The Government of India has a comprehensive policy framework on foreign direct investment ("FDI") in the circular on consolidated FDI policy issued by the Department of Industrial Policy and Promotion ("DIPP"), Ministry of Commerce & Industry, Government of India ("FDI Policy") which permits offshore investment under the: (i) automatic route (i.e. without government approval) or (ii) government route (i.e. with prior approval) subject to sectoral conditions.

What is the change and why?

In light of the economic and financial crisis caused by the COVID-19 pandemic, the DIPP on 17 April 2020 revised the FDI Policy through Press Note 3 of 2020 ("Press Note") imposing stricter norms on foreign investments in Indian companies by investors from bordering countries. This has been incorporated into Rule 6 of the Foreign Exchange Management (Non Debt Instruments) Rules, 2019.

Now, any foreign investment by a non-resident from a country that shares a land border with India will require prior Indian government approval, irrespective of the sector in which the investment is made. Even though the countries have not been specifically set out in the Press Note, the restriction applies to entities from China, Pakistan, Bangladesh, Nepal, Myanmar, Bhutan and Afghanistan ("Neighbouring Countries"). Prior government approval is also required for any transfer of ownership of any existing or future FDI in an Indian entity, directly or indirectly, resulting in the beneficial ownership being situated in a Neighbouring Country. Investments in India from Bangladesh and Pakistan anyway require prior government approval before investing and this represents an extension of that policy at a time of global fear. The restriction was largely imposed to protect corporates from opportunistic or hostile acquisitions which may arise due to volatility of their share prices in the market.

How are beneficial owners determined?

Introduction of a "beneficial owner" test is new under the FDI policy and intended to catch investments that may not be made directly from Neighbouring Countries but indirectly made, via Singapore or Mauritius. How to determine "beneficial owner" remains an unanswered question. The Press Note and the FDI Policy do not provide the calculation methodology or conditions for determining beneficial owners and a clarification is expected from DIPP. This is important since many Indian companies and offshore entities, such as private equity funds investing in India have Chinese investors. Ultimately a definition may emerge that resembles Section 90 of the Companies Act, 2013 ("Act") and Companies (Significant Beneficial Ownership) Rules, 2019 ("Rules"). Under this, a "significant beneficial owner" in relation to a reporting company means an individual, who acting alone or together, or through one or more persons or trusts, possesses one or more of the following rights or entitlements: (i) holds indirectly, or together with any direct holdings, at least 10% of the shares or at least 10% of the voting rights of the shares; (ii) has the right to receive or participate at least 10% of total distributable dividend in a financial year whether directly or indirectly; or (iv) has right to exercise, or actually exercises, significant influence or control, in any manner other than through direct-holdings alone. However the definitions in foreign exchange are different to the Companies Act and need to be clarified.

Key takeaways and conclusions

This change seems to be a protectionist government policy move particularly in terms of investments from China. It is alleged that this change is a government reaction to People's Bank of China raising its stake in HDFC from 0.8% to 1.01%. Another concern is that companies with existing FDI, specifically Chinese FDI may face additional problems. Various Chinese companies including Alibaba, Tencent and Xiaomi have heavily invested in India and hold substantial stakes in large to start-up companies including PayTm, Big Basket, Zomato and Ola. The amendment could jeopardise future capital infusions for companies by their existing shareholders from Neighbouring Countries.

The amendment has a major impact on transactions signed or in advanced stages of negotiation but yet to be completed and funded. It has created uncertainty amongst investors as to the conditions under which government approval will be given as well as timing for approvals given the COVID-19 crisis. In addition, whether this will also affect the downstream investment by Indian companies to their investee companies, is not clear. A more appropriate approach would have been to provide thresholds in specific sectors such as defence, telecom, IT and banking. It is expected that DIPP will issue operating guidelines on the approval procedure which it is hoped will provide much needed clarity.

The changes under the Press Note amend the FDI Policy and will not apply to foreign portfolio investors ("FPI") for their investment in Indian capital markets, although SEBI is working on a framework. Consequently, no prior government approval will be required if the investment by a single foreign investor including its investor group is below 10% of the total paid-up equity capital (fully diluted basis) of a listed company in India. Even though China doesn't account for top 10 jurisdictions for FPIs in India, in an unusual move, SEBI has asked custodians to provide details of ‘ultimate beneficial owners' of FPIs based in China and Hong Kong.

China specifically amongst the Neighbouring Countries has been actively investing in Indian start-ups and therefore it became crucial to protect Indian entities against opportunistic takeovers. This could prove beneficial in the long run and protect the companies whose valuations have been hit given the correction in equity markets resulting from the pandemic and lockdown.

India is not the only country which has modified its FDI Policy and various countries including Australia, United Kingdom and Japan have also proposed restrictions on foreign investment. The aim of the amendment is to preserve and protect the Indian manufacturing and technology sectors. While there are certain legislative clarifications expected from DIPP, the amendment has left both investors and Indian entities concerned at the moment.

Originally published 25 May 2020

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