Revamped Overseas Investment Rules: A Critical Insight

With an aim to improve the 'ease of doing business' and simplifying/ liberalising the investment regime, the Government of India in consultation with the Reserve Bank of India ("RBI"), amongst others, has been progressively revamping and liberalizing the foreign exchange regime in India. In view of the foregoing, the Government of India vide Notification No. G.S.R 646(E), dated August 22, 2022, issued the Foreign Exchange Management (Overseas Investment) Rules, 2022 ("OI Rules") and the RBI issued the Foreign Exchange Management (Overseas Investment) Regulations, 2022 ("OI Regulations") and Foreign Exchange Management (Overseas Investment) Directions, 2022 ("OI Directions"; collectively with the OI Rules and OI Regulations, the "OI Regime").

Similar to the approach adopted by the Central Government and RBI in overhauling the regulatory framework for foreign direct investment, the Central Government notified the non-debt investment framework through OI Rules while the RBI notified the debt investment framework through OI Regulations. The OI Directions summarize the significant changes brought about by the OI Rules and OI Regulations, and also provides clarity on the relevant operational frameworks.

Set out below are certain key changes brought about by the OI Regime:

• Definition of Foreign Entity: The concept of JV/ WoS under the erstwhile overseas direct investment ("ODI") regime has now been substituted by the concept of 'foreign entity,' which means an entity formed or registered or incorporated outside India, including International Financial Services Centre ("IFSC") having limited liability. The requirement of limited liability does not apply to a foreign entity having its core activity in strategic sectors such as oil, gas, coal, mineral ores, submarine cable system, start-ups and any other sector as deemed necessary by the Central Government. While the concept is similar to the erstwhile definitions of JV/ WoS, the OI Regime has specifically introduced the requirement of 'limited liability' to ensure that the liability of the Indian party is clear, identified and limited.

• Overseas Direct Investment and Overseas Portfolio Investment: The long-standing confusion between a portfolio investment and ODI by an Indian party now stands resolved by inclusion of a clear and distinct definition of overseas portfolio investment ("OPI"). OPI means any overseas investment which is not ODI, other than investment in any unlisted debt instruments or any security issued by a person resident in India who is not in an IFSC. Under the erstwhile ODI Regime, only listed entities were permitted to make portfolio investment. The investor universe has now been expanded by including unlisted Indian companies, resident individuals ("RIs"), mutual funds ("MFs"), alternative investment funds ("AIFs") and venture capital funds ("VCFs").

• Control: The OI Regime has introduced the definition of the term 'control' to refer to the right to appoint majority of the directors or control the 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. The definition of 'control' is in line with the widely prevalent definition of the term 'control' albeit a mere 10% voting rights will also be considered as 'control' under the OI Regime. It is possible that the introduction of 10% threshold has been done with an intent to maintain a clear demarcation between ODI and OPI.

• Pricing Guidelines: Under the erstwhile ODI regime, valuation was mandatory in certain cases such as transfer of shares, swap of shares and/ or partial/ full divestment. However, the concept of pricing guidelines as applicable for foreign direct investment was not specifically applicable to overseas investments. The OI Regime has now, subject to certain exceptions, introduced the concept of pricing guidelines whereby for all equity capital issues or transfers of shares of foreign entities from persons residing outside of India, from persons residing in India to persons residing in India who are eligible to make such investments, or from persons residing in India to persons residing outside of India, must be priced on an arm's length basis. The responsibility has been placed on the Authorized Dealer ("AD") bank to guarantee adherence to arm's length pricing while taking into account the valuation in accordance with any generally recognized international pricing methodology for valuation.

It is recommended that RBI specifies the relevant guiding principles to establish "arm's length pricing," for AD Banks to exercise a considered and controlled discretion on this aspect and avoid ambiguity.

• Recognition of the flip-structures: This is one of the most welcome changes brought about by the OI Regime. While the erstwhile ODI regime did not expressly prohibit the flip structures, but such structures were prohibited by way of 'FAQs' issued by the RBI. The OI Regime now clearly permits an Indian entity to invest in a foreign company having/ (intending to) establish a subsidiary in India subject to the overall structure not resulting in more than two layers of subsidiaries.

• Investment in Financial Sector: The erstwhile ODI regime only permitted entities engaged in financial services to invest in financial sectors outside of India. The OI regime now permits all Indian entities to invest in foreign entities engaged in financial sector activities (except insurance and banking) without permission from the sectoral regulators; provided that such Indian entity has posted net profits during the preceding three financial years.

