Context-

Foreign investments are crucial for achieving India's $5 trillion economy goal by FY 2025-26. However, attracting these investments requires removing bottlenecks for Indian companies and foreign investors. A significant obstacle is the amendment to the Indian Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (FEMA NDI), which poses challenges for Indian companies, especially start-ups and smaller enterprises seeking foreign investments.

Amendment Puzzlement

●       Overview of the Amendment

The amendment to FEMA NDI, introduced through press note number 3 of 2020 (PN3), has created significant challenges. It requires prior government approval for any investments in Indian companies, whether direct or indirect, from entities located in countries that share land borders with India (Neighbouring Countries) or where the “beneficial owner” of the investment is situated or is a citizen of these Neighbouring Countries.

●       Intent Behind the Amendment

Promulgated during the COVID-19 pandemic, the amendment aimed to curb opportunistic takeovers or acquisitions of Indian companies by Neighbouring Countries during difficult times. However, it has introduced considerable uncertainty due to the lack of a clear definition of 'beneficial owner'. Other laws that define the term are context-specific, adding to the ambiguity.

●       Industry Response and RBI's Conservative Stance

Initially, the industry adopted a lenient view, relying on beneficial ownership thresholds from other laws. However, since late 2023, the Reserve Bank of India (RBI) has taken a conservative view on issues not explicitly covered by FEMA NDI. For instance, foreign-owned or Controlled Companies (FOCCs) began receiving notices from the RBI regarding their downstream investments. The industry now believes that FOCCs will be subject to the same restrictions as non-residents on ambiguous aspects of the law. This has led investors to question other industry practices where FEMA NDI is silent. Law firms that previously took a lenient approach are now advising clients to rely solely on the beneficial ownership thresholds under other laws.

The Burden of Compliance

●       Time-Consuming and High Rejection Rate

Navigating the prior government approval route is time-consuming and has a high rejection rate. Although official data on pending or rejected applications is not published, some government officials indicate that proposals worth ₹50,000 crore from neighboring countries are either pending, withdrawn, or rejected. A staggering 201 applications have been rejected in the past three years.

●       Severe Penalties and Legal Battles

The onus of compliance lies with the Indian company receiving foreign investment, with regulatory authorities having the discretion to impose fines up to three times the investment received. The legislation's vagueness, coupled with severe penalties, raises doubts about the survivability of these companies. Many start-ups receive investments far beyond their revenue or assets, making such fines potentially insolvency-inducing. Non-compliance could lead to legal battles, adding to India's already significant backlog of court cases.

Issues and Solutions

●       Indemnity Challenge

Indian companies might consider requiring foreign investors to provide representations backed by indemnities regarding their compliance with the PN3 Requirement. However, this may deter foreign investment due to potential liabilities.

●       Need for Comprehensive Definition of 'Beneficial Owner'

There is an urgent need to amend the PN3 Requirement to define 'beneficial owners' comprehensively, including ownership thresholds and control tests.

●       Ownership Thresholds

The definition should specify a precise threshold for ascertaining beneficial ownership, potentially ranging from 10% (as provided under Indian company law) to 25% (as recommended by the Financial Action Task Force). The threshold can be customized to align with the government’s objective of scrutinizing varying levels of foreign investment across different sectors. For example, sectors such as telecom and defence, which are sensitive, may warrant heightened scrutiny compared to sectors like manufacturing and construction, which need additional capital.

●       Control-Conferring Rights

The definition should also specify control-conferring rights beyond ownership thresholds to capture entities with significant influence. For example, rights regarding board meeting quorums or veto powers over operational matters like capital expenditure or loans should be included. However, investor value protection rights, such as veto powers over mergers or the right of first offer, should be excluded as they do not constitute control.

●       Time-Bound Consultation Mechanism

Even with the clarification of control-conferring rights, some ambiguity may persist due to the skilful drafting of peculiar clauses in charter documents. To mitigate this issue, FEMA NDI could incorporate a time-bound consultation mechanism with regulatory authorities to determine whether specific clauses are control-conferring, similar to Indian competition law.

Conclusion

In conclusion, while the intent behind the amendment to FEMA NDI was to protect Indian companies from opportunistic takeovers during the COVID-19 pandemic, it has introduced significant challenges for Indian companies seeking foreign investments. The lack of a clear definition of 'beneficial owner', coupled with the time-consuming and high rejection rate of the prior government approval process, has created uncertainty and potential legal battles. To attract foreign investments and support India’s goal of a $5 trillion economy, it is crucial to amend the PN3 Requirement to define 'beneficial owners' comprehensively and incorporate a time-bound consultation mechanism to address ambiguities. This will provide clarity and confidence to both Indian companies and foreign investors, facilitating the growth of India's economy.

Source- The Hindu