[Kunwar is a student at School of Law, Christ University.]
The new ‘overseas investment’ framework (New Framework) comprises the Foreign Exchange Management (Overseas Investment) Rules 2022 (OI Rules), the Foreign Exchange Management (Overseas Investment) Regulations 2022 (OI Regulations) and the Foreign Exchange Management (Overseas Investment) Directions 2022 (OI Directions). Introduction of the New Framework is crucial for promoting offshore investments by resident Indians. It is not surprising that the stakeholders and industry participants have received it positively. The New Framework replaces the following legislations: the Foreign Exchange Management (Transfer or Issue of any Foreign Security) Regulations 2004; the Foreign Exchange Management (Acquisition and Transfer of Immovable Property Outside India) Regulations 2015, and the Master Direction – Direct Investment by Residents in Joint Venture/Wholly Owned Subsidiary Abroad.
The author has particularly analysed the restrictions on the number of layers of subsidiaries provided in the OI Rules and attempted to resolve the confusion surrounding the relevant provisions of the New Framework. To determine the scope and potential impact of the new overseas investment laws, a comparative analysis with the Companies Act 2013 (Companies Act) and its rules regarding key definitions of "subsidiary" and "control" has also been undertaken.
Round Tripping and Calculating the Number of Layers of Subsidiaries
Round tripping in the present context can be explained as a practice of an Indian company investing in a foreign subsidiary company and that subsidiary company ultimately investing back in India. It can also be seen as a method of foreign direct investment (FDI). Previously, the round tripping of investments was strictly prohibited by a blanket ban imposed by RBI via the erstwhile clarification issued under the FAQs on Overseas Direct Investment (updated as of 19 September 2019) (ODI). This blanket ban was imposed by FAQ 64 of the RBI’s FAQs on ODI by restricting the foreign entity from setting up Indian subsidiaries or investing in a ‘joint venture’ that already had direct or indirect investments in India.
The new framework under Rule 19(3) of the OI Rules expressly allows the Indian entity to invest in a foreign entity with up to two layers of subsidiaries. Nevertheless, this instantly raises doubt as to whether this rule applies in the context of the Indian entity or its foreign subsidiary. In the event the rule in question applies to the Indian entity, only one step down subsidiary (SDS) can be held by such Indian entity in addition to its foreign subsidiary. If the rule applies to the foreign subsidiary, the foreign subsidiary can further hold two more SDS (i.e., three layers subsidiaries in total for the Indian entity). We can have a definite answer by referring to different provisions of the New Framework.
Clause 20(2) of OI Directions provides that the foreign entity which invests back in India cannot invest directly or indirectly in more than two layers of the SDS as per Rule 19(3) of the OI Rules. Furthermore, the note to Clause 20 states that a subsidiary is an entity over which the foreign entity has control. This provision also expressly enables the practice of round tripping investments as it mentions the process of round tripping, unlike Rule 19(3) of the OI Rules, which only provides for restricting the number of subsidiaries to two. More importantly, it becomes clear that the foreign entity should be considered the base for assessing the SDS. In addition, the definition of a subsidiary under Rule 2(1)(y) of the OI Rules defines a subsidiary with reference to the foreign entity.
Another authoritative confirmation in favour of foreign entities is provided by the instructions for Form FC under the Master Direction – Reporting under the Foreign Exchange Management Act 1999, which states that the level of SDS shall be calculated by treating the foreign entity as the parent. Hence, the above-stated provisions frame a more precise picture of a more liberalised interpretation of Rule 19(3) for computing the number of layers of subsidiaries. It can also be seen as a way of promoting round tripping investments in India by the RBI after years of dissent. If the Indian entity were used as the base level for computing the following two levels of subsidiaries, it would have severely restricted the scope of round tripping investments in India. Having the foreign entity as a base for calculating the layers of the subsidiary provides more flexibility for the investor to round trip investments back in India.
Comparative Analysis with Company Law and Rules
The provision to Rule 19(3) refers and adheres to Companies (Restriction on Number of Layers) Rules 2017 (Layer Restriction Rules) to restrict the subsidiary rules from applying to banking companies, NBFCs, insurance companies and government companies. However, the Rule 2(1) of the Layer Restriction Rules conflicts with Rule 19(3) of OI Rules as it provides an exemption to foreign subsidiaries even if the number of layers exceeds two. The fact that OI Rules refers to the Layer Restriction Rules means that OI Rules should not be entirely interpreted by isolating Companies Act and its rules. As it stands, the contradiction between the two above stated provisions needs to be clarified.
Another dichotomy of provisions is seen in the definition of 'subsidiary' and 'control'. OI Rules have defined 'subsidiary' as an entity over which the foreign subsidiary has control. The term 'control' is again defined as having 10% of voting rights in the entity and the right to elect a majority of the directors. This is a diversion from the definition of 'control' under Section 2(27) of the Companies Act and Regulation 2(1)(e) of the SEBI (Substantial Acquisition of Shares and Takeover Code) Regulations 2011 (SAST Regulations) which do not include the 10% threshold in their definition of 'control'.
Section 2(87) of the Companies Act requires a holding company to have more than 50% of the voting power in the subsidiary company. Instead, the 10% voting rights requirement of OI Rules in a subsidiary company seems to be much closer to the concept of 'significant beneficial owner' (SBO) provided under Section 90 of the Companies Act and the Companies (Significant Beneficial Owner) Rules 2018 (SBO Rules). An SBO under Rule 2(1)(h) of the SBO Rules will hold 10% of the voting rights or shares in the entity either directly or indirectly, similar to the qualifications of a subsidiary under the OI Rules. The identification and compliance of the SBO under Section 90 of the Companies Act and the SBO Rules have been laid down with detailed provisions and strict penalties in case of non-compliance. It does imply that a subsidiary under the OI Rules should not be viewed in any less seriousness than that provided under the Companies Act. In affirmation of this, placing the bar at 10% instead of over 50% for qualification as a subsidiary under the OI Rules helps to cast the net wider to cover more and more foreign entities, and these covered entities will then have to face the restrictions on the number of layers of subsidiaries. All in all, a principal Indian entity with a significant financial commitment to another foreign entity but not over 50% will be unable to evade the liabilities of restrictions on layers of subsidiaries due to a wider cast net.
The New Framework is yet another step forward in the government's quest to enhance the ease of doing business in the country. The OI Rules strikes the right balance between the flexibility and rigidity of investing overseas and other incidental matters. It is interesting to note that as recently as in 2021, the Draft Foreign Exchange Management (Non-debt Instruments - Overseas Investment) Rules 2021 provided for not allowing any investments by the Indian entity in the foreign entities if it was ascertained that the investments are being round tripped for tax evasion. These provisions did not make it to the enacted new framework. Hence, the New Framework provides sufficient flexibility to allow the practice of round tripping in the first place and determine the SDS of the foreign entity as the first layer of the subsidiary.
However, at the same time, it is rigid enough to divert from existing definitions of 'subsidiary' and 'control' to cover any loopholes regarding round tripping. The regulators' foresightedness to define ‘subsidiaries’ by a mere 10% financial commitment will ensure that round tripping cannot be used to commit any illegal financial investment. If the same qualifications for defining subsidiaries were used as that of the Companies Act, the Indian entities would have invested a significant amount in other foreign entities to round trip those investments back to India but would have ensured that the investment margin remained below the threshold of 50%.