India: Tightening Beneficial Owner Framework: The Press Note 3 Impasse

1. INTRODUCTION

By now, the people initiated to the subject matter have been well aware of the protectionist measure undertaken by the Government of India (the "GoI") towards curbing opportunistic takeovers or acquisitions of Indian companies during the COVID-19 pandemic, by issuing the press note dated April 17, 2020 and its related amendment to the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (the "NDI Rules") (famously known as the "Press Note 3")¹. In essence the Press Note 3 provides that an entity of a country, which shares land border with India (the "Bordering Countries")² or where the beneficial owner of an investment into India is situated in or is a citizen of any such Bordering Country, can invest (whether by subscription of shares in a primary issuance or by acquisition of shares in a secondary sale) only with the prior approval of the GoI. As of the date, the relevant department of the GoI for the purposes of approval under Press Note 3 is the Ministry of Home Affairs.

Thus, currently prior approval from the Ministry of Home Affairs would be required for (a) any foreign direct investment by an entity from a Bordering Country or where the 'beneficial owner' of an investment into India is situated in or is a citizen of a Bordering Country, and (b) transfer of ownership of any existing or future foreign direct investment in India entity, directly or indirectly, which results in the 'beneficial ownership' for such investment falling within the purview of (a) above.

The most controversial issue around the Press Note 3 from the day of its issuance has been the meaning of term "beneficial owner". Neither the consolidated foreign direct investment policy 2020 (the "FDI Policy") nor the NDI Rules prescribe a definition of a 'beneficial owner' or provide which countries may be deemed to be Bordering Countries. However, in conventional practice and according to the undertakings sought by various authorized dealer banks (the "AD Banks") which facilitate foreign investments (and hold delegated powers from the Reserve Bank of India (the "RBI") for processing filings with respect to foreign direct investment), the definition of a 'beneficial owner' is borrowed from either the provisions of the Companies (Significant Beneficial Owners) Rules, 2018 read with the Companies Act, 2013 (the "CA 2013") or the Prevention of Money Laundering Act, 2002 read with the Prevention of Money Laundering (Maintenance of Records) Rules, 2005 (the "PMLA"). In most such formats provided by the AD Banks, the following countries are considered for restricting investments from entities or beneficial owners of such county, being China, Hong Kong, Macau, Afghanistan, Bangladesh, Pakistan, Bhutan, Myanmar and Nepal.

Our attempt here is to (a) discuss the dichotomy previously present in the CA 2013 and the PMLA in relation to the definition of a 'beneficial owner', and (b) the recent amendment to the PMLA and to the master direction on know your customer norms issued by the RBI (the "KYC Norms"), which has in effect attempted to address the said dichotomy.

2. CONUNDRUM PERTAINING TO THE DEFINITION OF 'BENEFICIAL OWNER'

The term 'beneficial owner' in relation to Press Note 3 and the NDI Rules is critical to assess, for the purpose determining when will a subscription or acquisition (through a transfer) of securities in an Indian entity come within the purview of Press Note 3.

In the initial stages after the amendments to the NDI Rules were notified, the definition of 'beneficial owner' and the threshold applicable to such definition was extensively debated in the industry, as the term was defined differently under the CA 2013, the KYC Norms and the PMLA.

The definition under the CA 2013 can be broken down to a 'beneficial owner' being an individual (either acting alone or acting in concert with any other person) (i) directly or indirectly holding not less than 10% (ten percent) of the shares of a company; or (ii) directly or indirectly holding not less than 10% (ten percent) of the voting rights in the shares of such company; or (iii) has right to receive directly or indirectly at least 10% (ten per cent) of the total distributable dividend; or (iv) has right to exercise directly or indirectly significant influence or control in the management of such company.

In relation to a company, the erstwhile definition under the KYC Norms and the PMLA provided that a beneficial owner in case of a company is an individual who (either acting alone or acting in concert with any other person or juridical person) has an ownership or entitlement of 25% (twenty five percent) of shares or capital or profits of the company (a "Controlling Ownership") or who exercises control in the company through control of the management or policy decisions. Similarly, a beneficial owner with respect to a trust was an author of trust or trustee or beneficiary of the trust who has an entitlement of at least 25% (twenty five percent) of interest in the trust or who exercises control in the trust through control of the management or policy decisions.³

In the above stated legislations, the intent pertaining to the definition of 'beneficial ownership' is more or less on similar lines, however, the percentage stake for determining beneficial ownership was 10% (ten percent) under CA 2013 as against 25% (twenty five percent) under the PMLA and the KYC Norms.

