In light of the disruption caused by the COVID-19 pandemic, the United States and Europe have altered their approach to foreign direct investment (FDI) by curbing opportunistic takeovers of domestic companies in a few strategic sectors or investments from certain jurisdictions. In addition, India has adopted a similar approach by restricting FDI from certain jurisdictions.
By way of a notification of 22 April 2020 issued by the Department of Economic Affairs of the Ministry of Finance and amending the Foreign Exchange Management (Non-Debt Instrument) Rules 2019, the government has introduced measures to curb opportunistic takeovers (direct or indirect) of Indian companies by persons or entities of any country which shares a land border with India ('bordering countries'). While not specifically listed in the notification, the following countries constitute 'bordering countries':
- Pakistan;
- Bangladesh;
- Afghanistan;
- Nepal;
- Bhutan;
- Myanmar; and
- China.
A grey area remains as to whether Hong Kong, Macau and Taiwan also fall within the notification's remit given:
- their political status and relationship with China; and
- the fact that they do not share a land border with India.
The notification limits itself to FDI and does not regulate foreign portfolio investments (ie, investments of less than 10% in listed Indian companies) through registered foreign portfolio investment entities, including those from a bordering country, whether direct or indirect. However, it is understood that the government is considering additional checks on portfolio investments by Chinese investors and is in talks with the market regulator, the Securities and Exchange Board of India, on this matter.
Therefore, from an FDI perspective, the following investments now require prior approval from the government:
- FDI by entities situated in a bordering country; and
- FDI where the beneficial owners reside in or are citizens of a bordering country.
The use of the term 'citizen' in the context of beneficial owners and the fact that the term 'beneficial owner' is distinct from the term 'entities' indicates that the notification's purpose is to identify the ultimate natural persons behind an investment.
Notably, contrary to the declared goal of restraining opportunistic takeovers, the notification does not seek to distinguish between financial or passive investments and investments leading to a person in a bordering country taking control of an Indian company. Consequently, even an insignificant investment from such a person will fall within the ambit of the notification and trigger the requirement to obtain the government's prior approval.
Contrary to expectations, the notification does not clarify who constitutes a 'beneficial owner'. In order to appreciate the overall reach of these changes, this term must be defined.
Given that the Reserve Bank of India (RBI) is the primary regulator under the Foreign Exchange Management Act 1999, the parameters set out by it in this respect are relevant. The Know Your Customer (KYC) Direction 2016 (KYC Master Direction) – which the RBI issued on 25 February 2016 to establish a customer identification procedure in line with the Prevention of Money Laundering Act 2002 – defines 'beneficial owner' in respect of juridical persons. For instance, with respect to a company, a 'beneficial owner' is a natural person who – acting alone or with other beneficial owners, or through one or more juridical persons – has a controlling ownership interest or exercises control through other means with regard to the company.
The KYC Master Direction defines:
- a 'controlling ownership interest' as the ownership of or entitlement to more than 25% of the shares, capital or profits of the company; and
- 'control' as including the right to appoint the majority of the directors or control the management or policy decisions, including by virtue of their shareholding or management rights or shareholder or voting agreements. For other juridical persons (eg, limited liability partnerships, trusts and unincorporated associations), the threshold is 15% of the investment.
The KYC Master Direction thus traces the ownership interest of the ultimate natural person in order to ascertain beneficial ownership, irrespective of the number of intermediate layers of juridical persons. This also meets the intent of the amended FDI policy, as the restriction cannot be bypassed merely by investing through intermediate entities situated outside the bordering countries.
In line with the above, an investment threshold of 25% may be notified for determining beneficial ownership. This proposition is bolstered by the Department of Economic Affairs' recent recommendation that the Department for Promotion of Industry and Internal Trade set the investment threshold for determining beneficial ownership and consequently triggering the requirement to obtain prior governmental approval at 25% of the investment.
(Un)intended implications of notification
The quick implementation of the notification coupled with its lack of clear and unambiguous guidance on certain key issues has led to a slow down in foreign investment, especially from bordering countries. A few situations reflecting the notification's impact are set out below.
Fundraising by Indian companies
Any further funding (including by way of a rights issue) by companies that are wholly owned subsidiaries of entities from bordering countries, or that have existing investment from entities from bordering countries, which involves investment by such a foreign investor will require prior governmental approval. Given the time taken to grant such approval, Indian companies may explore other options to meet immediate cash-flow requirements. Since the notification does not cover external commercial borrowings, one option may be to raise debt from shareholders (including non-resident shareholders without an option to convert to equity) or domestic lenders.
Impact on private equity and venture capital funds
Given the lack of a clear definition of 'beneficial owner', private equity and venture capital funds that have raised capital from their partners situated in a bordering country or Hong Kong, Macau or Taiwan may have to re-evaluate whether they can invest in India under the automatic route by way of FDI.
Increased compliance obligations for Indian companies
Indian companies must review the shareholding structures of potential and existing investors to ascertain whether they are directly or indirectly linked to any person from a bordering country or seek appropriate disclosures to that effect. Indian companies must undertake this exercise even for a transfer of their shares between non-residents, which typically (for automatic sectors) does not require any regulatory filings under foreign exchange regulations.
Impact on grant of ESOPs by Indian companies to non-resident employees or directors
While the foreign exchange regulations permit Indian companies to grant employee stock ownership plans (ESOPs) to employees or directors of their overseas entities, any grant of an ESOP to employees from a bordering country will require prior governmental approval. In addition, any exercise by such employees of options granted to them prior to the notification's issuance may also require prior governmental approval before shares can be issued pursuant to the exercise.
Based on the revised FDI policy, prior governmental approval will be required for:
- FDI from entities or natural persons (residents or citizens) of a bordering country in Indian entities engaged in permitted sectors;
- FDI where the beneficial owners are residents or citizens of a bordering country in Indian entities engaged in permitted sectors (direct or indirect); and
- a transfer of existing or future FDI which directly or indirectly results in a change in the beneficial ownership of such FDI to residents or citizens of a bordering country.
The incidental implications of the broadly worded restrictions in the notification have left certain stakeholders perplexed. On the flip side, keeping the wording broad allows the government to maintain control over such transactions.
While identifying a transaction involving direct investment by an entity or natural person situated in a bordering country appears simple, clarity on the determination of beneficial ownership and whether Hong Kong, Macau and Taiwan constitute bordering countries is required to understand the reach of the revised FDI policy. Until there is official clarity in this regard, the notification's ambit remains unclear.
In light of the 25% threshold recommended by the Department of Economic Affairs, it is hoped that the government will soon prescribe the parameters for determining beneficial ownership. This will iron out creases for investors and investee companies and ensure clarity for authorised dealer banks, which will then be able to identify beneficial ownership and classify cases requiring governmental approval with certainty.
Even though the notification suggests that the restrictions are temporary (being linked to the effects of the COVID-19 pandemic), given the strained relationship between India and China, the notification is not likely to be withdrawn in the future. However, it is hoped that the government will provide detailed clarifications to address the gaps in the notification and help to increase FDI in India.
Nayanika Majumdar, senior associate, assisted in the preparation of this article.
