Downstream Investment under foreign exchange law

In India, since the time of liberalisation and globalisation, foreign investment is the source of funding for many businesses. Such foreign investments are regulated under the Foreign Exchange Management Act, 1999 (“FEMA”). Downstream investment was first allowed without the Government approval by Press Notes 2 and 4 of 2009 Series issued by the DIPP. Under the prevailing FDI Policy, downstream investment by an investing company which is ‘owned and controlled’ by ‘foreign persons / entities’ has to be in compliance with the sectoral caps and the conditions attached to it, if any. Provisions of downstream foreign investment is governed under section 23 of Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“FEMA NDI Rules”), which are discussed in this article in detail.

Foreign investment means any Investment made by a person resident outside India on a repatriable basis in equity instruments of an Indian Company or to the capital of LLP.

Indirect Foreign Investment means downstream investment received by an Indian entity from another Indian entity which has received foreign investment, where such Indian entity is not owned and not controlled by resident Indian citizens or is owned or controlled by persons resident outside India. In case of investment vehicle, indirect foreign investment means downstream investment received by 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.

Indian entity for the above purposes shall mean an Indian Company or LLP. Ownership for the above purposes shall mean beneficial ownership of more than 50% of the equity interest in an Indian Company or in LLP, in the form of equity instrument or capital, respectively. Control for the purposes of above shall mean the right to appoint majority of the directors or to control the management or policy decisions including by virtue of their shareholding or management rights or shareholders agreement or voting agreement. For the purpose of LLP, control shall mean the right to appoint majority of the designated partners, where such designated partners, with specific exclusion to others, have control over all the policies of LLP.

Accordingly, where an Indian entity is owned and controlled by a person resident in India or by NRI / PIO on a non-repatriable basis, such an Indian entity is considered as Indian owned and controlled entity (“IOCE”). Similarly, where an Indian entity is owned and controlled by person resident outside India, on a repatriable basis, such an Indian entity is considered as a foreign owned and controlled entity (“FOCE”). IOCE making downstream investment is not governed under FEMA provisions and such investments are akin to domestic investment. Whereas, FOCE making further downstream investment into an Indian entity is considered as foreign downstream investment under provisions of FEMA NDI Rules and is required to adhered to conditionalities and provisions, which are described henceforth.

Indian entity making downstream investment into another Indian entity is required to comply with following conditionalities:

1. To obtain approval of board of directors for making downstream investment;
2. To enter into shareholders agreement for making downstream investment;
3. To utilise funds for such downstream investment out of its internal accruals or foreign funding;
4. Not to raise any domestic capital for making downstream investment.

As investment from outside India is subject to provisions for entry routes, similar provisions apply for indirect foreign investment as well. Accordingly, foreign investment in a company is subject to government approval and sectoral caps, if Indian company is engaged in sectors restricted under Government approval route, and no such approvals are required where Indian Company is engaged in sectors where foreign investment is allowed under automatic route. Foreign investment upto 100% is allowed where foreign investment is allowed partially under automatic route and partially under approval route, subject to sectoral caps. In addition to entry routes as explained above, compliance with pricing guidelines and other FDI linked performance conditions are also required to be complied with in each of the respective entry routes. In case, where an Indian entity is LLP, downstream investment is allowed only in operating sectors or activities where foreign investment upto 100% is permitted under automatic route and there are no FDI linked performance conditions.

Special provisions for calculation of downstream investment:

• With effect from the 31st day of July, 2012, downstream investment(s) made under Corporate Debt Restructuring (“CDR”), or other loan restructuring mechanism, or in trading book, or for acquisition of shares due to defaults in loans, by a banking company, as defined in clause (c) of section 5 of the Banking Regulation Act, 1949, incorporated in India, which is foreign owned and controlled, are not been counted towards indirect foreign investment. However, their strategic downstream investment is to be counted towards indirect foreign investment for the company in which such investment is being made;
• Any equity holding by a person resident outside India resulting from conversion of any debt instrument under any arrangement shall be reckoned for total foreign investment;
• Foreign Currency Convertible Bonds and Depository Receipts having underlying of instruments in the nature of debt shall not be reckoned for total foreign investment;
• The methodology for calculating total foreign investment shall apply at every stage of investment in Indian companies and thus in each and every Indian company;
• For the purpose of downstream investment, the portfolio investment held as on 31st March of the previous financial year in the Indian company making the downstream investment shall be considered for computing its total foreign investment;
• 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;
• A FOCE may transfer its downstream equity investment into another Indian entity to, –

1. 1. a person resident outside India, subject to the reporting requirements as specified by the Reserve Bank;
   2. a person resident in India subject to adherence to pricing guidelines;
   3. an Indian entity which has received foreign investment and is not a FOCE;

The FOCE making downstream investment shall be responsible for ensuring compliance with the provisions of these rules for the downstream investment made by it into another Indian entity and so on and so forth. Such FOCE shall obtain a certificate to this effect from its statutory auditor on an annual basis and such compliance of these rules shall be mentioned in the Director’s report in the Annual Report of such FOCE, as the case may be. In case statutory auditor has given a qualified report, the same shall be immediately brought to the notice of the regional office of the Reserve Bank in whose jurisdiction the Registered Office of an Indian entity is located and shall also obtain acknowledgement from the Registered Office.

Thus, provisions related to downstream investment are to be looked into in its substance rather than in its form. It is imperative to comply with provisions of FEMA whenever any foreign investment or control is established as explained above.

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