New Overseas Direct Investment (ODI) Scheme 

Introduction Over the last two decades, India Inc. (Corporate India) has acquired a slew of foreign companies, across a variety of sectors, as a part of its strategy to expand its footprint and establish Indian MNCs across the globe. Previously, it was unthinkable for any Indian company to acquire a company that is 5 times its size (like Tata Steel’s acquisition of Corus) – and India Inc.’s risk appetite for overseas acquisitions is among the most interesting chapters of India’s growth story, post the economic reforms of 1991. The cumulative overseas direct investment (ODI) outflows for the April 2000 - January 2023 period stood at a staggering USD 289,033 million, a lion’s share of which was received by financial services, insurance, manufacturing and hospitality sectors1. Further, as per publicly available data, ODI is mostly concentrated in Singapore, Mauritius, USA, the Netherlands and the UK. The key drivers for ODI include – (a) entry into new markets; (b) access to resources and new technologies; (c) economies of scale; and (d) diversification of business and expansion of the product mix. The availability of superior technologies as well as the creation of synergies and economies of scale have greatly benefitted Indian consumers. As a result, they now have access to better-quality products (QCO Rules) at competitive prices. The period between 2005 and 2008, often referred to as the golden period, saw the highest outflow of ODI totalling approximately USD 60,000 Million. While Indian companies continue to make strategic overseas acquisitions, the ticket size of the ODIs witnessed a steady decline from the highs of the golden period. Even the outbound financial commitment, which stood at USD 5,478.15 million in July 2011, more than halved in size to touch USD 2,047.79 million in December 2021. 

It is worth noting that for many large corporate houses, their ODI deals have not proved to be particularly profitable. Over time this has contributed to a decline in the overall ticket size of ODI deals. Other factors responsible for the decline in ODI include – (a) the rise in protectionist legislations framed by various countries, with a view to safeguard the domestic industry; (b) existing geopolitical tensions; and (c) the current global economic slowdown. In this backdrop, following an extensive consultation process that lasted for more than a year, the Ministry of Finance (MoF) and Reserve Bank of India (RBI) notified the new overseas investment (OI) regime on August 22, 2022 (New Regime), with a view to further liberalise the regulatory framework for OI, reduce the compliance burden and promote ease of doing business for India Inc. The New Regime inter alia comprises the OI Rules, 20233 notified by the MoF (Rules), the OI Regulations, 20224 (Regulations) notified by the RBI and the Master Directions issued by the RBI to authorised persons. The New Regime supersedes the erstwhile regime under FEMA 1205 and the circulars and directions issued thereunder (Old Regime). The New Regime can be broadly divided into three buckets i.e. equity, debt, and OI by resident individuals. In this blogpost, the authors discuss the key changes made under the New ODI Regime, from an equity perspective. Grandfathering of Existing Investments Rule 6 clarifies that any OI made in compliance with the Old Regime shall be deemed to be compliant with the New Regime. However, for an OI that was not in compliance with the Old Regime, there is no deeming provision stating that such investment shall be compliant with the New Regime. 

A Liberalized Framework: Key Changes and Their Implications 

FOREIGN ENTITY “JV” and “WOS” have now been replaced with ‘Foreign Entity’ which inter alia means “an entity formed or registered or incorporated outside India..” In a welcome move, the New Regime expands the meaning of ‘Foreign Entity’ and ‘incorporation’ of a Foreign Entity is not a mandatory requirement. This is relevant for LLPs in jurisdictions like the United States, which are registered but not incorporated. INDIAN ENTITY “Indian Entity” includes companies, body corporates, LLPs and interestingly, even partnership firms registered under the Indian Partnership Act, 1932. CONTROL “Control” means the right to appoint majority of the directors or to control management or policy decisions exercisable by a person/ persons acting individually or in concert, directly or indirectly, including by virtue of shareholding or management rights or shareholders’ agreements/ voting agreements that entitle them to ten per cent or more of voting rights or in any other manner in the entity.8 As the Rules have introduced a new 10% voting rights test (10% Test), there is a material distinction between the tests for control under the Rules, and the applicable tests under Section 2(27) of the Companies Act, 2013 (Companies Act) and the takeover regulations. The 10% Test assumes relevance whilst determining whether the overseas entity would be regarded as a ‘subsidiary’ or a ‘step-down subsidiary’ (SDS). Under the Rules, a subsidiary is defined as an entity, in which a foreign entity has control. By virtue of the 10% Test, a Foreign Entity may be regarded as a subsidiary/ SDS even when it does not meet the ‘subsidiary test’ under Section 2(87) of the Companies Act. 

ODI vs OPI: A Clear Demarcation

In a welcome change, there is now a clear segregation between an overseas direct investment (ODI) and an Overseas Portfolio Investment (OPI). An ODI inter alia includes: 

• Acquisition of unlisted equity capital of a foreign entity; or 

• Subscription as a part of the MoA of a foreign entity; or 

• Investment in 10% or more of the paid-up equity capital of a listed foreign entity; or 

• Investment with control where investment is less than 10% of the paid-up equity capital of the listed foreign entity. 

OPI is defined as investments 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. OI ONLY IN “BONA FIDE BUSINESS ACTIVITIES” “Bona fide business activity” means any business activity permissible under any law in force in India and the host country. Further, the three no-go areas for ODI are: 

(i) real estate activity; 

(ii) gambling; and 

(iii) dealing with financial products linked to the Indian Rupee, without specific RBI approval. 

The Rules are silent on the test to be applied for determining whether a business activity is ‘permissible’ in India. In India, certain business activities like multi-brand retail, online gaming or sale of liquor may be legal only in certain States, and clarity is awaited on whether ODI can be made in such sectors. 

