Vidushi Dubey*
INTRODUCTION
India's evolving regulatory landscape recently witnessed a significant change with the introduction of the Foreign Exchange Management (Non-debt Instruments) (Fourth Amendment) Rules, 2024 ("Fourth Amendment"). The Fourth Amendment modifies the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 ("Rules 2019"), which aim to streamline cross-border investments and align Indian regulations with international practices, holding far-reaching implications for both domestic and foreign businesses.
A key highlight of the Fourth Amendment is the introduction of equity swaps, enabling Indian companies to exchange shares with foreign entities. This mechanism helps facilitate cross-border mergers and acquisitions. Additionally, the revised definitions of "control" and "startup" offer greater clarity and consistency, simplifying business compliance.
This article thoroughly explores these amendments, analysing their potential impact on the Indian investment climate. By examining the specific provisions and their broader implications, we aim to shed light on the opportunities and challenges these changes present for businesses operating in India and abroad.
KEY AMENDMENTS IN FOREIGN EXCHANGE REGULATION
1. Clarifications on Control and Startup Company Definitions
The recent amendments to the Rules 2019 bring key changes to Rule 2, which previously served as the definitions clause outlining key terms used throughout the legislation. However, it did not contain specific definitions for 'control' and 'startup company.'
A newly inserted clause, "(da)," defines the term "control" to align with the Companies Act, 2013, as now, it includes the right to appoint the majority of directors and the ability to control management or policy decisions, either directly or indirectly, through various mechanisms like shareholding or multiple agreements. This alignment ensures clarity, especially in structuring mergers, acquisitions, and private equity transactions. For Limited Liability Partnerships ("LLPs"), "control" is defined as the right to appoint a majority of designated partners who hold exclusive power over the policies of the LLP. This clarification helps identify and determine the meaning of control in both companies and LLPs, aiding compliance and governance.
Additionally, clause "(an)" has been revised to redefine the term "startup company." The term is now to align with the criteria established by the Department for Promotion of Industry and Internal Trade ("DPIIT"), as outlined in G.S.R. 127 (E), dated 19 February 2019. The revised definition includes a maximum incorporation period of 10 years, a turnover threshold of INR 100 crore, and a focus on innovation, scalability, and high potential for employment or wealth generation, ensuring consistency and clarity for businesses seeking to retain startups.
The definitions of 'control' and 'startup company' have been amended to ensure standardisation and consistency across various legislations. The definition of 'control' has been relocated from Rule 23 to Rule 2, aligning it with the Companies Act 2013 to reduce ambiguity and facilitate easier compliance. Similarly, the redefinition of 'startup company' aims to encourage structured governance by requiring startups to meet specific criteria set by DPIIT. By providing clear definitions, the amendments to the definitions of 'control' and 'startup company' facilitate easier compliance and governance, which can attract more foreign direct investment ("FDI") and support the growth of startups.
Updates on Equity Instrument and Capital Transfer
Rule 9A of the Fourth Amendment pertains to the swap of equity instruments and equity capital between residents and non-residents. This rule facilitates the transfer of equity instruments of an Indian company between a person resident in India and a person resident outside India through swap arrangements. The swap can involve either the equity instruments of an Indian company or the equity capital of a foreign company.
Swap of Equity Instruments: This can be done following the rules laid down by the central government, such as Foreign Exchange Management (Overseas Investment) Rules, 2022. It must adhere to pricing guidelines, require valuation by a registered merchant banker, and be reported to the Reserve Bank of India ('RBI").
Swap of Equity Capital of a Foreign Company: This transfer must comply with the rules prescribed by the central government, including the Foreign Exchange Management (Overseas Investment) Rules, 2022, and the regulations specified by the RBI through Master Direction on Foreign Investment in India.
Previously, Indian companies were allowed to issue equity instruments to a non-resident in exchange for equity instruments held by the non-resident in another Indian company. The new amendment introduces the provisions that explicitly permit Indian companies to issue new equity instruments to a non-resident in exchange for equity capital held by the non-resident in a foreign company, provided compliance with the Overseas Investment Rules is met. This change is expected to promote cross-border share swaps, enabling Indian businesses to adopt reverse flipping and simplified share-swap structures for mergers, acquisitions, and cross-border restructuring while adhering to applicable laws. It is imperative to note that prior approval from the central government is required for these transfers wherever applicable.
Revisions to Indirect Foreign Investment Calculations
Rule 23, which deals with downstream investments, has been updated in the Fourth Amendment. It outlines the regulatory framework for investments made by Indian entities that have received foreign investment and are not owned or controlled by resident Indian citizens. The amendment follows the removal of sub-clause (d) after sub-rule (7), which originally addressed the calculation of indirect foreign investment.
The new explanation states that an investment made by an Indian entity owned and controlled by a Non-Resident Indian ("NRI”) or an Overseas Citizen of India ("OCI”), including companies, trusts, and partnership firms incorporated outside India, will not be counted towards the calculation of indirect foreign investment if it is made on a non-repatriation basis, thereby simplifying compliance and encouraging capital inflow. This move aims to boost investments from NRIs/OCIs without impacting foreign control metrics in Indian entities, which refers to the extent of foreign authority over Indian entities, considering ownership thresholds, voting rights, board composition, and decision-making powers under Foreign Exchange Management Act regulations.
