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Context

• Foreign investments are critical for India's ambition to achieve a $5 trillion economy by the financial year 2025-26.
• However, attracting these investments necessitates the removal of bottlenecks faced by Indian companies receiving foreign funds and foreign investors betting on India's growth story.

BACKGROUND: FOREIGN EXCHANGE MANAGEMENT (NON-DEBT INSTRUMENTS) RULES, 2019

• The Ministry of Finance has, by way of notification dated April 27, 2020, amended the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (‘FEMA NDI Rules’) with effect from the date of the notification. The key amendments brought about by the amendment are set out below.

Acquisition of Securities in a Rights Issue by way of Renouncement:

• Rule 7 of the FEMA NDI Rules, which deals with acquisition of equity instruments (other than warrants) by a person resident outside India in case of a rights issue or bonus issue by an Indian company, inter-alia, provides that in case of an unlisted Indian company, the rights issue to persons resident outside India will not be at a price less than the price offered to persons resident in India and in case of a listed company, the rights issue to persons resident outside India will be at a price determined by the company, and the general pricing guidelines will not apply.
• The FEMA NDI Rules also contained an explanation that provisions of Rule 7 will also apply in case of subscription to rights shares by a person resident outside India which were renounced by the person to whom they were originally offered.
• Pursuant to the amendment, the above explanation to Rule 7 has been deleted and a new rule, Rule 7A, has been inserted which provides that the pricing guidelines specified under the FEMA NDI Rules will apply to the subscription of shares where a person resident outside India acquires rights shares that were originally offered to a person resident in India and were subsequently renounced.

Single Brand Retail Trading:

• As per the FEMA NDI Rules, foreign investment in an entity engaged in single brand retail trading (‘SBRT’) is permitted up to 100% under the automatic route. The FEMA NDI Rules stipulate that for proposals involving foreign investment beyond 51% in an entity engaged in SBRT, 30% of the goods procured need to be sourced from India, and such procurement requirement is to be met for the first time as an average of 5 years’ total value of goods procured beginning 1^stApril of the year of the commencement of SBRT business (i.e. opening of first store or start of online retail, whichever is earlier) and annually thereafter.
• However, these sourcing norms were not applicable for 3 years from commencement of business (e.‘opening of first store’) for entities undertaking single brand retail trading of products having ‘state-of-art‘ and ‘cutting-edge’ technology. The amendment now clarify that the exemption will not apply for 3 years from the earlier of opening of first store or commencement of online retail.

Insurance Intermediaries:

• The Government of India had, by way of Press Note 1 of 2020 dated February 21, 2020, approved changes in the foreign direct investment policy for insurance intermediaries.
• The Government had permitted 100% foreign direct investment in insurance intermediaries under the automatic route, subject to certain conditions.
• These changes have now taken effect from the date of amendment to the FEM NDI Rules April 27, 2020.

Conditions for Divestment by FPIs / Reclassification of Investment:

• The FEMA NDI Rules prescribe the manner of divestment by a foreign portfolio investor (‘FPI’) if the FPI invests beyond the prescribed limits and that if the FPI chooses not to divest, its entire investment in the company will be treated as foreign direct investment. The amendment adds an additional condition that the aforesaid divestment and/or reclassification will be subject to further conditions, if any, as may be specified by Securities and Exchange Board of India and the Reserve Bank of India.

Key Amendments to Foreign Exchange Management (Non-debt Instruments) Rules, 2019

On January 24, 2024, the Ministry of Finance notified significant amendments to the Foreign Exchange Management (Non-debt Instruments) Rules, 2019. These amendments, effective immediately, introduce several new provisions and changes to existing regulations to facilitate foreign investments in Indian companies listed on international stock exchanges.

Introduction of "International Exchange"

• Definition: The term “International Exchange” has been introduced, referring to stock exchanges in permissible jurisdictions as listed in Schedule XI of the Rules.

Expansion of "Listed Indian Company"

• Previous Definition: Initially, a “Listed Indian Company” was defined as an Indian company with equity or debt instruments listed on a recognized stock exchange in India.
• New Definition: The definition now includes Indian companies registered on an International Exchange, broadening the scope for foreign investments.

New Provisions for Investment by Permissible Holders

• Chapter X: This new chapter allows permissible holders to invest in Indian companies listed or to be listed on an International Exchange under the Direct Listing of Equity Shares scheme outlined in Schedule IX.

