Foreign investment in India – shift in regulatory powers.

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Rishabh Bharadwaj

Khaitan & Co, Bengaluru

rishabh.bharadwaj@khaitanco.com

Neil Deshpande

Khaitan & Co, Bengaluru

neil.deshpande@khaitanco.com

Introduction

India’s journey, from a closed and restricted economy to a preferred investment destination, is an intriguing one. Though the economic reforms introduced in 1991 removed a slew of barriers for foreign investments, with measures like current account convertibility being adopted in August 1994, India still does not have a full capital account convertibility and has a regulated regime for foreign investments. Until recently, foreign investment in India was primarily regulated by India’s Central Bank – the Reserve Bank of India (RBI) – pursuant to the Foreign Exchange Management Act 1999 (FEMA) enacted by the Indian Parliament, read with (a) the Foreign Exchange Management (Transfer or Issue of any Security to a Person Resident Outside India) Regulations 2017 (TISPRO) framed by the RBI pursuant to its powers under FEMA, and (b) in case of foreign direct investments (FDI) (ie, foreign investment in equity instruments of an unlisted Indian Company or in ten per cent or more of the paid-up equity capital of a listed Indian company), the consolidated FDI policy issued by the Government of India (‘FDI Policy’).

However, on 15 October 2019, the Government of India notified the amendments to the FEMA that were passed by the Indian Parliament in 2015 (the ‘2015 Amendments’). Pursuant to the 2015 Amendments, (a) RBI’s power to specify and regulate (in consultation with the Government of India) all classes of permissible capital account transactions has now been limited only to the ones pertaining to ‘debt instruments’; and (b) the Government of India has been empowered to: (i) specify and regulate (in consultation with the RBI) the classes of permissible capital account transactions not involving ‘debt instruments’; and (ii) to determine which instruments will be specified as ‘debt instruments’ for purposes of the foregoing. In furtherance of the 2015 Amendments, on 17 October 2019: (a) the Government of India has issued the Foreign Exchange Management (Non-Debt) Rules 2019 (‘Non-Debt Rules’); and (b) the RBI has issued the Foreign Exchange Management(Debt Instruments) Regulations 2019, in each case superseding the TISPRO regulations and thereby shifting the regulatory jurisdiction pertaining to equity foreign investment (ie, foreign investment involving non-debt instruments or securities) from the RBI to the Government of India.

For purposes of this article, reference to ‘foreign investment’ means investment in non-debt securities or instruments. The exchange control regime for investment in or acquisition of immovable property in India, which forms part of the Non-Debt Rules, is not discussed in this piece.

Key highlights of the recent changes relevant for equity investments

Distinction between debt and non-debt instruments

Non-debt instruments are all equity instruments (ie, compulsorily and fully convertible preference shares, compulsorily and fully convertible debentures, share-warrants (in some cases) and partly-paid-up shares) of entities incorporated in India (public, private, listed and unlisted); capital participation in limited liability partnerships; other instruments of investment permitted in the FDI Policy; investment in units of alternative investment funds; real estate investment trust and infrastructure investment trusts; investment in units of mutual funds and exchange traded funds investing more than 50 per cent in equity, the junior-most layer (equity tranche) of securitisation structure; instruments pertaining to acquisition or sale of or dealing in immovable property; contribution to trusts; and depository receipts issued against equity instruments. Debt instruments are government bonds; corporate bonds; all tranches of securitisation structure which are not equity tranche; and borrowings through loans and depository receipts whose underlying securities are debt securities. Any instrument that does not fall under either of the above-mentioned categories will be deemed to be a ‘debt instrument’. While practically nothing much has changed on this front other than the shift in regulatory jurisdiction, it will be interesting to see the evolution of and changes to the scope of these instruments (and consequent regulation thereof) in the future.

Other investment instruments

Under the TISPRO regime, only equity shares, compulsorily and fully convertible preference shares, compulsorily and fully convertible debentures, share-warrants (in some cases) and partly-paid-up shares were permitted to be issued by an Indian company against receipt of foreign investment. This position continues even in the Non-Debt Rules. However, it is interesting to note that a term ‘hybrid securities’ has been mentioned in the Non-Debt Rules, which has been defined to mean hybrid instruments that can be issued by an Indian company or a trust to a person resident outside India, such as optionally or partially convertible preference shares or debentures and other such instruments as may be specified by the Government of India from time to time. While this definition of ‘hybrid securities’ has been inserted in the Non-debt Rules, no specific provisions regulating issuance of such securities have been set out in the Non-debt Rules. The Government of India may possibly permit such instruments in the future.