Updates on Equity Instruments, Foreign Investment Conditions, and White Label ATM Operations
An Indian company can now issue equity instruments to foreign residents in compliance with the rules set by the central government and regulations from the RBI. Acceptable methods for issuance include swapping equity instruments, importing capital goods (excluding second-hand machinery), covering pre-operative expenses, and swapping equity capital of foreign companies in compliance with the relevant regulations.
Additionally, a new category has been introduced for "White Label ATM Operations" (“WLAO”). This entry establishes a sectoral cap of 100% and an automatic entry route for investments. To set up White Label ATMs, a non-bank entity must have a minimum net worth of rupees hundred crores (Rs. 100 crores), as reflected in their latest audited balance sheet. Additionally, if the entity is involved in any "Other Financial Services,” foreign investment must comply with the minimum capitalisation norms applicable to those services. Furthermore, Foreign Direct Investment (“FDI”) in WLAO will be subject to specific criteria and guidelines issued by the RBI under the Payment and Settlement Systems Act, 2007.This update simplifies the process for foreign investment in WLAO, encouraging investment in the sector while ensuring that entities maintain financial stability.
FOREIGN PORTFOLIO INVESTOR GROUP DEFINITIONS AND STARTUP INVESTMENT CONDITIONS
The explanation in paragraph (1), subparagraph (a), clause (ii) states that if two or more Foreign Portfolio Investors (“FPIs"), including foreign governments or their associated entities, share common ownership, either directly or indirectly, of more than fifty percent or have common control, all such FPIs will be considered as part of an investor group. However, this could also lead to complexities for FPIs in structuring their investments, as they must now navigate these definitions to avoid unintended group classifications that could affect their investment strategies.
Additionally, Schedule VII has been revised to allow investment in equity or equity-linked instruments or debt instruments issued by Indian startup companies, regardless of the sector in which these startups operate. However, the applicable sectoral caps, entry routes, and associated conditions will still apply if the investment involves equity instruments. This change will likely attract more foreign capital into the startup ecosystem, providing much-needed financial support to early-stage companies.
IMPACT ON INBOUND AND OUTBOUND INVESTMENT
The Fourth Amendment is poised to significantly impact inbound and outbound investments in India. On the inbound front, the changes in compliance requirements for foreign investors streamline the process of entering Indian markets. The government has simplified the approval process, relaxed FDI limits, clarified rules for NRI and OCI investments, and introduced equity swaps to facilitate cross-border transactions. These changes make India a more attractive destination for foreign investors, boosting economic growth and job creation.
For outbound investments, the amendments have facilitated cross-border transactions through equity swaps, relaxed FDI limits for Indian companies, and simplified compliance procedures. These changes empower Indian businesses to expand globally, diversify their revenue streams, and compete globally. This is particularly important in a globalised economy where access to international markets can drive growth and innovation.
BENEFITS AND DRAWBACKS
By streamlining compliance requirements for foreign investors, these changes make it easier for them to enter the Indian market, which will likely translate into an increase in FDI inflows, stimulate economic growth and create jobs. The Fourth Amendment represents a significant step forward in India's efforts to attract foreign investment and facilitate outbound investment. Additionally, clarifying rules for NRI and OCI investments and introducing equity swaps have opened up new avenues for cross-border transactions.
However, while these changes hold immense potential, they also come with certain risks. The increased reliance on foreign capital can expose the Indian economy to global economic fluctuations. Moreover, the potential for market saturation in specific sectors could put pressure on domestic businesses. The central government must balance attracting foreign investment and protecting domestic interests. By carefully monitoring the impact of these reforms and making necessary adjustments, India can maximise the benefits of foreign investment while mitigating potential risks.
CONCLUSION
The Fourth Amendment to India's regulatory framework significantly enhances the mergers and acquisitions ("M&A") regime, creating new avenues for cross-border deals. By providing more flexible structures for transactions, such as earn-out agreements linked to performance metrics, these changes empower acquirers and targets to negotiate more effectively. This facilitation is expected to attract foreign investments, as international entities will find it easier to pursue M&A opportunities in India, thereby enhancing their global footprint. Streamlined processes for executing reverse-flip transactions and aligning the non-debt instrument rules with overseas investment regulations further simplify operations for residents and NRIs.
In conclusion, these amendments are a critical step toward modernising India's investment landscape, aligning it with international practices and promoting a more conducive environment for business. The clarified definitions and new provisions aim to encourage greater foreign participation while safeguarding domestic interests. While the introduction of broader definitions and the need for government approvals could pose challenges, the overall effect is likely to invigorate the M&A sector, stimulate competition, and enhance the ability of Indian firms to compete on a global scale. This balanced approach fosters an ecosystem where economic growth and strategic national interests coexist, ultimately supporting India's ambitions in the worldwide marketplace.
*Vidushi Dubey is a final year law student at Amity University and has experience working with esteemed legal firms like Shardul Amarchand Mangaldas & Co., Economic Laws Practice etc. Her interests include corporate law, mergers and acquisitions, and PE-VC. For any discussions related to this article, she can be reached at vidushi.v.dubey@gmail.com.
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