPP”), the expression “downstream investment” means indirect foreign investment by one Indian company into another Indian company (either by way of purchase of shares or by way of fresh allotment of shares).
Until Press notes 2, 3 and 4 were issued by the DIPP in 2009, there was considerable ambiguity surrounding the treatment of such indirect foreign investment. Although the issuance of these press notes sought to clear the ambiguity, the DIPP unwittingly gave room for further uncertainty by creating new classes of companies called “operating companies”, “investment companies” and so on. As a result, stakeholders were required to apply the downstream rules contained in these press notes after determining which category a given company fell. This was a difficult exercise to undertake.
Fortunately, the DIPP did away with most of these differentiations through the FDI policy released in April 2011. Ever since, the downstream investment rules are being continuously pruned. Press note 12 of 2015 read with the amendments to the FEMA (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 (the “2016 FEMA Amendment”) dated 15 February 2016 has further liberalized these rules. But despite numerous attempts of the Government and the Reserve Bank of India (RBI) to fine tune these rules, I submit that some issues and ambiguities persist. I provide a few illustrations below.
Ambiguity in the expression “foreign investment” as appearing in paragraph 184.108.40.206 of the FDI Policy
Chapter 3.10 of the FDI Policy specifies that (for the purpose of that chapter) the expression “foreign investment” would have the same meaning as in Paragraph 4.1. Paragraph 4.1 does not contain a specific definition of foreign investment. It however specifies that foreign investment into an Indian company comprises both direct foreign investment (i.e. a non resident entity directly investing in an Indian entity) and indirect foreign investment (i.e. one Indian company /LLP with foreign investment investing in another Indian company/LLP). It goes on to state that for the purpose of counting foreign investment in an Indian company/entity, all of the direct foreign investment by a non-resident would be counted towards foreign investment. As far as counting indirect foreign investment goes, the same would be counted towards calculating foreign investment if the investing Indian company/entity is either owned or controlled (or both) by non-residents.
Be that as it may, paragraph 220.127.116.11 of the FDI Policy specifies that foreign investment into an Indian company engaged only in the activity of investing in the capital of other Indian companies will require prior Government / Foreign Investment Promotion Board approval, regardless of the amount or extent of foreign investment (emphasis supplied). The ambiguity arises when one compares the aforesaid language to the language and intent of paragraph 4.1 (which clearly mentions that indirect foreign investment by Indian companies owned and controlled by resident Indian citizens would not be counted towards foreign investment). What then is the intent of using the expression “regardless of the amount or extent of foreign investment”? Does it mean that only for the purpose of paragraph 18.104.22.168 even indirect foreign investment by companies which are owned and controlled by Indian companies and / or Indian citizens would be counted towards foreign investment? That should clearly not be the case (and presumably, the intent).
Therefore, a couple of possible solutions could be to either amend the definition of the expression “foreign investment” or delete the language “regardless of the amount or extent of foreign investment” (which was emphasized above).
No guidance around the meaning of the expression, “domestic market”
The downstream investment rules of the FDI Policy specify that: (i) an Indian company undertaking downstream investment would have to bring in requisite funds from abroad and not leverage funds from the domestic market (emphasis supplied); (ii) this would however not preclude downstream companies with operations from raising debt in the domestic market; and (iii) downstream investment through internal accruals are permitted. The 2016 FEMA Amendment defined the expression “internal accruals” for the very first time in the context of these rules to mean profits transferred to the reserve account after payment of taxes.
The expression “domestic market” used in the rules has created some uncertainty as there is no regulatory guidance as to what is the meaning of the same. This is particularly so in transactions which involve one Indian company (say “X”, owned and controlled by non-residents or owned or controlled by non-residents) lending to an Indian subsidiary company (say “Y”) for the purpose of Y making investment in another unrelated Indian company (say “Z”).
In this context, I have come across several stakeholders who tend to concentrate only on the word “domestic” to the exclusion of “market” and argue that investment by Y into Z is not permitted under the automatic route (i.e. without Government / FIPB approval). Typically, they interpret “domestic market” to mean “domestic source”. However, in my view the intent of the policy is not to prohibit such downstream transactions; or make them subject to the approval route. The intent is to regulate transactions where Y, instead of obtaining a loan from its holding company X, raises funds from a bank or a financial institution or a non-banking financial company to fund the acquisition. As per Black’s Law Dictionary, “market” means: (i) place of commercial activity in which goods, commodities, securities, service, etc. are bought and sold; (ii) a public time and appointed place of buying and selling; also purchase and sale. The rules also use the expression “raise debt”. Typically, the word “raise” means raising a loan in the debt market or through a bank or financial institution.
Based on the above, I submit that from an exchange control law perspective, the intent is not to prohibit lending by a holding company to a subsidiary company for making investments. The reason X is lending to Y is on account of the relationship that they share. Hence, it should be covered under the automatic route. In this connection, one needs to also examine the legality of these transactions from an Indian Companies Act, 2013 perspective. That is a different topic and not part of the scope of this post.
Confusion around using the escrow mechanism
Exchange control laws permit parties to an FDI transaction to set up an escrow account with an authorized dealer bank wherein consideration payable on account of transactions may be deposited in the escrow account for a period of six months. This is allowed under the automatic route (i.e. without taking special RBI permission). In case the parties intend that escrow to be operational beyond six months, they need to obtain special RBI permission. Recently, some relaxations have been made available in this respect. Where parties to a transaction so agree, an escrow account, wherein not more than twenty five percent of the total consideration is deposited, can be operational for a period up to eighteen months without taking special RBI permission.
While the above rules seem clear enough, when it comes to their application in a downstream investment scenario, things get slightly muddied. The relevant language in the downstream investment section of the FEMA Regulations specifies five [(a) to (e)] conditions, none relating to opening an escrow account to undertake downstream investments. Therefore, when it comes to opening an escrow account for downstream investment, one would assume that parties are not required to comply with the rules relating to escrow (even the recently released FEMA Deposit Regulations seems to suggest the same).
However, some stakeholders (including a few authorized dealer banks) have taken a view that since downstream investment is indirect foreign investment, an escrow account for the purpose of facilitating downstream transactions should also be subject to the same rules. As there is no express regulatory guidance on this, most transactions are structured after taking the inputs of the authorized dealer banks (who in turn would have obtained some sort of comfort from the RBI after presenting all the facts to the RBI, mostly on a no-names basis). In the absence of clear regulatory guidance, the RBI’s approach may have been based on transaction-specific facts (and slightly ad-hoc). In my view, having clarity on this issue would go a long way in avoiding this case to case approach currently being adopted.
It is hoped that the new FDI policy (scheduled to be released soon by the DIPP as per past precedents) would address some of these issues.
- Ajay G. Prasad