[The Viewpoint] Significant reforms in the Indian Overseas Investment regime

After years of deliberation on the subject, and with an aim to simplify the process of making overseas investments, the Reserve Bank of India (RBI) enacted the Foreign Exchange Management (Overseas Investment) Rules, 2022 (OI Rules) and the Foreign Exchange Management (Overseas Investment) Regulations, 2022 (OI Regulations) on August 22, 2022.

The OI Rules and the OI Regulations supersede the previous regulations that had been issued by the RBI. We have summarised the key changes introduced by the OI Rules and OI Regulations below and provided our insights on the same.

(i) Control – Control has been defined to mean the right to appoint majority of the directors or to control 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 10% or more of voting rights or in any other manner in the entity. [Rule 2 (c), OI Rules]

(ii) Foreign Entity - It is pertinent to note that in the erstwhile regime, foreign entities were referred to as "Joint Ventures" (JVs) and "Wholly Owned Subsidiaries" (WOS), both terms have now been replaced with the term "Foreign Entity". Foreign entities covers entities formed, registered or incorporated outside India, including International Financial Services Centres (IFSCs), that have limited liability. [Rule 2(h), OI Rules]

(iii) Overseas Investment - The OI Rules have bifurcated overseas investments into two terms: (a) Overseas Direct Investment (ODI); and (b) Overseas Portfolio Investment (OPI). [Rule 2(q) and Rule 2(h), OI Rules]

ODI, in respect of an unlisted foreign entity, means investment by way of acquisition of capital of a foreign entity or subscription as a part of the memorandum of association of a foreign entity. In respect of listed foreign entities, it means investment of 10% or more of the paid-up equity capital of such listed foreign entity or investment with control, where investment is less than 10%. Investors would be able to make non-controlling investments of less than 10% in foreign entities without these investments being qualified as ODI, which is an important development from the previous regime.

OPI means investment 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 an IFSC.

(iv) Financial Commitment - While the limit for the total financial commitment made by an Indian entity in all foreign entities (at the time of undertaking such commitment) remains the same in the OI Rules, i.e., 400% of its net worth as on the date of the last audited balance sheet, changes have been made to the definition of "Financial Commitment". The OI Rules defines "Financial Commitment" as the aggregate amount of investment made by a person resident in India by way of ODI, debt other than OPI in a foreign entity or entities in which the ODI is made including the non-fund-based facilities extended by such person to or on behalf of such foreign entity or entities. [Rule 2(f), OI Rules]

(v) Strategic Sector Investments - The previous regulations had separate provisions for investments in industries such as oil and natural gas and maintenance of submarine cable systems under the automatic route, which have now been subsumed under the definition of "Strategic Sector". The Central government may on approval permit financial commitment in these sectors above the limits laid down in the OI Rules. [Rule 2(z), OI Rules]

(vi) Subsidiary or Step Down Subsidiary of a Foreign Entity - has been defined to mean an entity in which the foreign entity has control. [Rule 2(y), OI Rules]

Investors and Indian entities had grave concerns regarding the issue of round-tripping under the previous regulations. The erstwhile regulations did not permit an Indian party under the automatic route: (a) to set up Indian subsidiaries through a foreign WOS or JV; and (b) to acquire a WOS or invest in a JV that already has direct/indirect investment in India. [FAQ No. 64, Reserve Bank of India - FAQs (rbi.org.in)]

For instance, under the automatic route - X, an Indian company, could not invest in Y, a foreign company, if Y already had a subsidiary company Z in India, since such a transaction would be classified as round-tripping. Prior approval of the RBI was required to undertake such an overseas investment.

However, the OI Rules now allow persons resident in India to make financial commitments in a foreign entity that has invested or invests in India (directly or indirectly) at the time of making such financial commitment or at any time thereafter, if it does not result in a structure with more than two layers of subsidiaries. [Rule 19(3), OI Rules; the restriction on the number of layers does not apply to: (a) a banking company; (b) a non-banking financial company; (c) an insurance company; and (d) a Government company]

Thus, X would be able to invest in Y, even though Y has a WOS in India, since it would not result in a structure with more than two layers of subsidiaries. Investors would now be able to capitalise on new M&A opportunities owing to this relaxation.

