India: Much Ado About Half Measures! Reform Happens In Bit And Pieces

Last Updated: 4 March 2009
Article by Sakate Khaitan

In a bid to streamline, rationalise and liberalise the method of calculation of indirect foreign investment across sectors and make the foreign investment regime in India more transparent from the perspective of downstream investment, the Indian Government amended the existing guidelines recently through issue of Press Note 2 of 2009, Press Note 3 2009 and Press Note 4 of 2009 ("the Press Notes") or ("the Guidelines")1.

Though, the Press Notes assert to clarify the legal position on oft debated issues like cascading or downstream foreign investments in Indian companies through Indian investing companies and transfer of shares in companies that have sectoral caps, in essence these new Guidelines only partially address the real issues involved. The clarifications may be a non-starter as the policy makers seem to have failed to comprehensively achieve the intended objective and have created more confusion in the bargain.

In order to understand the attempted overhauling of the framework relating to downstream investments by Indian companies holding foreign investments, it is important to examine all the Press Notes contextually.

Before Press Note 2 of 2009 ("PN 2")

PN 2 essentially tries to homegenise the method of calculation of indirect foreign investment in Indian investee companies that secure investments from other Indian companies with foreign shareholding.

Prior to this, FDI was calculated in three different ways being – a) Proportionate method as stipulated under sectoral guidelines for telecom, print media, private sector banking etc b) Press Notes issued by DIPP on investing companies in services and infrastructure and c) Guidelines for calculation as provided in the regulations framed under statute as in the case of insurance sector. PN 2 stipulates a uniform method of calculation of indirect foreign investment for all sectors except insurance which is governed under separate regulations framed under statute.

PN 2

According to PN 2 , downstream investment by Indian companies which are 'owned and controlled' by resident Indian citizens2, irrespective of their foreign shareholding, would not be considered as indirect foreign investment.

Owned and Controlled

An Indian company is considered to be "owned" by resident Indian citizens if more than 50% of the equity in that company is held by resident Indian citizens, and it is considered to be "controlled" by resident Indian citizens if majority of the directors are nominated by resident Indian citizens. In order to avoid the classification of downstream investment in the investee company as indirect foreign investment, both the conditions of ownership and control as stated above must be satisfied. If the investing company is either owned or controlled by a non resident, then its entire investment in the Indian investee company is considered to be foreign investment.

Operating cum Holding Company a mirror image:

Downstream investments by Indian investing companies either owned or controlled by non-residents is deemed as indirect foreign investments in the investee companies. In such cases, the entire investment made by the Indian investing company in the downstream company will be treated as indirect foreign investment. (i.e. if the investment by the Indian company (owned or controlled by non-residents) in the downstream company is 60% then the indirect foreign investment in the downstream company will be considered to be 60%).

Thus foreign investment in an Indian company will include both direct investment and indirect foreign investment i.e. investment through another Indian investing company and such indirect foreign investment would be calculated in the manner stated above.

In Indian companies in sectors that attract FDI caps, the balance equity above the stipulated FDI caps must be beneficially held or owned by resident India citizens or Indian companies that are both owned and controlled by Indian resident citizens. Accordingly, companies in sectors with 49% FDI caps like broadcasting, credit information etc, will have to be owned and controlled by the resident Indian citizens or Indian companies owned and controlled by resident Indian citizens.

Press Note 3 of 2009 ("PN 3")

PN 3 deals with the procedures to be followed for the transfer of ownership or control of existing Indian companies from Indian residents to non-residents. It states that in sectors which have prescribed sectoral caps, prior approval of the Foreign Investment Promotion Board ("FIPB") in all cases will henceforth be required for the transfer of ownership or control of existing Indian companies from Indian residents to non-residents. It further provides that where an Indian company is being established with foreign investment and non-resident ownership or control of such company is contemplated in sectors which have prescribed sectoral caps, then prior FIPB approval will be required. Importantly, these provisions do not apply to transfer of ownership in sectors where 100% FDI is permitted under automatic route.

Accordingly, it has been clarified that in cases involving transfer of ownership or control, in sectors with caps on FDI like defence production, insurance, telecommunication etc, a prior approval of FIPB/Government is required.

Press Note 4 of 2009 ("PN 4")


Notoriously famous for being an obstinate regulatory hurdle in many cases was Press Note 3 of 1997 which inter-alia, provided that setting-up of 100% foreign owned holding company in India and all subsequent downstream investments would require prior approval of the FIPB. It was followed with Press Note 9 of 1999, with the intention of, "further simplifying the investment procedures for downstream investment" referring to Press Note 3 of 1997. It provided that foreign owned Indian holding companies could make downstream investments in activities falling under the automatic route without FIPB approval, subject to satisfying certain conditions.

Both these Press Notes use the term 'foreign owned holding company'. Interestingly, neither the term "foreign owned" nor 'holding company' had been defined in these Press Notes or under FEMA. As per general inference and common understanding, foreign owned came to be considered as majority owned by non-residents and holding company as one whose primary activity is that of holding investments and earning dividend and capital appreciation thereon.

