RBI To Tighten Rules On Overseas Direct Investment, Ease Up On Round-Tripping

The Marina Bay Sands beyond Merlion Park in the central business district of Singapore.  (Photographer: Lauryn Ishak/Bloomberg)

RBI To Tighten Rules On Overseas Direct Investment, Ease Up On Round-Tripping

The Reserve Bank of India has proposed to tighten overseas direct investments and financial commitments by Indian businesses. But more importantly, the regulator is proposing to liberalise the regulatory framework for ODI-FDI structures.

ODI-FDI structures are, simply put — an Indian entity investing in a foreign company which invests or already has investments in India — typically referred to as round-tripping.

The current Foreign Exchange Management Act regulations do not clearly define round-tripping. It is market practice to approach the RBI when Indian companies acquire or invest in foreign companies which in turn have holdings in India, Akila Agrawal, partner at Cyril Amarchand Mangaldas, said.

Now what the regulator is proposing is that if the Indian entity is investing in a foreign entity that in turn is investing into India, there shouldn’t be tax avoidance or evasion.

One could interpret this to mean that in the future the RBI may be fine with such structures so long as they are not put in place for tax evasion / tax avoidance purposes. We await the final regulations and FAQs to understand the import of this provision.
Akila Agrawal, Partner, Cyril Amarchand Mangaldas

The exact language reads:

“The financial commitment by a person resident in India 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, which is designed for the purpose of tax evasion/ tax avoidance by such person is not permitted and any contravention under this rule shall be considered to be a contravention of serious/sensitive nature.”

Vivek Gupta, partner at KPMG India, holds a similar view.

The current understanding is that if the structure involves round-tripping, then whether or not it was for tax reasons, the regulator’s explicit nod is needed, he said. “Now, the draft rules seem to suggest if it’s for tax purposes, we have a problem. Otherwise, you can do it.”

In the past, the RBI has directed companies to collapse round-tripped structures, irrespective of whether the primary objective for that structure was tax efficiency or something else, Gupta explained.

If this change occurs in the manner written up, genuine offshore structures like SPACs etc. set up for non-tax reasons will clearly benefit. Today, an Indian company can’t do a SPAC without tripping over FEMA ODI regulations.
Vivek Gupta, Partner, KPMG India

Illustratively, let’s say an Indian start-up ‘X’ wants to merge with a U.S. company Y. As a result, Y will end up owning some shares in the domestic entity — this can’t be done right now without the RBI approval.

“If this change comes in, then so long as the structure is not for tax purposes, explicit permission does not seem to be needed,” Gupta said.

Besides this liberalised view on ODI-FDI structures, three important changes stand out in the proposes rules.

  • Distinction between ODI and OPI

  • Treatment of step-down subsidiaries

  • Plugging the ‘Gift’ Gap

ODI vs OPI

Currently, overseas direct investment is defined as:

  • Investment by way of contribution to the capital, subscription to the Memorandum of Association of a foreign entity, or

  • By way of purchase of existing shares of a foreign entity either by market purchase or private placement or through stock exchange, but does not include portfolio investment.

Now, the regulator has proposed a threshold for ODI. The new proposed definition includes-

  • Acquisition of equity capital of an unlisted foreign entity, subscription to the Memorandum of Association of a foreign entity.

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

  • Acquisition of direct/indirect control in the foreign entity.

This means that an investment of even $1 in an unlisted foreign entity will amount to ODI, Bhavin Shah, partner at PwC India, pointed out.

So far, there was no numerical distinction between ODI and OPI. The RBI is now proposing to replicate the thresholds for both as they exist for inbound investments. Anything less than 10% in a foreign listed entity will be overseas portfolio investment. More than that will be ODI. Also, any outbound investment in the unlisted space will be seen as ODI, which will have closer RBI oversight.
Bhavin Shah, Partner, PwC India

Perhaps the objective is to say that ODI needs to be a lot more controlled to see where the money is going, Shah explained.

Regulating Financial Commitments

Currently, an Indian party is permitted to give loans or guarantee in favour of an offshore entity in which it has equity participation. The draft regulations propose to tighten the existing regime, Vaibhav Kakkar, partner at Saraf and Partners, pointed out.

The RBI is proposing to enhance the eligibility threshold by saying that such financial commitments can be given only in cases where the offshore entity is controlled by the Indian party.
Vaibhav Kakkar, Partner, Saraf and Partners

With that objective in mind, the proposed rules define for the first time — foreign entity and step down subsidiary. Financial commitments an Indian entity can give on their behalf have also been spelled out.

Foreign entity will mean:

  • an entity incorporated and registered outside India, or

  • an unincorporated entity engaged in a strategic sector

And if such a foreign entity having ODI and control by an Indian entity sets up a subsidiary, it will become an SDS. A subsidiary of an SDS will also be an SDS.

The Indian entity and its promoters can give corporate, performance, personal, bank guarantee on behalf of both the ‘foreign entity’ and ‘step down subsidiary’ within the overall limit of financial commitment as per FEMA.

According to KPMG’s Gupta, the aim is that any loan, pledge or guarantee that an Indian entity gives for either a foreign entity or an SDS should abide by ODI rules. Non-portfolio investments and step down subsidiaries are also sought to be brought under the entire regulatory framework, he added.

Plugging The ‘Gift’ Gap

The current FEMA rules permit individuals to acquire foreign securities as gift from any person. Consequently, various ingenuous offshore structures have been implemented in the past through third parties (including even consultants!), Kakkar pointed out.

Third parties would make gifts of securities of offshore entities to Indian founders. And then such offshore entities will ultimately end up acquiring the Indian business of such founders.
Vaibhav Kakkar, Partner, Saraf and Partners

Typically, here’s how externalization of Indian businesses happened, especially between 2010-2015, experts told BloombergQuint, on the condition of anonymity.

Let’s say an Indian founder gets a friendly lawyer or consultant to float a company in Singapore with a capital of $1. This lawyer/consultant would then gift 100% equity of the Singapore entity to the Indian founder, who would disclose it so. Now the Singapore entity will raise money from private equity, institutional investors etc. And consequently, through the Singapore entity, they would buy the business of the Indian founders.

So, via the ‘gift’ route, Indian founders avoided round tripping concerns, remitting money outside and consequent stricter ODI compliances. To deter Indian founders from transferring value of domestic assets in this way, the RBI has proposed restriction on receipt of gift of foreign securities from relatives only.

“Acquisition by way of gift or inheritance: A resident individual may acquire foreign securities by way of gift from a person [who is or was] resident outside India, who is a relative…”

Given the regulator’s concerns on these structures, the draft rules propose to limit this permission by allowing receiving of gifts only from relatives, as defined under company law, and not from any person/third parties, Kakkar added.

To sum up the overarching objective of the proposed rules, they seems to match with the basic directional objective that we have now been seeing across our economic laws — that value transfers occur at fair prices and are not effectively done by understating or overstating values, Gupta said. “In the context of FEMA, this principle has been strengthened for a foreign company controlled by a domestic entity.”

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