Investment in foreign entities in the financial services sector – Under the OI Rules, an Indian entity not engaged in financial services activity in India is now allowed to make direct investment under the automatic route in a foreign entity engaged in financial services activity (except banking and insurance). Such entities must meet the condition of posting net profits in the preceding 3 financial years. An exemption has been provided for COVID-19 years, 2020-21 and 2021-22, which permits the Indian entities to exclude these years from the 3-year profitability period.

Unlisted companies allowed to undertake OPI – Indian unlisted companies were excluded from undertaking OPI in the erstwhile regime. Now, an Indian unlisted company may make OPI by way of: (a) acquisition of equity capital (rights issue or bonus shares); (b) capitalisation of any amount due towards the Indian entity from the foreign entity, the remittance of which is permitted or does not require prior permission; (c) the swap of securities; and (d) merger, demerger, amalgamation or any scheme of arrangement as per the applicable laws.

It is also relevant to note that "swap of shares" has been substituted with "swap of securities" in the OI Rules, which will allow Indian entities to swap securities other than shares.

Any resident individual may make ODI or OPI subject to the overall ceiling of USD 2,50,000 in a financial year under the Liberalised Remittance Scheme and this is aligned with the earlier regulations.

Earlier, resident individuals were not permitted to set up or acquire a JV or WOS (unless it was an operating entity) and the JV or WOS so set up/acquired could not set up/acquire a step down subsidiary in India. For instance, if A, a resident individual had invested in a JV/WOS abroad, B, this foreign company could not incorporate a step down subsidiary, C, in India.

Under the OI Rules, a resident individual may make or hold ODI in an operating foreign entity not engaged in financial services activity and which does not have a subsidiary or a step down subsidiary, where the resident individual has control in the foreign entity. However, ODI may be made by a resident individual in respect of (i) inheritance; (ii) acquisition of sweat equity shares; (iii) acquisition of minimum qualification shares issued for holding a management post in a foreign entity; and (iv) acquisition of shares or interest under Employee Stock Ownership Plan (ESOP) or employee benefits in a foreign entity whether or not such foreign entity is engaged in financial services or has a subsidiary or step down subsidiary where the resident individual has control.

Now, under the new Rule, if A has invested in B, and at the time of A's investment, B did not have a subsidiary in India, B is not restricted to then set up a step down subsidiary, C, in India, unless A has acquired control in B. Similarly, under the new Rule, A would not be permitted to acquire control in B, if B already has a subsidiary or a step down subsidiary at the time of such investment. The new rule provides respite to foreign companies which had received investment from resident individuals and were struggling to incorporate subsidiaries in India.

Restriction on investment in start-ups – Indian entities are not permitted to use borrowed funds to make an ODI in overseas start-ups. These investments shall be made by an Indian entity only from the internal accruals whether from the Indian entity or group or associate companies in India, and in case of resident individuals, from the own funds of such an individual. The definition of start-up will be considered according to the host country law.

Transactions under the automatic route - The earlier requirement of approval for the following has been dispensed with: (a) the acquisition of equity capital in a foreign entity on a deferred payment basis; and (b) the issuance of corporate guarantees to or on behalf of second or subsequent level step down subsidiary.

No Objection Certificates - Investment/disinvestment by certain persons resident in India who in the previous regime were on the RBI's exporter's caution list, on the list of defaulters, or otherwise under investigation by any investigation/enforcement/regulatory agency may obtain a no objection certificate from a lender bank/regulatory body/investigation for making such overseas investment or disinvestment.

In view of the above, we note that the OI Rules and OI Regulations have considerably simplified the Overseas Investment framework in India which was riddled with ambiguities. On continuity of investments, the OI Rules state that any investment or financial commitment outside India made in accordance with the Act (or the rules or regulations made thereunder) and held on the date of publication of the OI Rules, shall be deemed to have been made under these OI Rules and OI Regulation. It is not clear at this point if transactions that flouted the earlier regulations would be deemed legal, if permitted under the OI Rules. Further clarity is required to understand the implications of the same.

Ashima Obhan is Partner and Seerat Bhutani is an Associate at Obhan & Associates.