While Press Note 9 of 1999 was not per se retrograde, the interpretation lent to this guideline recently by the government created confusion. All Indian companies with foreign investment, irrespective, of its quantum were expected to seek FIPB approval before making downstream investment. As per this stand of the FIPB, in addition to complying with other requirements of Press Note 9 of 1999, the Indian company with a foreign shareholding, was to obtain the status of 'operating cum holding company', before making downstream investments. To the dismay of the investors, most of them being Indian companies, this view of FIPB was extended to sectors falling under the automatic route and where the downstream investments were made in the sectors covered under the automatic route.

PN 2 notified in February 2009 clarified the method of calculation of foreign investment and when read in conjunction with PN 4 issued subsequently, provides some degree of clarity in respect of downstream investment.

PN 4 pursuant to which Press Note 9 of 1999 stands deleted, clarifies that downstream investment by Indian companies owned and controlled by non-residents must be in compliance with existing FDI policy on entry routes, conditions, sector caps etc. Thus indirect investment through an Indian company owned by and controlled by non-residents will be required to adhere to all norms that relate to FDI. Interestingly, however, an Indian company with less than 50 per cent foreign holding and controlled by resident Indian citizens, as set out in PN 2 may be permitted to make investments in sectors where FDI is restricted or capped.

Operating Company, Operating cum Investing Company and Investing Company

Further, PN 4 has for the first time provided definitions of an operating company and an investing company. An operating company is an Indian company which undertakes operations in various economic activities and sectors and an investing company is an Indian company that holds investments in another Indian company, directly or indirectly, other than for trading of such holdings/securities.

As per guidelines stated in PN 4, foreign investment in an operating company and an operating cum investing company will have to be in accordance with entry routes, sector caps and other applicable conditionalities. An Indian company owned and controlled by non-residents is permitted to make downstream investments in Indian operating companies as well as operating cum investing companies subject to existing FDI policy. In case of operating cum investing companies, the subject Indian companies into which downstream investments are made by such companies will also have to comply with the relevant FDI regulations.

Foreign investment in investing companies require prior FIPB approval, regardless of the amount or extent of foreign investment. The Indian companies into which downstream investments are made by such investing companies would have to comply with the relevant sectoral conditions on entry route, conditionalities and caps in regard of the sector in which the subject Indian companies are operating.

Further, for any foreign investment in a company which is neither an operating company nor has made any downstream investments – the popularly referred as "shell" company, prior approval of the FIPB will be required.

It has been clarified that FIPB approval would be required for downstream investments by operating-cum-investing companies only if such approval is required as per the applicable FDI regulations relating to entry route, caps and other conditions. In case of non operating companies or pure investing companies FIPB approval will be required, irrespective of the quantum of investment.

PN 4 also provides that downstream investments are to be made subject to certain conditions, such as, interalia, that the DIPP, SIA and FIPB shall have to be notified of all downstream investment within 30 days of such investment and the investing companies would have to bring in requisite funds from outside India and not leverage funds from domestic market for such investments.

Press Note 9 of 1999 mandated expansion of equity base of the downstream company through acquiring new shares of the downstream company. The language of PN 4 does not specifically require issue of new shares by the downstream company and seems to thus allow transfer of existing shares.


The Press Notes are a welcome step to the extent that they have in a limited way been able to address confusions and concerns in regards to indirect foreign investment through Indian entities. However, while the Press Notes were notified with the object of bringing about "clarity, uniformity, consistency and homogeneity" into the exact methodology of calculation of foreign investment and downstream investments, they have also given rise to some significant questions:

  • The term 'beneficial ownership' in context of foreign investment in sectors with FDI caps, used in PN 2 has not been defined. It is unclear as to how existing beneficial ownership beyond the FDI caps as per the previous Press Notes be calculated and if these breach the current Press Notes, how they will be treated.
  • There is lack of clarity on how investments in Indian companies such as those by foreign venture capital investors through wholly owned venture capital funds be treated. This gains particular significance given that such vehicles have been used to route significant investments into Indian sectors, which have FDI caps.
  • PN 4 requires FIPB approval for "shell" companies or the companies that are neither operating nor investing companies. A possible interpretation is that FIPB approval is required for the formation of any new Indian company with foreign shareholding. Further, companies that are incorporated on behalf of foreign investors by residents for operational ease and ownership subsequently transferred before the actual commencement of business may also require FIPB approval prior to transfer.

It, therefore, appears that the Press Notes have resulted in the unsettling of many settled positions, while at the same time giving some much needed clarifications on some oft debated issues. Given the significance of FDI to the Indian economy it is now imperative that Indian Government clarifies its position in respect of the questions raised above.


1. Foreign Direct Investment ("FDI") in India is regulated through the provisions of Foreign Exchange Management Act, 1999 ("FEMA") and the Rules and Regulations notified under FEMA by the Reserve Bank of India as well as well as the Press Notes issued by the Department of Industrial Policy and Promotion ("DIPP"), Ministry of Commerce and Industry, Union Government.

2. Resident Indian Citizen shall be interpreted in line with the definition of a person resident in India as per FEMA 1999 and the Indian Citizenship Act, 1955.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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