Direct Listing of Equity Shares on International Exchanges

• Chapter XI: This chapter sets conditions for Indian public companies to issue equity shares or offer existing shares on international exchanges.
• Listing Requirements: The shares must be listed on specified International Exchanges.
• Compliance: The listing is subject to prohibited activities and sectoral caps.
• Equity Shares: Must be dematerialized and rank pari-passu with shares listed on Indian stock exchanges

Definition of Permissible Holder

• Permissible Holder: This includes holders of equity shares listed on an International Exchange, including beneficial owners.
• Approval Requirement: Holders from countries sharing land borders with India or entities from such countries must obtain Central Government approval to hold shares in public Indian companies

Compliance Obligations for Indian Companies

Indian companies listing shares on international exchanges must comply with multiple regulations, including:

• Securities Contracts (Regulation) Act, 1956
• Securities and Exchange Board of India Act, 1992
• Depositories Act, 1996
• Foreign Exchange Management Act, 1999
• Prevention of Money-laundering Act, 2002
• Companies Act, 2013
• Relevant Equity Issuance Laws: Companies must adhere to existing laws related to the issuance of equity shares and requirements prescribed in the new scheme.

Pricing of Issued Equity Shares

• Minimum Price: Equity shares issued on international exchanges must be priced at least as high as those issued to domestic investors under applicable laws.

These amendments aim to facilitate foreign investment and streamline the process for Indian companies looking to leverage international capital markets while ensuring compliance with domestic and international regulations.

Amendment Conundrum

FEMA NDI Amendment

• Press Note Number 3 of 2020: This amendment to the Indian Foreign Exchange Management (Non-debt Instruments) Rules, 2019, has created significant challenges for Indian companies, especially start-ups and smaller enterprises seeking foreign investments.
• PN3 Requirement: Investments from entities or beneficial owners in countries sharing land borders with India require prior government approval. This aims to prevent opportunistic takeovers during crises like the COVID-19 pandemic.

Issues with the Amendment

• Undefined ‘Beneficial Owner’: The term 'beneficial owner' is not clearly defined, leading to industry reliance on thresholds from other laws.
• RBI’s Conservative View: Since late 2023, the Reserve Bank of India has taken a more conservative stance on undefined aspects, impacting downstream investments by Foreign Owned or Controlled Companies (FOCCs).

Industry Response

• Notices to FOCCs: Numerous FOCCs have received RBI notices regarding their downstream investments.
• Shift in Legal Advice: Law firms now advise against relying on beneficial ownership thresholds from other laws due to the RBI's conservative interpretation.

Approval Route Challenges

• Time-Consuming and High Rejection Rate: The prior government approval process is slow and has a high rejection rate. Some government officials noted ₹50,000 crore worth of proposals from neighboring countries are pending, withdrawn, or rejected, with 201 applications rejected in the past three years.
• Compliance Burden: Indian companies face severe penalties for non-compliance, up to three times the investment received. This vagueness and potential fines threaten the survival of start-ups.

Issues and Solutions

Indemnity Challenge

• Current Practice: Indian companies may require foreign investors to provide indemnities for PN3 compliance, potentially discouraging investment.
• Solution: Amend the PN3 Requirement to include a comprehensive definition of ‘beneficial owners’, specifying ownership thresholds and control tests.

Defining ‘Beneficial Owners’

• Ownership Threshold: Establish a clear threshold for beneficial ownership, ranging from 10% (Indian company law) to 25% (Financial Action Task Force recommendation).
• Sector-Specific Scrutiny: Customize thresholds based on sector sensitivity, with higher scrutiny for sectors like telecom and defense compared to manufacturing and construction.
• Control-Conferring Rights: Define rights beyond ownership thresholds that confer control, such as board meeting quorums or veto powers over operational matters. Exclude investor protection rights like veto powers over mergers.

Consultation Mechanism

• Addressing Ambiguity: Introduce a time-bound consultation mechanism with regulatory authorities, similar to Indian competition law, to clarify whether specific clauses in charter documents confer control.

Conclusion

• To attract the necessary foreign investments and achieve the $5 trillion economy target, it is crucial to address the challenges posed by the FEMA NDI amendment.
• This involves clarifying the definition of ‘beneficial owners’, establishing a consultation mechanism, and ensuring that compliance requirements do not unduly burden Indian companies.

PRACTICE QUESTION Q: Discuss the recent amendments to the Foreign Exchange Management (Non-debt Instruments) Rules, 2019, and their implications for foreign investment in Indian companies. How do these changes aim to balance facilitating foreign investments with ensuring national security?