The ministry of commerce and industry has issued a series of press notes outlining the revised foreign direct investment (FDI) guidelines announced by the cabinet committee on economic affairs. Press Notes 2 and 3, dealing with calculations of foreign investment in downstream entities and requirement for Foreign Investment Promotion Board (FIPB) approval in relation to transfer of ownership or control in sectoral cap companies, were issued on 11 February.
These press notes have raised certain issues, including in relation to downstream investment by Indian companies having minority foreign holding. In response to some of these issues, Press Note 4 was issued on 26 February.
This article seeks to deal with what emerges out of the press notes.
Under the FDI policy before the 11 February press note, foreign investment was allowed in an Indian company under the automatic route (that is, without prior approvals) in almost all sectors except: (a) certain prohibited sectors such as gambling and betting, the lottery business, atomic energy, retail trading (except single-brand retail) or (b) where prior government approval is specifically required.
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The issue of the method of computation of sectoral caps has been engaging the attention of the government and the controversy and confusion of an operating and holding company owes its genesis to this issue. In essence, the government was taking a stand that regardless of the quantum of foreign investment in an Indian company (ICO), an investment by an ICO in a downstream operating company (DCO) would require FIPB approval, even if the DCO operates in the automatic sector. In fact, FIPB has been giving approvals with retrospective effect for such investments, subject to the requirement of compounding by the Reserve Bank of India.
Press Note 2 of 2009
Under Press Note 2 of 2009, foreign investment in an Indian company shall include all types of foreign investment, namely FDI, by non-resident Indians (NRIs), portfolio investment by foreign institutional investors (FIIs)/NRIs, American depository receipts (ADRs)/global depository receipts (GDRs), foreign currency convertible bonds (FCCBs), convertible preference shares/convertible debentures. This note provides for a framework for calculation of total foreign investment (direct and indirect) in Indian companies, which is based on ownership and control of such firms.
Illustration: Jayachandran / Mint
According to the new FDI policy, Indian companies (which are owned and controlled by Indian resident citizens directly or through Indian companies) will be considered “pure” Indian companies. Accordingly, any downstream investments made by such companies will not be considered as having any flow-through foreign investment (compared with a view in the earlier regime of having pro rata foreign investment). However, this methodology for computation of foreign investment does not apply to sectors that are governed specifically by a separate statute such as the insurance sector.
If, however, there is an Indian company that is either foreign-owned or controlled (as opposed to owned and controlled); the downstream investment therein will be subject to sectoral caps. For example, if a foreign company owns 55% in an ICO and the ICO has made an investment in a DCO of 75%, foreign investment in the DCO would be considered as 75% (earlier, it would have been considered at 55% of 75%).
Press Note 3 of 2009
This press note applies to all cases involving transfer of ownership or control from Indian resident citizens to non-resident entities in sectors/activities that either have an FDI cap or require prior FIPB approval. In these sectors, FIPB approval will now be required for transfer of ownership or control of Indian companies either directly to foreign entities or to an Indian company set up with foreign investment and which is owned or controlled by non-resident entities, irrespective of whether such a transfer is taking place through merger, amalgamation, acquisition, etc. This effectively means a step back in the liberalization process, where prior FIPB approval is now required even in cases that did not require such approvals earlier. It is important to realize this press note is not talking about downstream investment, but investment in an Indian company per se.
Press Note 4 of 2009
This press note seeks to clarify compliance with foreign investment norms compared with downstream investments. Although the language in the operating part of the press note is not very clear, the introductory paragraph suggests that it is restricted to downstream investments by an ICO if the ICO is owned or controlled by non-resident entities, as opposed to downstream investment by ICOs that are owned and controlled by residents. It categorizes such ICOs (foreign-owned or foreign-controlled ICOs) into three baskets:
• Only operating companies: sectoral caps and conditionalities to be complied with.
• Operating-cum-investment companies: In such cases, the DCO would have to comply with the relevant sectoral caps and conditionalities.
• Investment companies: If the ICO is an investment company (i.e. neither an operating company nor an operating-cum-investment company), foreign investment in the ICO will require FIPB approval regardless of the amount or extent of foreign investment. Further, the DCO will have to comply with conditionalities and sector caps.
There are some additional conditions also prescribed in relation to downstream investment by an ICO in a DCO, if the ICO is an operating-cum-investing company, or just an investment company. Two of the conditions are procedural and require certain intimations of downstream investment within 30 days of investment and certain board resolutions to be submitted. The two other conditions are substantive and require compliance with certain pricing guidelines as well as the ICO being required to bring funds from abroad and not borrow domestically for downstream investments.
