The Foreign Exchange Management Act, 1999 (“FEMA”) serves as the principal legislation governing cross-border transactions, foreign direct investments and the crux of the matter at hand today – Downstream Investments. Downstream investment refers to indirect foreign investment where an Indian entity, having received foreign investment, further invests in another Indian company. FEMA (Non-Debt Instrument) Rules, 2019 [“NDI Rules”] is the major legislation that regulates downstream investments in the country. This article provides an overview of legal framework for downstream investments, covering key provisions, reporting requirements, and compliance obligations.
Regulatory Framework for Downstream Investments
1. FEMA
2. NDI Rules
3. Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019 (“Foreign Investment Reporting Regulations”)
4. Consolidated FDI Policy
5. RBI Master Direction – Foreign Investments in India (“Master Directions”)
What is Downstream Investment?
The introduction to this article provides the definition for Downstream Investments. The definition uses the term ‘indirect foreign investment’, which has been explained in Explanation (i) of Rule 23 of NDI Rules and Clause 9.1.15 of the Master Directions as:
Downstream investment received by an Indian entity from –
a) another Indian entity which has received foreign investment and which is not owned and controlled by resident Indian citizens or is owned or controlled by persons resident outside India; or
b) an investment vehicle whose sponsor or manager or investment manager is not owned and not controlled by resident Indian citizens or is owned or controlled by persons resident outside India.
FEMA Compliance
The broad requirements for downstream investments have been provided in Rule 23 of NDI Rules r/w Clause 9 of the Master Directions. The compliances can be listed as below:
a) Ensuring Compliance: Investment shall comply with the entry route, sectoral caps, pricing guidelines and other attendant conditions as applicable for foreign investments. As per the Master Directions, the guiding principle is that “what cannot be done directly, shall not be done indirectly”. It can be clearly implied that FDI Policy and its amendments from time to time, Press Notes, Master Circulars & Directions which are applicable on FDI must also be applicable to foreign indirect investment.
b) Inclusion in Total Foreign Investment: Any equity holding by a person resident outside India as a result of conversion of any debt instrument shall be included.
c) Exclusion from Total Foreign Investment: FCCBs and DRs having underlying of instruments in the nature of debt shall not be included.
d) Methodology: Portfolio investment of the Indian company making the downstream investment as on 31st March of the previous financial year shall be used to compute total foreign investment.
e) Wholly Owned Subsidiaries: Indirect foreign investment received by a wholly owned subsidiary of an Indian company shall be limited to the total foreign investment received by the company making the downstream investment.
f) Board Approval: Downstream investment shall have the approval of the Board of Directors as also a shareholders’ Agreement (if any).
g) Requisite Funds: The Indian entity making the downstream investment shall bring in requisite funds from abroad and not use funds borrowed in the domestic markets and the downstream investments may be made through internal accruals (internal accruals means profits transferred to reserve account after payment of taxes).
h) Transfer of Equity Instruments: Equity instruments of an Indian company held by another company receiving foreign investment may be transferred to a person resident outside India; a person resident in India; an Indian company which has received foreign investment and is not owned and not controlled by resident Indian citizens or owned or controlled by persons resident outside India.
i) Responsibility of Compliance: The first level Indian company making downstream investment shall be responsible for ensuring compliance with the applicable provisions for the downstream investment made by it at second level and so on and so forth.
j) Certificate: The first level company referred in point (i) shall obtain a compliance certificate effect from its statutory auditor on an annual basis and such compliance shall also be mentioned in the Director’s report in the Annual Report of the Indian company. In case statutory auditor has given a qualified report, the same shall be immediately brought to the notice of the regional office of the RBI in whose jurisdiction the Registered Office of the company is located and shall also obtain acknowledgement from the Registered Office.
k) Special Condition for LLPs: Indirect foreign investment by an LLP is allowed in an Indian company operating in sectors where foreign investment up to 100% is permitted under automatic route and there are no FDI linked performance conditions. Further, an indirect foreign investment is permitted in an LLP in sectors where foreign investment is allowed 100% under automatic route and there are no FDI linked performance conditions. It follows that any downstream investment by, or in, the LLP engaged in a sector which is not under 100% automatic route would require prior approval of the RBI.
Reporting Framework
An Indian entity making downstream investment in another Indian entity which is considered as indirect foreign investment shall file Form DI with the RBI on the FIRMS portal within 30 days from the date of allotment of equity instruments.
Conclusion
Downstream investments are a major part of the Indian foreign investment sector driving growth. However, since these are multi-level investments that can get highly complicated, adhering to regulatory framework is important for smooth and legally sound transactions. This article provides an overview of the requirements under the NDI Rules. However, there is an intrinsic web of closely connected circulars, directions, rules and regulations. Interested individuals are recommended to refer to this article as an overview and dive into the details as they delve into the ambit of downstream investments.