Rule 23 of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (hereafter referred to as the "NDI Rules") addresses downstream investments and outlines a distinct approach for an Indian entity that has received foreign investment but is not controlled or owned by an Indian resident and is instead controlled or owned by a person who is not a resident of India (i.e., Person Resident Outside India).

In such instances, the foreign-owned or controlled corporation (abbreviated "FOCC") serves as a mechanism for foreign investors to participate in indirect foreign investments. Despite the fact that the NDI Rules establish specific restrictions for downstream investments, there are still questions about how FOCCs should be addressed. The purpose of this study is to investigate the regulatory barriers to downstream investments in India that require immediate attention and resolution from the appropriate authorities.

FOCCs and Reporting Requirements

A Downstream Investment is defined in Rule 23(7)(g) of the NDI Rules as an investment made by a Foreign-Owned and Controlled Company (FOCC) in the capital instruments or capital of another Indian firm.

The NDI Rules, Rule 23(5), specify three instances in which a FOCC may be involved. First, it entails the transfer of stock instruments in an Indian firm by a FOCC to a Person Resident Outside India (PROI), which needs compliance with the Reserve Bank of India's (RBI) reporting requirements. Second, it relates to a comparable transfer made by a FOCC to a person residing in India, where pricing criteria must be followed. The third example is a comparable transfer from one FOCC to another where neither the price standards nor the reporting criteria must be fulfilled. As is obvious, the NDI Rules only apply to transactions in which the FOCC transfers equity instruments from one Indian firm to another. The guidelines do not address the standards that must be met when a FOCC purchases equity securities from an Indian firm.

Because of the varied handling of FOCCs, this uncertainty becomes crucial. Reporting obligations apply to FOCCs only when they transfer equity instruments to a PROI, according to Rule 23(5) of the NDI Rules. Foreign investment reporting requirements alert the government about cross-border financial transfers and facilitate the execution of other applicable obligations under foreign investment regulations. As a result, the fact that the NDI Rules compel a FOCC to conform to reporting requirements when transferring equity instruments to a PROI shows that FOCCs are recognised as resident businesses for reporting purposes.

The question today is whether the reporting rules apply if a FOCC (Foreign Owned and Controlled Company) acquires equity instruments from another FOCC known as a PROI (Person Resident Outside India). Because the NDI Rules (Non-Debt Instrument Rules) do not cover this specific issue, the AD Banks (Authorised Dealer Banks) make various conclusions. AD Banks are commercial banks, state co-operative banks, or urban co-operative banks that have been authorised to trade in foreign currency by the Reserve Bank of India (RBI) under Section 10 of the Foreign Currency Management Act, 1999.

In circumstances when a FOCC purchases an equity instrument from another FOCC, it has been found that some AD Banks demand a new filing of Form DI (Declaration of Investment). Form DI must be filed when a FOCC makes a downstream investment in an Indian firm, according to Regulation 4(11) of the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019.

It is worth noting, however, that transfers between two FOCCs are excluded from any reporting obligations under Rule 23(5) of the NDI Rules. Despite this exception, some AD Banks have incorrectly applied the reporting requirements to such transactions, most likely because to the uncertainty surrounding the handling of FOCCs in this context.

FOCCs and Pricing Policies

The pricing criteria were developed to guarantee that the government maximises foreign exchange inflows while limiting outflows. Pricing standards must be observed in transactions between a Person Resident Outside India (PROI) and an Indian resident, but not in transactions between two PROIs, as per the Rule 21 of the NDI Rules. Rule 23(5) of the NDI Rules, on the other hand, requires pricing rules when a Foreign-Owned and Controlled Company (FOCC) transfers capital instruments to an Indian person. The purpose of the pricing guidelines implies that this Rule regards a FOCC as a PROI. However, as previously stated, the NDI Rules consider a FOCC to be an Indian resident for reporting purposes.