• ODI in Start-ups: ODI in start-ups has been specifically separated from other investment avenues overseas as the OI Regime permits in case of the Indian entity their internal accruals and in case of resident individual their own personal funds for overseas investment in start-ups. According to the OI Regime, this investment may be made in "startups" that are recognized as such by the host country's or host jurisdiction's legal system. There are not many nations that precisely define what constitutes a "start-up", and hence this term loses its meaning in any nation without a definition. The RBI may need to make its position on this clearer.

• Investment by Resident Individual: The erstwhile ODI Regime did permit RIs to acquire shares in overseas entities through routes such as LRS, ESOPs, gifts, etc., however, there was clearly a lack of defined procedure and rules in this regard. This has been addressed by the OI Regime that clearly identifies and lists out the procedures and rules relating to overseas investment by RIs. The RI is now permitted to acquire shares by way of (a) OPI, (b) ODI in an operating company and having no subsidiary in case the RI has control over such foreign entity, (c) through inheritance, ESOPs, acquisition of sweat equity shares, etc. and (d) gift. The investment by the RI has to be made in accordance with the OI Regime only and the provisions of liberalized remittance scheme will not apply.

• Gifting of Foreign Securities: Gift of foreign securities was under general permission under the erstwhile ODI regime, and that led to some confusion in the market regarding compliance requirements in relation to gifting of securities by non-resident to resident Indian entities/ individuals, especially in cases where the non-resident was not a relative of the resident Indian. The OI Regime now permits an RI to acquire shares by way of inheritance from a person resident in India or by way of gift from relatives who are person resident in India; however, a gift of foreign securities from a person resident outside India is made subject to compliance with the provisions of Foreign Contribution (Regulation) Act, 2010. This imposes a significant restriction on RIs as compliance conditions under FCRA are currently not very clear or identified. We may have to wait and see if some amendments to FCRA or rules related thereto are made by the Government to address this gap.

• Loan and Guarantees: The OI Regime now requires the Indian entity to have control over the foreign entity prior to providing any loans, making investment into debt instruments or providing any other non-fund based commitment to such foreign entity. Furthermore, there is no restriction at the level of step-down subsidiary whose obligations can be guaranteed by the Indian entity.

• Transfer or Write-Off: The erstwhile ODI regime had put several conditionalities and restrictions on transfer/ write-off of the overseas investments made by the Indian entity. The OI Regime has now simplified the procedure and remove specific conditions concerning write-off. Now the Indian entity will have to follow the same conditions for write off-as applicable to a normal transfer of overseas investments.

• Pledge of shares and creation of security: The OI Regime now permits creation of: (a) pledge over the shares, and (b) assets, of foreign entity including the step-down subsidiaries, in favour of a debenture trustee registered with SEBI for the fund bases facilities availed by the Indian entity. In addition, the OI Regime now also permits creation of a charge over the assets of the foreign entity including step-down subsidiaries in favour of a public financial institution for availing of fund or non-fund based facilities, for the Indian entity or the foreign entity in including the step-down subsidiaries.

• Clarity on certain existing concepts of previous ODI Regime such as calculation of financial commitment, definition of net worth, definition of debt and non-debt instruments, introduction of late submission fee, concept of 'strategic sector', etc. has been brought about by the OI Regime.

While the spirit and intent underlying the revamping of the laws governing foreign investment are laudable, it may be noted that based on the OI Directions, it can be observed that AD Banks have considerable freedom to decide how to comply with these regulations. It would be best to provide explanations as soon as possible regarding the KYC requirements for "round-tripping" structures, the scope of start-ups, the applicability of the two-layer rule to other structures, and the FCRA's applicability to share gifts. Overall, it is impossible to deny that the applicable requirements have been made easier to follow. Practical challenges brought on by the previous regime have been acknowledged, and major relaxations have been made.

Accordingly, the recent notified OI Regime, 2022 seek to clarify and simplify a number of facets of the previous framework for foreign investments. In other words, these laws expand the range of alternatives available to resident Indians who are looking for relevant investment opportunities abroad. There is a clear foundation to start with, for entities affected by mergers and acquisitions or entrepreneurs who want to launch their business. Overall, it appears that the most recent laws provide standard transactions with much-needed clarity and a sigh of relief. As a result, more residents looking for chances in international markets will engage in foreign investment activities.

Authors: Ketan Mukhija, Partner (Link Legal) And Gaurav Priyadarshi (Associate Partner) at Link Legal. Views are personal.