The Reserve Bank of India on 22nd August, 2022 introduced new set of rules for resident Individuals, domestic Indian entities and start-ups, opting for Overseas Direct Investment route (ODI), which has long lasting impact on their business structure and their Regulatory Planning. Though, we shall come up with a detailed analysis of the rules- here are the 5 Primary observation from the rules.

Overseas Portfolio Investment can’t be in unlisted shares –

The Guidelines clearly define “Overseas Portfolio Investment” or “OPI” as investment, other than ODI, in foreign securities, but not in any unlisted debt instruments or any security issued by a person resident in India who is not in an IFSC. Here, “ODI” means investment by way of acquisition of unlisted equity capital of a foreign entity, or subscription as a part of the memorandum of association of a foreign entity, or investment in ten per cent, or more of the paid-up equity capital of a listed foreign entity or investment with control where investment is less than ten per cent. of the paid-up equity capital of a listed foreign entity. In other words, irrespective of the investment amount or percentage of holding, any investment in unlisted shares can only be treated as ODI and not Portfolio Investment.

Importance given to Fair Value of the Shares –

The rules state that all transactions of ODI must happen at fair value. Valuation of the concerned securities is of huge importance and the RBI has entrusted the AD Bank on the same. Under Clause 16 (2) of the rules it states that the AD bank, before facilitating a transaction under sub-rule (1), shall ensure compliance with arm’s length pricing taking into consideration the valuation as per any internationally accepted pricing methodology for valuation.  

Formation of Step-Down Subsidiary –

RBI has indirectly allowed person residing in India to form two Layers of Subsidiaries. However, these Companies cannot be dealing with the banking business, NBFC, Insurance and cannot be Government Companies. This has been long awaited and it seems for now that Indian Tech Entrepreneurs can have an Overseas Holding Company which can have a Step- Down Subsidiary back in India. However, further clarity is being awaited in this regard from the Government and the final interpretation can be done based on it.

Challenges in Gifting –

RBI has put in several conditions for Resident Individuals to get shares of overseas companies as Gift. It stated that –

(1) A resident individual may, without any limit, acquire foreign securities by way of inheritance from a person resident in India who is holding such securities in accordance with the provisions of the Act or from a person resident outside India.

(2) A resident individual, without any limit, may acquire foreign securities by way of gift from a person resident in India who is a relative and holding such securities in accordance with the provisions of the Act.

(3) A resident individual may acquire foreign securities by way of gift from a person resident outside India in accordance with the provisions of the Foreign Contribution (Regulation) Act, 2010 ( 42 of 2010) and the rules and regulations made thereunder.

RBI categorically defines “What is Control”

RBI has defined Control and it has a major impact in understanding what construes as Subsidiary.

It is to be noted that “Subsidiary” or “step down subsidiary” of a foreign entity means an entity in which the foreign entity has control. Now “Control” here means the right to appoint majority of the directors or to control management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders’ agreements or voting agreements that entitle them to ten per cent. or more of voting rights or in any other manner in the entity.

In other words, if it can be established that the Foreign Entity by virtue of holding just 10% shares in a third entity and through an indirect right has the control over the policy decisions of the company then this third entity can be deemed to be a step-down subsidiary of the Foreign Entity.

FDI Approval Route Decoded

The Government of India over a period time has already brought a lot of categories of Foreign Direct Investment (FDI) under the Automatic route; however, there still remain a lot of areas and investment types which requires approval from the government and falls under the FDI Approval Route.

To start with, a Foreign Investor can commence business in India under three different models, namely;

1. a) Indian Company set up as a Joint Venture or Wholly Owned Subsidiary,
2. b) Foreign Company as a Liaison Office or Branch Office, or Project Office, and
3. c) Limited Liability Partnership (LLP)

The special focus would be on the first model that is an Indian Company set up as a Joint Venture (JV) or Wholly Owned Subsidiary (WOS). The entity can be set up either directly as a JV or WOS during the incorporation or later by way of share transfer or fresh share issuance. This structure may fall under the Automatic Route or may also be subject to sectoral caps or approval under the FDI Approval Route.