The key principle emerging from Press Note 2 is that as long as an Indian company is owned and controlled ultimately by resident Indians, foreign investment in the Indian company would be ignored in relation to downstream investments made by the Indian company.
While the purpose of this press note is purportedly to simplify matters, it has several implications, some of which are as under (for the purpose of explanation, a foreign company investing in an ICO is being referred to as FCO).
1. The concept of indirect foreign investment now needs to be looked at vis-a-vis whether the ICO is owned and controlled by Indian citizens/ultimately Indian-controlled companies. If so, a downstream investment is not considered to be FDI even if there is investment of an FCO in the ICO, as long as the investment of the FCO is below 50%. If that is the case, it appears that if the ICO invests in a DCO, even if the DCO is functioning in a sectoral cap segment, that should be irrelevant and the sectoral cap, therefore, should not have any relevance. For example, if the ICO makes an investment in a hitherto FDI-restricted sector, multi-brand retail, for example, on a plain reading of Press Note 2, that should not be violative of FDI norms. The reason is that an ICO investment will be deemed not to be a foreign investment, not even proportionate. Press Note 4 seems to clearly support this interpretation implicitly, because the restrictions envisaged are only for foreign-owned or foreign-controlled resident ICOs.
2. For determining foreign ownership/control, the wording is “owned or controlled” as distinct from “owned and controlled”, which is the situation described in Point 1 vis-a-vis an ICO being considered a “pure” Indian company. In other words, if an ICO is owned more than 50% by several unconnected foreign entities, then the question arises as to whether it is to be considered as not being exempt from downstream sectoral caps. On a plain reading, the answer appears to be that investment by an ICO in such cases would be subject to sectoral caps, although one understands that this matter is under review, given that this may not be the intent.
3.The press note seems to deal with more than 50% Indian ownership or more than 50% foreign ownership. It does not deal with a situation of a 50:50 joint venture.
4. An important issue is whether this press note has dealt with the controversy of operating and holding companies. While it does not expressly do so, it seems clear that if an ICO is an Indian-owned and controlled company, then the issue of downstream investment requiring FIPB approval does not arise because it is not considered to have any foreign investment in the first place. Here again, Press Note 4 seems to support this proposition implicitly, because even in that, the conditionalities of government approval seem to be linked only with foreign-owned ICOs.
5. The issue of control being defined as the ability to appoint a majority of the members of the board of directors may not always be the appropriate benchmark for control. For example, in the case of private equity investment with significant veto rights, but without the power to appoint a majority of the board, it would not be construed as foreign control, but at the same time would put significant fetters on the ICO. Perhaps what the government had in mind is “positive” control, as distinct from “negative” control.
6.The unification of the categories of foreign investment brings up other issues:
• In the case of ADRs or GDRs, voting rights are not exercised by foreign investors, but the investments are included.
• FII investment is very volatile. Hence, the inclusion of that in foreign investment has its own set of issues. In fact, in order to compute the level of FII investment, the date of 31 March has been prescribed. Therefore, if a sectoral cap is to be computed today, the FII investment as on 31 March 2008 would be looked at, which could be significantly higher given the huge FII pull-out that has happened. Clearly, a tricky issue and one would think that one will hear much more about this in the days to come.
The contents of Press Note 4 have already been explained above, including vis-a-vis Press Note 2. A couple of additional issues:
• The way the press note is worded, it seems that if an ICO is Indian-owned and controlled with minority FCO interest, such FCO investment will be ignored vis-a-vis the sector in which the ICO can invest by way of downstream investment.
• Second, if the ICO has internal accruals, the ability of the ICO to use such internal accruals has not been dealt with by the press note. Logically it should be permitted to use such funds, but one wishes that the press note had clarified this issue expressly.
While the intent of the press notes may be laudable, new issues have arisen, as discussed here, including a possibility that some sectoral caps have been made meaningless and potential downstream investment in restricted sectors has been probably made possible. In addition, some avoidable requirements of going back to FIPB have been reintroduced by Press Note 3 of 2009.
On a more macro basis, foreign entities are not likely to invest in Indian-owned and controlled companies simply because of the ability to make downstream investments by such Indian companies in restricted/prohibited sectors. Clearly, commercial reality will dictate that rather than regulatory “liberalization”.
Ketan Dalal is executive director and Manish Desai is associate director, PricewaterhouseCoopers. Your comments and feedback are welcome at firstname.lastname@example.org