Calculation of Total Financial Commitment (TFC Limit): Greater Flexibility, But With Boundaries

Whilst the TFC Limit has been retained at 400% of net worth, the definition of ‘net worth’ has been aligned with Section 2(57) of the Companies Act and now includes security premium account, thereby potentially increasing the headroom available to the Indian Entity. However, the Indian Entity can no longer utilise the net worth of its subsidiary/ holding company, which could impact large conglomerates where subsidiaries are used to structure ODI. The Rules provide that the TFC Limit should be determined at the time of undertaking the financial commitment. Whilst the same wording was not present in the Old Regime, a conjoint reading of the Rules and the FEMA Master Directions on Reporting suggests that the earlier ODIs would have to be computed at the old rate mentioned in the Form FC and the new ODIs would be worked out using the current exchange rate. It is also pertinent to note that the TFC Limit only includes ODIs, and a separate limit of 50% of net worth has been provided for OPIs. Further, as a noncontrolling investment of less than 10% in a listed foreign entity is treated as an OPI, it may not fall within the TFC Limit of 400% of net worth. 

I-NOC Requirement

An NOC requirement for making financial commitment has been introduced for any person resident in India who:
• Has an NPA account; or
• Is classified as a wilful defaulter; or
• Is under investigation by a financial service regulator or by investigative agencies in India, viz, CBI/ED/SFIO. 

There is also a deemed approval provision if the agency fails to furnish the certificate within 60 days, which is a significant departure from the erstwhile regime of obtaining prior RBI approval in such situations. 

Pricing Guidelines

Whilst India’s foreign direct investment (FDI) regime has historically provided for elaborate pricing guidelines, the New Regime has for the first time introduced pricing guidelines for ODI. The pricing for ODI should be on an arm’s length basis, based on valuation undertaken as per any internationally accepted pricing methodology. The AD banks are responsible for ensuring compliance with arm’s length pricing requirements. It will be interesting to see the guidelines that may be framed by AD Banks in relation to arm’s length pricing; and whether AD banks will insist on a valuation certificate from an investment banker or a chartered accountant before certifying compliance. In this regard, it is relevant to note that an Indian Entity can lend or invest in any debt instruments issued by a Foreign Entity only if the rate of interest is charged on an arm’s length basis.

ODI in financial services activity

In a significant change that will liberalise ODI in the financial services space, an Indian entity not engaged in financial services activity can now make ODI in a foreign entity engaged in financial services activity, except banking and insurance, provided certain eligibility conditions are met.18 One of the conditions is that the Indian entity has reported net profit during the preceding three financial years; and the Covid-19 period i.e., FY 2020-21 and FY 2021-22 can be excluded while determining profitability. Further, ‘financial services activity’ has been defined as an activity that, if carried out by an entity in India, requires registration with or is regulated by a financial services regulator in India.

Round Tripping (ODI-FDI Structures) 

While the Old Regime did not explicitly mention round-tripping in the text of the law, FAQ No.64 of RBI’s ODI FAQs effectively enacted substantive law by mandating prior RBI approval for round-tripping transactions (ODI-FDI structures). Under the New Regime, ODI-FDI structures shall be permitted, subject to compliance with the layering restrictions set out under Rule 19(3), which provides that “no person resident in India shall make financial commitment in a foreign entity that has invested or invests into India, at the time of making such financial commitment or at any time thereafter, either directly or indirectly, resulting in a structure with more than two layers of subsidiaries.” A plain reading of the Rules suggests that for computing the number of layers of ‘subsidiaries’, a foreign entity will be regarded as a ‘subsidiary’ even if the 10% test is independently met. The key aspect to note here is that the New Regime removes the long-standing taboo surrounding roundtripping and ODI-FDI structures, and clearly recognises that in most cases, ODI-FDI structures are legitimate, and not necessarily devised in a manner that results in tax avoidance/evasion or siphoning of funds. While the Rules recognise that many ODI-FDI Structures are pursuant to legitimate commercial considerations, and may not always be abusive, greater clarity is awaited on how to compute the number of layers. Further, the RBI needs to clarify that when the ODI turns back into India as FDI under Rule 19(3), will it be seen as pure FDI from the compliance/ FOCC/ disinvestment perspective or will it be seen as an IOCC under the consolidated FDI Policy and the NDI Rules, 2019. 

It is interesting to note that the Draft Rules had provided that ODI-FDI structures would be permitted subject to the ascertainment that the transaction was not designed for the purpose of tax avoidance/ tax evasion. While the regulatory intent is to prevent round-tripping and tax avoidance/ tax evasion, this subjective requirement has been omitted from the Rules – and the Rules prescribe an objective threshold based on the number of layers of subsidiaries. For ODI-FDI Structures where it is not commercially feasible to comply with the layering restrictions (such as ODI-FDI structures in the infrastructure space), parties can approach the RBI for prior approval based on sound commercial justifications. All in all, legitimising ODI-FDI Structures will provide more flexibility to Indian as well as overseas investors in structuring their legitimate investments. It is also expected that the RBI may soon come out with a slew of FAQs to clarify their position on all the contentious issues, from the standpoint of ensuring that the industry, AD banks and other stakeholders adopt a consistent view on key issues. Nevertheless, there are many bright spots in the New Regime – that will surely act as an enabler for Indian companies to become global, and venture into new markets. Global economic meltdown due to inflation and war, may present good opportunities for Indian parties to acquire strategic assets at an attractive valuation, and expand their footprint.

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  For conservative people, the present is the end of the past."