The NDI Rules do not clarify whether pricing standards apply when a FOCC purchases capital instruments from a PROI, another FOCC, or an Indian resident in terms of reporting obligations. Some Authorised Dealer Banks have used price standards in transactions between a PROI and a FOCC, whereas others have not. This mismatch can create ambiguity, particularly when a FOCC purchases capital instruments from both a PROI and an Indian resident. As a result, a clear and comprehensive framework to govern transactions involving a FOCC is required.

FOCCs and Other Regulatory Obstacles

While the NDI Rules describe downstream investments as investments made by FOCCs into the capital instruments of other Indian businesses, the NDI Rules do not define what "capital instruments" entail. The NDI Rules, on the other hand, define "equity instruments" under Rule 2(k), which includes equity shares and convertible debentures among other things. This begs the question of the precise scope of the term "capital instruments."

An Optionally Convertible Debenture ("OCD") is a form of debt security that can be converted into shares of a company at a certain price and within a set time frame, at the debt-holder's or investor's discretion. The question is whether a FOCC's investment in the OCDs of an Indian firm is considered a downstream investment.

In a FAQ published prior to the NDI Rules, the RBI clarified that an investment by a FOCC in a non-capital instrument of an Indian entity would not be deemed a downstream investment. However, there is no such explanation in the NDI Rules, which may allow capital and equity instruments to be regarded equally. As a result, there is still question over whether a FOCC can invest in OCDs.

According to Rule 23(1) of the NDI Rules, the conditions for Foreign Direct Investment (FDI), including the entry method, sectoral caps, pricing rules, and other associated criteria, apply to downstream investments. Because the wording "other attendant conditions" is fairly wide, it is unclear how much of the restrictions controlling foreign investment apply to downstream projects. If full FDI standards are enforced on downstream investments, Foreign-Owned and Controlled Companies (FOCCs) will be treated on same footing with non-resident firms, generating a regulatory burden and deterring such transactions.

Suggestions and Conclusion

FOCCs are currently regarded as PROIs for pricing and as Indian residents for reporting purposes. This dual strategy is unsustainable and will raise regulatory complexity and investor uncertainty. To properly control such businesses, it is recommended that FOCCs be treated consistently as PROIs in India as they are managed or owned by the PROIs.

Both price criteria and reporting requirements should apply to any acquisition or sale of equity instruments in an Indian firm between FOCCs and resident corporations or PROIs. This is due to the fact that such transactions may include foreign exchange inflows or outflows as well as an indirect change in control of a local corporation in favour of a foreign entity. Transactions between two FOCCs, on the other hand, would be facilitated by the governing PROIs and would not require foreign exchange inflow/outflow or a change in control of the domestic firm. In such instances, no price criteria or reporting obligations should be applied, according to Rule 23(5)(c) of the NDI Rules.

To eliminate ambiguity, the NDI Rules must define "capital instruments" and state that a FOCC's downstream investment happens when Obsessively Convertible Debentures (OCDs) are converted into equity shares. Furthermore, the meaning of "other attendant conditions" under Rule 23(1) of the NDI Rules requires clarification, with a request to read it narrowly to avoid downstream investment restrictions becoming as cumbersome as those for FDI.

The NDI Rules currently treat FOCCs differently depending on their perspective: as PROIs in terms of pricing and as Indian residents in terms of reporting. Because of this dual status, downstream investments in India face regulatory challenges. To address this, a consistent approach should be taken, with FOCCs being treated as PROIs across the board. To alleviate concerns associated with FOCC investments in domestic firms' OCDs, it is recommended that such investments be treated as downstream investments when loan instruments are converted into equity capital. Furthermore, needless FDI criteria should not be applied in the case of downstream investment. It is critical to clear any issues that may occur in executing the NDI Rules in order to simplify the process of downstream investments in India. The legislature is expected to quickly introduce relevant changes to clarify the issue regarding FOCCs in India.



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