The scenario or requirement of ‘FDI Approval Route’ depends on the nature of transaction. To put this more practically, a case study has been highlighted below.  

 Facts of the Case:

1) X1 is a Pvt. Ltd. Company registered in India under the Companies Act 2013 having two shareholders, ABC Pvt. Ltd. and DEF Pvt. Ltd. holding 50% each and both being Indian registered companies under the companies act 2013.

2) H1 is a company registered in USA having three shareholders; ABC Pvt. Ltd., DEF (UK) Pvt. Ltd., and Mr. Z, a US resident individual.

 Note:

(i) DEF Pvt. Ltd. and DEF (UK) Pvt. Ltd. are related parties with DEF Pvt. Ltd. holding majority shares in DEF (UK) Pvt. Ltd. , a company registered in United Kingdom (UK).

(ii) The Directors in X1 and ABC Pvt. Ltd. are same and related parties.  

 Problem Statement:

The promoters of H1 have agreed to make X1 as the wholly owned subsidiary of H1 which would hold 99% shares in X1.

With the above problem statement, and considering the regulations by the Reserve Bank of India, an Indian Party cannot make an Indian Subsidiary through its Foreign JV or Wholly Owned Subsidiary (WOS) and thus to address the above problem statement, prior approval has to be sought.

 FDI Approval Route Decoded

The brief process for application under FDI Approval Route is as follows:

1) The approval shall be sought from the DPIIT (Department for Promotion of Industry and Internal Trade) under the Ministry of Commerce.

2) An application shall be made to the DPIIT which shall forward the same to the concerned Ministry responsible, who may allow or disallow the matter depending on the merit of the case.

3) The concerned Ministry shall further forward the case to the RBI for their opinion on the matters and also for their comments on the perspective of FEMA (Foreign Exchange Management Act).

4) The entire proposal shall be scrutinized by the relevant departments and other regulatory bodies including Ministry of Corporate Affairs.

5) On successful satisfaction of all the regulatory bodies and approval of the relevant Ministry involved in the case, the approval shall be granted by DPIIT and an Approval Letter shall be issued.

6) On receiving the approval, the remittance shall be made and then the Form FCGPR shall be filed under the approval route with necessary documents and the approval letter.

 Documents required for seeking approval from the DPIIT:

1. a) Details of the proposed shareholders
2. b) Statement of existing and proposed shareholding pattern of the company
3. c) Annual audited accounts with the Board Report and Auditors Report
4. d) Annual audited accounts of foreign entity
5. e) Annual Performance Report (APR) submitted to the RBI
6. f) Detailed Shareholding structure of all the entities involved
7. g) A detailed write-up about the proposed holding company
8. h) A detailed write-up about the reason behind making Indian entity as a WOS
9. i) Net Worth certificate of holding company certified by the Auditor
10. j) Certificate of Incorporation, Memorandum of Association and Articles of Association
11. k) Certificate of Incorporation and other Charter documents holding company
12. l) Income Tax Returns and acknowledgment
13. m) List of Names, addresses and identification proof of all individuals and who shall be representing the entities and also details of every Director
14. n) Copy of any existing Shareholders’ Agreement or JV Agreement, Technology Transfer or Trademark or brand assignment agreement or any other agreement, if any
15. o) Copy of relevant past FIPB/SIA/RBI approval, if any
16. p) Valuation Report
17. q) List of Names, addresses and identification proof of all foreign collaborators of the holding Company/Entity
18. r) Affidavit stating that all information provided is correct
19. s) Board Resolution from all the entities involved in the transaction

The compliance surrounding FDI with respect to a company involves filing of various forms and reporting the transaction to the RBI under the FEMA. Although, the transactions and FDI under ‘Automatic Route’ have to be reported after the money is received; the transactions falling under the ‘Approval Route’ would require prior approval and hence the determination of nature of transaction is of prime importance in understanding the route which would ascertain the compliance procedure.