Over the years, India has emerged as a preferred destination for foreign investment. Besides the sustained gross domestic product growth of the economy, which has expanded the market in India, the enabling environment and a transparent, open policy regime have significantly contributed to this emergence.
Foreign investors can invest in India directly or through an intermediary Indian entity. Direct investment by foreign investors is termed Foreign Direct Investment ("FDI"). In cases where such investments are channelled through an entity established in India, they are known as indirect foreign investment or 'downstream investment'. For instance, if a foreign holding company invests in an Indian entity via its Indian subsidiary, this would constitute a 'downstream investment'.
The regulatory framework for downstream investments in India is provided under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 ("NDI Rules"). NDI Rules define 'indirect foreign investment as1, downstream investment received by an Indian entity from:
- Another Indian entity (IE) which has received foreign investment and is either not owned and controlled by resident Indian citizens or is owned or controlled by persons resident outside India or
- An investment vehicle whose sponsor, manager, or investment manager is either not owned and controlled by resident Indian citizens or is owned or controlled by persons resident outside India."
Per the NDI Rules, an Indian entity that receives foreign investment and is either not owned and controlled by resident Indian citizens or is owned or controlled by persons resident outside India ("PROI") is classified as a Foreign Owned and/or Controlled Company ("FOCC").
On the contrary, when an Indian entity that receives foreign investment does not meet the threshold to qualify as being 'owned' or 'controlled' by a PROI and makes an investment in another Indian entity, it is regarded as a domestic investment only.
Differentiating "owned" and "controlled"
An Indian company is "owned" by PROI if the PROI is the beneficial owner of more than fifty percent of the equity instruments of such company.2 Whereas an Indian company is "controlled" by a PROI if they have the power to appoint a majority of its directors or to control management or policy decisions, including by virtue of their shareholding or management rights, shareholders agreement, or voting agreement.3
Navigating Regulatory Restrictions
As per the NDI Rules, an Indian entity receiving indirect foreign investment must comply with entry routes, sectoral caps, pricing guidelines, and other applicable conditions for foreign investment, as substantiated below:4
A. Pricing Guidelines
Rule 21 of the NDI Rules provides the pricing guidelines that primarily govern transactions between a PROI and an Indian resident. A conjoint reading of Rule 21 and Rule 23 implies that FOCC is treated on par with PROI regarding the applicability of pricing guidelines in case of downstream investment.
Hence, in a downstream investment, the price of equity instruments of an Indian company issued to a FOCC has to be determined as per any internationally accepted pricing methodology for valuation on an arm's length basis.5
B. Transfer of Equity Instrument held by FOCC
NDI Rules further outline certain pricing and reporting requirements for transactions involving the transfer of equity instruments held by an FOCC in three scenarios.
- First, when an FOCC transfers equity to a PROI, only reporting requirements apply.
- Second, when an FOCC transfers equity to a person resident in India (Resident), only pricing guidelines apply.
- Third, when an FOCC transfers equity to another FOCC, neither reporting requirements nor pricing guidelines apply.6
C. Reporting Requirements
With respect to reporting of downstream investments, the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019 ("Reporting Regulations") mandates the FOCC making downstream investments in another Indian entity (considered as an indirect foreign investment) to file 'Form DI' with the Reserve Bank within 30 days from the date of allotment of the equity instrument.7
D. Other Conditions
As per Rule 23(1) of the NDI Rules, downstream investment is treated on par with foreign direct investment, and all FDI conditions, including entry routes, sectoral caps, and other attendant conditions, apply pari passu. It is further to be noted that the term "other attendant conditions" is not explicitly defined, but by necessary implication, it broadly encompasses all other compliances applicable to FDI.
For example, the restrictions imposed on FDI from neighbouring countries would also apply to FOCCs owned or controlled by investors from such countries, requiring prior approval in case of downstream investments.
Conclusion
The regulatory framework for downstream investment is grounded in the principle that 'what can be done directly can be done indirectly, and what cannot be done directly cannot be done indirectly'.8 Hence, the same conditions that apply to Foreign Direct Investment (FDI) are broadly extended to downstream investments. Given that the investee company bears the primary responsibility for compliance, it is imperative that thorough due diligence is conducted to ascertain whether the investing entity or investment vehicle is of foreign or domestic ownership.
Footnotes
1 Explanation (i) to Rule 23 of Foreign Exchange Management (Non-Debt Instruments) Rules, 2019.
2 Explanation (a) to Rule 23 of Foreign Exchange Management (Non-Debt Instruments) Rules, 2019.
3 Explanation (d) to Rule 23 of Foreign Exchange Management (Non-Debt Instruments) Rules, 2019.
4 Rule 23(1) of Foreign Exchange Management (Non-Debt Instruments) Rules, 2019.
5 Rule 21(2) of Foreign Exchange Management (Non-Debt Instruments) Rules, 2019..
6 Rule 23(5) of Foreign Exchange Management (Non-Debt Instruments) Rules, 2019.
7 Regulation 11 of Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019.
8 Paragrah 9, Master Direction – Foreign Investment in India (RBI/FED/2017-18/60, FED Master Direction No.11/2017-18), Reserve Bank of India, available at: https://www.rbi.org.in/scripts/BS_ViewMasDirections.aspx?id=11200.
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