3. THE DECLARATIONS SOUGHT BY AD BANKS

Given that the Press Note 3 was a protectionist measure, the AD Banks were seen exercising caution in terms of implementing the objective of Press Note 3, and thus each of them started taking an undertaking with respect to the Press Note 3 from the investee company or the foreign investor for any foreign direct investment.

On perusal of various formats of undertakings prescribed by different AD Banks, the common theme emerged to be a declaration stating that beneficial owners of the relevant foreign investor are not residents or citizens of Bordering Countries or that residents or citizens of Bordering Countries do not cumulatively hold beneficial interest in the foreign investor entity crossing the threshold prescribed in the definition of 'beneficial owner'. Such threshold, due to the conundrum stated above, differed from one AD Bank to another, wherein some AD Banks applied the threshold of 10% (ten percent) as stated in the CA 2013 and some applied the threshold of 25% (twenty five percent) as stated in the PMLA and KYC Norms.

4. AMENDMENT TO THE PMLA, THE KYC NORMS, AND ITS IMPACT ON THE PRESS NOTE 3

The Ministry of Finance (Department of Revenue), through an amendment notification⁴ dated March 07, 2023 (the "PMLA Amendment"), amended the definition of a beneficial owner as provided in the PMLA, to reduce the threshold for Controlling Ownership for a beneficial owner as regards a company, from 25% (twenty five percent) to 10% (ten percent). Similar change was also carried out in the KYC Norms through an amendment dated April 28, 2023, issued by the RBI⁵, for reducing the relevant threshold from 25% (twenty five percent) to 10% (ten percent). The PMLA Amendment and change in the KYC Norms, in effect, is expected to put the dichotomy for the definition of beneficial owner under the PMLA and KYC Norms, and the CA 2013 at rest. Accordingly, the AD Banks may now insist that the undertaking regarding beneficial ownership is linked to 10% (ten percent) threshold.

5. INDUSLAW VIEW

The PMLA Amendment and change in the KYC Norms is a welcome move by the GoI to provide much needed clarity on the dichotomy created by the CA 2013, the PMLA and the KYC Norms with respect to the definition of a beneficial owner and the threshold percentage applicable in relation to the said term. While the AD Banks are yet to roll out formats of their new undertakings with respect to the Press Note 3, it is expected that they will align these with the amended position.

It is unfortunate that these amendments (being legislations not in relation to the Press Note 3) only provide interim clarity for the purpose of interpreting the term 'beneficial owner' under Press Note 3 and the NDI Rules. Moreover, these only provide clarity with respect to the ownership threshold. There are other components to the term "beneficial owner" which also need clarity, most importantly the threshold of control. Currently, different AD Banks use different thresholds and standards while testing control. While some consider a negative veto as control, while others are even wary of a board seat (even when it does not constitute a majority on the board). In the interest of ceasing any ambiguity whatsoever in relation to the definition of a 'beneficial owner', the GoI should consider prescribing a clear definition of the term (including its facets like 'control') for the exclusive purpose of the Press Note 3 and the NDI Rules.

Footnotes

1 https://dpiit.gov.in/sites/default/files/pn3_2020.pdf

2 The Press Note 3 only uses the phrase 'an entity of a country, which shares land border with India' and does not provide a list of such Bordering Countries. However, as per the geographical limits of India, Bordering Countries include China, Afghanistan, Bangladesh, Pakistan, Bhutan, Myanmar, and Nepal.

3 The KYC Norms and the PMLA also mention the definition of beneficial owner for partnership firm or unincorporated association or body of individuals, in which such beneficial owner is an individual (either acting alone or acting in concert with any other person or juridical person) having an ownership of or entitlement to more than 15 (fifteen percent) of capital or profits of the partnership or such unincorporated association or body of individuals, respectively. Further, where such no natural person/individual is identified for the purpose of beneficial owner above, the beneficial owner is the relevant natural person who holds the position of senior managing official. The above threshold hasn't been impacted by the PMLA Amendment and continues to remain the same.

4 Prevention of Money-laundering (Maintenance of Records) Amendment Rules, 2023: https://egazette.nic.in/WriteReadData/2023/244194.pdf

5 Amendment to the Master Direction (MD) on KYC: https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12497&Mode=0

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