The Indian economy is back on foreign investors’ radar and with a vengeance. Capital inflows to the country in the first seven months of the current fiscal are an impressive $38 billion, comprising about $20 billion in foreign direct investment (FDI)—strategic investment—and more than $18 billion in portfolio investment from foreign institutional investors (FIIs).
While the capital inflows clearly demonstrate the inherent attractiveness of doing business in India, the World Bank and International Finance Corporation report Doing Business 2010 does not paint a very pretty picture; it ranks India at 133 (among 183 nations) in terms of ease of doing business.
Also Read Ketan Dalal’s earlier columns
In an attempt to improve the investor image, the government has initiated a number of policy reforms, be they in the form of the new direct tax code or goods and service tax regime or otherwise in the form of the Companies Bill, e-filings, introduction of the limited liability partnership regime etc.
Insofar as the FDI framework is concerned, the ministry of commerce and industry has proposed to consolidate the existing FDI policy. As a background, ever since India allowed foreign investment in 1991, the changes and updates to the FDI policy have been brought in through various Press Notes on a need basis. This has led to the policy being spread across several standalone Press Notes. The consolidation is expected to help simplify the policy and provide a clearer understanding of the foreign investment rules on a single platform. The consolidated policy, which is currently open for public debate, is proposed to be issued in April and thereafter be updated every six months.
While the simplification and consolidation initiative is definitely laudable, one hopes the government will use this as an opportunity to clarify certain common issues faced by investors, as also iron out certain inconsistencies that have crept into various sectors.
Illustration: Jayachandran / Mint
Sectoral caps: Portfolio (FII and NRI) investment—whether counted?
Under the current policy, most sectors are under the 100% FDI route and there are no sectoral cap issues. However, certain sensitive sectors such as telecom, single brand retail and banking continue to have sectoral caps prescribed in terms of the foreign equity that can be held in an Indian firm engaged in these sectors.
While different sectoral caps can be clearly understood depending on the sector sensitivity, the sector-specific policy announcements over the years have resulted in certain inconsistencies in computing the foreign equity share across sectors. For instance, the 74% ceiling in telecom includes FDI, FII and NRI investment and also through instruments such as foreign currency convertible bonds (FCCBs), American depositary receipts and global depositary receipts.
However, the sectoral cap for banking, broadcasting and commodity exchanges only includes FDI and FII investment. In several other sectors, such as in newspapers, the investment cap applies vis-à-vis FDI only and not portfolio investment. In some, a separate portfolio investment cap is prescribed besides FDI cap.
The issue was further complicated by Press Note 2 (of 2009), which seeks to clarify the computation of indirect FDI in Indian firms. The note states that all direct investment by a person residing outside India should be considered for computing direct foreign investment. This implies that all forms of direct investment—FDI, FII, NRI etc—need to be considered for determining the sectoral caps, though the original sector FDI policy may provide otherwise.
One hopes that the consolidated FDI policy irons out the inconsistencies in computing the sectoral ceilings.
As stated above, in relation to certain sectors, such as telecom, even investments held through convertible instruments like FCCBs are to be considered in calculating the FDI cap. Clearly, until conversion, such instruments are treated as external commercial borrowing, i.e. debt. At times, the conversion ratio is not fixed in advance but is linked to the share valuation close to a predetermined conversion date. In such cases, it would be impossible to compute the FDI in the Indian firm taking into account such convertible instruments.
Given the practical difficulty in such cases, the consolidated FDI policy should provide for considering convertible instruments in calculating the FDI caps only once they are converted into equity and not otherwise.
Valuation guidelines: Applicability to convertible instruments
Investment by way of compulsorily convertible instruments (be it debentures or preference shares) is treated as FDI. Under the automatic route for making investments into an Indian company, the issue of shares would have to comply with the valuation guidelines prescribed by the Reserve Bank of India. The guidelines deal largely with valuation of equity shares and not convertible instruments.
Insofar as convertible instruments are concerned, the policy is unclear as to whether valuation guidelines need to apply at the time of issue of the convertible instrument or at the time of issue of equity shares on the conversion date or on both occasions.
The consolidated FDI policy can address this by providing that the valuation guidelines need to be complied with only at the time of the initial issue of the convertible instruments provided that the conversion ratio is built in, or if not, then, at the point of time when the conversion ratio is fixed by the company.
Transfer of shares: Overseas mergers
The current regime allows the free transfer of shares of an Indian company by one non-resident to another by way of sale or gift, subject to compliance with the sectoral norms. Incidentally, the rules do not cover the transfer of shares in an Indian firm pursuant to a merger arising overseas between two foreign companies. This leads to doubts as to whether such transactions fall under the automatic route or whether the Foreign Investment Promotion Board’s (FIPB) approval is required.
It seems strange that a big ticket global merger and acquisition requires the blessings of the Indian regulator for consequential changes in the shareholding of the Indian company, in which 100% FDI is allowed, in any case, under the automatic route.
Transfer of shares within sectoral cap
In respect of sectors with FDI caps, Press Note 3 (of 2009) mandates FIPB clearance for the transfer of shares from resident to non-resident in case such a transfer results in a change of ownership or control of an Indian firm in favour of a non-resident.
This seems to only add to the administrative burden in the otherwise liberalized FDI regime. One hopes the consolidated FDI policy will take this into consideration.
Fund raising through warrants and partly paid shares
The recent trend in fund raising by Indian corporate firms has thrown up alternate options such as the issuance of share warrants and deferring investments through partly paid shares. Under the current regime, FIPB approval is required for them. This procedural approval, especially in sectors where 100% FDI is allowed, only delays the allotment process.
Since quite some time, there have been press reports indicating that the government is evaluating dispensing with the requirement of obtaining such approvals. Prompt action on this front in the consolidated FDI policy should help Indian industry’s fund-raising plans.
Ketan Dalal is executive director and Vishal Shah is associate director, PricewaterhouseCoopers.
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