E-commerce entities to mandatorily be Indian entities

Under the TISPRO regime, an e-commerce entity (ie, an entity that carries and engages in buying and selling of goods and services, including digital products, over digital and electronic networks) included: (a) companies incorporated in India; (b) companies incorporated outside India having (directly or through an agent, physically or through electronic mode) a place of business in India and which conducts any business activity in India; and (c) any office, branch or agency, owned or controlled by a person who is not resident in India. However, under the Non-Debt Rules, only companies incorporated in India can be ‘e-commerce entities’ and other entities would no longer be permitted to operate an e-commerce platform and operate as an e-commerce entity. This effectively means that foreign e-commerce players cannot operate in India unless they incorporate an entity in India. It will be interesting to see how this condition is implemented given the very nature of the internet.

Foreign investment in single-brand retail

Indian companies engaged in retail trading of single-brand products are now allowed to have FDI up to 49 per cent without governmental approval and up to 100 per cent with governmental approval. It is interesting to note that prior to the Non-Debt Rules (ie, under the TISPRO regime), this was 100 per cent without governmental approval.

Pricing of convertible equity instruments

The requirement to determine upfront the conversion price or conversion formula of a convertible equity instrument (a compulsorily and fully convertible preference share or debenture) is no longer applicable for issuance of these equity instruments. The conversion price of such equity instruments will now be determined in terms of the guidelines set out in the Companies Act 2013 and rules made thereunder, thereby making it at par with domestic investments to an extent. Accordingly, the conversion price of such equity instruments may either be determined upfront or within a 30-day period prior to the date on which the holder of convertible security becomes entitled to apply for underlying shares upon conversion. Another condition from the TISPRO regime, mandating that the conversion price should not be less than the fair value as on the date of issuance convertible equity instruments, is missing in the Non-Debt Rules.

Investment vehicles

Definition of an ‘investment vehicle’ has now been widened to include mutual funds which (a) invest more than 50 per cent of their corpus in equity instruments and (b) are regulated under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996. Under the TISPRO regime, investment vehicles were limited to real-estate investment trusts, infrastructure investment trust and alternate investment funds, in each case governed by the regulations framed by the Securities and Exchange Board of India (SEBI). Accordingly, foreign investment can now be made in such qualified mutual funds.

Foreign portfolio investors

Investment in ten per cent or more of the paid-up equity capital of a listed Indian company is treated as foreign portfolio investment. A host of changes with respect to investment by foreign portfolio investors (FPIs) registered with SEBI have been introduced by the Non-Debt Rules, including: (a) additional categories of alternative investment funds and offshore funds in which FPIs can invest; (b) earmarking aggregate limits on investments by FPIs to the relevant sectorial foreign investment caps applicable to the Indian investee entity (to be effective from 1 April 2020); (c) specific permission for FPIs to invest (up to 24 per cent in aggregate) in sectors in which FDI is generally prohibited; and (d) one-time permission for Indian companies to reduce (for a specified time period) or increase (not exceeding sectorial limits of foreign investment) the limits of their share capital that can be held by FPIs. In case FPI investment thresholds are exceeded, such FPI entity would have five trading days to divest the excess holding, failing which, the investment would be re-categorised as FDI. Prior to the Non-Debt Rules, under the TISPRO regime, an aggregate limit of 24 per cent for all FPI investments and a ten per cent limit for an FPI or its investor group was prescribed and if the ten per cent limit was breached, the investment by such FPI was treated as FDI.

Foreign venture capital investors

Foreign venture capital investors registered with SEBI have been permitted to invest in equity, equity linked instruments or debt instruments of Indian start-ups (ie, the entities that are registered with the Government of India and recognised as ‘start-ups’), regardless of the sector in which the start-up is engaged in.

Concluding remarks

These changes to the FEMA and the consequent shift of regulatory jurisdiction regarding foreign investments is a welcome change as; (a) it will help avoiding conflicts with the FDI Policy, which had arisen in the past under the TISPRO regime (since the authorities responsible for (i) formulating the FDI Policy and (ii) framing and implementing TISPRO were different); and (b) consequently, any changes or modifications to this new regime will be made faster.

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