India’s venture capital (“VC”) ecosystem is fast expanding, with the market receiving USD 16.77 billion across 888 deals from January-November 2024 (a 21.8% rise YoY). With such a huge amount being already invested in the Indian market, Indian investors are now looking for opportunities beyond the Indian boundaries to get a high return on their investment. Overseas Direct Investment (“ODI”) allows Indian investors to invest in foreign startups, emerging industries, and high-growth markets, diversifying their portfolios and enhancing returns. This article provides an overview into the comprehensive web of laws that govern ODI so that Indian Venture Capital Funds (“VCF”) can get cracking on their first deal abroad.
What are Venture Capital Funds?
As per Regulation 2(1)(b) of SEBI Alternative Investment Fund (AIF) Regulations, 2012 (As amended till August 06,2024), VCFs form a part of Alternative Investment Fund which are defined as any fund established or incorporated in India in the form of a or a company or a limited liability partnership or a body corporate which is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors; and is not covered under the SEBI (Mutual Funds) Regulations, 1996, SEBI (Collective Investment Schemes) Regulations, 1999 or any other regulations of the Board to regulate fund management activities.
Laws for Governing ODIs by VCFs
There are four important laws when it comes to ODI:
1. Foreign Exchange Management (Overseas Investment) Rules, 2022
2. Foreign Exchange Management (Overseas Investment) Regulations, 2022
3. RBI Master Direction – Overseas Investment
4. SEBI Guidelines for overseas investment by Alternative Investment Funds (AIFs) / Venture Capital Funds (VCFs)
What is Overseas Direct Investment?
As per Rule 2(1)(q) of the FEM (OI) Rules, 2022, ODI is defined as –
“investment by way of acquisition of unlisted equity capital of a foreign entity, or subscription as a part of the memorandum of association of a foreign entity, or investment in ten per cent, or more of the paid-up equity capital of a listed foreign entity or investment with control where investment is less than ten per cent of the paid-up equity capital of a listed foreign entity”
Legal Overview
1. FEM (OI) Regulations 2022: The Regulations prescribe conditions regarding –
a. Mode of Payment (Regulation 8);
b. General Obligations of persons making the investment (Regulation 9) including submission of share certificates (or comparable documents in the host country) to the AD bank, obtaining a Unique Identification Number (UIN) from RBI for the foreign entity, designating an AD Bank for routing the transactions, realisation and repatriation of dues receivable to India, receipt of consideration on transfer or disinvestment or receipt of value of assets in case of liquidation, placing remittances towards earnest money deposit or participating in the bid process;
c. Reporting requirements (Regulation 10) which includes reporting of financial commitment at the time of sending outward remittance or making a financial commitment, disinvestment within thirty days of receipt of proceeds, restructuring within thirty days from the date of such restructuring, report of sale or transfer on a half yearly basis to be done within sixty days, submission of an Annual Performance Report (APR), submission of an Annual Return on Foreign Liabilities and Assets (FLA).
d. Late Submission Fees to be submitted along with the documents as prescribed under Regulation 9 and 10, whose reporting has been delayed as per the method prescribed in the Regulations.
2. FEM (OI) Rules, 2022: The Rules provide conditions regarding –
a. Instruments of Debt & Non-Debt Investment (Rule 5) have been provided under the Rules. Debt instruments include Government bonds, corporate bonds, all tranches of securitisation structure which are not equity tranche, loans, depository receipts whose underlying securities are debt securities. Non-Debt Instruments include equity in incorporated entities, capital participation in LLPs, investment as recognised in the FDI policy, investment in AIFs, ReITs and Infrastructure Investment Trust, investment in MFs & ETFs which invest more than 50% in equity, junior-most layer (i.e. equity tranche) of securitisation structure, acquisition, sale or dealing directly in immovable property, contribution to trusts depository receipts issued against equity instruments;
b. Any person holding equity in a foreign entity is allowed to invest in rights issue and be granted bonus shares of the said entity (Rule 7);
c. The foreign entity must be engaged in a bona fide business activity (Rule 9) which means any business activity permissible under any law in force in India and the host country. Investment shall be made directly or through step down subsidiary or the SPV, subject to the limits and the conditions laid down in the rules and regulations;
d. No Objection Certificate (Rule 10) is to be obtained by an individual who has an account appearing as a non-performing asset or is being investigated by CBI, ED, SFIO or any financial service regulator from such authority which maintains his account or is conducting his investigation.
e. Manner of making ODI has been prescribed in Rule 11 read with Schedule 1 –
- ODI may be held by way of subscription as part of MOA or purchase of equity capital, listed or unlisted, acquisition through bidding, acquisition of equity capital through rights issue or bonus shares, capitalisation, of any amount due towards the Indian entity from the foreign entity, the remittance of which is permitted under FEMA or does not require prior permission of the Central Government or the RBI under the Act, securities swap, merger, demerger, amalgamation;
- The total financial commitment in all the foreign entities taken together at the time of undertaking such commitment shall not exceed400 percent of its net worth as on the date of the last audited balance sheet or as directed by the Reserve Bank, in consultation with Central Government from time to time.
f. ODI is subject to certain restrictions and prohibitions (Rule 19) –
- Prohibited in real estate, gambling, financial products linked to the Indian rupee without specific approval of RBI;
- ODI shall be made only from the internal accruals whether from the Indian entity or group or associate companies in India and in case of resident individuals, from own funds of such an individual;
- No investment shall be made in a foreign entity that has invested or invests into India, either directly or indirectly, resulting in a structure with more than two layers of subsidiaries.
Note: Does not apply to a banking company, NBFCs, insurance company, and a government company.
3. RBI Master Direction – Overseas Investment: The Directions provide further clarity on the requirements, restrictions, prohibitions and limits provided in the OI Rules & Regulations. Since the Directions provide a very intricate view of the compliances, Indian investors are advised to go through the fine print here.
4. SEBI Guidelines for Overseas Investment by AIFs / VCFs: The Circular provides the following –
a. An application is to be filed with SEBI for allocation of overseas investment limit in the format as provided in Annexure A of the Circular;
b. A VCF can make investment only in a company which is incorporated in a country whose securities market regulator is a signatory to the International Organization of Securities Commission’s Multilateral Memorandum of Understanding or a signatory to the bilateral MoU with SEBI;
c. Investment is not allowed in a company in a country identified by the Financial Action Task Force (FATF);
d. Transfer/sale of investment can be made only to the entities eligible to make overseas investments as per FEMA;
e. Furnishing of sale/divestment details in overseas entities to SEBI as per the format in Annexure B;
f. Overseas investments sold/divested till date, shall also be reported to SEBI as per the format in Annexure B;
g. Submission of undertaking by Trustee/Board of Directors/Designated Partners to SEBI as prescribed.
Conclusion
Navigating ODI compliances as an Indian venture capitalist requires a clear understanding of the regulatory framework, including FEMA, RBI guidelines, and sector-specific restrictions. While the liberalized regime offers exciting opportunities for global expansion, adherence to investment limits, reporting requirements, and other requirements effectively is crucial to mitigate risks. This article offers an overview of the regulatory framework which must be looked into by an investor before considering an overseas investment.